As you can imagine, it’s really impossible for me to give recommendations on what you specifically should do, especially when we get into the details of your retirement income. So what I’m going to do today is talk about something that I get asked about often, which is: Should we keep, or sell, our rental real estate in retirement?
In today’s post, I’ll go through the pros and cons of having rental real estate as a way to generate income in retirement. And hopefully, it can help you make an informed decision about what to do. So let’s dive right into it.
Why do people turn to rental real estate? For a lot of people, they are looking for other ways to invest their money than the traditional stock and bond portfolios. To some, the stock market doesn’t make as much sense, since everything is seemingly intangible. Whereas with real estate, you can see it, you can drive by it, you can even live in it, and as the saying goes, “people will always need a place to live.”
So for a lot of people who don’t like the stock market, they turn to real estate instead.
In addition, many people do have traditional stock and bond portfolios, but they are also looking for ways to diversify their portfolios beyond traditional investments and are turning to rental income in retirement.
What is Rental Real Estate Income?
Traditional real estate income comes from buying properties, fixing them up, and renting them out. You buy a property, get a renter to pay you monthly, use that to pay off any mortgage, property taxes, insurance, etc that you may have on the property, and earn some kind of cash flow from the property. In addition, you can also earn appreciation as the home’s value increases.
The Benefits of Real Estate Income
Investors realize many benefits of rental real estate income in retirement including the following.
Non-Stock Market Income
Real estate income is separate from stock market income. If the stock market crashes, it doesn’t mean real estate will too. Real estate operates on its own accord.
Of course, there are some instances when the stock market and real estate go hand in hand, like during the Great Recession during 2007 – 2009.
Having money separate from what’s going on in the market, which can change daily, is a nice change of pace as it may bring a sense of comfort and confidence.
You can Leverage your Investment
You can invest in a home that’s worth much more than you can pay in cash today. So you come up with the typical 20% down payment on a $500,000 home, then you’ll only need to come up with $100,000 while you will have access to use and rent out a $500,000 home.
If you invest in stocks, you typically can only buy as many shares as you have the money to pay for at the time.
So when you invest in real estate, you can leverage your credit score, your down payment, as well as a bank or lender to help you invest in a home worth much more than you put down when you buy the house.
Earn Monthly Income
Assuming you can keep the property occupied, you earn money each month for rent. The rent received can cover the mortgage payment, taxes, insurance, and HOA dues, plus leave you with a little profit. And if you’ve paid off the mortgage, that’ll free up even more cash flow for you.
The point with this isn’t the actual dollar amount coming in, although that’s important. But for a lot of rental real estate investors, it’s the knowledge and comfort knowing that set dollar amount is coming in next month, regardless of what’s on the WSJ or CNBC.
Some Tax Advantages
- When you sell the property, you get to claim the gains as capital gains, which are lower than ordinary income rates.
- Throughout the years, you’ll be able to write off certain expenses + deductions on the property every single year. Some common examples include Interest, Depreciation, Repairs, maintenance, and travel. And there’s one more called the Qualified business Deduction, which allows most landlords to deduct up to 20% of their net rental income, but make sure you qualify for that deduction with your CPA/tax professional.
- Lastly, since we’re talking rental property, if you ever decide you want to sell the property and buy a new one, you can take advantage of a 1031 exchange. If you follow that process to a T (which we can’t get into today), you will sell your current rental property and then buy a new one, without having to pay capital gains on the same of the original home. So this is an amazing way of being able to defer taxes on a rental that has appreciated in value quite a bit. This is a complex transaction and you should absolutely work with an expert in this if you’re interested in going forward with it.
The Downsides
Like all investments, there are downsides too. Understanding what could go wrong can help you decide if it’s a good choice.
Investing in Real Estate Takes a lot of Work + Money
When you buy stocks or bonds, you obviously make sure you buy a diversified portfolio, click a few buttons online, and boom, you own that portfolio now.
Real estate is a lot more complicated. You do your research in terms of cities and states, types of properties, view the properties, place offers, and hopefully, one gets accepted. Then there are inspections, mountains of paperwork, commissions, and then you seal the deal and finally own the property. After that, you have to make sure it’s ready to rent out to someone, then find renters, determine how you’re going to service the rental (are you going to do it or will you hire a property manager), and then get the renter in there so you can finally get some cash flow on the property.
And that’s just to get it started. On an ongoing basis, you have to make sure that the renter is happy, paying their rent, make sure the property is maintained and repaired properly, find new renters when they decide to leave, etc. Which again goes into the point of will you manage this yourself or will you hire someone else to.
For a lot of people close to retirement that I work with, they don’t want the hassle of having to manage this property, after realizing for years how much work this entails.
And they honestly aren’t that keen on a property manager, because that will obviously cut into their cash flow. But beyond that, and maybe more importantly, they are still on the hook for maintenance and repairs on the property. So I’ve worked with a couple of new clients recently and we were making projections on what they should do with their financial plan, and in between meetings they had something happen with their rental property and they had to come up with $20-$30K quite unexpectedly. And so that obviously is going to impact the financial plan that we were creating.
Unfortunately, those types of expenses aren’t unusual, and you should expect to be paying a certain amount to maintenance and repair of whatever property you own.
So in sum, for this point, for a lot of people close to retirement that I work with who are close to retirement, they don’t want to commit the time that a real estate investment requires. They don’t want to cut into their cash flow by having a property manager. And they especially don’t want these $20-$30K repairs popping up every now and then disrupting their retirement.
Real Estate Income is Ordinary Income
Now as I said before, yes, you do get some deductions and tax benefits on your homeownership.
However, after that, the money you receive from your rental is counted as ordinary income, which is higher than capital gains taxes.
On the other hand, with your stock portfolio, if you keep the stocks for over one year, you’ll pay the lower capital gains rate instead of the ordinary income rate.
Long-term capital gains are taxed at either 0%, 15%, or 20%. Whereas ordinary income goes up to 37%.
For a lot of retirees, especially those who are worried about their taxes in retirement, having this extra rental income included in their ordinary income affects other things like the taxes they have to pay on Social Security, their Medicare Part B premiums (which increase the higher your income is), as well as lowering your ability to do Roth conversions at certain tax brackets.
So with rental income taxed as ordinary income, you lose a lot of flexibility in terms of your taxes and you might have to pay higher taxes on other items.
Real Estate isn’t As Liquid As Stock/Bond portfolio
If you have a traditional stock/bond portfolio, and you realize that you need some cash quickly, you could sell your stocks or bonds and get some money into your bank account within a week or so. Of course, you’ll be on the hook for the tax liabilities and you may pay penalties depending on the investment you have and the age you distribute it, but you can get your hands on the cash.
Real estate isn’t nearly as liquid. To get your money you must either sell the house entirely or tap into the equity with a home equity loan or line of credit. Both options take time and effort, plus they’re going to cost you in terms of accessing those features.
Final Thoughts
Investing in real estate has its good and bad sides, just like any other investment. Obviously, the financial component of this decision is really important, but as I’ve said in this episode, I think it’s also really important to consider the lifestyle aspect and how much work this will entail going forward. If it fits into your desired lifestyle, you understand all the pros and cons and you find a property that you’d love to rent out, then this could make a lot of sense.
On the other hand, if you want less hassle and more flexibility in terms of your lifestyle and financial situation in retirement, then I think the traditional stock/bond portfolio would be better for you.
If you’d like to discuss how rental income could affect your lifestyle, taxes, and everything else in retirement, then I’d love to chat with you. You can schedule a no-obligation 30-minute conversation with me at StartMyRetirement.US.