Steven Perkins had been in court the day before. “I was involved in a dispute involving my rental property in Southfield,” he recalled, referring to the Detroit suburb where he lives and works. “An oak tree by the driveway had been damaged by someone I’d hired to do some cutting. I’ve owned that house more than 20 years, and I’ve been in court often enough to have learned quite a bit about how to make a suitable case.”
Have such trips to the courthouse sapped his desire to be a landlord? Not really. “Even with the hassles, it’s worth it,” says Perkins, 52, a psychologist with a private practice as well as a position with the local school district. “Over the years, I’ve added other properties, such as two lakefront houses, one in Canada and one in Holton, Michigan, that I use myself when they’re not rented out, and a co-op that I just bought in downtown Detroit. Some of those properties have appreciated a great deal, and I’m counting on them for my retirement funds.”
Perkins’ experiences illustrate both the highlights and pitfalls of owning residential real estate that you rent to tenants. While there are certain risks and obligations potential landlords need to be aware of, the financial rewards can be ample.
There’s no denying the benefits of owning rental properties, especially when real estate values almost consistently trend upward. Among the perks are:
Current income: Landlords collect rent from tenants; over the years, increasing rents can provide another source of cash flow. “I receive about $1,000 a month from the house I rent in Southfield, or $12,000 a year,” says Perkins. “After expenses, I probably clear about $6,000, which I consider ‘play money.'”
Appreciation: Perkins says that the Southfield house, originally bought for around $30,000, is now worth more than $200,000. “My lakefront properties have gone up even more, in a few years, and the Detroit co-op I just bought has already jumped in value.” Perkins bought his Holton property for $180,000, with a $40,000 down payment. The property has nearly tripled in value in six years, to $500,000, giving him an eightfold return: a $320,000 gain on a $40,000 outlay.
Daryle Jordan, 45, an attorney in Alexandria, Virginia, also relates a tale of success in rental real estate. “I owned a property in Georgia for a year and another in Virginia for about 10 years,” he says. “Even though I had some negative cash flow, I wound up selling the properties for a substantial profit. I’ve been using those proceeds to invest for my daughters’ college education.”
Leverage: Rental property can be bought largely with borrowed funds, increasing the effective return if the property gains value. “When you borrow money to buy investment property, it’s typically on a ‘qualified non-recourse’ basis,” according to Larry Torella, tax partner at Eisner L.L.P., a New York accounting firm. “The property secures the debt, not your other assets, which limits your downside if things don’t work out.”
Tax advantages: “The tax laws are very favorable to real estate investors,” says Torella. “If you do receive net cash flow from the property, after expenses, some or all of that income may be tax-free.”
Whether or not you have positive cash flow, you may wind up with a loss, for tax purposes, and such a loss might provide you with a tax deduction [see sidebar, “Tax Tips for Landlords”]. Torella points to other tax advantages: you can pull out tax-free cash by refinancing your loan if the property appreciates, you can enter into a tax-free exchange if you want to switch investment properties, and you can eventually sell the property and pay tax at favorable long-term capital gains rates.
That’s the good news. The bad news? Becoming a landlord is no easy path to profits. “I’ve probably heard more horror stories than success stories,” says Frank S. Arvai, a CPA and certified financial planner in Troy, Michigan. “Some very smart people have bought rental property and suffered through late payments and bounced checks, only to wind up selling the real estate at a loss. Midnight calls from tenants with problems can drain you after a while.”
There’s no magic formula that can guarantee success in rental real estate, but there are some steps you can take to tilt the odds in your favor:
Have reasonable expectations. “Some people expect to buy a property and enjoy positive cash flow right away,” says Wallace Gibson, who heads a property management company in Charlottesville, Virginia. “That probably won’t be the case unless you’re making a very large down payment. Often, you’ll go three to five years before cash flow turns positive.”
Positive cash flow — meaning that the rent you collect from tenants exceeds all of your out-of-pocket expenses — is critical for real estate investors. Gibson says that in her experience, this usually happens when the investor makes a large down payment and has relatively low mortgage costs. Most investors prefer to maximize leverage with a large mortgage, so it may take years for rental increases to grow enough to outstrip fixed mortgage interest costs.
