In years past the United States has been one of the most attractive places in the world to own your own property. It offers beautiful land, a world-class economy and, until last year, huge tax advantages to owning your own home versus renting. The tax reforms of 2018 have dramatically shifted the playing field and while it is still often more advantageous to be a homeowner than a tenant, that gap has narrowed.
According to Zillow, 44% of homes were worth enough money to take the mortgage interest deduction under the old laws, but with the near doubling of the standard deduction to $24,000 for married couples, this is predicted to fall to 14.4%. Further, the advantages which now exist for real estate investors far exceed those of homeowners or tenants. Given that, my wife and I are considering selling our home, investing the proceeds into rental properties and then renting a home to live in. I call this strategy “tenantvesting,” and it may be right for you, too.
If you have lived in your primary residence for two of the last five years, you can sell your home and take the profit tax-free (up to $250,000 if you are single or $500,000 if you are married). If you live in a very nice area, then you could sell your home, reinvest in another area and very likely double or triple the rental income, yield and/or cap rate. Capitalization rates in A grade areas tend to be 2%-5% whereas investor grade areas can see cap rates between 6%-15%.
This new equity can be used to invest in real estate. If you invest the proceeds of your home sale in a rental property, you will be able to depreciate the property, unlike on an owner-occupied property. For example, if you have a $500,000 structure on a 27.5-year flat line depreciation, this would equal a write off of $18,181.00 per year.
Investment property owners can write off operating expenses such as routine or one-time maintenance and more. With an investment property, mortgage interest and taxes are not included in your standard deduction, meaning you can have your cake and eat it too: Come tax time, you can write off mortgage interest without the $750,000 cap that you would find on an owner-occupied property and write off all of your local property taxes without facing a cap.
You can utilize 1031 Exchange for your investment property and defer the entire gain, even if it exceeds $500,000 (married) or $250,000 (single).
As an investor, you can utilize a pass-through entity such as an LLC and likely find yourself in a lower tax bracket than you would pay as an individual for the same amount of income.
As a tenant:
As a tenant, you can call your landlord if your furnace breaks or the roof starts leaking. Your landlord may even pay for some of your living costs such as water, sewer and trash. The headaches of homeownership are no longer yours.
Renting offers flexibility a mortgage doesn’t. If your lease ends at the start of summer, you could move to Chile with the kids for a few months without having to worry about a vacant property or needing to rent your home. You could even be collecting income while on vacation with all of that equity you invested when you sold your home and invested in rental properties.
Cons Of Tenantvesting
As an investor:
Not all real estate investors want to be hands-on. If you don’t want to be a property manager, then you will need to hire one. Most property managers charge roughly 6%-10% for long-term rentals, and up to triple that amount if you own short-term vacation rentals. As the landlord, you may be required to pay for costly repairs on your rental properties such as a new furnace or water heater. You will likely pay a higher interest rate on an investment property than an owner-occupied property, and if your tenants don’t pay or your property is vacant, you will not have income to pay for your mortgage.
As a renter:
Renting has its downsides, too. Your landlord can give you notice and make you move, and you can’t paint zebra stripes on the walls without your landlords permission. If you do work on the property, you won’t ultimately reap the financial fruits of your labor.
Before You Choose Tenantvesting
Before you take the plunge into tenantvesting, it’s crucial that you talk to your CPA about the tax consequences for your personal situation. Talk to an attorney on how best to take title (i.e., individual vs. LLC) and talk to a real estate agent who understands investment property. Talk to a reputable property manager to find out what type of vacancy rates and operating expenses you can expect.
Know your numbers. Consider estimated rental income, vacancy rates and bad debt, repairs, down payment requirements, maintenance, utilities, property taxes, insurance, property management fees, mortgage principal and interest and tax preparation.
Have an inspection conducted on your investment property so that you are not blindsided when that 25-year-old furnace goes out or the roof starts leaking. It’s also wise to set up and fund an operating account to take care of major repairs and vacancies.
Many homeowners have equity in their primary residence which could be converted to equity within an income property. If this income property can generate double to triple the revenue of your primary residence while giving you preferential tax treatment, then it could make financial sense for you to become a tenantvestor. For many, including myself, you could go from paying a mortgage on a primary residence to generating enough income on a rental portfolio to pay your entire rent on a similar property.