Written by Blanche Evans
With rental prices rising, you may be wondering if now’s the time to become a landlord. There are advantages to renting your current home while you purchase another to live in.
The advantage to renting your home is that you’re likely paying a homestead mortgage interest rate, which will make it easier to make a profit than if you purchased rental property with a mortgage at a higher interest rate. As you’ve owned your home, it’s likely appreciated in value, allowing your home to compete well in the rental market so you can use profits to put back into the home to keep it rentable.
Real estate has always served as a hedge against inflation and against other investments, so the first thing to do is find out how rents compare to home prices in your area. Your real estate professional can provide you with market comparables that show you how much homes are renting for per square foot and how quickly they rent, as well as for what prices comparable homes are selling.
If the rental income is enough to cover your mortgage, you’re in good shape, but there are other expenses to consider, such as income taxes, advertising, listing and management fees, and maintenance.
For income tax purposes, your current mortgage isn’t considered a cost of doing business that you can deduct like office supplies or equipment purchases. You’ll pay taxes on this gross amount, less repairs and management fees, if any. On the bright side, if you sell the property within five years and you’ve occupied the home two of those five years, you’ll likely pay no capital gains at all up to $250,000 for an individual or $500,000 for a couple.
To qualify for a mortgage on another home, your lender follows a typical multiple home formula. Even though you may have your home rented, plan to deduct approximately 20% of rental income from your “investment.” Why? Most homes have a period where they are not rented while they’re on the market, which means no rental income. Your lender wants to make sure you can handle periods when your home isn’t rented.
When you turn your home into a rental, it’s no longer a homestead, but an enterprise. Tax laws require you to make a profit within three years of launching an enterprise, or otherwise you won’t be able to take deductions associated with it. Also, expect to pay more in property taxes as you will also lose the homestead deduction rate, since you’ll be applying for the homestead deduction on your new home.
On the other hand, one of the best ways to build equity is to have someone else pay your mortgage for you. The longer you own your home and the longer it’s rented, the more the amortization tables turn in your favor. Every loan payment is made of principal and interest. The longer you own your home, the larger the percentage that goes toward reducing principal.
Based on the purchase price of your home, you can deduct “depreciation” from your income every year you rent it, but this amount decreases with time. You can also deduct some maintenance and improvement expenses which are not available to homesteaders. See your tax professional for more information.
There are other pros and cons of becoming a landlord. You’ll be dealing with people who don’t respect your home as much as you do and could cause damages. They may skip out without paying the final month’s rent. You’ll have two homes to maintain, and could get broken plumbing or appliance calls in the middle of the night. On the bright side, renters of single-family homes tend to be older, more responsible and remain occupants longer. Also many losses are tax-deductible to landlords.
Ask your real estate professional or someone else that you know who owns rental property for more insights. They’ll be able to share real-life property management situations and costs that may help you to decide if this is the right step for you.