The road to real estate riches can be paved with problems. Tenants, toilets, termites, and taxes can all conspire to eat into your returns.
I would love to tell you that you simply purchase a property, find a good tenant and everything will run smoothly. Of course, real life is never that simple and problems will arise along the way as you build up your rental property portfolio.
The key is to be prepared. Just like you need an emergency fund to cover your living expenses if you lose your job, you need an emergency fund to cover unexpected expenses that come up with your rental property investments.
Screening tenants are the first step in safeguarding your investments. Every landlord wants the perfect tenant. Good tenants pay rent on time, keep the property clean and maintained, notify you of problems and leave the property in good condition when they move out.
Bad tenants can cost you money, time and headaches. Tenants could stop paying the rent forcing you to start a lengthy eviction process. Tenants could have criminal activity going on in your house. Tenant’s pets could urinate all over your floors. These are just a few tenant horror stories I have heard over the years.
Once you find good tenants, keep them happy! Fix things in a timely manner, don’t dramatically increase the rent on someone who has paid on time every month, and is responsive to your tenants’ needs. It all starts with good communication when you are screening your tenants. Make sure they understand your expectations and what is required of them.
When you begin screening tenants you should ask their previous landlord “Would you rent to them again?” Hopefully the previous landlord will be honest and not just attempt to dump their bad tenant on to you.
You can confirm their employment information by calling their employer or asking for copies of their pay stubs. You can also run a credit report to check if they pay their bills on time, how much debt they currently have and whether they have filed for bankruptcy.
Even if you do everything right, it is possible to still pick a bad tenant. The tenant might lose their job or have a major medical issue. They might start dating the local drug kingpin and one day you get a call from the police saying you have a meth lab in your house! They might think it’s fun to punch in doors or drywall when they get angry.
We once had a young family renting from us that just stopped paying their rent. The property manager went by the house and it was completely empty. They moved out before their lease ended and never bothered to tell us. It turned out they had a premature baby and needed to move closer to the family to help take care of the needs of their new baby.
They left the house in good condition so we immediately listed it for rent and within two months we had a new tenant in place. We kept the original tenant’s security deposit to cover a month of lost income. We could have pressed the young family to pay for the months of rent owed, but in the long run, it was just better to move on and get a paying tenant into the house.
At any given moment, something can break or need to be replaced. Repairs and maintenance can eat up a big chunk of your profits which is why we set aside money for these planned and unplanned costs.
Preventative maintenance can extend the life of a home and reduce long term costs. Major items like heating and air conditioning require annual inspections to identify problems early.
Roofs and gutters, especially those near trees, require cleaning every fall and spring. Tenants are the first line of defense against nagging problems that can become costly problems long term, and so it helps to encourage them to report any issues as soon as they are discovered.
It is also important to keep maintenance logs for all rental properties. For example, if a tenant damages the carpet in their unit then the logs will be necessary to provide accountability when changing tenants. This can save a lot of money, especially during the tenant change process.
Most of the danger in this category is due to the investor not planning ahead. Understand that things will break, wear down and need to be replaced over time. A few years ago the old copper pipes in one of our rental properties started to break down in the kitchen and the bathrooms.
The tenant reported saggy floors in those areas and when we investigated we saw leaking pipes and rotting sub floors. All the copper pipes in the house needed to be replaced with PVC pipes and the sub floors in many areas had to be replaced.
This was an expensive repair! But with planning and saving ahead of time, we averted a crisis for our pocketbook. We fixed the leaks and floors quickly for the tenant. Homeowners insurance can cover some of these repair issues, leaving only the deductible to the home owner.
Many houses for sale have obvious mold issues in the bathrooms that the tenants either failed to report or the home owner never fixed. The bathroom mold could be an inexpensive ventilation repair or it could be a much larger plumbing and drywall issue that needs professional mold removal.
If you identify these issues before purchasing a home, you can offer much less than the asking price since you know expensive repairs will be required to make it rent ready.
If using a property manager, the property manager should be handling and tracking these repairs for you, but the home owner still needs records as well for deductions on income taxes.
A decent property management company will provide photos of any repairs it makes. This will help in the case of a tax audit by providing evidence of the repair or renovation. Photos also prove that work was actually done; I have heard stories of shady property management companies billing investors for fake repairs.
