It’s no secret that housing is in high demand. Beyond financing and building a unit, pay attention to code enforcement and tax implications.
Across the United States, people are looking for affordable places to stay, and finding that task more and more difficult to achieve. This creates an opportunity for anyone who might be interested in renting out a portion of their home, be it a spare bedroom, a finished basement, garage apartment or accessory dwelling unit.
But how do you get started? Between the renovations, inspections, potential loans and tax implications, the process of becoming a landlord can be more than a little intimidating. By following the right steps and working with the right experts, homeowners can make a smart investment in their property that will over time become financially beneficial and provide a new unit of housing for someone who needs it.
Below are expert tips for each step of the process.
Finance…
If you’re looking to create a unit to rent out that’s fully up to code, it’s likely to include a significant amount of construction. For this, most homeowners will have to take out a loan.
How much you need to spend depends on a host of factors, including the condition of the rental, whether it’ll be leased for short- or long-term use, and what the competition looks like. It’s important to make sure you budget enough to build a quality unit.
“One tip is if you are doing any work with shared walls between your home and the rental property, don’t go cheap on insulation,” said Larry Pershing, CEO of Optimum Retirement Planning, a Chicago-based financial adviser. “You want to make sure you can’t hear them walking in their living room, and they can’t hear you.”
Pershing knows from experience — he once bought a three-unit apartment building, living in one unit and renting out the other two.
He also recommends biggerpockets.com, which includes a forum where landlords of smaller properties and other dwellings can ask questions and get responses from folks in the know.
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Another factor is knowing how much to charge for rent. Pershing suggests focusing on a range of potential prices rather than a single figure, and to always be conservative and assume the low end of your estimate.
One research tactic is to visit rental websites and search your area for properties with various amenities and prices. This will tell you which amenities correlate with better rates. Real estate agents can also be tasked with performing an analysis to come up with a reasonable estimate.
“Doing market research like this can help you determine what to remodel,” Pershing said. “If you find that in-unit washer and dryer properties command considerably more rent, all other things equal, that could help you determine if it will be worth it to spend the money on this.”
Other considerations to make before taking your new rental to the market include contacting your home insurer, as the addition of a tenant will likely increase the rate you pay.
Nate Nieri, a personal financial adviser in San Diego and the founder and owner of Modern Money Management, said it’s also important to understand the legal rights enjoyed by tenants in your jurisdiction, and to be very specific about what’s expected of renters in your lease agreement.
“Ask tenants for references and actually call them,” he said. “Also, run a credit report. You want a financially stable and responsible tenant that will pay on time. This cannot be overstated.”
Construction
It’s expensive to turn an unfinished basement or garage into a rental space, and construction estimates for these projects often lead to sticker shock for would-be landlords.
Humberto Garces works with a lot of D.C. residents who want to rent out their basement. It’s a common practice, but he said the upfront cost to do so can run between $80,000 and $150,000.
“We do a lot of additions and basement renovations for people who want to rent out their units for Airbnb, to students or just working people here in D.C.,” said Garces, the owner of Green Construction Services Group and a member of the Metro DC Hispanic Contractors Association. “A lot of houses here are 80 or even 100 years old. Many of those houses have lead paint and asbestos, and we have found that some houses don’t have proper footings, so we have to build what’s called underpinnings.”
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And that’s not all. In the District there’s a minimum ceiling height of seven feet, which means lowering the floor if that’s not met. Rental units must have front and rear entrances and homeowners are advised to include soundproofing between the basement and first floor along with waterproofing in the walls to prevent mold. From there, cosmetic finishes to update kitchens and bathrooms are also needed to make the place attractive enough to land tenants.
“It requires a lot of concrete, water and foundation work,” said Garces. “People don’t expect [the high prices], but usually they see that it’s worth it, and most of them go ahead and do it using a construction loan.”
For those who really want to think big, there are options for even bigger projects. In some cities, homeowners can add a third or fourth story to their building to create three or even four units on a single property, though you’ll definitely want to check ahead of time to see if this is allowed in your area.
Regulations regarding rentals vary quite a bit depending on which state and city you live in, so it’s always advisable to check local regulations early and often.
Code enforcement…
Given the high costs of renovations often associated with rental conversion, it’s no surprise that some owners try to rent units illegally by forgoing the formal certification process.
Pete Roque has seen it all, from units hidden behind garage doors to apartments in treehouses and backyard pools. Roque is the director of code enforcement at construction management firm 4Leaf, and a former enforcement manager for the city of Garden Grove, Calif.
As with the other aspects of renting, codes will vary depending on whether the rental is short- or long-term and based on local ordinances.
Along with the obvious concerns over building inspections, there are other factors to consider. Roque said he’s gotten calls from tenants saying the landlord is charging them the entire property’s water bill, which is not only unethical but often a code violation.
Most legitimate rentals also require their own separate mailing address, which can be arranged through the U.S. Postal Service.
“The first thing I would do is look up your local municipal code on the city or county website,” Roque said. “Look in the search box and you can find requirements for rental units. You can also call the city or county and ask for the business license department to learn whether or not you’ll need a rental license.”
Some cities don’t allow basements or attics to be rented, while others regulate heights and ingress/egress.
Common violations Roque sees include the buildup of mold due to water leaks, units lacking proper smoke and carbon monoxide detectors, or newly constructed bathrooms lacking an exhaust fan.
Roque said code enforcement officers sometimes get calls from upset neighbors or from tenants after their relationship with the landlord goes south.
“A lot of folks get scared they’ll be evicted, so they try to tell the landlord about the issue, and if the landlord doesn’t respond they will call us,” he said. “Most landlords will respond to complaints, but some just say, ‘You’re paying cheap rent, handle it yourself,’ then the tenant will call code enforcement.”
Roque’s advice is to take the time and effort to make your unit legitimate before renting it out.
“Unfortunately, I’ve seen illegal units catch fire because they weren’t wired correctly, there were no windows and people died,” he said. “It’s never recommended that somebody rents an illegal structure because there are so many things that can go wrong if they are not properly inspected. Insurance companies often won’t cover losses if a homeowner is sued for an illegal unit. It’s just an unsafe practice.”
Taxes…
Once your unit is up and running and you start collecting rent, the final step is to report income and expenses from the venture on your taxes.
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Unfortunately, that may lead to you paying a bigger tax burden at the end of the year. In most cases, money collected as rent must be reported as income on a tax return, even if the unit doesn’t turn a profit.
“A lot of people look at it like, if you’re renting a room for X dollars and the mortgage is X dollars then you’re just trying to break even,” said Misty Erickson, a tax content specialist with the Wisconsin-based National Association of Tax Professionals. “The IRS doesn’t look at it that way.”
For IRS purposes, if it’s income it needs to be reported as such.
Landlords can report expenses for the unit as a tax deduction, but have to allocate between what space is rented and what’s a common area.
“If I rent out one bedroom and we share the kitchen and bathrooms, I can really only look at the bedroom as what’s being rented,” she said.
Typically, repairs and a portion of utilities can be used as a tax write-off, but renovations cannot. Depreciation, or wear and tear on the property, can also be written off but may have to be recaptured later. Erickson’s advice: Seek a professional to ensure you’re handling the process correctly.