Rental property can be an excellent income-producing investment, if you know what you’re doing. However, it can be disastrous if you fail to plan – and the list of potential problems is long. Do your research, including talking to experienced landlords, and get professional tax and financial planning advice before diving in. Here are some basics.
1. It’s a business. Seek continual improvement in your business practices, including evaluating, purchasing and maintaining properties; screening tenants; managing cash flow and taxes; and knowing when to cut losses and get out of a particular holding.
Create a business entity to own rental property – don’t own it directly with “sole proprietor” titling. Getting this correct now may protect your own personal assets from unforeseen legal problems later.
2. Vet tenants and get a signature. Always run background and credit checks on prospective tenants.
Their monthly income should be at least three times the monthly rent. Insist on at least two past landlords as references and two employment references. Check all references, and never let a prospective tenant’s words, an immediate cash offer or anything else sway you from your established tenant evaluation process. A new tenant may be in a big hurry to move for a perfectly legitimate reason; or it may be a scam. You don’t know them, so you can’t assume they’re honest, and you can’t assume they’re not. You must have a process, and you must follow it every time. An experienced tenant understands this; an inexperienced tenant needs to learn this or rent elsewhere.
Give tenants a document specifying when rent is due, rules about pets, noise – everything. Get a signature and enforce the rules. Imagine you’re in small claims court and it’s your word against theirs, nothing in writing and inconsistent enforcement. In fact, an enforced, signed agreement can prevent court appearances, because legal issues live in the “gray areas” where one or both parties aren’t clear about their obligations.
Let nothing sway you from your process. It’s worth a month or two of vacancy to avoid potentially serious problems.
3. Price rent correctly. Periodically check the going rate for similar nearby units, and raise rents if appropriate.
Otherwise, you may compromise the value of your units when it’s time to sell – and you don’t want to have to play catch-up at some point by suddenly raising rents dramatically for good current tenants.
4. Get an accountant. Specifically, one who is experienced with rental real estate tax rules.
This can be a minefield. For example, if you fall under the IRS definition of a “passive owner” because you don’t actually work a certain number of hours per year in the business, then you may not be able to take some tax deductions. If you’re a landlord but not a licensed real estate professional, your activities may be considered passive regardless of how much work you put in.
That’s not to say you can’t take any tax deductions at all. You may be able to deduct advertising costs, depreciation, management fees, cleaning and maintenance, supplies – even pest control. But there are special limits when compared to deductions for real estate professionals.
This is just one example to show how deep the tax ramifications can go. There are lots of other tax rules for landlords that affect how you do business, the deductions and depreciation that may help reduce your tax bill, and even what happens when you sell the property. So again, work with a tax professional.
5. Diversify and have an exit plan. The 2008 recession was a wake-up call for landlords who thought property values could only go up.
If your portfolio is too heavily weighted in real estate, consider some diversification into stocks, bonds, bank instruments, annuities or alternatives that may provide growth potential and spread your risk across the broader economy.
And the day likely will come when you no longer want to live the landlord life. Plan way ahead to turn over management to others or to get out entirely. And understand that you receive “sweat equity” as a landlord that you likely won’t get from other investments. It’s very difficult to sell a rental property and generate a similar stream of income in any other investment. Replacing some of that income stream, and planning for the remaining income gap, will require careful planning.