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Termites, bedbugs, cockroaches, beetles, fleas, wasps, rodents…is your skin crawling yet? These little bugs and animals can cause serious structural problems and health issues for rental properties.
Beetles and termites bore into wood and can cause serious and costly damage to the structure of a home. Wasp nests can form in attics; the nest can drip secretions which break down drywall. Fleas, cockroaches, nd flies don’t cause structural damage, but they could be a sign of plumbing issues like blocked drains or poor hygiene tenants or animals.
Rodents, like rats, mice and squirrels, can cause numerous issues. They love to chew wires, plumbing, insulation and woodwork. They also make nests in attic insulation and leave rodent droppings wherever they go. The best deterrent is to inspect the outside of your home for any points of entry and keep mesh covers over attic vents.
A pest inspection is standard precaution before purchasing a rental property. It normally costs around $100 and is worth the fee to ensure the house doesn’t have an infestation problem.
In between tenants is also a good time to have a rental home inspected for pests. For example, bedbugs can cost thousands of dollars to eradicate. Demonstrating that the house is free of pests before the next tenant moves in will eliminate the liability of the home owner. In the event bedbugs are found in the property as a result of the tenant’s activities, the tenant is responsible for the costs of getting rid of them.
The landlord has the responsibility to treat any pest problems immediately to avoid costly repairs and to avoid any legal action from tenants. Luckily I have not dealt with these issues yet, but I have read many horror stories of tenants moving out and leaving trash or food inside the house where it rots and attracts bugs.
There are many tax issues with real estate, but also many more benefits. This can get complex and I suggest meeting with an accountant prior to a purchase. For a more in depth discussion read this post from realestate.com.
There are a few different ways a rental property owner is taxed, and you should be setting aside money from rental income to pay for these additional taxes. From the local level you will have property taxes. These taxes are highly dependent on the city in which you choose to invest. I have yearly property taxes that are $800, $1900 and even $7,100!
Some local governments will also require purchase of an annual landlord permit, which in my town is $200 a year. These taxes are set and there isn’t any fancy accounting to decrease these costs. You should however look over your property tax bill and make sure all the information is correct.
In the event of an error, like a 2,100 square foot home being listed as 2,700 square foot, contact the assessor’s office to correct this information. Most cities re-evaluate the property every 1-2 years and will adjust tax bills up or down depending on their home value assessment.
At the federal and state level you will pay ordinary income tax. You will be taxed on all rent received minus any allowed deductions. Typical deductions are property management, advertising, maintenance, insurance, mortgage interest, repairs, utilities, travel to the property and depreciation.
Unlike a personal residence, the government allows investors to claim property depreciation over 27.5 years. However, be aware that while the amount you depreciate reduces your annual taxes now, it will be added back in when you sell the property and it will increase your taxable capital gains down the road.
The capital gains tax is a tax paid when selling the home. If you are a house flipper you will pay short term capital gains for any house owned for less than a year and if you’re a long term buy and hold investor you will pay long term capital gains.
This tax is the same one used for stock and bond investments. You will pay taxes on the difference between the selling price and your tax basis. Your tax basis is the purchase price minus any depreciation taken over the duration of the ownership plus any renovations or improvements made over that period.
There are advantages and disadvantages with any investment. I feel like real estate has several advantages but it does require more preparation and planning than just buying the S&P 500 index fund.
There are ways to decrease risks and increase your profits: identify potential problems with a home before purchasing it, screen tenants thoroughly, set aside money to pay for repairs and maintenance and use all allowable tax deductions to reduce your tax burden.
Never stop learning about real estate. A good reference book is “Making Money with Rental Properties.”
Things will go wrong along the way. You may have to evict a tenant and they decide to completely trash the property on the way out. You could rent to a couple who break up and now the single income tenant struggles to make the rent payment.
A hurricane could destroy the entire home forcing you to deal with insurance companies for months trying to get reimbursed. Or you could have the ideal tenant that pays on time every month, calls you when something needs repair and stays in the property for over five years. The more properties you have the more diverse your tenant pool will be and they will help insulate you from the risk of one bad tenant.
Don’t let the fears of some tenant horror stories scare you off from investing. If you purchase good homes, screen your tenants and save up for future repair and tax bills, you should succeed in real estate investing.