By Dr. Margaret Curtis, WCI Columnist
In 2004, my husband and I bought what we thought would be our forever home: a farmhouse on a hillside in Vermont with a barn and a pond on 27 acres. Six years later, we moved to Maine for my work, sure we would be back in Vermont in just a few years. We plan, God laughs, and here we are still in Maine 12 years later.
We love Maine, but we have never considered selling the farmhouse because we are planning to move back sooner or later—when we retire or the kids are in college (more planning, you get it). My husband is happiest when he is tapping maple trees on the hill above the house, and he swears the only way he will leave Vermont again is when he is carried out feet first. In the meantime, the house is rented to a long-term tenant, and we have become Accidental Landlords: homeowners who decide to rent out what was once a primary residence.
This is a common-enough scenario among high-income professionals: you own a home you no longer live in and have to decide what to do with it. Maybe you moved for work, or your family changed and the house no longer suited you, or maybe you inherited a family property (it does happen). You may be reluctant to sell the house because you plan to return to it or because it has sentimental value to you. You might be underwater on the mortgage, although this is much less common now than it was 10 years ago. Or you may be interested in real estate investing and think this may be an entry point for you.
Real estate investing is incredibly popular right now. You only have to read the newspaper headlines to know that real estate has appreciated at extraordinary rates in the past two years, and investors armed with low-rate mortgages have been fighting over available inventory. You may also have heard that real estate offers a tax shelter to high-wage earners like physicians (more on that below). If you wander over to the Bigger Pockets website—or any of the many others like it—you will hear breathless pundits telling tales of financial freedom and bountiful cash flow, all wrapped up in a mindset of personal growth.
These pundits are not wrong: real estate investing can be a powerful tool to build wealth. But real estate is not a get-rich-quick or get-rich-easy tool, and a primary home may not make a sound investment property.
After a previous (terrible) tenant, I decided we had to be more professional in how we handled our rental activity. I read real estate investing books, joined online forums, and asked questions. I would now put myself in the “conscious competence” stage of learning about REI; I’m like a really good intern in April. With the obvious caveat that you should do your due diligence and consult professionals as needed, here is a primer on real estate income and taxes and how they apply to the Accidental Landlord.
More information here:
Should You Turn Your First Home into a Rental Property?
How Rental Real Estate Makes Money
#1 Cash Flow
Cash flow is how much money you get to keep after all expenses (including mortgage, taxes, maintenance, repairs, etc.) are paid. The main source of income is rent, although some properties have ancillary sources of income, such as coin-op laundry or storage units.
Here is a very basic spreadsheet showing our income and expenses from our home in Vermont for 2021. (Note that this is retrospective, not prospective, and does not include every potential expense.)
Sharp-eyed readers will notice something important: we are $914 in the red for 2021. I anticipate we will at least break even in 2022, but even so: this is not a good investment. Our approximately $400,000 in equity in the home is earning us -0.2% cash. If we were early career or trying to pay down expensive debt, this would be a truly terrible investment.
Specific Considerations for the Accidental Landlord: If your home is expensive, be aware that higher-end rentals are the first to experience vacancies in an economic downturn. Our house is a three-bedroom in an area with high rental demand, so . . . easy to rent. In addition, you may have to pay higher homeowner’s insurance and maintenance expenses that you used to DIY, and you will lose the Homestead Exemption on your taxes if you had one.
More information here:
If It Doesn’t Cash Flow, Don’t Buy It
#2 Appreciation
Appreciation is the increase in value over time. Some investors will buy negative cash-flow properties hoping that they appreciate, but most investors agree that cash flow is more important for an investment property. If your rental needs repairs or you have a prolonged vacancy, you could incur a very large expense. You also can’t count on appreciation—just ask anyone who owned property in 2009. Our home has roughly doubled in value since we bought it, but I don’t count this on our balance sheet because this will benefit our heirs, not us.
Specific Considerations for the Accidental Landlord: There are ways to increase the value of a property (this is called “forced appreciation” and is beyond the scope of this article). You may be able to do this with your home-turned-rental, but it may be easier with an inexpensive rental bought with this in mind. You may also lose the “primary residence” exemption when you eventually sell the property depending on how long it was rented out—again, consult a tax professional.
How Real Estate Tax Write-Offs Work
Rental expenses can be deducted from rental income, bringing the tax on your rental income down to zero. We don’t pay any tax on the $21,000 of rent we collect, and that is before we calculate the biggest write-off in real estate: depreciation. Depreciation is the annual decrease in value of a property. Of course, in reality, properties that are maintained tend to increase in value over time (see #2 above), but according to the IRS, the value of a residential property goes to zero over time. Determining the annual depreciation amount is a process itself. Depreciation is a “paper loss,” meaning there is no money actually coming out of your pocket. This is not exactly “free money” because the IRS will “recapture” the depreciation when you sell the property, but can save you on your present-day taxes.
