While the reality might not be quite so rosy, rental properties do offer distinct advantages over other investments. In this article, we look at the main pros and cons of owning a rental property, outlining the key analyses needed when deciding whether to invest in this asset class.
When considering the pros and cons of investing in rental property, the key question, as with any investment, is whether it offers an attractive risk-adjusted return. For rental properties, unpacking that question involves understanding financing conditions, tax benefits, and property management among others. Only after those questions are answered can one decide whether buying a rental property is worth it.
Buying a rental property offers several advantages for investors. These include:
Appreciating real estate values
Deductions and tax benefits
Passive income is one of the primary advantages of buying an investment property. By renting out the property, you can receive regular rental payments, providing a steady stream of income. This income can help cover your mortgage and property expenses, potentially generating positive cash flow. However, while it is called passive income, it is anything but passive — it requires time and effort to acquire and maintain rental properties even if day-to-day maintenance is handled by a property manager.
Real estate has the potential to appreciate in value over time. Home prices have grown at over a 4% rate for the past 30 years, according to the nationally recognized Case-Shiller National Home Price Index, which was created, in part, by Nobel Prize-winning economist Robert Shiller. If the home’s value appreciates, one can benefit from that growth, potentially selling the property at a higher price in the future. Additionally, buying a rental property in desirable areas with strong market conditions or favorable growth prospects can lead to an increase in property value in excess of the overall market.
Rental property ownership often comes with several tax deductions and benefits that can help reduce your overall tax liability. These include:
Mortgage interest deduction. You can deduct the interest paid on the mortgage used to finance the rental property. This deduction reduces your taxable income, thereby lowering your overall tax burden. Note that the allowable amounts will depend on how much income the property generates, so it’s best to work with a tax advisor to understand the nuances.
Depreciation deduction. The value of the property — excluding the land — can be depreciated over time, providing an annual deduction. This non-cash expense helps offset rental income and reduces taxable income.
Property expenses deduction. Many expenses related to the rental property, such as property management fees, repairs and maintenance, insurance, property taxes, and advertising costs, can be deducted from your rental income.
1031 exchange. If you decide to sell a rental property and reinvest the proceeds into another one, you may be eligible for a 1031 exchange. This allows you to defer capital gains taxes on the sale of the property, provided the property was held for investment purposes and you have identified a replacement property within 45 calendar days of the sale of the first property. There are some other restrictions too, so it is best to discuss these with a qualified tax professional or investment advisor.
Passive activity loss deduction. If you actively participate in managing the rental property, you may be able to offset that rental income with passive activity losses from other investments or businesses, subject to specific rules and limitations.
Given the range of tax deductions and benefits, working with a knowledgeable financial advisor at FinanceHQ can help you maximize these benefits based on your unique situation.
While the foregoing advantages may make it seem like owning a rental property is a no-brainer, there are several disadvantages that potential investors should consider. Here are some common drawbacks associated with rental property investments:
Acquiring financing for a rental property often involves upfront costs, such as origination, title search, and other closing costs. Additionally, interest rates and loan terms can affect the overall cost of borrowing. While using borrowed funds can improve the return on investment if the property is eventually sold for a profit, that benefit is entirely reversed if the property declines in value and you could be left having to pay back a mortgage that exceeds the sale price. Therefore, expecting a profitable sale to offset excessive borrowing is a risky strategy.
Rental properties require ongoing maintenance and repairs, which can be costly. Regular upkeep, addressing tenant requests, and handling unforeseen repairs are all part of property ownership. These expenses can eat into the rental income and impact profitability. Budgeting and planning for maintenance costs are essential to mitigate this disadvantage.
When a rental lies vacant, there’s no income. During such periods, the owner is still responsible for expenses such as mortgage payments, property taxes, utilities, and general maintenance. Extended vacancies can significantly impact cash flow and make it challenging to cover property-related costs.
Managing rental properties can be time-consuming and demanding, especially for individuals who have multiple properties or lack the necessary experience. Property management includes tenant screening, lease agreements, rent collection, property maintenance coordination, and handling tenant concerns. When considering buying a rental property, you should decide if you have the expertise or time to understand each of these requirements. If you don’t, hiring a professional property management company is a valid option, but that comes with two other issues. Is the manager competent and do the costs of such management still make ownership profitable? Even if you answered in the positive for both of these, bad tenants can still ruin a good return on investment.
Real estate investments — including rental properties — are generally considered illiquid assets. Unlike stocks or bonds that can be easily sold or liquidated, selling a rental property takes time. Market conditions, finding a buyer, and time to close can delay accessing the funds tied up in the property. If you need cash fast for one of life’s unforeseen hurdles, selling a rental property is generally a risky option.
Understanding the advantages and disadvantages of rental property ownership is crucial to making an informed investment decision. Helping individuals magnify the advantages while mitigating the drawbacks is one of the key benefits of working with a competent advisor.
Deciding on whether to become a rental property owner is never an isolated decision, requiring thorough financial planning and careful analysis of how such ownership fits into one’s long-term financial goals, risk tolerance, and available resources.
Amanda brings 30 years of experience in banking and finance.