Buying a house is a way to put down roots in a particular place, which really runs counter to being a digital nomad. So, for those who are constantly on the move, is rental real estate a good idea? What about the risk? The old saying, “It’s safe as houses,” indicates that investing in real estate is the safest way to enjoy long-term growth of your investment. Many people who invested at the height of the sub-prime mortgage bubble might disagree. There is a real risk to investing in rental real estate. However, it remains a really attractive option for growing your nest egg. This week, we’re going to break down some of the basics of investing in real estate, tax considerations, and some special considerations for digital nomads.
So, you buy a home and rent it out to tenants. You are responsible for the mortgage, taxes, insurance, and any maintenance issues. The rest is yours! Easy enough! Well, there are a few things to consider.
Finding a Home
Homes are relatively illiquid assets. You can’t log in to your Schwab or Vanguard account and sell off your investment with a few clicks of a mouse. With this in mind, do some research and figure out where to buy. Remember that this is an investment, so think cash flows. When you’re buying your forever home, you may want to splurge a little bit on things that YOU want. This probably isn’t a good idea for a rental property. Anything that brings you an additional expense should be justified- that is, it allows you to charge additional rent. Think about areas that are likely to have strong demand for rental real estate regardless of the economy. Universities and military bases usually produce a steady flow of individuals looking for a home to rent.
It always pains me when I see young people who can pay their bills disregard them because they think it doesn’t matter if payments are late. The truth is that your credit is going to be front and center on the mind of lenders when you are applying for financing for your rental property. Make sure your credit is where it needs to be. If it’s not- take steps to right the ship.
Most of the rentals that I purchased required a 25% down payment. This can be a substantial sum for many young buyers- especially digital nomads. If you see rental real estate in your future, begin growing your nest egg so you have adequate funds for a down payment. Securing additional financing usually comes at a premium (paying a higher rate). Bear in mind that most lenders want to see six months of payments in reserve. This is in addition to any closing costs and prepaid expenses associated with purchasing the home. Depending on where you are buying, it may be customary to ask the seller to cover these expenses- freeing up additional funds for you to apply to your down payment. Again, do your due diligence here.
Taxes *this applies to Americans- check w/ your local tax authorities
Passive income is such an important part of being able to retire (hopefully early). It is especially important if you are a digital nomad and have a job, such as online teaching, that lacks stability. Bear in mind that any income you earn from rental real estate is taxable. As digital nomad expats, many of us get to enjoy the foreign earned income exclusions (FEIE). However, this applies only to earned income. Income from rentals is a form of investment income that cannot be excluded. So, it is taxable. However, there are many tools that can help minimize- or even eliminate the tax liability associated with rental income.
Mortgage Interest, Taxes, Insurance, & Repairs
This is where accountants utilize the matching principle. Any expense incurred in the process of producing assessable income is deductible. So, mortgage interest and property taxes are deductible. These may also be deductible on your primary residence (depending on your tax situation). However, rental real estate allows other expenses to be deducted. This includes any insurance that you pay on the property, homeowner’s association dues, and any repairs that you make. If you have leaky faucet in your own home, the plumber is an expense that you have to absorb. If it’s your rental real property, you get to write that off.
This is perhaps one of the biggest benefits to owning rental real estate. Your home is an asset which has a useful life. Most assets decline in value over their useful life and are expensed accordingly. So, what does that mean? You get to write part of the value of your home off your taxes (as an expense that you never paid) throughout the period of your home’s useful life. The IRS uses the Modified Accelerated Cost Recovery System (MACRS) to determine how much of the value of your home you can expense. Rental real estate is considered to have a useful life of 27.5 years. Let’s look at an example:
Purchase price of rental unit = $130,000
Value of land = $30,000 (land cannot be depreciated)
Value of the home = $100,000
$100,000 / 27.5 years = $3,636 per year in depreciation expense
There is a downside to the depreciation expense. You need to recapture the depreciation that you claim. Internal Revenue Code is clear here- it is claimed or allowable depreciation. So, even if you don’t receive the benefit of the depreciation, you need to recapture it. Let’s look at what that means. Your asset (rental property) has a cost basis. In the example above, it is $130,000 (including land). Imagine you own the home for ten years and claim $36,363 in depreciation. Your cost basis is reduced by this amount. The new cost basis in your home is $93,637. This will impact the capital gains that you have to pay in the event of a sale.
Capital gain = Sale Price – Cost Basis – Transaction Costs
Recaptured depreciation may incur a higher rate of taxation than normal capital gains as well.
There is a way to defer this capital gain. If you roll the proceeds of the sale of your rental real estate into a new (more expensive) rental property, you can take an adjusted cost basis in this property- thereby deferring your gain until you sell that new property. This is called a 1031 exchange (or like-kind exchange). Check with a title company or a tax attorney for assistance as there are guidelines pertaining to how and when funds can be used.
Considerations for Digital Nomads
The biggest consideration is that you may be on the other side of the world. How in the world are you going to be able to manage the property? Truth be told, unless you have a very special situation, you won’t be able to manage it on your own. You need to decide if you want to have a property manager or if you would prefer to have a friend or family member manage the property for you. Of course, there are costs associated with having a property manager. They usually charge a leasing fee and take a percentage of the monthly rent. I have always had a property manager. The fees may vary significantly. In Georgia, the property management company I used took a leasing fee that ranged between $100-200 per month. In addition, they took 10% of the monthly rent. In Florida, the leasing fee was equal to 75% of the first month’s rent for the same company. When you add the regular cut of 15% of monthly rent in FL, the first month’s check wasn’t all that much. Consider these costs when you are researching where you want to buy.
Benefits of having a property manager are many. If you are overseas, they handle the leasing, rent collection, and repairs for you. This makes the income truly passive for you. You also get a nice document at the end of the year that makes your tax preparation easy to handle. Property management companies vary in terms of cost and service as much as properties vary in what they offer a prospective buyer. Find a company that suits your needs.
If you are considering investing in off-shore real estate, check out this great blog from The Entrust Group on doing your due diligence as an off-shore real estate investor.
Being thousands of miles away from an investment as big as a home is a big leap to take and can be a huge source of stress. It can also help to build substantial wealth. When you are considering your own financial future, think of the potential of rental real estate as way to solidify your financial future.