Financial rewards are possible from rental property ownership. Consider the dangers and obligations if you’re considering investing in this kind of real estate.
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Overview of Rental Properties
It may seem appealing to purchase a house or apartment to resell for a profit. However, there are ups and downs when purchasing a rental property for income and long-term capital growth. For example, geography, supply and demand, and the state of the economy can all affect the housing market.
Due to the actual risks involved, the financial return on the rental property must exceed the return on conservative investments like bonds and dividend-paying blue-chip companies for it to be considered truly lucrative. Furthermore, not all people are capable of managing real estate and tenants.
Advantages of Rental Homes
Having a rental property has several advantages. Among them are:
Tax Advantages
Several costs related to rental property are deductible by the Internal Revenue Service under the following categories:
Typical and essential costs
Enhancements
Devaluation
This implies that you may write off insurance, mortgage interest, upkeep expenses, and normal wear and tear on your home.
You may be able to offset a small loss from depreciation against other sources of revenue. Put otherwise, it is possible to get a positive net cash flow from rental revenue less costs, yet nevertheless end up with a negative net tax loss. However, keep in mind that depreciation lowers a property’s cost basis for determining capital gains when you sell it.
Additionally, landlords can take advantage of certain tax incentives provided by the 2017 Tax Cuts and Jobs Act. As long as your total taxable annual income from all sources after deductions is less than $250,000 for singles or $500,000 for married couples filing jointly, you may now deduct an amount equal to 20% of your net rental income if you own a flow-through entity, also known as a pass-through business. This can be done whether the entity is a sole proprietorship, limited liability company, partnership, or S corporation.
Temporary Accommodations
If you rent out your property seasonally, you can still deduct your expenditures if you utilize it for personal use for 14 days a year, or 10% of the days you rent to others at a fair market price.
Exchange of 1031
You can invest in a “like kind” property and sell a rental property through a 1031 exchange, which spares you from paying capital gains taxes.
Hiring Additional Space
A portion of the mortgage interest and other costs can be written off against the income of the room or area that you treat as a rental, such as a garage, basement, or accessory dwelling unit. However, you should be mindful of the potential drawbacks of renting out extra space, such as local zoning laws.
Drawbacks of Rental Properties
The ownership of a rental property has disadvantages as well. Among them are:
Insufficient Liquidity
A liquid asset is not real estate. A transaction may take many months to close, even in the hottest markets. Furthermore, you might not get the greatest price if your desire to sell quickly is due to an emergency or other unforeseen circumstance.
Growing Insurance Premiums and Taxes
Even while your mortgage’s interest and principal are set, there’s no assurance that taxes won’t climb more quickly than rent increases. Insurance costs could also rise, as they always do after a natural disaster.
Uncooperative Tenants
Even with your best efforts to screen potential tenants, you may still end up with less than ideal tenants. They could be obnoxious or needy, pay bills after the fact, fail to turn off the water, and so on. Alternatively, they could be harmful, in which case the tax code’s depreciation limit might be woefully insufficient. Still, you may always include a rider to the normal lease form that outlines specific guidelines for things like occupancy, pets, smoking, renter insurance, and other things. Here, a security deposit may also be beneficial.
Neighborhood Deterioration
Ideally, your investment house will thrive in the company of other well-kept homes, and the neighborhood’s amenities will get better. Your cash flow will rise gradually as a result, while your expenses will stay the same. On the other hand, neighborhoods can alter and your investment may lose value over time. Just like you would where you live, you should be aware of the local politics where you invest. By exercising caution, you can reduce this risk.
Unfavorable Tax Code Changes
Changes can occur to the tax code. The tax benefits associated with homeownership and flow-through enterprises may be reduced, eliminated, or both in certain cases.
The Landlord Position
Landlording is not a career for everyone. Conflicts may result from your shyness about raising rent or your protectiveness of how other people handle your property. Your tenants could even become friends with you, or they might already be family. You risk receiving rent that is significantly less than market value or owning a property that is undervalued if you are unable to enforce strict policies about things like property maintenance and rent increases.
Maintenance
Both little and large repairs are necessary for maintaining a home. By conducting the job yourself, some property owners are able to save money. But most don’t have the time, resources, or know-how to fix their homes. You should budget for recurring contractor payments.
Particular Points to Remember
When purchasing a permanent residence or a rental property, it is crucial to take the current state of mortgage interest rates into account. In general, low-rate mortgage debt works well as an inflation hedge. One strategy for landlords to counteract inflationary increases in maintenance costs is to periodically raise rent.