It wasn’t that long ago that most people sold one home before buying another. Owning rental property was reserved for the 1% who had the right connections. Today, times have changed, and a growing number of homeowners are buying a second home and turning the first one into a rental to generate a little extra income and build long-term wealth.
While there are several potential benefits to renting out a first home, there are also drawbacks to think about. In this article, we’ll look at the 5 steps to follow to buy a second home and rent the first, beginning with key benefits of keeping a home as a rental instead of selling to an investor.
- Advantages to renting out a first home include rental income, the potential for positive cash flow, and the tax benefits enjoyed by real estate investors.
- Home prices have historically appreciated in the U.S., making real estate a good choice for people wanting to build wealth over the long term.
- Steps to follow to purchase a second home and rent the first one out include assessing your personal financial situations, understanding the different ways to raise a down payment, and crunching the numbers to understand potential financial returns.
Benefits of renting out your home
Selling your current home and buying another may seem like the path of least resistance. However, there are benefits of using the first home as a rental and buying a second one to live in.
Monthly rent collected from a tenant is used to pay for the mortgage, property taxes and insurance, HOA fees, and repairs. When a rental property has positive cash flow, there’s extra money left over at the end of each period that a landlord can save.
For example, let’s assume a single-family home worth $250,000 could rent for $2,500 per month. According to the 50% Rule, operating expenses such as repairs, insurance, and property taxes take about half of the gross rental income. If the mortgage payment is $900 per month (principal and interest only), the home would have a positive cash flow of $350 per month.
Of course, cash flow isn’t always the same from one month to the next, and could even be negative in some months. Sometimes repair costs are higher or lower than expected, or it can take longer to find qualified renters, and in the meantime bills still have to be paid.
Good ways to figure out what a home could actually rent for include online tools like the Stessa Rent Estimate, Rentometer, the Zillow Rental Manager, or simply by driving around the neighborhood and looking for similar homes available for rent.
Tax laws in the U.S. are friendly to real estate investors. In addition to deducting operating expenses from rental income, a landlord may also be able to deduct travel costs to visit a rental property, and money spent on continuing education and a home office.
A landlord can also use a depreciation deduction to reduce taxable net income. The IRS allows the cost of a residential rental property to be depreciated over a period of 27.5 years. Land can’t be depreciated, so if a home is worth $250,000 and the lot value is $30,000, the annual depreciation expense would be $8,000 per year:
- $250,000 home value – $30,000 lot value = $220,000 cost basis / 27.5 years = $8,000 annual depreciation expense
That depreciation expense is then claimed on a landlord’s tax return as a reduction from any net income an investment property generates. A primary residence can’t be depreciated, but once a first home is turned into a rental property tax benefits and depreciation begin.
Robert Kiyosaki, best-selling author of Rich Dad Poor Dad, once said “Real estate investing, even on a very small scale, remains a tried and true means of building an individual’s cash flow and wealth.” Instead of selling one home and buying another, hanging onto the first home and renting it out may be the first step on the path to financial freedom.
As this chart from the Federal Reserve shows, the median sales price of houses sold has increased by 81% over the last 10 years (Q3 2011 to Q3 2021). So, if home price appreciation follows the same trend, a home worth $250,000 today might have a value of $450,000 ten years from now.
Of course, just as with cash flow, home prices can also go down as well as up. That’s why many real estate investors use a strategy of buying and holding rental property for the long term.
5 steps to buy a second home and rent the first
While there are several benefits to renting the first home out, having two homes is something to think carefully about. Here are 5 basic steps to follow to buy a second home and rent the first one out.
1. Assess your financial situation
Having 2 homes may also mean having 2 mortgages, which can potentially create a financial burden. Before buying a second home, experts suggest paying off high interest debt, creating a livable financial budget, and setting aside enough cash as a rainy day fund for personal emergencies. Speaking with a financial planner or property manager may be two good ways to understand the costs of keeping the first home as a rental.
2. Find money for another down payment
Coming up with the cash for a down payment on a second home may be an obstacle that is easily overcome. A home equity loan or home equity line of credit (HELOC) is a loan used to pull equity out of a first home to fund the down payment of a second home. Other sources for finding money for a down payment may include tapping into a retirement account, doing a cash out refinance, or borrowing from family and friends.
Here is an additional resource for coming up with a down payment.
3. Ensure the first home will make a good rental
Even though the demand for rental property is strong in most markets, some homes generate more financial return than others.
This simple spreadsheet by Roofstock provides an easy way to view the potential financial performance of a given property. You can use it to forecast the potential return of a property. Simply enter some information to view projected key return on investment (ROI) metrics, including cash flow, cash-on-cash return, net operating income, and cap rate.
4. Decide how to manage the rental home
Some of the common tasks of being a landlord and self-managing a rental property include:
- Reading and understanding local and state landlord-tenant laws and federal fair housing laws.
- Getting a home ready to rent by making it attractive to prospective tenants.
- Marketing the home, screening tenants, and signing a lease agreement.
- Collecting the monthly rent, taking care of maintenance and repairs, paying the bills on time, and conducting periodic property inspections.
- Providing proper notice for a rent increase, or evicting a tenant for violating the lease agreement.
Managing a rental property takes a lot of knowledge and work, which is why many investors hire a property manager. Local property managers make it easier to enjoy the benefits of renting the first home without the traditional hassles of being a landlord.
5. Set up a good bookkeeping system
There’s a surprising amount of paperwork involved when even one home is rented out. Items such as lease agreements, rent payment receipts, paid maintenance invoices, and records of landlord-tenant communications all need to be organized and safely stored.
Free rental property financial software from Stessa automates income and expense tracking, making it easier to maximize potential profits and claim even tax deduction that comes with being a real estate investor.
Stessa records transactions securely, auto-categorizes them for easy reporting and tax prep, and offers free cloud-based storage to organize and store real estate documents, receipts, and reports.
Buying a second home and renting the first one out isn’t the best choice for everyone, but the option may certainly be worth considering, with the growing demand for rental property. Before turning a home into a rental, be sure to consider the pros and cons, assess your financial situation, and crunch the numbers to understand the potential return.