Becoming a landlord primarily to establish rental history

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Becoming a landlord primarily to establish rental history

Steve Ellison
Laurel, MD · Member since 2015 · 7 posts · 0 votes

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.

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Christopher Brainard
Rental Property Investor · Rockwall, TX · Member since 2015 · 891 posts · 701 votes
10y

@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 

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  • John Whittle
    Vendor · Cincinnati, OH · Member since 2014 · 144 posts · 58 votes
    10y

    If you lose money renting it out you are not making any income.  I'm pretty sure the banks want to see you can make money in real estate not lose it.

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  • Steve Ellison
    OP
    Laurel, MD · Member since 2015 · 7 posts · 0 votes
    10y
    Originally posted by @John Whittle:

    If you lose money renting it out you are not making any income.  I'm pretty sure the banks want to see you can make money in real estate not lose it.

    That is an interesting point I hadn't considered or maybe misunderstood. I assumed the additional income would positively impact my DTI and therefore make it easier to qualify for the next mortgage. Clearly I wouldn't qualify for another mortgage now, but how much better is my position next year if I can show new income to cover 75% of the monthly debt? Thanks.

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  • Andy Luick
    Real Estate Investor · atlanta, GA · Member since 2013 · 456 posts · 237 votes
    10y

    Let's talk about the condo and what it is....first.....if it's a two bedroom or bigger, I'd look at doing shared housing...where you stay put and rent the one or two bedrooms separately.  There won't be any management fee as you can do it yourself.  It's just a smarter move for a bunch of reasons....there is ZERO affordable housing in your market..similar to metro Atlanta....and you can get some great renters who come from a variety of situations and backgrounds.  I do this as a business and honestly, a passion of mine to create affordable, flexible housing.  You can maximize income this way....without the risk of tenants trashing the place or filing bankruptcy and squatting for free.

    People are always asking me what kinds of tenants we get....and they always think the worst because of rooming house mentality.  We DON'T do rooming houses EVER...thes folks all sign 6-month leases and go through an extensive background check...we don't care about credit as that's why the majority rent with us.  Recent/current renters include:

    well established attorney who went through a divorce/medical issues - $850/mo;

    IT professional, 15 years with same company - divorcing - $900/mo for bedroom at lake estate;

    IT contract worker with home & family elsewhere - $550/mo - unit was "empty" 2 days from previous renter; This rent is more than previous real estate broker landlord got for entire house!

    Mortgage broker with totally destroyed credit - $900

    Single Mom with SSI plus outside income $850 - has one child

    Insurance Adjuster for Major Firm - 20 years - $750 for room plus garage space.

    Just a small sampling but gives you idea....much of the success in this area comes to truly likely people, having some street smarts and filing a largely untapped need.

    Happy to chat about it sometime.  Our 2nd generation of properties are getting ready to cashout and all are doing pretty well.  We've helped many local homeowners keep their homes out of foreclosure simply by getting a housemate or two....it isn't easy but it works.

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  • Christopher Brainard
    Rental Property Investor · Rockwall, TX · Member since 2015 · 891 posts · 701 votes
    10y

    @Steve Ellison

    Let me first point out that negative cash flow consequences is not my area of expertise, so please take that into account and make sure you verify anything said with a qualified professional. I don't want to steer you in the wrong direction. Hopefully, someone well versed in the Tax Code specifics will get involved. 

    Since the place you are considering renting costs the same amount as the place you currently live, I don't see the benefit in moving. The vacancy and management costs you will incur from renting out the old condo will actually increase your DTI and make it harder for you to get a loan later. I also see no benefit to showing a year of rental income, when that income will be negative. Lenders are looking for safe places to earn interest and I don't think showing them a year of negative cash flow is going to have a positive effect.

    These will be classified as passive losses, so you can't write it off against active income you may personally have. While it is true you can deduct the mortgage interest, management fees, and other expenses, when your passive losses outweigh your income, you end up eating the loss. 

