Should You Rent Out A Property? It Depends

September 27th, 2023 by Blake Pinyan

Rental properties have gained significant popularity in recent years, thanks in part to the influence of social media platforms like TikTok, which portray them as a top-tier investment opportunity.

While there is certainly merit in the notion that renting out property for additional income can enhance one’s financial stability, it is important to recognize that social media promoters tend to emphasize the positives while neglecting the potential downsides.

This article aims to provide a balanced perspective by examining both the advantages and disadvantages of rental property ownership. By shedding light on these aspects, it aims to empower those teetering on the edge of a decision regarding whether to purchase a rental property or convert an existing home into a rental unit.

Why Rent a Property?

Renting a property can significantly bolster one’s financial standing. This is attributable to the fact that it can:

• Expand one’s real estate portfolio
• Generate a supplemental income stream
• Qualify a family for favorable tax advantages

Expanding One’s Real Estate Portfolio

While it’s essential to acknowledge that real estate investments aren’t foolproof, historical data reveals a relatively consistent appreciation in real estate values over time. Many homeowners have been blessed to see their property values rise since their initial purchase. This has led to home equity now contributing substantially to many family’s retirement plans.

The COVID-19 pandemic and the rise of remote work compelled many individuals to move away from urban centers and flood the suburbs. This had a hand in driving up property values, and it seems that the pace has barely slowed down. The demand for housing still outpaces the available supply, which favors real estate owners, as property values continue to steadily increase.

Like any investment, pouring additional funds into real estate does not guarantee a profit, nor should one approach it with unrealistic expectations. Nonetheless, historical trends indicate that real estate values have consistently appreciated year after year, making it an appealing addition and diversifier to one’s investment portfolio.

Generate A Supplemental Income Stream

Individuals tend to venture into renting a property to establish a supplemental income stream. This materializes through rents paid by long-term tenants or short-term stays with platforms like Airbnb or VRBO. The allure of a rental property is when it operates as a cash flow-positive asset. In essence, this means that the rental income exceeds the expenses incurred. Considering this, property owners are financially motivated to set rental rates at a level commensurate with the prevailing fair market value, ensuring that they derive profit from their investment.

When a rental property maintains positive cash flow, it can serve as a consistent supplementary income source for individuals. The predictability of this income depends upon factors such as tenant longevity, property location, and seasonal performance. For instance, a rental property in San Diego with tenants on annual leases is likely to yield a stable monthly income. In contrast, an Airbnb property in a seasonal location like Big Bear Lake may experience fluctuating income levels due to shorter-term rentals and seasonal demand. Notably, the Big Bear Airbnb is likely to have fewer vacancies during the winter and summer seasons, when skiing and water sport enthusiasts flock to the area compared to the spring, and fall.

Overall, the additional income stream can sometimes be invaluable for a family’s financial situation. It offers diversification from stock market returns, potentially providing individuals with a consistent income source, particularly during market downturns.

Tax Advantages

Rental properties offer several notable tax benefits. First off, rental property income typically enjoys more favorable tax treatment compared to ordinary income, largely because the expenses associated with the rental property are deducted against the rents received. Not all rental income is taxable, as it can be offset by various costs associated with the rental property.

Examples of deductible rental expenses might include:

• Repair and maintenance costs
• Management fees
• Property taxes
• Depreciation

In essence, if an expense is connected to the rental property, it is generally considered deductible.

While most expenses can be deducted in the tax year they are incurred, some must be spread over a specific time frame, necessitating depreciation. Depreciating a rental property expense entails deducting a portion of its cost each year, as determined by the depreciation schedule, until the expense is fully depreciated. The IRS defines an expense as a “major improvement” rather than a repair if it enhances, restores, or adapts the property to a new or different use. Though this can be somewhat subjective, the IRS provides specific examples of expenses that require depreciation.

Additionally, rental property owners can benefit from the annual depreciation of the physical property itself (the building, not the land) over a 27.5-year straight-line schedule. For instance, if your building was acquired for $300,000, you can typically claim a depreciation deduction of approximately $10,909 each year for a maximum of 27.5 years, or until you sell the property. However, be aware that this depreciation can have tax consequences upon property sale, known as depreciation recapture tax.

In terms of other tax advantages, rental property owners can potentially use losses incurred each year to offset other, non-rental related income, depending on their level of participation in the property. There are two categories of participation for rental property owners: active and material.

Active participation is relatively easier to meet than material participation. Generally, active participants must engage in management decisions, such as approving tenants, setting rental terms, and authorizing expenses. Even if an owner employs a property manager, they can still qualify as an active participant.

Under the passive activity loss limitation rules, active participants can deduct up to $25,000 of rental losses against other income in a year, subject to certain income thresholds. This deduction is available if their adjusted gross income (AGI) is below $100,000, with a gradual phase-out as AGI exceeds $100,000 and a complete phase-out at $150,000. Any suspended losses can be carried forward to offset future rental income or be applied upon the sale of the property.

Material participation, on the other hand, requires a significant annual commitment, often involving hundreds of hours spent overseeing the rental property. Few rental property owners qualify for material participation, as it is typically met by real estate professionals who are deeply involved in daily property operations. Those who meet this criterion are not subject to passive activity loss rules, meaning there is no limitation on the amount of losses they can deduct against other income.

Lastly, rental property owners can potentially exclude rental income from taxation if the property is rented for less than 15 days per year, a provision known as the Augusta rule. This rule was implemented after homeowners began renting their properties during events like the annual Masters golf tournament. As long as the property is rented for less than 15 days, the income collected is not subject to taxation, and related expenses are not deductible.

Why Not Rent a Property?

