Corporate Executives Investing in a Rental Property - 3 Common Misconceptions

As a high-earning corporate executive, you may have considered investing in a rental property.

You have the cash flow, you want to diversify away from the typical stock/bond investment portfolio and you want to take advantage of the tax benefits. These are all valid reasons to look into investing in a rental property, but it is important to understand the reality of owning a rental property.

Why Does it Seem Everyone is Investing in Real Estate?

Over the last several years, I’ve noticed an increasing interest from investors with no prior real estate investment experience considering buying a rental property. I believe there are a few reasons that real estate investing is more front and center for new investors these days:

1.) The Idea of Passive Income – Technically, rental income is classified as Passive Activity income in IRS terms, but owning a rental is hard work. I’m not sure the idea that you sit back, relax and collect rent checks is the normal reality.

2.) Low Interest Rates – Yes, 5% yield looked great when rates were so low. To add fuel to the fire, the cost of debt to purchase a rental property was extremely low.

3.) Binging HGTV – Fun to watch and they make it look so easy and fun, but it is not a proxy for reality (like all reality TV, of course.)

4.) Rise of Short-Term Rentals – Demand for short-term rentals increased significantly over the last few years. Short-term rentals tend to have higher rents (and expenses) than long-term rentals.

5.) If they can do it, so can I (FOMO) - Most people know someone that has had success with a rental property or flipping a house. It may sound like it was easy and happened overnight, but it was likely hard work and risky.

3 Common Misconceptions of Owning a Rental Property

Of course, just because you have no experience with real estate investments does not mean you should avoid it. In fact, you should consider it if you have an interest, but it is important to understand the reality of owning a property. Here are 3 common misconceptions:

1. Rental Losses Offset My W-2 Income

Probably Not. This is the most common (and wrong) assumption I hear.

For a corporate executive working at a Fortune 500 company, this is rarely the case. In the eyes of the IRS, you have three types of income: Earned, Investment and Passive Activity. Unfortunately, losses from one type (typically) do not offset taxable income from another. Since your W-2 income is Earned Income and Real Estate Income (or Losses) is Passive Activity Income, you must carry forward Real Estate losses to a year that you generate Real Estate Income (or sell the property.)

But, of course there is an exception! If you (or your spouse) qualifies as a Real Estate Professional, the IRS allows you to deduct real estate losses from your earned income.

To qualify you must prove that you (or your spouse) “materially participated” in the rental activity by working at least 750 hours in real estate for that tax year. This is not the case for most corporate professionals working a full-time job (or their spouses) and the IRS knows it.

I’ve seen people get aggressive with their facts when preparing their tax return in order to qualify. It may work for a few years, but eventually you will have questions to answer and probably some back taxes and penalties to pay.

2. Rentals Generate Tax Free Income

Not really.

Real estate properties allow you to defer taxes, but you will pay taxes eventually. Good thing is that the losses accumulated each year (again, which you can’t use to offset earned income) will carryover and offset the capital gains and depreciation recapture taxes from the eventual sale of the property.

One of the reasons real estate is so tax efficient is due to the 1031 Exchange rule. A 1031 exchange allows you to defer the capital gains and depreciation recapture taxes by using proceeds from the sale of a rental property to purchase another rental property. But again, you are deferring taxes to a later date because the cost basis follows you (creepy). A good thing but not "tax free good."

3. Rentals Generate a Higher Yield than the Stock Market

It depends.

The Real Estate market is vast and offers investments with varying risk and return profiles. While the real estate market(s) may be less efficient than the stock market, you are likely earning a yield in line with the risk you are taking on.

Of course, the most important factors in predicting yield are Price, Location and Expenses. If you are knowledgeable of a market – such as a your local market or one related to your profession – and have access to more information and opportunities than other investors you may be able to achieve a higher yield in exchange for less risk - a.k.a. a great investment.

Finally, an important factor in keeping expenses down is the decision to hire a property manager. The property manager fees (and other expenses) can make your yield look like a T-Bill. Some managers do a great job for a fair price, others not so much.

Mark Chisenhall, CFA is the founder of Taurus Financial Planning, a wealth management firm specializing in helping high earning corporate professionals reduce taxes, optimize investments and accelerate retirement. If you are interested in learning more about the firm, you can schedule an introductory call here.

This publication is for informational purposes only and is not intended as tax, accounting or legal advice or as an offer or solicitation of an offer to buy or sell or as an endorsement of any company security fund or other securities or non securities offering. This publication should not be relied upon as the sole factor in an investment making decision. Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any recommendations made by the Author, in the future, will be profitable or equal the performance noted in this publication.