    With all that said, I'm not sure why you're doing what you're doing. If you have the cash and you want to buy a personal residence, it sounds like you have sufficient capital and income to support a new (modest) house and the losses you will incur on the condo.  Once the condo is above water, you can dump it or ride it out until it is paid off. By renting a second place for a period of time, you are just worsening your financial situation by increasing your expenses while not adding anything to the asset column.

    Personally, if you're OK with living where you are now, I would use down payment and go hunting for an investment property that will produce positive cash flow to help offset your existing losses on the condo. You can also try to find some creative solution to bail yourself out from your current condo faster - I have a friend that rents out all the bedrooms in his place and uses that money to pay down the additional principal. 

    -Christopher

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  • Christopher Brainard
    Rental Property Investor · Rockwall, TX · Member since 2015 · 891 posts · 701 votes
    10y
    Originally posted by @Steve Ellison:
    Originally posted by @John Whittle:

    If you lose money renting it out you are not making any income.  I'm pretty sure the banks want to see you can make money in real estate not lose it.

    That is an interesting point I hadn't considered or maybe misunderstood. I assumed the additional income would positively impact my DTI and therefore make it easier to qualify for the next mortgage. Clearly I wouldn't qualify for another mortgage now, but how much better is my position next year if I can show new income to cover 75% of the monthly debt? Thanks.

    DTI means Debt To Income - it is just a fraction - when the debt you have is increased further, that ratio is going to go up, not down. I think you're forgetting that you will have new expenses from renting the new condo, plus the increase in expenses from the old one. The current plan will negatively impact your DTI.

    -Christopher

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  • Steve Ellison
    OP
    Laurel, MD · Member since 2015 · 7 posts · 0 votes
    10y

    @Christopher Brainard, thank you for the detailed reply.  To your first point of verifying with a qualified professional – what type of professional would you suggest?  An attorney with a certain specialty, or someone else?  I’d like to do this but don’t know where to start.

    Let me see if I can explain my rationale for losing more money.  I could sell now, but it would wipe out my ability to make a downpayment for quite some time.  Alternatively, I believe I can sell the condo and break even in five years, due to improvements in the neighborhood and paying down the principal during that time.  The gamble is whether the annual loss on the rental scheme will be mostly covered when I eventually sell the condo.  Any shortfall would be my “investment” to enable me to qualify for a mortgage sooner rather than later, which might be very well worth it for lifestyle improvement.  That may be flawed logic if I’m misunderstanding the rental income piece, which I will try to clarify…

    Let's say I was starting from scratch and wanted to buy a $500k house (numbers are just an example). I could make a $100k downpayment and my income allowed for $2,000 monthly payments, and I'm approved. Great. Now let's say I have the same situation – I can make the $100k downpayment and my income allows for the $2,000 monthly payments – BUT I have this condo hanging over my head. I explain to the lender, "I'm a nice guy, I've never missed a payment, I have excellent credit, and my condo can easily earn $2,000/month in rent." What is the lender's response? My understanding is the lender would say, "$2,000/month, are you sure? Show me some proof!" That is why I'm looking for documented rental income, so I can show that the rental income will offset my new mortgage payments. Yes, my debt would be a little higher, but let's also assume my non-real estate income gradually increases too so DTI is roughly the same. Again I mean "roughly the same" given all sources of income (including this new income) regardless of whether the rental business is profitable on its own.

    Yes, I could probably afford a modest house as opposed to renting someplace else, but I think I end up with the same result.  Or possibly worse if the market crashes again and now I’m stuck with two underwater properties, neither of which are where I’d like to live long-term.  There is also the option of not doing anything, which has been my default “do nothing” strategy for the past several years, but family needs have finally pushed it to the breaking point.

    I really appreciate the feedback and getting different viewpoints.  Trying to answer your questions also really helps me frame my questions better.  Please correct my logic or let me know if I can provide other details.

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  • Elizabeth Colegrove
    Hanford, CA · Member since 2013 · 5k+ posts · 1k+ votes
    10y

    If you are going to move into another house can you just buy it as a personal and only put 5% down as conventional loan. We have bought multiple houses moving just out of our personal. I have found that while I have to shop around brokers, I have had no problem getting them to count the rental income. 