“Investors also need to have a reasonable idea of how much rent they’ll be able to charge,” says Gibson. “That’s probably the most common question I get from new landlords. I tell them that they can do their own homework, checking out how much comparable properties rent for, or they can work with a property management firm like mine.”
Decide between earnings and effort. Should you hire a property management firm? “I did, for my two ventures as a landlord,” says Jordan. “I paid about 5% to 6% of my rental income to have someone else deal with the tenants. It was worth it to me, not to have all the headaches of being a landlord. I got paid on time, and my tenants left the property in good condition.”
Gibson says that property managers in her area generally charge 6% to 8% of rental income, plus half a month’s rent for putting a tenant in place. “Other fees may be added,” she says, “depending on the types of services a property manager is asked to perform.”
Across the country, property management fees normally run from 7% to 10% of income, according to Jeffrey Dennison, government relations manager of Tri-County Apartment Association in San Jose, California. “They might go as high as 25%,” he says, “for a vacation home that requires a considerable effort in finding short-term tenants. You need to look at the numbers carefully because paying a manager will reduce your income and may make it difficult for you to carry the property.”
You should look carefully at property managers, too, in order to find a reliable firm that won’t bring in tenants who’ll trash your place. “I got some recommendations and met with a few management firms,” says Jordan. “Eventually, I chose people who made me feel comfortable working with them.”
Know the rules. Landlords have to cope with a bewildering array of laws and regulations, according to Janet Portman, an attorney who is also an editor with Nolo Press, a publisher in Berkeley, California. “Federal laws cover areas such as fair housing and lead paint disclosure,” she says. “State and local laws vary widely, covering everything from interest on security deposits to inspections to compliance with building codes to rent controls. In some areas, you may need a license to do business as a landlord. If a tenant wants to run a business out of the home you’re renting, you’ll have to check on local zoning laws.”
Dennison suggests that landlords have their property inspected before renting to tenants. “Besides lead paint, you should know if there are any risks relating to asbestos or mold, for example. Envir
onmental issues are increasingly important, in many areas, so you should be sure you’re complying with all the regulations.”
You also need to be sure your tenant leases are drafted properly, in case there’s a challenge. “A lot of landlords just draw up their own lease agreements,” says Gibson, “and those contracts may have provisions that are not acceptable in their local area.”
Know your tenants. Another key document is the application that prospective tenants fill out. The biggest mistake landlords make, according to Portman, is failing to properly screen renters. That can be a minefield, though, because of antidiscrimination laws. “You can’t refuse to rent to people just because they’re Catholics, say, or Asian Americans,” she says. “Even if you have good intentions, you can’t refuse to rent to a single mother with a young child, for example, because the house you’re renting is in a neighborhood that might not be safe.”
That said, there are things that you can do — should do — to avoid living through a Pacific Heights-type of nightmare. “You should run a credit check,” says Portman. “You don’t even need the applicant’s permission, as long as you have a valid purpose. All you need is the applicant’s Social Security number and perhaps a date of birth. Check with former landlords and verify current employment. You’ll find that people tend to be pretty consistent: those who show up late for work may not pay their rent on time, either.”
Jeffrey Taylor, who runs the MrLandlord.com Website, says that landlords need to go beyond an applicant’s financial picture to get an idea of how cooperative an individual would be as a tenant. “Ask a prospective tenant how he or she gets along with the current landlord. If you hear bad-mouthing, that’s a bad sign, because problems tend to go along with the same people. Also, before you accept new tenants, look at the place where they’re currently living. That’s what your place will look like in six months if you rent to them.”
Even if you hire a property manager, you should not abdicate responsibility for selecting tenants. “My manager would send me a packet of information to review,” says Jordan. “My approval was necessary before a contract was offered to a tenant. Sometimes I would turn down an applicant if I felt uncomfortable.”
