4 Things You Need To Consider Before Purchasing A Rental Property
Contrary to popular belief, real estate investing isn’t all HGTV flower boxes and passive income filling your bank account. Whether you’re purchasing a single-family home, duplex, or commercial property, managing a rental property is a huge financial and personal undertaking.
Before you dive headfirst into a real estate project, you’ll want to do your homework.
So what factors should you consider?
Rental Properties Are Highly Concentrated Assets
Investing in rental properties will likely tie up a significant portion of your net worth in one place. A quick google search will show you all the millionaires and billionaires who got rich investing in real estate.
What we fail to realize is that investing in real estate at that level of wealth is very different from making your first real estate purchase. These investors have an abundance of financial resources and real estate expertise to handle any unexpected scenarios—flooded basements, crumbling foundations, rising interest rates, construction costs, and delays, etc.
Points to consider:
- Liquidity: After you have invested in your first property, how much cash do you have leftover? If you are unable to rent your property for a period of time, can you afford the monthly costs? What if the water heater fails and you need repairs? Do you have the cash available to cover that expense? Unlike stocks and bonds, you can’t just sell your assets when something goes wrong or circumstances change. This concept is known as “lacking liquidity”.
- Diversification: How much of your total assets will a rental property account for? 30%? 50%? More? Real estate investing (particularly for those in the early stages) can be an extremely concentrated investment. If something goes wrong with that particular asset, it can wipe out a large portion of your overall wealth. This concept is known as “lacking diversification”. In other words, you put too many eggs in one basket. That may not be the best way to build wealth, especially when your investments are three feet below sea level.
- Sophistication: With rental properties, there is a big difference between speculation and sophistication. Do you have a deep awareness of market conditions? Are you looking at comparable properties to get a better sense of available inventory? Do you know just how expensive it will be to do the repairs you want? Are you familiar with the rental market in that area? Do you have the numbers to back up your gut sense that the property is a good or bad deal? When it comes to rental properties, learn from the pros: buy low and sell high. Don’t be a target for professional investor’s “leftovers”—make intentional, financially sound choices.
Your Tax Situation Gets More Complicated
If you are currently a W-2 employee working for a company, your tax responsibilities may be extremely simple. The moment you decide to jump into the world of rental property investing, that tax situation changes completely.
What tax elements should you be thinking about?
- Rental Income Tax Treatment: Income generated from rental properties is taxed at ordinary income tax rates (yikes!). If you’re not careful, you could be paying an unnecessary amount of taxes associated with your new rental property.
- Tax Deductions: You can use the costs associated with the property to offset the rental income. These deductions typically include things like mortgage interest, PMI, homeowners insurance, cleaning/maintenance, property manager costs, utilities, depreciation, etc.
- Business Entities: If you want to get serious about rental property investing, you will likely want to open some form of business entity (i.e. an LLC). This will allow you to further optimize your tax situation and stay organized. If you do not have a business entity, business income/expenses and personal income/expenses tend to blend together and make things messy and complicated.
- Estimated Tax Payments: Say goodbye to the days of automatic payroll deductions. It is now your responsibility to pay quarterly taxes to account for net income generated throughout the year on your properties.
- Rental Property Sales: You also need to consider the taxes associated with a future sale or exchange of your property. Assuming you held the property for over 1 year, any gains on the sale will be taxed at long-term capital gains rates. Calculating your “gain” is a discussion for another blog but can involve depreciation recapture at ordinary rates. Recapture is a clawback of previous tax benefits that you will need to consider before investing. For now, just understand that you will need to be diligent in the ongoing management of your rental property investment.
While investing in real estate can actually be a plus for your tax situation relative to the income/wealth generated, it is important to understand the work that goes into managing properties over time and how selling the property impacts your finances.
Landlords Spend A Lot of Time On Their Properties
The concept of “passive income” as it relates to rental properties is a bit overstated. When done correctly, real estate investing can and should be relatively passive. Unfortunately, most novice investors jump in without a strategic plan and end up spending hours and hours on their properties.
Do you have an answer to the following questions?
- If you need a repair (i.e. the toilet breaks), who is going to fix it?
- Who will clean your rental and fix any damages when one tenant leaves and another is starting a lease?
- Speaking of tenants, who is responsible for finding new tenants? Will you need to pay a finder’s fee?
- Who will track your income/expenses and file your annual tax returns?
If the answer to any of the above questions is “you”, you might want to think twice about this whole passive income idea.
Your time is valuable, so perhaps you start to think about your time in terms of billable hours. If you charged yourself for the countless hours you spent at the rental property, you’re likely losing money.
Think about it like this: how much would you charge someone else if they asked you to do any of those services?
Remember, your time has a lot of value, and there are likely several other areas where it could be better-suited than cleaning up after your tenants.
Your Rental Property Should Fit Into Your Personal & Financial Goals
It is critical to ask yourself one (two-fold) fundamental question.
“Why am I investing in a rental property, and what will it help me achieve?”
You need to be crystal clear on your intentions and purpose. There should be a clear road map to where you are, where you want to go, and how rental properties will help you get there. In our experience, investors with the following characteristics will likely benefit from adding rental properties to their portfolio:
- Above Average Assets: Real estate investors should have a “foundation” in place. They have already built up a large amount of cash and other investments (such as investments in public markets and their primary residence). At a certain point during the wealth accumulation process, investors can benefit from adding real estate investments for diversification purposes. Additionally, they are financially capable of paying for unexpected short-term expenses.
- Financially Savvy: They have a firm understanding of the financial implications of rental property investing (growth potential, tax implications, upfront costs, long-term costs, business entities, etc.). For the areas in which they are not experts, they have team members with subject matter expertise (i.e. an accountant or financial planner).
- Mechanical Inclination: Knowing how to turn a wrench or and knowing who to call for help will make it easier when the 2 am wake-up call comes.
- Intentional: They know what they want and how real estate investing will get them there. For example, they believe that in 20 years from now, they will have 5 rental properties that will provide them income in retirement.
Is a Rental Property for You?
Investing in rental properties can be an excellent way to diversify your portfolio, provide additional income, and expedite the wealth accumulation process. With that said, there are several elements to consider like cash flow, ongoing maintenance, taxes, and your broader financial goals.
At Bienvenue Wealth, we seek to help you build investments with purpose and intention. Every investment should be designed to help you reach your goals, and if real estate investing is important to you, let’s talk about it. Schedule a call with our team today to learn how we can help you create a personalized plan for your financial future!