    The real key is how much is your debt to income ratio and how uch can you leverage on your salaries.

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  • Christopher Brainard
    Rental Property Investor · Rockwall, TX · Member since 2015 · 891 posts · 701 votes
    10y

    @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 

    1Reply
  • Steve Ellison
    OP
    Laurel, MD · Member since 2015 · 7 posts · 0 votes
    10y

    @Christopher Brainard, I agree with your points.  This plan does degrade my financial situation by some amount so I need to be careful.  Everything I’ve heard is that I need established rental history on my tax returns, but I should probably talk to some more brokers, it has been a while.  I do think the appreciation will cover the negative cash flow, but then again, my crystal ball got me in this mess in the first place!  Can anyone reading this refer me to a smart investor in the Maryland suburbs of DC to talk about the specific market in more detail?

    @Elizabeth Colegrove, thanks for the response. I was actually reading your blog last night because the title caught my eye – Reluctant Landlord, because that's what I'd be. Don't get me wrong, the investment side of things is attractive, but unfortunately I don't have the risk tolerance at this point in my life. Anyway, if I can make a 20% downpayment, what is the advantage to 5% instead? By making the downpayment out of savings, the monthly expenses are much more in line with my monthly income. Assuming DTI is most important, I'm not sure how savings/downpayment play into it. Also when you say you've had no problem getting them to count rental income, do you mean without rental history on the property(ies)? You also have a track record as a landlord so I wonder if that plays into their decision? I have no experience as a landlord but I would hire a professional management company.

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  • Joe Ellis
    Fort Worth, TX · Member since 2015 · 121 posts · 28 votes
    10y

    I am probably the least qualified person on this forum so take what I say with a grain of salt. Two things stick out to me most about this; one being that everyone starts somewhere, even @Elizabeth Colegrove, she had to have her first rental and she probably didn't really know all that much about it when she started but she picked things up as she went and probably read a lot of information here on BP. The other thing to me is that unless you're going to be moving far out of the area from your condo for a job or something (think more than an hour) I think you should do what @Andy Luick said about "househacking". That way you're in a better position to "train" your tenants and you're getting them to help you with your bills at the same time. 

    Just my two cents. 

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  • Dimitar Yankov
    Great Falls, VA · Member since 2015 · 11 posts · 1 vote
    10y

    I am new into all this, but have been doing some research lately as I am also looking to invest and hold. Thus don't take anything I say for granted. However I have a townhouse that I bought over a year, and it has been rented for 12 months now. That being said, I think if you have 12 month (or so) rental history, your bank will have easier time to count that rental income against your first mortgage. If your condo rent were higher than the mortgage, there would be a "washout" so to speak. If I am not mistaken, a bank would take approximately 75-80% (the rest is for maintenance and etc) of your rental income and count it towards your mortgage expenses, which will help your debt to income ratio.   However, that is not the case. Your rent will be less, so I THINK from bank's perspective, your primary source of income (your salary) will have to cover the new mortgage, plus everything the condo rental income does not cover, plus 20-25% of your rental income (which are maintenance costs the bank will assume you will have while renting the condo).

    Again, I am sure people here will correct me if I am wrong on this. :)

    But to really answer your question, I don't think you MUST have 12 month rental history. Many people buy a primary residence and then decide to buy a larger home (upgrade) while keeping and renting their original home. In that case, I think all you need to show the bank is that you have a fully executed 1-2 (or more) years lease agreement locked in with a tenant, who has given you a non-refundable security deposit (1-2 month worth). Also plan to have 6 months worth of expenses put aside, to cover any vacancies. If you get all this, I think a bank should be able to consider your condo as a rental property. 

    If all above is correct, I agree with the rest of the folks. Stay in your condo, rent out a room (or two), and 18 months from now sign a long term lease so you can secure a loan for your next house. Hope that helps. 

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