Out of all of the personal financial strategies, one of the most lucrative financial moves is that of purchasing property to lease out to renters. Doing this, if done correctly, can earn you a fantastic return for your investment, as well as earn you a passive income. If you follow some basic guidelines, it could be a viable option for you. Below is a basic real estate investing guide for beginners, with answers to basic questions first time rental investors often ask.
Photo by Skaneateles Suites via Flickr
What is passive income?
Any time you make money, the IRS will have to be involved, so it is important to know their rules and definitions. The IRS states that passive income is income “from trade or business activities in which you do not materially participate”. Basically, if you are not physically active in making your money, then it is passive income.
If you go to work at a job and collect a paycheck, that is active income. One of the most common forms of passive income is rental properties — second popular only after dividend investing. This is not true if renting out properties is your main source of income and how you spend your time, but for those who have a rental property or two in addition to another active job, it is indeed passive income.
What are the different kinds of rental properties?
There is the possibility of buying a commercial building and renting to a business, but the financing for that becomes tricky since you have to go the commercial lending route. Most investors choose to rent residential properties. The absolute most common is to rent out a single family home. This will be the easiest to find a tenant for, and easier to sell later.
You can also purchase duplexes, triplexes, and four-plexes to rent. As long as there are fewer than five units, you can finance them as homes, making that part of the deal much easier.
You can choose to go with low income housing, and although your collected rent will be less, so will all related expenses. Last, but not the final choice by any means, you can buy vacation homes and rent them on a daily or weekly basis. There are many other creative ways to buy and rent buildings, but these choices give you a defined outline of the options.
Do I need to hire a property management company?
Can you handle all the necessary requirements of being a landlord on your own? If you can answer yes to any of the following questions, you may want to consider hiring a property management company:
- Do you live quite a distance from your property or properties?
- Are you prepared to deal with the hassles and possibly messy situations (collecting late rent, fights on the premises, etc.)?
- Are you already overwhelmed by the pending duties and responsibilities?
- Do you need help finding tenants?
- Are you aware of the laws and tax ramifications and ready to do all the recordkeeping these require?
- Are you able to be on call for your tenants at all times?
I’m a huge fan of outsourcing the work to a property management firm — this makes your income more passive, and gets rid of a lot of the headaches associated with rental property.
How do I hire a property management company?
Keep in mind that the company will act on your behalf in many situations, so be sure they will represent you well. Make sure to compare the fees to what they offer in exchange. The cheaper company may not do as much for you and create more expense for you in other ways. Review the details of any contract before signing and make sure you know all fees you must pay as well as all the fees they pay. Do a background check on any company you are seriously considering and check their references.
Personally, I’m all for hiring someone to outsource the dirty work — this allows you to focus on other ways to earn a passive income. Outsourcing allows you to focus on expanding your income, rather than with just keeping what you already have.
What kind of return can I expect?
There is no set answer to that question, but what your tenant is paying will be the key factor. It is smart to pick a rent charge that will cover your mortgage payment, real estate taxes, and any insurance you are required by state law to have on the building. In addition, you should be putting some money into reserves for future repairs and maintenance.
Also be sure to have some funds saved up for tax time. Any income you make on paper will be taxed. When you file your yearly federal tax return (and possibly state) you will file a Schedule E along with it. This form will detail your rental income and expenses. Applicable expenses are mortgage interest, insurance, real estate taxes, repairs and maintenance, the property management fees if you use a company, and a depreciation value for the building.
The difference between your income and these expenses will be your taxable passive income. Any professional tax preparer should be able to help you with this, and their fee is tax deductible as well — one of the reasons you should hire a tax professional. Don’t forget to also factor in the interests on any debt you’ve collected because of debt; all costs will eat away at your overall profit margin.
The information here is not all inclusive, of course, but should help you decide if building a passive income with rental property is a good avenue for you. Make sure to read the guide to investing in fixer-upper rentals. Once you do all the groundwork, building a passive income from rental property is one of the best passive income streams.
Shaun Connell is a full-time personal finance blogger and student living in rural Arkansas. He runs several blogs on investing and finance, including a daily blog on gold, and a weekly blog on wealth management. Shaun firmly believes in dividend investing, debt-free living, and long-term financial planning.