Buying an investment property can be an excellent way not only to generate income, but to build wealth over time. However, as with any other investment, it's important to know exactly what you're getting into before you buy your first rental property. With that in mind, here are three things you may be surprised to learn about rental income.
As a former rental property owner, I would have to say that the biggest thing to keep in mind about rental income is that it isn't the consistent income stream many people believe it is.
There are several variable costs of owning rental property that can cut into your net income. For example, property taxes and insurance costs change every year -- and usually not in your favor. Maintenance expenses can vary dramatically over time, as you can have several trouble-free years and then suddenly be forced to complete an expensive repair, such as replacing an HVAC system.
In addition to the variable costs of property ownership, be sure to consider unexpected breaks in your income stream, such as the possibility that your property will sit vacant between tenants for longer than you anticipate. Hopefully, you'll never need to go through the process of evicting a tenant, but I can tell you from experience that it can be lengthy and costly.
The point is that the money you collect in rent can produce varying amounts of net income from month to month and from year to year. Be sure to plan for the unexpected when buying a rental property -- not just the best-case scenario, as many rookie landlords incorrectly do.
One aspect of rental properties many people don't know about is that if you rent out real estate on a more casual basis, you might not have to pay any taxes on the income you earn. If you rent out a vacation home or other property that you use for residential use, then you can qualify for a special exemption that prevents you from having to report the income that your rental generates. The maximum period for which you can rent the vacation home over the course of a year and still qualify is 14 days, but if you stay at or below that level, then the ordinarily extensive reporting requirements essentially disappear. Many people take advantage of the 14-day rule with second homes, especially if they happen to be located in areas where certain annual events regularly happen.
One thing to keep in mind with this rule is that you're also not allowed to take any deductions for expenses related to the rental of your vacation home. However, with most vacation homes, your personal use of the property precludes you from taking deductions for losses in any event. The 14-day rule lets you get a taste of rental income without all the hassles involved in committing to making your property available year-round.
All real estate investors aim to make money on their property, but there's an upside to losing money, too.
Depreciation is a real estate investor's best friend. Over time, the tax code allows you to depreciate the value of a home to zero, even though it is more likely to have gone up in value than gone down. Thus a home purchased for $150,000 would create $5,455 per year in depreciation expenses against the rental income it generates for the next 27.5 years.
Rental income is classified as passive income. However, depending on how much you earn each year, you may be able to use passive paper losses from real estate investments to offset income from other sources. Those who earn less than $100,000 per year in adjusted gross income can use up to $25,000 of losses from passive investments like real estate to offset other income. This benefit eventually phases out for the highest earners, but it can be a significant advantage to investing in real estate, as paper losses can help shield more of your returns from the tax man.