There’s a phenomenon we’re starting to see more of as financial planners working with employees to improve their finances—something that was unheard of just a few years ago: People accidentally becoming landlords. Namely, not intending to buy investment property but ending up in a situation where they can’t sell their home and also can’t afford the mortgage.
The solution that has emerged is an interesting alternative to foreclosure or to taking a steep loss on the sale of your home — moving to lower cost housing and renting out your current home. If you are lucky with this strategy, the rent you receive covers or more than covers the mortgage. Even if you aren’t so lucky, the difference between what you receive in rent and what you pay out in renting your new home still puts you in a better position with your monthly cash flow. And because you are renting, the situation is temporary. When the real estate market improves, you will be able to sell their your home for a much better price, without damaging your credit in the process.
There are considerations of course—no financial decision is without trade offs and the accidental landlord strategy can indeed become a nightmare if you don’t plan effectively. Here are some things to consider before you decide to rent your home and move to lower cost housing:
Make sure converting a home to a rental property is even possible. This first step is a must and many potential landlords have realized the hard way that potential obstacles exist that prevent the conversion of a primary residence to rental property status. Be sure you obtain a copy of the covenants, conditions, and restrictions prior to listing the property for rent as some homeowner associations restrict rental properties. It is also advisable to make sure the mortgage does not have any restrictions against renting the property. In most cases, as long as the original mortgage was intended for use as a primary residence this shouldn’t be an issue. The process of switching your homeowner’s policy to a landlord policy will usually notify the lender of your change in status. While many lenders don’t care, it’s important to know the rules, especially if you haven’t been in the property for at least one year.
The next issue and probably the most critical involves whether or not it is realistically possible for you to assume the role of a landlord. If you are relocating to a different part of the country then hiring a professional property manager may be your best bet. This, of course, will eat into your profits as most property managers will keep between 10-15% of rental income. Sometimes this extra cost can provide much needed peace of mind to know that when the phone rings in the middle of the night someone else is available to respond on your behalf. Of course, since it’s your property you ultimately bear the responsibility of paying for the cost of any repairs and maintenance.
Establish rental criteria in advance. If you find yourself transitioning to the role of accidental landlord, keep in mind that you must manage your investment property like a business. Stay abreast of fair housing requirements and landlord-tenant laws in your area. Too many novice landlords make the mistake of being too trusting upfront. You can prevent this by doing credit checks, calling past landlords or employers, and checking references. Just be sure to comply with local laws and avoid getting yourself in trouble by following Federal Fair Housing Laws (available at hud.gov).
Consider your short and long-term financial plans. From the stories that our financial planners have shared over the years, deciding to convert a primary residence to a rental property can become an extremely emotional experience. Most financial planners agree that it is essential to acknowledge these emotions but strive to make a rational decision based on your short and long-term financial plans. This means doing some serious number crunching prior to taking the plunge into unfamiliar waters. Unfortunately, many amateur landlords make the mistake of jumping into the pool head first without first checking the water level. Accidental landlords run a huge risk of taking on more trouble than it’s worth. Every homeowner knows the exact costs of the mortgage, taxes, and insurance. However, unless you have a spending plan in place, the total costs of maintaining the home may have been a guessing game in the past. Estimated costs of things like lawn maintenance, repairs, and keeping the appliances in working order are needed to really get a good idea of just how much it costs to maintain the home.
There is more to think about than the immediate impact on your cash flow situation. If you eventually plan on selling the house, include extra costs into your budget to prepare the property for the real estate market. It is no secret that your renters may not treat your home with the same TLC that you would devote to the property- there is simply less of an emotional and financial investment at stake. Carpet will need to be cleaned, repairs will be needed, and fresh paint is often essential to ready the house for a good showing to potential buyers. Should your plans remain to hold the property as long as possible, it is also necessary to consider the future costs of an adjustable rate mortgage if you have one. Mortgage interest rates are at historically low levels and although rate hikes haven’t happened as quickly as some economists have predicted, over time mortgage interest rates will have to start climbing back up. Many accidental landlords will find it more difficult to refinance an investment property without having at least 20-25% equity in the home. Interest rates are typically higher for investment properties should you need to refinance down the road, adding another potential headache.
Realistically assess the rental market in your area. The rental market as a whole is in the middle of a bull market, but not every region of the country is benefiting. Market cycles come and go and you may not always be able to rent your property for more than the cost of owning your home or you may not be able to find an affordable place to rent yourself that is appropriate for your needs. Check out rental vacancies in your area by scouring the newspaper, Craigslist ads, and real estate sites such as Realtor.com or Zillow. Take time to understand the ratio of rentals to owner-occupied homes. If there are a majority of owner-occupied homes in your community, consider staying and riding out the storm. Local knowledge is valuable so consider contacting a local realtor to provide you with information specific to the health of your real estate market.
Create a financial safety net. An emergency fund is a must for every household. Most financial planners recommend maintaining at least 3-6 months of basic living expenses in an account separate from your day to day checking. This may not be enough if you have a rental property. Not only would you need to have funds available for household repairs at your new home, you will also need to cover repairs for the investment property. This is a crucial mistake that many novice landlords make that can lead to financial ruin. So it’s advisable to increase your emergency fund to around 6-12 months basic living expenses just in case things don’t go as planned with your renters (or the appliances).
It also helps to calculate the breakeven point to determine how long the property can sit empty without having to dip into your emergency fund. If the rental income is similar to your total cost of maintaining the property, your financial margins will leave very little breathing room should the rental market struggle in your area (or the wrong tenants end up in your home). Prepare for vacancies by factoring in a 10-20% vacancy rate. For example, if you charge rent of $2,000 per month, you should keep at least $2,400 in a separate account ($24,000 x 10%). Other financial protections that you can take include setting up a separate free checking account to track income and expenses. Some landlords go so far as to incorporate the property as an LLC. Whatever solutions you choose, it is important to look at your total financial situation and have a plan in place to prepare for the worst and hope for the best outcome.
Understand the tax implications. Becoming an accidental landlord can be a rewarding alternative for homeowners unable to sell but willing to wait for the real estate market to improve. If you do have equity in your home and convert it to a rental, pay close attention to the capital gain exclusion rules for homeowners if you plan on selling within the next couple of years. As long as you live in the home for two out of the last five years before the home is sold, you qualify for the $250,000 home gain exclusion ($500,000 in the case of a married couple filing jointly). Just give yourself enough time to prepare the house to go on the housing market. If you don’t have equity in the home and are in an upside down mortgage you should keep in mind that the treatment of cancellation of debt income changes once you lose your primary residence status. According to the IRS, debt forgiven on second homes, rental property, business property, credit cards or car loans do not qualify for the tax relief provision. In some cases, however, other tax relief provisions – such as insolvency – may be applicable.