rental property: landlord basics

In short

A friend of mine bought a duplex a few years back and told me the hardest part was not the mortgage. It was learning that a rental is a small business with its own books. If you are thinking about renting out a home, start by learning what the property earns and what it costs. Keep rent money apart from your own spending money. Write down every expense, because the tax return will ask for them. Check your local rules on leases and deposits before you hand over a key. Know that the IRS counts rent as income, and that it also lets an owner deduct many costs of running the place. Come back to this page when the numbers feel fuzzy.

The whole of it

What it is

I once watched a retired schoolteacher hand a set of keys to her first tenant, and her hands were shaking a little. She said it felt like lending out a piece of her own life. That is a fair way to see it. A landlord owns a building or a unit and lets another person live there in return for rent. The rent is income. The costs of keeping the place going are expenses. What is left over is the profit, if there is any.

You have probably heard that rental property is a steady way to build wealth. It can be. It can also be a slow drain if the costs are guessed at instead of counted. The difference is almost always in the bookkeeping. Be honest about the work, too. A landlord answers the phone when the water heater fails. A landlord also follows the law about who may rent, how a deposit is handled, and how a tenant may be asked to leave. Those laws come from the state and the town, and they differ from place to place.

How it works

If you are holding a lease for the first time, here is the plain order of events. The owner finds a tenant and screens the application. The two sign a lease, which is a written contract naming the rent, the length of the stay, and who pays for what. The tenant pays a security deposit, which is money held against damage or unpaid rent. Each month the tenant pays rent. The owner pays the mortgage, the property tax, insurance, repairs, and any other cost of the place.

At tax time, the owner reports the rent as income on Schedule E, which is the IRS form for rental income and expenses. The owner subtracts the expenses that the IRS allows. The IRS explains these rules in Publication 527, called Residential Rental Property. One of the allowed items is depreciation. That is a yearly deduction that spreads the cost of the building over a set number of years, and the IRS lists that recovery period for residential rental property in Publication 527. Land is not depreciated, only the building. Depreciation is a paper cost, so the owner does not write a check for it, yet it still lowers the taxable income.

Repairs and improvements are treated differently. Fixing a leaky faucet is a repair, and the owner may deduct it in the year it is paid. Putting on a whole new roof is an improvement, and its cost is usually added to the building and depreciated over time. Mortgage interest, property tax, insurance, and fees paid to a property manager are also expenses. The mortgage payment itself is only partly an expense, because the part that pays down the loan balance is not.

Some owners also face the passive activity rules. These can limit how much of a rental loss a person may use against other income. The IRS describes them in Publication 925. They depend on the owner's income and how involved the owner is, so they deserve a careful read.

The numbers, and where to find yours

A neighbor of mine kept a shoebox of receipts for a whole year and never once added them up. Do not be that neighbor. A few figures matter, and several of them are set by law or by your own town.

The first is the rent you can reasonably charge. Look at what similar homes nearby are asking. Local listings will tell you more than any national average. The second is your total yearly cost. Add the mortgage interest, the property tax, the insurance, the repairs, and any management fee. The third is the depreciation amount. For residential rental property the IRS recovery period is the current figure, which the official source publishes each year, and Publication 527 shows how to figure it.

The security deposit cap, the notice a landlord must give before entering a unit, and the steps for ending a tenancy are all set by state or local law. Your state attorney general or housing agency usually posts a landlord and tenant guide. Search for it by your state name. The limit on how much a deposit may be, if your state has one, will be listed there rather than here.

If you use a loan, the lender sets its own terms. A lender may ask for a larger down payment on a rental than on a home you live in. Ask the lender directly and get the answer in writing. Flood and hazard insurance rules also come from the insurer and the lender, so the policy documents are the place to look.

A worked example

I want to tell you about a woman I will call Denise. She bought a small house and rented it out. She charges $1,500 a month in rent. Over twelve months that is 12 months at $1,500, which is $18,000 in rent for the year.

Her costs for the year come to this. The mortgage interest is $6,200. The property tax is $2,400. The insurance is $1,100. Repairs and upkeep are $1,500. So her cash expenses are $6,200 plus $2,400 plus $1,100 plus $1,500, which is $11,200.

Now the building. Denise paid $140,000 for the property, and the county records say $30,000 of that is land. The building is $140,000 minus $30,000, which is $110,000. Spread over 27.5 years, that is $110,000 divided by 27.5, or $4,000 of depreciation each year.

Add it up. Her total deductions are $11,200 plus $4,000, which is $15,200. Her rent was $18,000. The taxable rental income is $18,000 minus $15,200, which is $2,800.

Look at what happened here. Denise took in real cash. After the $11,200 in cash costs, she kept $18,000 minus $11,200, which is $6,800 before any principal payments on the loan. Yet the tax return shows only $2,800 of income, because depreciation did not cost her a cent. This is how the paper cost helps. The numbers are only an illustration, and her own return would depend on her whole tax situation.

Where it goes wrong

I have seen good people stumble on the same few stones. The first is mixing money. When rent lands in a personal account, the books turn to mush, and a tax preparer cannot sort it out. Open a separate account for the property.

The second is guessing at the costs. A new landlord often counts the mortgage and forgets the vacancy months, the repairs, and the slow wear on the place. A home that sits empty for two months earns no rent for those two months. Plan for that.

The third is skipping the local rules. A landlord must follow the lease law of the state and town. The landlord must hold the deposit as the law directs and must give the proper notice before entering a unit or ending a tenancy. Breaking these rules can cost real money in a dispute. When in doubt, the landlord should read the state guide or ask a licensed attorney.

The fourth is the tax side. An owner who forgets that depreciation lowers the tax basis may be surprised when the property is sold. The IRS can recapture some of that benefit as tax at sale. Publication 527 and Publication 544 cover this. A tax professional can walk through it.

The fifth is the tenant. Rent late once and people are kind. Rent late three times and the owner must act. Clear terms in the lease, applied fairly to everyone, spare both sides a great deal of grief.

Questions to answer before you leave this page

Have you worked out what similar homes near you actually rent for, and does that rent cover your mortgage interest, tax, insurance, and repairs with something left over? Do you know your state and local rules on deposits, entry, and ending a lease, and have you found the official landlord guide for your state? Have you set up a separate account for rent and a simple way to record every expense? Do you understand how the 27.5 year depreciation schedule would apply to the building and not the land, and have you read IRS Publication 527 to check it? Have you asked your lender and your insurer what they require for a rental, and do you have those answers in writing? And finally, have you set aside money for the months when the place sits empty or the furnace quits?