Becoming a landlord: the work behind the rent

Rent is one of the most popular ideas in FIRE. Buy a property, find a tenant, and a check arrives every month while the mortgage gets paid down. Many people have reached financial independence this way.

It's also the "passive income" with the most work hiding behind it. A rental is a small business: you're the owner, the customer-service desk and, unless you pay someone, the maintenance crew. This guide is the honest version of what that involves.

This is general education, not advice. It doesn't recommend buying any property, market or loan. Real estate, landlord-tenant law and taxes vary a lot by place and situation. Please talk with a licensed professional, such as a tax professional, attorney or real estate agent, before buying.

Why people choose rentals

There are real reasons rentals show up in so many FIRE stories:

• Income that can rise over time. Rents can go up with local demand, while a fixed-rate mortgage payment doesn't.
• Loan paydown. Each mortgage payment the rent covers builds your equity.
• Something you can see and improve. Some people simply prefer an asset they can visit and fix up.
• Tax rules such as depreciation, which can reduce the taxable part of rental income (more below).

None of that comes free, and some of it can run in reverse.

The real costs

Before you count rent as income, subtract what it takes to earn it. A rental's money usually goes to:

• Mortgage principal and interest.
• Property taxes and insurance (a landlord policy, which differs from a homeowner's policy).
• Repairs and maintenance, from leaky faucets to a new roof or furnace.
• Vacancy: the months between tenants when no rent comes in.
• Turnover: cleaning, painting, advertising and screening when a tenant leaves.
• Property management, if you hire someone to handle it.
• HOA fees, utilities you cover, permits, licenses and legal costs.

What's left after all of that is your cash flow. It can be positive, zero or negative, and it changes from year to year. Big repairs don't arrive on a schedule, so many landlords keep a separate cash reserve for each property.

The work: tenants, repairs and rules

Finding and screening tenants. Advertising, showings, applications, background and credit checks, and leases. Screening has to follow fair housing law. The federal Fair Housing Act prohibits discrimination because of race, color, national origin, religion, sex, familial status or disability (HUD). Many states and cities add more protections.

Repairs and calls. A burst pipe doesn't wait for a convenient time. You either handle it, have a reliable person who will, or pay a manager to coordinate.

Rules. Security deposits, notice periods, habitability standards, evictions and short-term rental rules are mostly set by state and local law and vary a lot. A local attorney or landlord association can explain yours.

Property managers can take most of the day-to-day work off your plate for a fee, which turns a rental closer to genuinely passive. But you still choose and oversee the manager, approve big repairs, and carry the financial risk.

Leverage: the double-edged part

Most rentals are bought with a loan. That's what makes the returns on a down payment look large, and also what makes rentals risky.

A made-up example: you buy a $300,000 property with $75,000 down (25%) and borrow the rest.

• If the value rises 10% to $330,000, your equity grows by $30,000: a 40% gain on your $75,000.
• If the value falls 10% to $270,000, your equity drops by $30,000: a 40% loss.

Those numbers ignore selling costs, which would make the loss bigger. Meanwhile the mortgage payment is due every month whether or not the unit is rented. A long vacancy, a big repair and a local downturn at the same time can turn a rental from an asset into a drain on your savings.

How rental income is taxed

IRS Publication 527 is the IRS's guide to residential rental property. A few basics (IRS Pub 527):

• What counts as rent. Rent is income when you receive it. Advance rent counts in the year you receive it, whatever period it covers. A security deposit you plan to return isn't income; any part you keep becomes income in the year you keep it.
• Expenses. In most cases you can deduct the expenses of renting, such as maintenance, insurance, taxes and mortgage interest.
• Repairs versus improvements. Repairs and maintenance can generally be deducted. Improvements, which better, restore or adapt the property, have to be capitalized and depreciated instead.
• Depreciation. You can't deduct the cost of the building all at once. A residential rental building is generally depreciated over 27.5 years. Land isn't depreciated.
• Where it goes. Rental income and expenses are generally reported on Schedule E (Form 1040).
• Personal use. If a home counts as used as a home for tax purposes (your personal use is more than the greater of 14 days or 10% of the days it's rented at a fair price) and you rent it fewer than 15 days in the year, you generally don't include that rent in income. When you both use and rent a property, special rules apply for splitting expenses (IRS Pub 527).

Passive loss rules

Rental activities are generally treated as passive, even if you work hard at them (IRS Topic 425). Passive losses generally can only offset passive income, and unused losses carry forward.

There's a special allowance: if you actively participate, for example by approving tenants, setting rental terms and approving expenses, and own at least 10%, you may be able to deduct up to $25,000 of rental losses against other income. It's reduced by half of your modified AGI over $100,000 and gone at $150,000 (different rules apply if you're married filing separately) (IRS Pub 925). People who qualify as real estate professionals, which requires more than 750 hours a year and more than half your working time in real property businesses in which you materially participate, are treated differently, and even then their rentals are nonpassive only if they also materially participate in the rental activity (IRS Pub 925).

When you sell

Depreciation lowers your taxes while you own the property, but some of it comes back when you sell. The part of the gain from depreciation on real property (called unrecaptured section 1250 gain) is taxed at a maximum of 25% (IRS Topic 409). Rental income and gains can also be subject to the 3.8% net investment income tax at higher incomes (IRS Topic 559).

These rules have many details. A tax professional who works with landlords is worth it.

Rentals in a FIRE plan

A few things to think through:

• Concentration. One or two properties can be a large share of your net worth, tied to one local market. A broad index fund spreads risk across thousands of companies. See Index investing basics.
• Liquidity. You can't sell a bedroom to pay for a car repair. Selling a property takes time and costs money.
• Your time. If you plan to travel in early retirement, who handles the 2 a.m. call?
• Health insurance. Rental income counts toward the household income used for marketplace premium tax credits. See Health insurance before Medicare.
• Enjoyment. Some people genuinely like the work, and enjoying it may make the ongoing responsibilities easier to carry.

Questions to ask before buying

1. After every cost, including vacancy and a repair reserve, what's the realistic cash flow?
2. Could I cover the mortgage for six months with no rent?
3. Am I going to manage it myself, and for how many years?
4. What do my state and city require of landlords?
5. How would this compare with investing the same down payment in a diversified fund?
6. Does this fit the life I'm trying to build? See What will you retire to?

Next step

Work out how much you'd need to live on investments, then see where rental income might fit.

Try the FIRE number calculator →

For the bigger picture, read What "passive income" really means.