21st-Century Landlords
The strong housing market makes renting out property look attractive. But it pays to figure the dollars and cents of being a landlord before you jump in.
By Jeffrey R. Kosnett, Senior Editor
From Kiplinger's Personal Finance magazine, December 2004
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Landlord finances 101
Buying a house to rent isn't at all like investing in stocks or mutual funds. This is hands-on work that starts with finding a property capable of generating enough rental income to make the transaction pay off. Real-estate and tax pros are emphatic: Sharpen your pencil and see if the numbers work. "That's the first thing you have to do," says Alan Straus, a CPA from Chestnut Ridge, N.Y. Jim Seiler, a lawyer and real estate asset manager in Great Neck, N.Y., says you should try to make projections for five years. Anticipate increased costs -- for example, higher property taxes and insurance premiums -- and allow for one month a year without any rent.
Your objectives are to learn how much you can afford to pay for the property and to become confident that you'll collect enough rent to clear at least a couple of hundred dollars a month. If you sell, say, at the end of five years for the same price you paid (plus enough to cover the cost of the sale), will your profit be an adequate return for the risks and work of being a landlord? If not, how much will the place have to appreciate to give you a just reward? Is such appreciation reasonable?
To run the numbers, start with income -- which will mainly be the rent. If you'll charge extra for parking or utilities, add that. You can find out what similar properties are renting for in the area by scouring want ads and talking with other landlords.
On the expense side of the ledger, the big hits are familiar if you're a homeowner: the mortgage payment (you'll probably want to make as small a down payment as possible) and property taxes. Then there's insurance, routine maintenance, landscaping, utilities (if you'll pay them), the cost of advertising or paying a real estate agent to get tenants, and a management fee if you'll pay someone to handle those "the toilet's stopped up" phone calls at 2 A.M.
Let's say you buy a house for $150,000 with 10% down and a 30-year mortgage at 6%. Your mortgage payment will be $809 a month. Taxes are $1,500, or $125 a month. Insurance, maintenance, and odds and ends take another $100 a month. So the monthly nut is $1,034.
Obviously, you want to bill at least as much or more than your outflow, so ask for $1,250. If you get it, that's $15,000 of income. At tax time, you get to deduct all of your out-of-pocket expenses, including $8,055 in interest, $1,500 in property taxes and $1,200 for insurance, maintenance, and odds and ends. (For simplicity's sake, we're assuming you buy the house on January 1 and get a full year's worth of rental income and expenses.) That brings your profit down to $4,245. And in this example, it's effectively tax-free.
For tax purposes, residential real estate is depreciated over 27.5 years, letting you write off each year about 3.6% of the property's tax basis--which is what you pay for the building and any capital improvements, not including the cost of the land. (If you convert your own house to a rental, your basis for the purposes of depreciation is what you originally paid plus the cost of improvements, and not the value at the time of the conversion.) Let's assume that your basis in this example is 80% of the $150,000 you paid for the house, or $120,000. A full year's depreciation deduction would be $4,364.
That means for tax purposes you actually have a $118 loss. But you have $216 a month in your pocket -- enough to cover you if the furnace blows or to help carry you over if you go a month or two between tenants.
Whether you can deduct the loss depends on whether you are actively involved in the rental -- if you set rents and pick tenants, you are -- and your income for the year. If your income is under $100,000, you can deduct up to $25,000 of rental losses each year to reduce the tax bill on your other income. (That allowance gradually disappears as your income rises to $150,000.) If your income is too high to deduct rental losses, the "passive loss" rules (written to put the kibosh on tax shelters) put your losses into suspended animation. Although they are of no value now, they come back to life to offset taxable profit when you sell. And, as noted in the accompanying story, that profit will include recapture of all the depreciation deductions you claimed over the years. (IRS Publication 527, the bible on rental property, explains these tax matters well.)
--Research: Joan Goldwasser