I haven’t included depreciation on my income and expense analysis above because our actual expenses already exceed our rental income. If I did, it would look like this:
With depreciation, we could potentially write off $22,732, but we already brought our rental income taxes to zero and these deductions can’t be applied to our physician (W2 and 1099) income. So, where are the huge tax advantages that real estate investors talk about? This is another area that creates a lot of confusion. Here is the internist version (too long) and the surgeon version (too short):
Internist version: Investors with Real Estate Professional Status (REPS) can deduct rental property losses—including depreciation—from other kinds of income, including W2 and 1099.
REPS is not a license or certification you can apply for. REPS is an IRS designation for taxpayers whose primary occupation is real estate and, specifically, their own rental investments. If you want to learn more, the Tax Smart Real Estate Investors podcast did an excellent series on REPS. The criteria for qualifying for REPS are complex, and I highly recommend learning more about this topic and consulting a tax professional.
If you work 0.5 FTE or more as a physician, by definition, you do not qualify for REPS. If you or your spouse has REPS, you could then use real estate deductions to shelter your physician income. In our case, we could deduct a total of $22,732 from our W2 income and save $6,819.60 on our taxes at a 30% tax rate (that’s been our effective tax rate in the past. I haven’t calculated it yet this year because I don’t want the agita).
Surgeon version: The biggest tax benefits of real estate investing are not available to a full-time physician.
Now that you understand how rental properties make money, you have to run the numbers and ask yourself: would I accept this rate of return on another investment? If the answer is yes, then keeping your property as a rental might make sense. If the answer is no, then you should sell the house—or keep it and recognize that this is an emotional decision, not a financial one. We kept our home in Vermont as a home—not because the numbers work (they don’t, see above)—and we rent it out to keep it at least cash-flow neutral. We have revisited this many times and are happy with our decision.
How to Be a Landlord
If you decide to become an Accidental Landlord, be professional. Even if your property is a beloved family home, it becomes a business as soon as you find a tenant.
You may love your home’s quirky charms, but not every potential renter will. You may need to repaint with neutral colors or replace wonky appliances. You will definitely need to bring the house up to code according to local laws. My in-laws once rented their house to a family who moved in and then refused to pay rent because a lead paint assessment had not been done. Since the house hadn’t changed hands in 50 years, the issue had never come up (there was no lead paint, and the tenants eventually left).
Once you have the house ready, screen your tenants. I once made the mistake of agreeing to rent to the first people who showed interest. They then left graffiti in the basement, started a chimney fire, and moved out before the lease was up. Get first and last months’ rent and a security deposit. I also failed to get last month’s rent from these same tenants. If I had, cleaning up the mess they made would have been a little less frustrating.
Also, you need to keep the books correctly. Rental real estate (and REPS in particular) is one of the most heavily audited areas of personal tax returns. We keep a separate bank account for the rental property, and our tenant deposits rent directly into it. This helps with record-keeping, and it has allowed us to build a cushion for larger expenses. I still do our taxes because our rental expenses and income are still straightforward enough for TurboTax. But if I add another rental property, I will hand this off to a CPA with expertise in high earners and real estate investing.
We live three hours away from our house in Vermont, which is doable in an emergency but not close enough to actually do the work ourselves. When the house needs something, we call the same plumber, electrician, etc., that we used when we lived there. One of our neighbors plows the driveway and mows the lawn (and bills the tenant). At this point, with a wonderful tenant in place, we spend, at most, a few hours a month coordinating the management of the property.
For us, keeping our home as a rental has had many benefits. The biggest is that we can look forward to living in our beloved home again (when all goes according to plan, which of course it will. Go ahead and laugh). We have a photo of the barn and a double rainbow hanging in our living room for inspiration.
Another benefit is that, by learning how to manage our single rental, I have learned enough about real estate investing to be looking for our first, honest-to-goodness rental property. Watch this space for my next article on real estate: “How We Became Intentional Landlords.”
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Have you become an accidental landlord? Is it making you money? Is there anything you would do differently? Comment below!
I DID become an accidental landlord when my children graduated and moved out of the townhome I bought adjacent to their university. The property became occupied by college baseball players and since it is located directly across the street from the baseball field it is a valuable recruiting tool for the head coach – so valuable I bought another townhouse to support the team! Athletes are easy to rent to – yes they are students but one word to the coach cures all tenant problems. (same if you rent to military). I am in the process of paying off the two mortgages, once I do the passive income will be a key to my being able to retire and not have to draw off my investments. (Note: my love of baseball and being a big supporter of this team makes this fun. I never wanted to be a landlord, if I didn’t rent to baseball players I might sell)
I’ve heard some great success stories from people who rent to students: consistent income (because parents co-sign the lease), and if they are athletes they tend to be pretty pulled together. Same for military – I would rent to a military family in a heartbeat. And baseball is just cool 🙂
We leased our first rental property to a group of college students. They destroyed the place! The damage deposit didn’t come close to covering the cost of repairs. I‘m glad we’re no longer in the rental business.
