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Landlords Pay No Taxes?
I’ve been writing a bit about technology startups lately. Let me flip back to the other end of the business spectrum — landlording — to share an interesting conversation I overheard recently:
Landlord One: How many landlords pay taxes on their rental income? It’s like no one. Everyone runs at a loss.
Landlord Two: Oh, no, my properties are very lucrative. I pay my taxes.
Landlord One: Then you’re doing it wrong. All of my properties are in separate trusts. My accountant shows me that each trust loses money every year, and if it were any other way, I’d get another accountant.
Let me explain what Landlord One means. Here’s what the income statement for one of his trusts probably looks like (I haven’t seen it; I have no connection to Landlord One):
The “depreciation” in the table above results from the following accounting practice: take the price you paid for the building, say, $250,000, divide that by 27.5 years, divide that by 12 months for our example, and the number you get, $757.58 per month, is how much you can deduct from your income for tax purposes. Repeat that for other “big purchases,” like a new driveway, a new roof, and new furnaces, and you can quickly get up to $1,200 per month in depreciation deductions.
Landlord One is thinking, “This is super. The IRS thinks I spent $1,200 per month, but I didn’t! Haha! That was cash going straight into my pocket!” Furthermore, the $200 per month loss can offset income from other sources, especially a salaried job, per the passive activity loss rule exception. (Sidebar: only the IRS would name a rule “passive activity”.)
The IRS can step in and say, “Your business has been losing money for too many years. We think it’s really a hobby. You can’t use your $200 per month loss to offset income from your job anymore.” As far as I know, this can happen for any business, but I’ve never heard of it happening for rental real estate.
Even if your business is never declared a hobby, there is still one big problem with Landlord One’s line of thinking:
Depreciation is a real expense.
It represents the ongoing capital you must invest in order for your business to remain in operation. Think about a house that hasn’t had any work done on its driveway, roof, or furnaces for 27.5 years. Would you want to rent an apartment there?
Think about it another way, as a function of purchase price. I wrote about this before, where I gave a similar example. If your depreciation is continually outstripping your income, it means you paid too much for your property.
Either way, your “fake” depreciation expense is going to come back around as a real reinvestment of capital. Either the roof will blow off and you’ll need to put a new one back on, making your entire year “cash flow negative,” or you’ll have to sell the degraded property at a steep discount to what the price would have been if it had been maintained.
So go ahead and claim those losses, Landlord One. They’re real.
A Month in the Life of a Landlord
In Massachusetts, residential rentals are highly regulated. To do it by the book, you need to have a non-discriminatory tenant finding procedure, an apartment that meets requirements for the sanitary code, no lead-based hazards, and a rental agreement that could stop bullets. You also need to have a nice place, an attractive ad, a responsive person on your end of the phone, and someone to show the place to prospectives. So how much does it all cost?
I recently tried to answer this question by tracking my time as I went through the whole process myself, from explaining the move-out procedure to the current tenants to welcoming the new tenants and opening their security deposit account. The goal was to rent a three bedroom apartment. The rent was at or below market. The advertising started off-season in February. Here’s what it looked like (these are scanned excerpts from the paper log that I kept):
The total time from February 2 through when I opened the new security deposit account on February 26 was 47.3 person-hrs. Basically, add up the times in red, and if I had to have someone helping me (like on February 6) count that time twice.
- February 2:
- First of all, note that regular landlording stuff is not separated out, like when I dealt with a 3am emergency call about a neighborhood disturbance. That almost never happens, but I left it in for color.
- Craigslist is great. It saves your ad from the last time you posted, so it took me about 18 minutes to check it over, tweak it, and get it listed again.
- Nothing interrupts your day like calls about an apartment. The average call lasts just a few minutes while I collect pre-screening info. You can see that on the day I posted my attractive ad, I started getting calls immediately, from 9:30 to 10:12, and so on, and again on the 4th, the 5th, and so on. The true cost is more than just the phone time because it interrupts what you were otherwise doing.
- February 4:
- It took me about two and a half hours to get my lease agreement up-to-date. The changes I made were things I had queued up from my reading and my learning best practices from my property owners association, and also from some changes in the law.
- Starting this day, it took me about five hours spread out over several days to repair some wall damage to the otherwise pristine apartment. Don’t let tenants put stickers on the walls.
- February 6: The final deleading inspection for this unit and one other (the work for which was completed before tracking began) took two people nearly four hours. All totaled the deleading cost me well over the $1,500 tax credit for this unit.
- February 12: Starting here, I spent about three hours reviewing tenant applications. (I also experimented with a wireless doorbell that I ended up returning.)
- February 16: Here’s when I made the decision to rent to one set of prospectives. Note that I also had to buy a change of locks and make a repair to the rear exterior door jamb.
- February 20: Having made the decision to rent, I went on landlord vacation. I dealt with about 18 minutes of calls while “off duty.”
- February 25: I spent almost three hours split between the previous tenants (itemizing their security deposit deductions) and the new tenants (explaining the rental agreement).
- February 26: My bank was terrible that day. It took me almost two hours to see someone and then set up a new security deposit account.
- February 27 and 28: I guess I didn’t write down what I did here. Just another 1.6 hours somewhere…
Fortunately, any given apartment isn’t likely to be vacant in a month, but when it is, you can expect to pay quite a lot to do it “by the book.” If I paid an employee to do all this at $22/hr, that’s $1,040, or by orders of magnitude, a month’s rent. So that’s where a property manager’s fee goes. Plus I had the added non-recurring expense of a deleading, plus the lost income.
So when you do get a tenant, be good to them and hope they stay a while.
Who gets to choose their customers?
Well, pretty much every service or knowledge business. Let’s look at landlording, manufacturing, and small business consulting as three examples.
Landlording is one of those embarrassingly interpersonal businesses: “Hello? I’m here to unclog your toilet.” “I’m not dressed! Just take care of it please!” Even with toilets that flush buckets of golf balls and other modern housing marvels, you’re trusting a breakable piece of a very expensive asset to a relative stranger. If they stop paying you or start causing problems, it’s very expensive and time consuming to end the relationship. After all, their basic home and shelter are at stake, so third party mediation (e.g., the courts) usually comes into play.
Different troubles await manufacturers, especially those offering fixed-price contracts. If you’re going to accept a job to make 100 of a new kind of widget, you want to feel warm and fuzzy about having the right drawings and knowing that they’re not going to change quantities or specifications once you start the run. In this case, you have to negotiate for up-charges, or offer concessions, or arrange a (hopefully) peaceful walk-away.
And for small business consulting, where you might feel you want every client you can get, you really want your customers to sing your praises and give you word-of-mouth traffic and their own repeat business. You definitely don’t want to try to please a habitual grouser, or to keep quoting a lookie-lou, or to otherwise commit to helping someone forever dissatisfied.
So What Can be Done?
Good landlords have a rigorous screening process (never discriminatory, always based on economics!) and so might lots of other businesses, except I very rarely see open communication about customer screening. As a potential customer for a lot of different services, sometimes I wish I could get feedback:
Dear Prospective Client:
You have had us requote variations of the same thing for the last three months. We’ll be happy to continue working with you after a one month hiatus, or you can sign and return one of our quotes and we’ll get started right away.
But when does that ever happen?
The best general advice that I can give is that sometimes it’s okay to say no to a prospect. As soon as you do, you’ll be thinking about the next prospect. Much better than wishing you weren’t locked into a bad situation.