As you might have noticed from my rental articles to date, I believe that landlording is a serious responsibility, not to be undertaken lightly. You can realize serious benefits from a rental property, but also serious repercussions.
Because of this, I read today’s CNN Money article on so-called “accidental landlords” with great interest.
In the article, Kate Ashford relates the story of a Maryland couple who, after purchasing a new home for themselves, decided to wait out the weakening market and rent out their former home in the hopes of benefiting from future appreciation.
While they never planned to become real estate investors, they suddenly became landlords.
The rationalization offered is indeed compelling:
The inventory of homes for sale is twice as big as it was three years ago, which could mean a longer wait to sell – and a longer time to shoulder two mortgages if you buy your next home first. And with home prices flat – or worse – in many markets, you may not clear enough to cover broker fees once you do sell.
The rental market, on the other hand, is robust. Rents were up 4.1 percent in 2006, according to the National Association of Realtors.
While there are a number of costs to consider, including insurance, legal fees, and maintenance, the single-biggest watchout for this type of situation concerns capital gains tax. If a couple ends up renting their former home for three years or more, their capital gains tax exemption on the first $250,000 in profits ($500,000 for a married couple) is lost. That can significantly affect their resale profits.
Renting for a few years to wait out the market can be a savvy move, but beyond that three-year mark, the profit model alters. At that point, it might make sense to hold onto the property for the long term, enjoying the rental income for as long as possible. Of course, all of this is based on the property having a positive cash flow throughout its rental years. Without that, the risks may outweigh the rewards.
Kate does encourage potential landlords to do some soul-searching, advising those who can’t handle the risk of months of expense without income during periods of vacancy to avoid renting. Landlording takes time, often unforeseen, inconvenient time, and that’s an important factor to consider against job and family responsibilities.
One of the hardest things for former homeowners to accept is that tenants may be much rougher on the house overall. While Kate mentions the need to prepare for some “wear and tear,” warning about breakables and renting to large families, this glosses over one of the most critical risks for landlords looking to resell in the short term–that the tenants may cause such damage that the property cannot be resold without additional capital investment. Sure, there’s a security deposit, but in severe cases where there’s damage leading to eviction, the months of lost rent may leave no funds remaining for the necessary repairs.
The risk is inherent by design–the aspects an investor considers when buying a rental property differ significantly from those a potential homeowner seeks. While ornate, expensive trimmings and finishes are great assets for a home and for resale, in rental properties they’re more of a liability. Functional, indestructible elements are key for rentals, but not always attractive to buyers, so any adjustments made to help a property be a better rental might not actually help its resale value.
And as I’ve said before, the codes affecting a house can change once that property becomes a rental. By the time you’ve altered your property to conform to rental regulations, your investment might be such that it no longer makes fiscal sense to sell it in two years. Or it might need so much repair work after the tenants leave that the resale profits are diminished, affecting the appreciation in value that was the justification for renting in the first place.
Kate Ashford’s article provides an interesting overview for those looking to become landlords, but I do feel it treats some of the potential risks too lightly. While happy accidents do happen, a well-informed and prepared landlord is better poised for success than one forced into the role by circumstance.
Can’t Sell Your Home? Be a Landlord [CNN Money]
Updated October 2, 2007 and originally published September 4, 2007. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @flexo on Twitter and visit our Facebook page for more updates.