Real estate is perhaps the most emotionally charged investment there is. Particularly when buying a home, investors are far more inclined to let emotions drive the decision, opposed to the fundamentals of the deal. Putting owner-occupants aside, many individual real estate investors are so bullish about their strategy of using all free cash to buy and rent investment properties, they’re hardly participating in the stock market, if at all. While buying real estate can certainly be a worthwhile investment, new property investors can fall victim to income property myths about the time requirements and tax benefits and fail to adequately assess the risks of being a landlord.
Does America’s Love Affair With Real Estate Make Financial Sense?
The passive income myth
The IRS considers rental income ‘passive income’ for most taxpayers who have a job outside real estate. Just because the IRS characterizes rental income as ‘passive’ does not mean you will just sit at home and collect checks as a landlord. The time, effort, and cost required to manage a rental property catches many new investors by surprise.
As a landlord, you will be on call for tenants as problems arise, 24 hours a day—nights, weekends, during your vacation, and so on. Paying a property manager or maintenance worker is the easiest solution, but it gets expensive and could eat up your profits. State laws will also dictate what you must provide as a landlord—services like snow removal may be another uncontrollable expense and unpredictable action item for you to coordinate.
Finding quality tenants can also be difficult in some areas. Hiring a real estate agent to manage the process is usually a no-brainer for landlords as they can require the tenant to pay the broker fee. This may not be the case forever though—New York City has banned tenant-paid broker fees, a move that’s being contested in court. Still, other cities are considering following suit.
Chasing down late rent checks and dealing with problem tenants, particularly in renter-friendly states like Massachusetts, can even create legal issues for landlords who don’t know the laws. Even tenant selection must be done with knowledge of the law and fair practices to avoid a housing discrimination claim. What you don’t know can really hurt you here.
Tenants might not be the only source of frustration, time, and expense for property owners. Small homeowners’ associations are self-policing groups, requiring the owners to work together to pay bills, agree on improvements, collect dues, manage cash flows, and adhere to the common bylaws. Disputes can arise outside of the building as well—parking or noise issues with neighbors are common in densely-populated metropolitan areas. Don’t underestimate the cost of your time.
The unlimited tax shelter myth
Real estate is commonly thought of as a tax shelter for investors. While that may be true for professional real estate land barons, for the part-time landlord with a full-time job in another industry and a rental property or two, the tax benefits may not be as significant as you expect.
Recall that the IRS considers rental income ‘passive’ unless the taxpayer is deemed to actively participate. Taxpayers with rental income in 2020 will generally be classified in one of three buckets for tax purposes:
Real estate professionals materially participating: landlords must qualify as both real estate professionals and material participants in real estate services to be able to deduct any amount of losses (subject to at-risk rules) from their other non-passive income. To qualify as a real estate professional for tax purposes, you must have spent at least 751 hours during the year working in real property businesses—this number must also represent at least half of your total working hours for the year. There are several ways to ‘materially participate’ per the IRS, such as working at least 500 hours per year, per property. If you have more than one property, you can file an election to have the properties treated as one single activity to qualify as a material participant.
Some deduction of losses for moderate income taxpayers actively participating: for landlords to be able to use rental losses to offset other income, they will need to meet income and participation tests. To qualify as an ‘active participant’ you must own at least 10% of the property and be involved meaningful management decisions for the property, which isn’t hard for many smaller landlords. Taxpayers with a modified adjusted gross income of $100,000 or less may typically deduct up to $25,000 per year of rental real estate losses against non-passive income. Individuals with income above $100,000 but not more than $150,000 can deduct a portion of losses.
Losses are suspended or only eligible to be deducted against non-passive income: landlords with incomes in excess of $150,000 per year who do not qualify as real estate professionals likely cannot offset regular income with rental losses. Disallowed losses are carried forward to future years and can be used to offset gains when the property is eventually sold.
With depreciation and deductibility of many expenses related to the property, it’s still possible for high-earning taxpayers to wind up with no taxable income on their rental income. That might sound enticing but run the numbers first—many expenses on the property may be deductible, but they also represent actual cash coming out of your pocket (except for depreciation).
Getting a mortgage can offer leverage which can improve your ROI (less cash required from you initially). The tradeoff is a higher monthly payment and cost of debt which make margins thinner. Discuss how the rental property may impact your cash flow with your financial advisor and tax situation with your CPA including how depreciation factors into your cost basis and the tax treatment of a gain when you sell the property.
Before buying, it’s important to be educated about the limitations of the tax benefits and understand that tax law can change at any time. If you earn too much to deduct depreciation-driven losses against other income, you’ll likely want to make sure the property is providing adequate cash flow and there’s a strong probability of price appreciation in rent and/or home prices in the area to help compensate the deferment of ongoing tax benefits.