Join the network. One key element, then, is to come up with an application that will allow you to screen out potential problem tenants without running afoul of any laws. “A local landlords’ association probably can help by providing model applications as well as sample lease agreements,” says Taylor. “Most of these groups welcome people who are interested in becoming landlords, even if you don’t yet own any properties.”
Gibson, too, says that joining a landlords’ association is a vital first step. “Tenants have various advocacy groups on their side, including Legal Aid,” she points out. “You need support too, which you can get through a landlord group. You can learn everything from how to advertise correctly in the local newspaper to how to prep your place properly to give it curb appeal.” Even if you join a local organization, Gibson suggests a trip to the bookstore for how-to help, specifically mentioning Every Landlord’s Legal Guide (Nolo Press; $44.99), of which Portman is co-author.
Build your own network. Taylor advises landlords to put together a team of experts who can be relied upon. “You should know a dependable contractor for any work that needs to be done as well as a real estate agent,” he says. “You don’t have to have a lawyer on retainer, but you should have some names to call when you need legal advice.” Dennison asserts that it’s worth paying legal fees, from time to time, if it helps you avoid fines that can be much steeper.
Also on your team should be a tax professional and a banker. “If you want to purchase property, knowing a cooperative lender may allow you to move quickly,” Taylor says. “Ideally, all of your team members will own investment properties themselves, so they’ll be familiar with the situations you might face and will have proven strategies to recommend.”
Cover your assets. Every landlord’s worst nightmare is winding up on the wrong end of an injury suit and having to pay a huge award for damages. “You need the right kind of insurance,” says Portman. “As a landlord, you should have commercial insurance, not a typical homeowner’s policy.”
Insurance might not cover everything,
though. For added protection, Portman suggests creating a limited liability company to own your rental property, rather than owning it personally. “If the property is owned by an L.L.C.,” she says, “your personal assets won’t be exposed. If you have multiple properties, you might want an L.L.C. for each one, so any damages attributed to one property won’t cost you the others. However, you should check on state tax laws and the costs of owning multiple L.L.C.s.” Portman notes that you can set up a series of L.L.C.s in Delaware with one filing, even if your rental properties are in other states.No matter how much legal protection you have in place, though, you still must have conscientious tenants paying reasonable rents to come out ahead as a landlord. “To succeed,” says Arvai, “you need the four Ts: time, training, tools, and temperament.” If you can cope with tenants, toilets, and trash, you may wind up with enough cash for tennis, travel, and Treasury bonds.
TAX TIPS FOR LANDLORDS
When your accountant tallies the results of your real estate rental property each year, you may have a loss, for tax purposes. Even if your cash income exceeds your outlays, non-cash deductions such as depreciation may provide a tax loss. If so, any cash flow you receive will be untaxed.
The question, though, is whether you can deduct such a tax loss on your personal return. “You might,” says Larry Torella, tax partner at Eisner L.L.P., a New York accounting firm, “depending on several factors, especially your adjusted gross income (AGI).”
Generally, these types of losses (passive losses, in tax code parlance) are deductible, up to $25,000 per year. “In order to take the full $25,000 deduction,” says Torella, “your AGI must be no more than $100,000 per year. Over $100,000, this deduction is phased out, $1 for every $2 over the threshold, until it disappears altogether at $150,000 in AGI.”
Suppose, for example, John Smith has a rental property that turns in tax losses, year after year. This year, John’s AGI is $98,000. He can deduct losses up to $25,000.
Next year, John’s AGI climbs to $120,000. He’s $20,000 over the cutoff, so his maximum loss is cut by $10,000. That year, he can deduct up to $15,000 worth of losses from his rental property.
The following year, John’s AGI reaches $152,000. Now, he can’t deduct any losses. What happens to losses that John can’t deduct right away? “They’re carried over to future years,” says Torella. “They can offset any taxable income from rental properties. Eventually, when the properties are sold, any unused losses will reduce the taxable gain from the sale.”
The laws are more favorable if you spend so much time as a landlord that you get to be treated as a real estate professional. “If you spend more than half of your working time on real estate — at least 750 hours a year — you’re entitled to deduct any losses right away,” says Torella, “regardless of your AGI.”