Have you heard that owning rental real estate is a great investment? You probably aren’t hearing the full story. It’s important to consider all the factors before moving forward with this strategy so let’s uncover 5 reasons why owning rental real estate may not be best for you. Spoiler alert – while it depends heavily on your situation, owning rental real estate may not be as great as it seems. This video addresses owning single family homes for rentals.
See the transcript below the video if you prefer to read!
I get a lot of questions about rental real estate. It can be a good strategy, but it’s not the best option for a lot of families. And in this video I’m talking about single family homes. I won’t be addressing commercial real estate or apartment buildings. So here are the top five reasons why rental real estate may not be best for you.
Managing Rental Real Estate Requires Time
Number one, it’s not at all passive when it comes to your time. You’re responsible for maintenance 24/7 and you’re responsible for finding new tenants if there’s a vacancy. Yes, this can be outsourced. But it’s typically expensive and this eats away at your income. So if you have young children, if you’re busy with your career, or even if you travel a lot, this is something to consider because it may not work well with your lifestyle.
Costs And Vacancies Are Usually Underestimated
Number two, most people underestimate the costs and vacancies. This is a common mental bias because you see the rent check coming in each month (or most months), but the expenses may be less frequent. Even though expenses may be large, it’s difficult for our brains to net it out.
The truth is that there are costs associated with real estate. There will be repairs. Another factor that many people forget to think about is updating the property. Over the years, if you still want to charge a competitive rate for rent, you need to make sure that the property is updated. That costs money too. Even if you decide to sell the property after so many years instead of continuing to rent it, it could involve a renovation or serious updates so that you can get the price you’re wanting when you sell. This is another common drawback to rental real estate held over the long-term.
Your Taxes Will Be More Complicated And There May Not Be Tax Advantages
Number three, you’ll have a more complicated tax situation without many of the tax advantages in many cases. So one key here is that it depends on your individual situation. But the tax law for rental real estate is very nuanced. You’ll want to work with a CPA.
The reason that a CPA is recommended is that mistakes can be made when you don’t fully understand the tax law. And this is one of those areas where mistakes are very commonly made. One element is depreciation. There can also be depreciation recapture. There is a deduction for depreciation, but even if it’s not taken, it’s still counted when calculating your cost basis. And this impacts the gain that you may realize when you sell the property. All of this leads to possibly more taxes that would be owed. Again, it depends on the situation. I’m not going to go into all of the details, but this is why I say it’s important to work with a CPA.
Another thing is that in a lot of cases, if there’s a loss in income from year to year, you may not be able to deduct that against regular income. It depends on your situation. Notice a pattern?
Tenants Aren’t Always Great
Number four, bad tenants. Oh, the horror stories I have heard. And I will tell you, it’s not a matter of if, but a matter of when, because eventually this is just part of owning rental real estate.
Another part of this is not fully understanding the tenant landlord laws in your state. In some states, the tenant may be heavily favored over the landlord, and that’s important to know. It could be very costly or time consuming to evict a tenant that isn’t paying rent. You may be thinking, Oh well, if there are damages I can just sue the tenant. And that’s true. But you still may not get your money back.
Inefficient Investment Strategy
Number five, this is an inefficient strategy for investment returns compared to investing in a low cost, diversified stock and bond portfolio held over the long-term. Now, of course, this depends on many factors like your asset allocation or even the region where the rental real estate would be located.
This is why it’s so important to work with a financial planner who can help you understand how all the factors work together and what may be best for your situation. More often than not, you won’t come out ahead with rental real estate when you look at the returns in both situations. But again, it depends.
Another part of this is that a stock and bond portfolio can actually have tax efficiency that a rental real estate property won’t have. Whenever you make rent, if there’s a profit, that will be taxed at your ordinary income rates. However, with a stock and bond portfolio, there are certain accounts where long-term capital gains rates may apply for income (i.e. qualified dividends). Long-term capital gains rates are lower than ordinary income rates, which means less tax.
So those are the top five reasons why rental real estate may not be the best for your situation. If you’re still considering it, I strongly encourage you to work with a financial planner who can help you to see how this works with your overall financial plan.
