It pays to own rental real estate

Many enjoy great tax benefits, market-value appreciation
By: Robert J. Bruss: Inman News
On a recent flight from San Francisco to Chicago, I sat next to a talkative businesswoman. After we exchanged pleasantries and she learned I invest in and write about real estate, she asked, "What type of real estate should my husband and I invest in?"

Rather than give a direct answer, I replied, "Well, do you have any realty investments now?" Just our townhouse, she replied. "Has that been a good investment?" I asked.

She said they bought it about four years ago and since then it has more than doubled in market value. I responded that was extraordinary, but it can happen for well-located homes.

Then I asked her, "How much of a cash down payment did you make?" She replied, "Ten percent down. We got one of those PMI (private mortgage insurance) mortgages for 90 percent financing." Next, she launched into a rant about what a ripoff her $124 per month PMI premium is.

After I politely explained how she could cancel the PMI with an on-time payment record for at least 24 months by asking the lender to cancel the PMI based on a new appraisal, she was very grateful. "Why didn't the lender tell me?" she asked.

Then I tactfully redirected the conversation to make two points: (1) She and her husband wisely bought for 10 percent down, and (2) They are profiting from the benefits of leverage by controlling the entire property-value increase with just a small cash investment.

IF ONE HOME IS GOOD, WOULDN'T TWO BE BETTER? During the conversation, my seatmate said she and her husband want to buy a larger house. I congratulated her on that wise decision, especially in the current "buyer's market" in most cities.

Then she asked if they should keep or sell the townhouse when they buy a larger home. Since she mentioned the townhouse is located in a good neighborhood and there seems to be strong rental demand, I suggested keeping the townhouse as a rental.

When my new friend asked about losing the $500,000 principal-residence home-sale tax exemption for a married couple filing jointly (up to $250,000 for a single homeowner), I explained the townhouse can be rented as long as 36 months before losing this benefit of Internal Revenue Code 121.

"That's presuming you and your husband owned and occupied it at least 24 of the last 60 months before the home sale," I reminded my seatmate. If the townhouse continues to go up in value over the 36 months after you move out, I continued, then you get to enjoy even more tax-free market-value appreciation up to $500,000.

Then I asked, "If one home is good, wouldn't two be better?" She got the point real fast. Next, I briefly explained the tax advantages of keeping the townhouse as a rental property for a few years before deciding to keep or sell it.

I explained the benefits of the noncash depreciation tax deduction for rental property, but I don't think I did a very good job. Saving tax dollars didn't seem to interest her.

PROS AND CONS OF OWNING RENTAL HOUSES. Although there are many tax advantages of owning rental houses, especially tax-free income deductions up to $25,000 if you earn less than $100,000 annual adjusted gross income, there are a few possible disadvantages.

The primary negative to owning rental houses is called "tenants and toilets." By carefully selecting quality tenants who are likely to pay the rent on time (based on their credit report and FICO score), the management problem can be minimized. Good-quality house renters often stay many years.

Another possible negative is maintenance. Periodically, house components need repair or replacement. Rental-house owners should have access to quick cash for an emergency, such as a roof replacement. A home equity credit line is the best source because it costs nothing (except a $50 annual fee) until it is used by writing a check.

PROFESSIONAL PROPERTY MANAGEMENT ISN'T CHEAP. Although owner management of rental houses is recommended to save costs if the property is located within an hour's drive, sometimes landlords either don't want to or are unable to manage their rental houses.

When that happens, there are professional property management firms available. Before hiring such a firm, investors should obtain client references and check out the firm extremely carefully.

Most professional property management firms charge fees of 10 percent to 15 percent of the gross rental income for houses. They often charge additional fees for supervising repairs and for renting vacancies. The best firms provide monthly computer printouts to owners showing rent collections and expense payments, along with a monthly check to the owner.

ARE APARTMENTS GOOD INVESTMENTS? My airline seatmate had one more important question: "Wouldn't apartments be a better investment since my husband and I travel a lot?"

Then I explained large apartment buildings can be good investments because the landlord can usually hire an on-site resident manager to collect the rents and manage the property. But I quickly added, "Then your job is to manage the manager."

My personal experience has been apartment buildings ... (1) usually don't appreciate in market value as fast as single-family houses and (2) problems with apartment buildings are usually big problems, such as malfunction of a key component or the need for an expensive repair, such as a new roof.

Also, if the local apartment rental market is soft, with too many vacancies, that severely hurts the rental cash flow.

Apartment buildings and commercial properties are valued depending on their capitalization or "cap rate," which depends on the net operating income. However, single-family rental-house market values depend on recent sales prices of comparable nearby houses rather than rental income and expenses.

BONUS ADVANTAGE OF RENTAL HOUSES. An extra advantage of investing in rental houses or any other type of real estate investment or business property (but not your personal residence) is it can be exchanged - tax-deferred - for other investment or business real estate of equal or greater cost and equity.

Internal Revenue Code 1031 makes it possible to pyramid realty investments from a small rental property into investment property worth far more, without the erosion of capital gains tax. Full details on this and other tax benefits are available from your tax adviser.