Many of us dream of becoming a landlord whose investment property pays for itself. You lease a house to renters whose monthly checks cover the mortgage payment plus maintenance costs. Later, when the property has appreciated in value, you sell it at a profit.
The good news: That dream is possible. The bad news, however, is that dream can turn into an expensive nightmare unless you prepare properly.
There's a lot more to being a successful landlord than merely having your name on the rent checks, explains Bill Slocumb, a Bakersfield, Calif., lawyer. The first thing to remember is that being a landlord is a business. You have to treat it as a business and become a businessperson.
There is one major similarity between living in the house yourself and renting it out. In both cases, the interest you pay on the mortgage is tax-deductible. You write off interest paid on your own home because it is your own home. You get to write it off on rental property because it is a business expense.
"You write off any sort of repairs or improvements you make to the (rental) house: a new roof, heating system, painting it, fixing the plumbing, and so on," Slocumb adds. You also get to depreciate the property, and that is kind of sweet.
Depreciation is based on the simple fact that most things wear out over time -- even homes. Since a home that is being rented is a product, you get to write off its depreciation on your taxes as a business expense. "What you do is separate the value of the land from the structure and start depreciating the structure, Slocumb says.
Buildings wear out. Land doesn't. Let's say the house costs $150,000 and the tax assessor says that $80,000 of that is the land. Divide the rest by 30, for 30 years. That works out to about $2,333 a year in depreciation. That means you get to subtract $2,333 from your gross income -- the rent you collect. This works well as long as someone is paying you rent. But it can put a hole in your pocket if the house sits vacant and you don't get paid but still have a mortgage to cover.
Vacancy is not your only worry. If your house is a rental unit it will likely be subject to more wear and tear. That's because if you own the house you live in, you generally have pride of ownership. It may sound like a trite phrase, but it is true. People tend to take care of their homes," Slocumb says. If a lawn sprinkler breaks, an owner doesn't mind spending the money to buy a new one, going to the store to get it, and getting his or her hands dirty to install it. If you are a renter, that $15 sprinkler becomes the landlord's problem.
Homeowners are also generally more willing to make sure the house and lawn look good. If a tree needs trimming, they trim it, or hire someone to do it. If the shutters need painting or the rain gutters need fixing, they take care of them. If you don't have a gardening service, you have to rely on the renter to take care the grounds. With renters, the lawns might not be mowed and the garden just might not be tended the way you would like.
Slocumb says the biggest problems a landlord faces are tenants who cause problems with the neighbors, damage the property, pay their rent late or don't pay at all.
If you have tenants who either cannot or do not pay the rent, you can't just ask them to leave. Well, you can ask. But as long as they are there, it is their house. You have to get a court order to evict them, and while the procedure is somewhat simple, there are rules. Those rules vary from state to state, but the process can drag on, get messy, and cost you money. There are times, Slocumb adds, when you just let the tenant walk away from what they owe you just to be able to take possession of the house so you can rent it again.
Don't forget, the mortgage company still expects to get paid regardless of any problems you might be having with your tenants.
Eventually, most landlords want to get rid of their rental units. But selling a rental house is not the same as selling the house you live in. Since it is a business, and since you have depreciated its value over the years, you must pay taxes on the profits--the difference between its depreciated value and its sale price.
It's one thing to have made $500,0000 in real estate, but it's another thing to sell it and be able to keep all $500,000, Slocumb says. There are two ways to avoid paying taxes when you sell a rental property. One way is covered in IRS section 1031; a like-kind exchange. You find a house where you want to live and trade your house for it. There are real estate companies that specialize in those exchanges that will do swaps, even three-way swaps. There is no tax.
Another way to avoid paying taxes is to turn your rental property into your residence. You move into it and stay there for six months. It then becomes your home, and the rules of selling a home apply. Then when you sell it, you are selling a home, not a business. Since it is your home, you will not be taxed as if you were selling a business. This can make being a landlord even more profitable, especially in light of the more- generous capital gains rules for homeowners vs. business owners. And if you live in the rental home as your own for at least two years, you won't pay taxes on the first $250,000 ($500,000 for you and a spouse) of capital gains.
Being a landlord can become a nightmare for some people. But with planning, having someone write you a rent check every month could be your dream come true.