“People think it’s a dream to make passive income off their real estate,” said financial adviser Yves-Marc Courtines, a principal at Boundless Advice in Manhattan Beach, Calif.
It isn’t.
Instead, it is a calculation that requires careful analysis of the risks and rewards that come with being a landlord. Tax consequences, cash flow, management and maintenance costs, and, above all, the inevitable headaches that come with having renters. It all has to be put on the table and weighed.
This could be a tempting moment for people who dream of buying a second home, making that their primary, and turning their old property into a rental cash cow. Mortgage rates are historically, and in some cases astonishingly, low. If you started with a jumbo loan and recently refinanced into a conforming loan, you may now hold a rate you never thought possible and fear you’ll never get again.
A lot of people are moving for reasons sparked by the pandemic; maybe someday they’ll want to move back once Covid has been vaccinated into oblivion. On the back of a napkin, rental income can appear huge relative to the monthly outlay on a mortgage you’ve held for years.
Here are some guidelines to help decide if being a landlord is right for you:
“A rule of thumb for maintenance is that it is approximately 1% of the property value a year,” said Daniel Granucci, president of Iron Path Wealth Management in Sandy Hook, Conn.
“You want your outlay for real-estate holdings, including investment properties, to represent a maximum of 28% of your gross income,” which would include the rental income, Mr. Granucci said.
If you want to get a new mortgage based on your rental income, you’ll need to wait until you’ve filed at least one tax return including that income.
Owners can defer or lower capital-gains taxes on the sale of an investment property by using a 1031 exchange or by re-establishing primary residency in the home, said Ms. Cahill.
That last scenario is the reason that one couple, who are Mr. Courtines’s clients, want to become landlords. The couple own a condo in Marina del Rey, Calif., worth roughly $1.6 million, but owe only $325,000 on it, he said. Now that they want a house, they want to turn the condo into a rental, which could fetch $6,000 a month. They are excited about the idea that the passive income could help them afford a $2 million to $3 million house for their growing family, he said.
A somewhat similar back-of-the-napkin calculation sent Paul Sydlansky, founder of Lake Road Advisors in Corning and Garden City, N.Y., headlong into a landlord adventure that ended poorly. He and his wife moved out of their starter-home condo in Stamford, Conn., in 2007 and, instead of selling it, decided to rent it out.
“We had fantastic tenants for the longest time,” said Mr. Sydlansky. When those tenants moved out, the couple rented to two rowdy young men. “It was a nightmare,” he recalled with a moan. The police came out twice and there were complaints from neighbors, he said.
Mr. Sydlansky said that during his nine years as a landlord, he was delighted by the tax deduction he got by taking depreciation on the rental unit. But upon selling, he learned that “the dirty little secret of depreciation is recapture,” he said.
The IRS charges 25% tax on the total amount of depreciation taken on a property that has been rented, and regular capital-gains tax (15% or 20%, depending on your tax bracket) on the appreciation from the cost basis to the sales price, said Lisa Cahill, a certified public accountant and chief financial officer of Realean Real Estate in St. Petersburg, Fla. By contrast, if Mr. Sydlansky and his wife had sold the home after moving out, they could have pocketed the gains tax free, up to $500,000.
It can be hard to anticipate all of the possible financial outcomes of a real-estate play. Rent prices, along with the ultimate sales value of the property, fluctuate. Tax rules also change, particularly over the course of many years during which a property is held. Curveballs can upend all plans: Even professional landlords could hardly have predicted that a global pandemic would usher in eviction moratoriums.
Do you own a rental property? What advice do you have for budding landlords? Join the conversation below.
There are some rules of thumb used by professional landlords and professionals advising clients. However, says Mr. Courtines, the most important question is this: “Do you actually want to be a landlord?”
“You’re going to get calls, you’re going to have interactions, you’re going to have to look for new tenants,” he said. Owners can outsource to a property manager, but they can charge 6% to 20% of gross annual rents depending on a variety of factors. Doing it yourself saves money but means that eventually, a call will come in the middle of the night and a toilet, heater or window will need to be fixed.
Here are some guidelines to help decide if being a landlord is right for you:
“A rule of thumb for maintenance is that it is approximately 1% of the property value a year,” said Daniel Granucci, president of Iron Path Wealth Management in Sandy Hook, Conn.
“You want your outlay for real-estate holdings, including investment properties, to represent a maximum of 28% of your gross income,” which would include the rental income, Mr. Granucci said.
If you want to get a new mortgage based on your rental income, you’ll need to wait until you’ve filed at least one tax return including that income.
Owners can defer or lower capital-gains taxes on the sale of an investment property by using a 1031 exchange or by re-establishing primary residency in the home, said Ms. Cahil.