Becoming a landlord primarily to establish rental history

[Steve Ellison]

About six months ago I posted about my situation and got some good advice.  Now that I’m ready to actually do something about it, I’d like to run it by everyone again with a little more detail.

My goal is to buy a new house in 18 months.  I am currently underwater on a condo I bought in 2007.  The cost to sell the condo is approximately the same as a 20% downpayment on a new house.  I can afford to do one of those, but not both.

I think my best move is to rent out my condo ASAP, and move into a temporary rental myself, so I can begin my rental income history ASAP.  And I say ASAP because an appropriate rental for me to move into just became available.

Here are my assumptions:

• The condo will be fairly easy to rent
• The rental income will only cover 75% of my monthly expenses on the condo (mortgage, taxes, HOA fees) but I'm stuck paying those regardless.
• The rent payment for my new place, and the rent I collect, will be the same on a monthly basis (break-even)
• Repair/maintenance costs will be the same whether I live in the condo or rent it out (break-even)
• I will incur new costs for professional management and potential vacancy
• The condo is in a good location and I won’t be underwater in five years
• My front-end DTI is 28% and I have excellent credit with no other debt

Here are my questions:

• From what I’ve read, there is some variation in what lenders require to use rental income to qualify for the next mortgage.  How likely is it that I’ll need at least a year of documented income?  Are there factors within my control or specific to my situation that influence this, or is it purely based on lender policy?
• Generally speaking, what are the tax implications?  Currently I can take the mortgage interest deduction on my primary residence.  In the rental scenario, I will have to pay income tax on the rent, but the mortgage interest deduction is the same right?  Plus I can deduct the management fee I assume.  Can I easily calculate how this affects my bottom line?
• Even though I plan to break-even on the monthly rent, I understand I will be losing money on management fees, potential vacancy, and possibly an increased tax burden.  Is that correct and/or am I missing anything?

Renting out my condo, and moving into a rental, will cost me some money and will be inconvenient.  I am willing to sacrifice convenience – and also some money – if it has a big impact on my ability to qualify for a mortgage in 18 months.  I would really appreciate your feedback about whether I’m missing any risks and whether it’s worth going down this road.  Thank you very much in advance.

[Christopher Brainard]

@Steve Ellison

Well, for better answers about your tax concerns, need to speak with a CPA. I don't know many here, but you could reach out to @Brandon Hall and ask his opinion. I'm fairly sure that your CPA is going to tell you that your rental income is passive income and that you will only be able to write your rental expenses off against that income and eat the losses.

The next piece is you need to speak to a mortgage banker or a lender. @Charlie Fitzgerald does private lending here in Las Vegas and I believe he can provide you with a lender's perspective, as far as how your existing condo would be viewed from a lender's perspective. I've never had any issues getting a lender to account for fair market rental income, but I suspect this may vary from lender to lender and also depend on your experience as a real estate investor. 

The rest is really a mathematical equation. 

If you're going to lose $500 a month, or whatever that negative cash flow is (including CapEx, maintenance, management, taxes, etc) for five years, that would be a $30,000 hit. If that number works for you and you are confident that you will get enough appreciation to get you out of your current hole and cover the monthly losses, you're all set. On a personal note, I am not a fan of speculation and my crystal ball doesn't see quite that far into the future. If your assumptions are based on how fast real estate values have been going up the last couple years, I would caution you that I do not think the current growth trajectory is sustainable. I would speak to a local investor who has a level head and see where they think the real estate market is going. Your threshold for buying that dream home may (or may not) be further on the horizon.

I would also add that I am a firm proponent of avoiding lifestyle improvements that come at the cost of your financial health. If you're dead set on owning a house, find a smoking hot deal that will reward you for purchasing it. I think the current plan is just going to increase your expenses and provide no additional net income, thus degrading your financial situation. It also has much higher risk - what happens if the people you rent to trash the place and you're stuck with the repair bill? 

-Christopher