How does one qualify for REPs? Would having 2 rental properties we manage ourselves do it?
750 hours on two rentals? Even if you could manage to spend that much time on those it probably wouldn’t be a good idea just for the tax break. But if you spent A LOT of time looking for other properties and learning about real estate maybe you could justify it early on. But the sooner you get to enough rentals to justify 750 hours the better.
There is no minimum property limit though. It’s at least 750 hours and no more than that doing anything else professionally.
Qualifying for REPS is difficult: 750 hours per year, at least 500 of which must be on your own rental properties, and more than any other activities. So if you work full-time as a physician (or any other job), you won’t be able to convince the IRS that you are a full-time real estate professional. And, unfortunately, education hours and hours spent looking at properties doesn’t count toward the 750: they have to be “material participation” meaning: cleaning, maintenance, collecting rent etc. The “Real Estate CPA Podcast” has done several episodes on REPS status, I highly recommend it.
I didn’t realize education didn’t count at all. That makes it much harder to qualify early on.
It used to be much easier to claim real estate investment losses, including depreciation, against active income regardless of level of “material participation” by the investor. That changed with Sec. 469 of the Tax Reform Act of 1986. REPS status was defined under Sec 469(c)(7)(B) and here we are.
In case you wanted to get a little tax law history with your weekend :).
Interesting. Thanks for sharing your experience. Very educative, especially with regards to REPS and depreciation. Have invested more in stocks via funds and ETFs mainly and indirect real estate via Public & Private REITS as well as Syndications/Crowdfunding. Have always wanted to invest in Direct real Estate (definitely with a Property manager), but having Analysis paralysis unfortunately. Many people have projected the depreciation tax benefits but I’m hearing about the REPS for the first time as a prerequisite to explore the depreciation tax deduction. Is this for real? Are u really not able to benefit from the depreciation tax deduction unless u qualify as REPS? That leaves u with just the cash flow and property appreciation potential. Any comments on this?
Against passive income? Yes. Against your clinical income? No.
It’s a bit of a Catch-22 for most though. In order to qualify for REPS you have to get rid of most of that clinical income you’re trying to use the depreciation deductions against! The work around seems to be one of the following:
1) Spouse does the real estate work
2) Transition out of medicine
The IRS divides all income into two broad categories: active (such as W2 and 1099) and passive (such as rental income, royalties etc). You can deduct losses you incur for your active income job (such as paying your own malpractice insurance) against your active income, and you can deduct losses from your passive activities (such as the mortgage interest on your rental property) against your passive income. You can’t deduct passive losses against active income – unless you are a real estate professional. If you have REPS, then your rental income is considered active and your rental losses can count against active income. Again, check out the “Real Estate CPA” podcast series on REPS status.
And to be clear: REPS is not a pre-requisite to deducting depreciation. Depreciation, like any other passive loss, can be deducted against your passive income. We can’t deduct it because we have already used up all our passive deductions and brought our rental income to zero for tax purposes. We don’t have REPS so we can’t deduct it from our active income.
I mention deduction specifically because it is a big “paper loss”, so you can lower your taxable income without actually spending money. Depreciation is a big factor in the tax savings that come with real estate investing.
Keeping the house makes sense for you because you are going to go back someday. But long distance landlording is a bad idea in many cases. You either have to give up much of the income to pay someone else to keep an eye on the renters or you have to pray and hope your tenant isn’t changing the oil in his Harley in your living room, because its raining outside. I think if someone leaves with no intent of ever going back they are far better off selling the place and buying something local if they want to go into the rental business. Personally I couldn’t even handle renting locally so my opinion is probably jaundiced on the subject. We are building a vacation house right now on the side of a mountain and we don’t even plan to VRBO it when we aren’t using it, because, renters.
Also not a fan of long distance direct investment. Lots of people try it though and a few even do okay with it. The key is high quality management, whether a residential manager on site or a professional company. Some even go so far as to use a turnkey company.
I know a lot of people that do long distance rentals and are doing it well. I have one across the country and one somewhat local I have only seen once. There is literally no difference in the management of both. I’m self managing the farther one and have PM for the closer property. You guys are giving generalizations when you clearly aren’t around people that are actually doing it. I know I’ll get responses about all the people you know who do long distance rentals and all the issues. But you clearly have a very small sample size since most REI I know mostly do long distance rentals are successful and love it.
