Rental Properties: A Powerful Tool for Building Wealth
Maybe you have a rental property or two, or maybe you’re wondering if a new role as a landlord is right for you. Maybe you know someone who can’t stop talking about the amazing success or tragic failure they had with rental properties. Is it right for you and your long-term plan?
It may surprise you to find out most financial/retirement planning software isn’t very well equipped to answer this question. To integrate rental properties properly into your plan, you’ll need to do some extra legwork and come prepared when you meet with your advisor. Real estate investments differ from traditional security investments in that they act like a business/investment hybrid. Taxes also require special consideration.
Let’s start with a list of why it’s more difficult to integrate personally-held investment real estate into your plan and the steps you should take to address these complexities. Then we’ll talk about why it may still be a powerful tool in your portfolio. Finally, we’ll pull it all together and talk about how your properties should fit into your plan.
Why is rental real estate ownership complicated and what can we do about it?
1 – The first challenge is data and tracking performance across time.
Traditional investments are often held by custodians who track your basis, transactions and growth as well as the majority of all tax-related items. Not so with rental property.
You will need to track your income and expenses year–over-year. If there is a cashflow loss, you need to add it to your capital investment because you are pulling funds from outside the endeavor to keep it going. This will be necessary to calculate real returns.
Track the depreciation deduction over time (an Excel spreadsheet will be your friend). There are deep wells of data available for planning software to use when estimating projected returns from traditional investment models. With real estate, all that data needs to come from you to incorporate your rental endeavors into your financial plan. The more accurate the data, the more accurate the projections will be.
Projecting appreciation is much more difficult than for traditional investments. Websites like Redfin and Zillow are great resources for short-term appreciation and rental trends in your area. For longer-term data on your target location, the House Price Index (HPI) calculator on the Federal Housing Finance Agency’s website is helpful. It is not property specific, but it can give you the long-term appreciation of residential real estate in your target area. And while the national average home price has increased around 4.3% historically, this varies significantly based on location so it’s important to find location-specific data to create accurate projections.
2 – Tax considerations are plentiful when you invest in rental properties.
This is true for taxes every year for the income portion of the endeavor as well as numerous future tax implications.
For instance, every single year you rent out a property, you can expense depreciation. The depreciated amount, multiplied by your marginal tax rate, can calculate a specific dollar benefit each year. Track this dollar amount across time because if/when you sell the property, the government will recapture that lost tax revenue. Knowing how much you saved over time will help offset the sting in the future.
When talking with your advisor, come prepared with your desired exit strategy. Will you hold the assets and include them in your legacy plan? Will you liquidate at one time or divest gradually? Each of these options comes with a different set of tax implications. Ask your advisor to research and provide insight into the tax implication of your desired plan.
3 – Risk characteristics are also more difficult to quantify with real estate vs. traditional investments.
Unlike traditional investing, where the most you could possibly lose is the amount you invested, you could find yourself in a scenario with real estate where you lose even more than you wanted to invest.
There could be an increase in risks for personal liability, vacancy, damage, unanticipated repair expenses, legal expenses — the list could go on. Planning ahead is key to mitigating some of these risks.
Purchasing the right amount of insurance for your family, screening tenants, getting the verbiage right in the lease agreements, maintaining the property and budgeting for improvements and repairs are some of the practical ways to address these risks. It’s easy to cut corners to enjoy early returns. In the long run, this approach will eat into the profitability of the endeavor. A healthy emergency fund is also key.
Hard-to-predict cash flows, complex tax considerations, unreliable data and increased risk exposure – this is a recipe on the “do not bake” list of many financial advisors. But does this mean investing in real estate is a bad choice for you? No. It just means it will take a little more diligence to map into your overall financial plan.
Why would you own rental real estate?
Does this seem more scary or tedious than it’s worth? I hope not. Because personally-held real estate can be a powerful tool in your financial plan.
One of the best advantages is that you can, relatively easily and cheaply, finance real estate investments. This allows you to own 100% of the appreciation of an asset in which you only invested a relatively small portion of the purchase price.
Suppose a property costs $300,000 and you put down $60,000 (20%). Then suppose, over the next five years, the property appreciates at the national average of 4.3%. Your property is now worth $370,000, and you still owe about $223,000 on the mortgage, so you have $147,000 in equity from a $60,000 investment. That is a 19.63% annualized return from a property that’s only been appreciating at 4.3%. This is a simplification of the hypothetical investment, but many of the more nuanced considerations from the rental activity can drive that return even higher.
Guess what? Someone else is buying you something! What do I mean by that? Every mortgage payment you make out of your rental income is buying more and more equity for you. So you own all the appreciation coming from a leveraged asset, and someone else is not just covering your expenses but also continually paying for you to have more equity. The upside potential for significant wealth accumulation is high.
How to fit rental real estate into your financial plan:
- Your advisor should include the value of your property as an appreciating asset. Use the most reliable data when assigning the appreciation expectation.
- Cash flows should be in net amounts (even if they’re negative for a period of time) and should adjust for inflation. The national historic average price increase for rent is about 3.17% annually. Again, this varies widely by location and property type, so look for data from your target location.
- Model changes to the anticipated cash flow for the anticipated mortgage payoff date.
- Plan for the use of current or future excess cash flow. If it’s spent to fund your lifestyle, it’ll be a one-time benefit. If you take the growth and invest it into the property or other investment vehicles, you could be unlocking growth on top of growth potential.
- Future inflows from any anticipated sales should be at the inflation-adjusted, after-tax amounts. Make sure the planning software turns off any tax implication of the inflow because you are inputting the after-tax estimate amount. When calculating these amounts, make sure to use the correct depreciation recapture amount and capital gain amounts. Details can be found by researching IRS Section 1250 depreciation recapture.
- Finally, you will be able to test this scenario against all other options and answer the question whether or not personally-held real estate investing is right for your plan.
Quick tips from an advisor who holds rental real estate
- Become familiar or make sure your advisor is familiar with IRS Section 1031 exchange options/requirements, passive activity loss rules and income considerations, and IRS Section 1250 depreciation recapture.
- Keep a healthy emergency fund. Emergency repairs become significantly more expensive if you need to use contractor-financing options.
- Plan for rent increases and articulate average rent increase expectations in your lease agreement. Small incremental increases over a long period of time have a significant impact on the profitability of the endeavor.
- Prioritize maintenance and upkeep. It’s much cheaper than repair.
- Leverage financing. It’s one of the most powerful tools of real estate investing.
- Don’t plan on excessive positive cash flow in the early years.
- Protect your credit score. This will keep the door open for future opportunities.
- Check to see if your state allows an owner-occupied exemption on real estate taxes on rentals. It could open up a significant reduction in property tax expenses by simply adding specific verbiage to your lease agreement.
Integrating rental properties into your financial plan may feel like a daunting task, but with the right strategy, it can unlock powerful opportunities for wealth building. By carefully tracking data, planning for taxes, and mitigating risks you can make rental real estate a productive part of your portfolio. Whether you’re looking to diversify your income, take advantage of tax benefits, or build equity through leveraged financing, rental properties can help provide a unique path to financial success. Work closely with your advisor to ensure these investments are aligned with your long-term goals so they contribute effectively to your overall plan.
Scott V. Williams
Financial Advisor
CFP®