Pros and cons of owning rental houses

A closer look at investment purchases

By Robert J. Bruss
Inman News

What is the best investment you ever made? Common stocks? Bonds? A small business? Your house? Other real estate?

Chances are your most profitable investment has been your personal residence. If you have yet to purchase your own home, today's "buyer's market" is an excellent time to do so.

However, if you already own your house, why not take advantage of current market conditions to buy one or more houses as rental investments? Let your tenants buy those houses for you by using their rent payments to pay the mortgage and other expenses.

WHY BUY RENTAL HOUSES? Realizing that profitable rental houses (and most other real estate investments) are long-term investments for at least five years, consider the advantages of such investments.

Your list of benefits will likely include probable appreciation in market value (although the home sale market is "flat" in many cities today), income tax shelter, maximum leverage to control the property with little cash, tax-free and tax-deferred sales benefits, and pride of ownership.

Yes, there are possible rental-house disadvantages unless you carefully qualify tenants before they move in to ensure they pay the rent on time and won't "trash" your property. But sound property management techniques minimize this risk and hold repair costs down by providing tenant incentives to avoid damaging your rental houses.

HOW TO GET STARTED BUYING RENTAL HOUSES. The easiest way to acquire a sound, well-located rental house is to buy one as your personal residence.

That might sound unusual. However, the key reason is buying your own home for owner-occupancy is the simplest way to purchase for little or no cash on the most affordable mortgage finance terms.

After owning and living in your home for a few years, perhaps fixing it up to add market value, then you can convert it to a rental house and move on to another house purchased the same way, eventually establishing a portfolio of rental houses.

Or, thanks to the tax magic of Internal Revenue Code 121, after living in the house at least 24 months and then moving out to rent it to tenants, you will have up to 36 months to decide if you want to keep the house as a rental or sell it and claim up to $250,000 (up to $500,000 for a qualified married couple) tax-free principal-residence-sale profits.

THE FORGOTTEN RENTAL-HOUSE TAX-SHELTER BENEFITS. Most prospective rental-house investors realize these properties can provide income tax benefits, but they are often hazy as to the details.

Thanks to the unusual benefits of the depreciation tax deduction for estimated wear, tear and obsolescence, most rental houses show a paper tax loss. The reason is that depreciation is a noncash-expense tax deduction, which requires no actual payment, as is necessary for mortgage payments, property taxes, insurance and repairs.

Current tax law allows depreciation deductions for rental properties over 27.5 years. Commercial properties require a 39-year depreciable useful life.

For example, suppose you buy a $250,000 rental house, allocating $50,000 to the nondepreciable land value. Dividing the $200,000 cost of the structure, each year for 27.5 years you can deduct on Schedule E of your income tax returns about $7,300 without having to pay in cash even $1 for any actual depreciation expense.

The likely resulting tax loss from the rental house, after paying the operating expenses from the rental income, is deductible up to $25,000 annually if your adjusted gross income (AGI) from other sources is less than $100,000. Between $100,000 and $150,000 AGI, the amount of deductible rental-property loss gradually declines.

But any unused rental-property tax loss can be "suspended" and saved for use in future tax years or when the property is eventually sold.

UNLIMITED DEDUCTIONS FOR REALTY PROS. However, "real estate professionals" can claim unlimited property-loss deductions from their other ordinary taxable income. If you spend at least 750 hours per year (about 14 hours per week) on your real estate activities, you may qualify for unlimited Schedule E deductions from your rental houses and other realty investments.

A real estate sales license is not required. Full-time real estate investors, property managers, builders, contractors and leasing agents can qualify. Either spouse is eligible.

For example, suppose a married physician earns $500,000 AGI. Normally, he would not be entitled to any Schedule E tax loss deduction from his rental houses because his AGI exceeds $150,000. However, if his wife manages their properties and she spends more than 750 hours annually supervising those investments, making management decisions, inspecting properties for possible purchase, and supervising sales and exchanges of their properties, they can qualify for unlimited "real estate professional" deductions on their joint income tax returns.

AVOID TAX WHEN SELLING YOUR RENTAL HOUSES. If you quickly buy and sell rental houses or other real estate after fewer than 12 months of ownership (called "flippers"), your capital gains will be taxed at ordinary income tax rates up to 35 percent plus state taxes.

However, if you own the property more than 12 months, then the maximum federal capital gain tax rate is currently only 15 percent, plus state taxes.

But various tax-avoidance methods are available to cut or eliminate these taxes. In addition to the principal-residence-sale tax exemption of Internal Revenue Code 121 (if the house was owner-occupied to meet the statute's requirements), tax-avoidance consideration should be given to tax-deferred exchanges and installment sales.

Also, remember that any unused annual property-tax losses from rental properties are "suspended" for use in future tax years or when a property is sold. Your tax adviser can provide full details.

Personally, I have sold several rental houses at considerable profits with no tax due because my suspended tax losses sheltered my capital gains from taxation. More information is available in my brand-new special report, "Pros and Cons of Investing in Rental Houses and Condominiums," available for $5 from Robert Bruss, 251 Park Road, Burlingame, Calif., 94010, or by credit card at 1-800-736-1736 or instant delivery at www.BobBruss.com.