Why do you own rental properties?

Jerry has been my loyal client for over 10 years. He started with one rental house and slowly brought it to six. True, this is not very impressive, but you and I know a lot of people like Jerry, holding very small rental portfolios. They are generally content with their modest cash flow, some equity and, of course, tax deductions.

Ah, the famous landlord tax deductions! Aren’t they nice? Up to a point, as Jerry recently discovered. See – something else was slowly but steadily happening during these years: Jerry’s salary kept going up. $80k, then $90k, then $100k, and by 2014 he was making close to $140k. Suddenly, his 2014 tax return shows that he owes more than $2,000 to the IRS. Why?!? Every year until now, Jerry had been getting a decent refund from the IRS, and now he has to write them a check? Something isn’t right!

No, it isn’t. Jerry is finally hammered by what we accountants call PAL – passive activity loss limitations. (Yes, accountants have weird pals.) These pesky IRS rules are a topic of a different blog post, but the short story is: once your income goes above $100k, your ability to deduct rental losses gets crippled. And when you reach $150k, as Jerry is about to accomplish next year, you lose the deduction entirely. Ouch.

As soon as I explained this predicament to Jerry, he bitterly exclaimed – then I’m going to get rid of these suckers! These suckers?!? Jerry, maybe you need to chill a little and re-examine why you bought “these suckers” in the first place.

The three reasons to own investment properties

As investors, we sometimes tend to focus on one thing and lose perspective of the big picture. There are three fundamental reasons to own rental properties.

1. Cash flow. Your monthly rent should be more than your total monthly costs: mortgage payment, property taxes, insurance, repairs, and overhead.
2. Appreciation or equity build-up. Despite market ups and downs, the value of the property should gradually go up with time. So, when it’s time to sell, you can sell it for much more than what you once paid for it.
3. Tax benefits. Phantom losses is the biggest one. Your property may cash-flow in reality, but on your tax return it may show losses and reduce your overall income tax, thanks to depreciation.

Ideally, you want to have all three, but sometimes it’s not the case. Investors often debate which is more important to have: cash flow or appreciation. One thing, however, is not debatable: tax benefits is the least important of the three reasons and, in fact, is optional. If you have it – it’s an icing on the cake. If you don’t – then it means that you have more important benefits: cash flow, appreciation, or preferably both.

Another way to phrase the same principle: you should never buy an investment property for tax benefits alone, and you should never sell an investment property only because it fails to generate tax losses.

You should never buy an investment property for tax benefits alone, and you should never sell an investment property only because it fails to generate tax losses.

So, is it time to sell?

While I understand Jerry’s frustration with suddenly losing his tax deduction due to the nasty IRS rules, he overreacted when he decided to sell on an impulse. Or did he?

Yes, I am suggesting that Jerry may actually be better off selling his properties that he passionately referred to as “suckers.” His choice of words may be telling. What if his properties are, in fact, duds?

To decide the case, we needed to step back and look at the other two factors:

• Do these properties provide Jerry with ongoing cash flow? and
• Did these properties appreciate substantially since he bought them?

As is typical in life, Jerry had mixed results. Some of his properties cash flowed better than others, and some appreciated more than others. However, all properties except one (his very first purchase, by the way) had at least one thing going strongly for them. That first one had mostly sentimental value. And sentimental value is a wrong reason to hold onto an investment. Jerry put it on the market, and rightly so.

When to stay away

Speaking of the wrong reasons to buy and keep rental properties, here’re a few more:

• All my buddies seem to be doing well with rentals. Hint: you do not know for sure, and your mileage may vary.
• It was so cheap, I could not pass it! See my recent blog post as to why such thinking is hazardous to your success.
• They said at the seminar that this is how you get rich. True, but only if you own the right properties – those that cash flow and appreciate. The wrong properties is how you get foreclosed and bankrupt.
• I enjoy fixing things around the house, and with rentals I will always have things to fix. You got that one right. Go get a job in construction or property management.
• They say it’s a peoples business, and I love people. Umm, not really. This is business first, people second. But there is a shortage of good teachers and social workers out there.
• My favorite: I just lost my job and have no savings, so I need to make money in real estate quickly. Stop! You cannot pay your own rent by buying rental properties. At least not right away. Learn how to wholesale properties instead.

What about you?

What are your reasons to hold to your rentals? When was the last time you evaluated your portfolio? Maybe it is time to purge some and get better ones?

And if sentimental attachment or some other sabotaging issues are challenging to deal with, or if you are ready to revisit your overall investment strategy and get to the next level – we are here to help.

“We” would be myself and real estate attorney Steven Newsom. Together, we run an innovative REI Pro Guard program. It may boost your success in this tough but rewarding business. Jerry is signing up.