Running a military-focused tax firm, I run into a similar situation year after year. A military spouse is sitting across the desk from me, arms crossed, jaw clenched, steam rising from her neck and shoulders. Her eyes are cast down at my desk and I find myself wishing I hadn’t left my letter opener in plain sight. She just wanted to be rid of that <expletive deleted> house and here it is taking another big bite out of their bank account. What is depreciation recapture anyway?
Having a rental was supposed to be easy money, right? Real estate investing is being hyped and touted everywhere I look these days. Learn the secrets of billionaires – invest in real estate! Sit on the beach drinking mojitos and let the money rain down on you from above! The reality I see is not even close to the hype. I firmly believe you can make money in real estate, but the people I know who are doing it are working their tails off. There is money, but it is NOT easy.
Serving military families and their money, I see a lot of them with rental properties. They are nearly all losing money. And now I am going to tell you why you are also going to lose money if you decide to rent your house.
You bought a home, not a rental property. Military families want their piece of the American dream just like everyone else. Part of that dream is home ownership. You need a place to live when you get to a new duty station, so you purchased a house. There’s nothing wrong with that…until…it’s three years later and you can’t quite get enough on the sale of that house to pay the loan and the realtor. So, you go with Plan B: become landlords. Your belief is if you get enough rent to cover the mortgage, you will be fine. Might even make a little money if the house appreciates, right?
The problem with this concept is this is NOT how serious rental property investors purchase rental properties. When you needed a place to live you were shopping for a home. Serious real estate investors are shopping for a bargain. They wait and wait and wait for an opportunity to buy at a discount. Real estate investors know that nearly all the money you make on a property comes from getting it at the right price. You didn’t do that when you bought your house. You might have negotiated a decent price for a home, but not for a cash-flowing investment. You started losing money on your rental property the moment you bought it as a home. Recovering from this will be no small feat.
You don’t run it like a business. You’ve converted your home into a revenue-generating business. You might not see it that way, but it is true. What do successful business owners do? They create a business plan. They keep good records. They study the market. They charge what their product or service is worth. They outsource for the assistance they need. They negotiate favorable deals. They extract maximum profit from their business.
You are not doing any of that. You find someone who agrees to pay rent that is something close to the mortgage payment every month. Then you move on. A minor repair comes up and you think I should probably save this receipt, and you start “the file”. This is not how you make money with a business.
You don’t become familiar with the tax laws associated with rental real estate. Housing is a major industry in the United States. It provides jobs for millions of workers and homes for their families. Our government recognizes this and provides significant tax incentives to own residential rental properties. There are tax incentives to purchase properties using leverage, tax incentives to maintain them, and tax incentives to improve the properties. It is possible to have positive cash flow from the property that results in zero taxable income. Residential rental property losses are the only form of passive losses that may be deductible from other forms of income. Income from rents is not subject to Social Security or Medicare taxes. You can even get creative and do things like hire your children, turning their allowance into tax deductible wages.
Serious real estate investors either become familiar with these tax laws or they hire a professional who is familiar with these tax laws (see ‘outsourcing’ above). You do not. You look for the cheapest option for getting your taxes done just to ‘keep it legal’. Year over year you overpay your tax bill.
You don’t learn how to screen tenants, property managers, or contractors. Nothing turns the dream of rental property profits into a nightmare faster than dealing with a jackass (or two, or six). Unfortunately, there is an abundance of them in ‘rental property land’. If you want to drive a car you have to get a license, but you don’t need a license to be a tenant. Anyone can apply. Even the jackass who will stiff you for the rent, trash your property, and sue you to get the security deposit back.
Do you know how you become a property manager or a handyman/contractor? You post on Craigslist that you are a property manager or a handyman. Then you wait for the landlords looking for a bargain to call. You show up, talk a good game, take some money up front for your services and then disappear.
The military spouse steaming in my office never actually reaches for the letter opener. Instead, she launches into a tirade about the jackass tenant/property manager/contractor who ripped them off and made being landlords a nightmare. There are good tenants, property managers, and contractors out there. Learning how to effectively screen for them will greatly reduce the likelihood of getting bad ones.
You bail as soon as you can. After several years of losing money, getting no tax breaks from Turbotax, and dealing with jackasses, the frustration mounts. That cute little house you wanted to live in years ago is now an anchor dragging down your family finances and causing marital strife. You adored that house once, but now you’re actually starting to hate it. Zillow says you can sell it for enough to pay off the loan, so it goes on the market. You don’t get the price you were hoping, but you sell it anyway so the Housezilla Nightmare can finally be over. Free at last, free at last, thank God almighty we are free at last!
Then, six months later you are sitting in my office learning about depreciation recapture. The arms cross and the jaw clenches as I explain that while OWNING rental properties can get you many tax breaks, SELLING them is another matter altogether. The government gave you some tax breaks for owning that rental property business, and even if you didn’t take them, you have to pay them back. Please do not kill the messenger.
We have clients who are making money investing in real estate. Military families can make money investing in real estate. The stark reality is that most do not because they do not approach it as a business. They approach it unintentionally by turning their home into a rental property, hoping they will come out ahead in the long run. Hope is not a plan. Before you become a landlord I encourage you to make a plan. If you would like some help with that, call us for a free consultation. (757) 752-8055.