While renting a property can hold appeal, it’s not a suitable choice for everyone, as it can:

• Demand a substantial amount of time
• Incur costs
• Restrict liquidity

Time-Consuming Responsibilities

Becoming a landlord entails a significant increase in responsibilities. Responsiveness to tenants’ needs and addressing property issues in a prompt manner become essential. Notably, if you opt not to use a property manager, you bear the responsibility of handling tenant requests around the clock, without the luxury of an “off switch.” Furthermore, you’ll need to cultivate relationships with repair professionals or even handle some repairs yourself. Managing one’s primary residence is already a demanding task, and overseeing another property can amplify stress, particularly when dealing with high-maintenance tenants. Beyond tenant requests, landlords must also manage tasks such as lease preparation, tenant recruitment, and rent collection.

This is precisely why many landlords outsource management responsibilities to property management companies in exchange for a portion of the rental income. Typically, the fee ranges from 8% to 12%. By entrusting various tasks to such entities, property owners can significantly reduce the time they spend on day-to-day management and focus more on strategic aspects, such as major property improvements.

Given our hectic lives, assuming the role of a landlord should not be taken lightly. Even with the support of a property management company, there will inevitably be activities, projects, and issues that require the owner’s personal attention.

In light of these considerations, individuals contemplating ownership of rental property should evaluate their existing commitments. Do they possess sufficient time, given their other obligations, to effectively manage a rental property? If they prefer not to hire a property manager, are they prepared to be on call 24/7 to address tenant concerns?

As with many aspects of personal finance, the time required for rental property management can vary significantly based on several factors. These include the involvement of a professional property manager, tenant demands, property condition, and property size/type (managing multiple tenants or a single unit). Overall, renting a property may not be suitable for everyone due to the substantial time investment it requires.

Cost Considerations

When pondering the decision to rent a property, it’s essential to recognize that it can be financially burdensome. As the property owner, you bear the full weight of expenses related to maintenance, cleaning, repairs, and renovations. You essentially become the financial backbone, especially for properties that are less established or require substantial maintenance. This financial responsibility can pose a significant challenge for families who lack sufficient savings. The unpredictability of the incurred costs underscores the importance of having an emergency fund, as rental property expenses can strain the finances of those unprepared for unexpected challenges.

Rental properties are often viewed as investments, and as such, it’s crucial to assess their expected performance over time. The performance of a rental property hinges on its cash flow, specifically whether it is cash flow positive or negative.

As previously mentioned, a rental property is considered cash flow positive when its income exceeds all expenses. Conversely, a property is considered cash flow negative when expenses (including maintenance, repairs, fees, etc.) surpass the rental income collected. By this logic, a consistently cash flow-negative rental property could be seen as a poorly performing investment.

It’s important to note that while rental income can be relatively consistent, it is not guaranteed. There can be circumstances in which the property sits vacant for long periods, yet expenses persist. Rental income can cease due to events like tenant turnovers, major property renovations, tenant evictions, or broken leases, resulting in a pause in rental income. During such situations, landlords are likely to continue facing recurring monthly expenses such as mortgage payments, property taxes, and homeowners’ insurance. This underscores the necessity of having an emergency fund to cover those rough patches.

Creating Illiquidity

One noteworthy drawback of rental properties is their potential to tie up liquidity within an individual’s financial portfolio. Liquidity refers to the ease with which an asset can be converted into cash, readily available for various financial needs.

Examples of liquid assets include bank and brokerage accounts. Even when investments are held in brokerage accounts, these positions can typically be sold, and the funds transferred to a primary checking account within a week.

It’s of utmost importance for families to maintain an adequate level of liquid reserves in case a need for quick access to funds arises, such as during an emergency. The common guideline for an emergency fund is to hold approximately 3-6 months’ worth of living expenses in cash. However, additional variables come into play, including the stability of the primary earner’s employment situation and the family’s risk tolerance. For instance, a primary earner with a secure government job or a well-established role in a large corporation may have a lower risk of job loss, while those in less defined roles like self-employment or startups may face greater uncertainty. Additionally, some families with higher risk tolerance may opt for a smaller emergency fund, while others who are more risk-averse may prefer to maintain a substantial cash reserve.

Emergencies that could necessitate tapping into an emergency fund include job loss, the loss of a family member, divorce, a car accident, unexpected health events, and more. In such scenarios, families can’t rely on their rental property for immediate access to a substantial sum of cash. Selling a rental property involves listing it, finding a buyer, and navigating the escrow process, which can be time-consuming. An exception would be if a Home Equity Line of Credit (HELOC) is already established on the rental property before the emergency occurs, providing a potential source of funds. However, this option typically comes with financing and interest costs.

Given the inherent illiquidity of rental properties, they should not be depended upon as a primary emergency reserve. Some avid real estate investors may overlook this aspect and allocate a significant portion of their assets to real estate, leaving them “house-rich” but “cash-poor.” While real estate can be an attractive investment, it should not be the sole focus. Liquid assets play a crucial role in positioning a family for financial success, ensuring they have readily accessible funds to address unforeseen needs.

Careful Consideration

Individuals contemplating property rental should be well-informed about the comprehensive pros and cons associated with this investment choice. Rental properties offer numerous benefits, including expanding one’s real estate portfolio, the potential for passive income, and advantageous tax features. Nevertheless, it is equally crucial to acknowledge their limitations, particularly their potential to demand substantial time, generate significant expenses, and restrict liquidity.

In the realm of financial planning, a comprehensive evaluation of both sides of the equation is imperative. At Anchor Bay, we guide our clients in thoroughly considering all factors before embarking on rental property ownership. It’s important to remember that just because a concept is promoted elsewhere does not necessarily make it the right fit for your unique circumstances. Our commitment to you is to tailor financial strategies to what best serves your unique situation. This is our guiding principle…what’s in your best interest is our only interest.