Glad your experience is different from mine. The key is high quality management.
I agree. We are only a few hours away and know our neighbors well so with the right tenant in place it runs very smoothly, but with the wrong tenant it can be (has been) difficult. I see lots of folks on the real estate investing forums talking about long-distance landlording – often because they live in HCOL areas and want cheaper, cash-flowing properties – but no thanks.
Thanks for the post and I hope this question doesn’t come off as too stupid:
Why is it when people are showing their profit and loss statements like yours in the article and the mortgage is put in on the loss side, it is only the interest payment and the principal is not entered in as well for the mortgage?
It’s never made sense to me because it’s still an expense but I never see the principal included
Thank you!
Not stupid at all! Mortgage interest is deductible under federal tax law, principal is not. It’s that simple.
Mostly because principal isn’t lost. It’s not an expense. It increases your equity.
Nice article, thank you for posting. It is not as bad as some people might initially think from a tax standpoint. The depreciation and any other expenses make it so that rent can be tax free income. Also, many high income people including docs can have other passive income through their businesses in addition to w2 income. Ancillary income, dividends from a surgicenter, practice profits in addition to strict clinical pay, and so on. Another reason not to be employed by a hospital.
Practice profits may be exempt from payroll taxes (if you’re an S corp), but they generally don’t qualify as passive income because you’re involved in running the business.
Interesting article and comments. Would you please recommend a few of your favorite online real estate forums.
I’m sure the author will chime in, but here a few to think about in the meantime. The WCI Forum has a real estate section that can be found here:
https://forum.whitecoatinvestor.com/real-estate-investing
We also have a real estate newsletter list:
https://www.whitecoatinvestor.com/free-monthly-newsletter/
Passive Income MD has a Facebook group with a heavy real estate focus:
https://www.facebook.com/groups/passiveincomedocs/about/
You can also check out BiggerPockets:
https://www.biggerpockets.com/forums
Bigger Pockets is the biggest forum, but can be very rah-rah real estate so take it with a grain of salt. Many different subforums. I have had some questions answered there.
I’m in several RE-oriented facebook groups. As with everything FB, you have to use some caution :). Passive Income MD, Semi-retired MD, Physician Real Estate Investing (not super active) are the most relevant. I’m also in my state’s “real estate investors” group which is not super helpful, mostly just ads by realtors.
Bigger Pockets also has a podcast, which is more “personal growth through real estate” than how-to. There is a spinoff podcast called “Rookie Real Estate Investor” which is more informational. And as I mentioned a few times, the Real Estate CPA (linked in the article).
Thank you both so much.
Do you think if one says they are REPS, that that is likely to trigger an IRS audit?
I have no idea. But since I never claim something on my taxes that is not true, that I cannot prove, and that is not reasonable, I am not particularly concerned about an audit.
Audits are pretty rare no matter what you claim though. I certainly wouldn’t leave a tax deduction I deserve on the table out of fear of an audit.
I don’t know the percentages of people who claim REPS who get audited, but it is does draw the scrutiny of IRS – probably because lots of of people try to claim it with fraudulently or without correct documentation. If you can legitimately claim REPS status and have documented your hours, even in an audit you will be fine. But if I were trying to claim REPS (and I have considered cutting back my clinical hours so I could) I would get a tax professional who is familiar with real estate investing to check out my documentation at least the first year.
I don’t do REPS but from what I understand you do have a higher risk of audit. This is why you will see people say you need to have good documentation of your REPS hours. From what I understand, by checking that REPS box on your taxes makes your taxes set up for automatic manual review by the IRS as opposed to a computer handling your tax return. I remember a CPA mentioning that on a podcast but I don’t know that for sure.
It’s a big enough tax break if I deserved I wouldn’t let a fear of audit keep me from claiming it. If you don’t deserve it, don’t claim it.
Excellent article and perspective! Seriously….. one of the most well written, well explained articles on the subject. I’ve ever seen. Really explains clearly what often is confusing with honest and real world examples. Thoroughly enjoyed this one. Big thank you to Dr. Curtis. Looking forward to more articles from her!!!
Thanks so much for reading, and for the kind words!
i don’t understand why the appreciation of the property is not counting as part of the return on the investment? 400k is a lot of money
It should count. Why wouldn’t it? This article includes a whole paragraph about appreciation.
If the appreciation is counted as part of the ROI, then the numbers cited above should look much different. The value of the appreciation alone, makes it a great investment. I know she states her heirs will be the ones benefitting from the appreciation, but she can do a cash out refinance and get most of it out. I know you cannot always count on appreciation, but in her case, it worked out nicely