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Welcome to NerdWallet’s Smart Money podcast, where we answer your real-world money questions.
This week’s episode starts with testing out ChatGPT’s ability to give financial advice.
Then we pivot to this week’s money question from Daniel, who wrote us this email: “Hey, guys. First, I love the podcast. Thanks for all the great insights into better ways to work with my money. I'm a white-collar professional in my mid-30s and trying to think of ways to increase my income outside of my job. I'm thinking about getting a second property and using it for rental income, whether for long-term or short-term rentals. My question is, what are some factors I should consider before going down this path? I know I need to consider mortgage, down payment, insurance and upkeep costs, but what else should I know or think about? Would I be better off just sticking with the stock market or other forms of investing? Thanks, Daniel.”
Check out this episode on any of these platforms:
Our take on using AI for financial advice
When ChatGPT, the chat bot from OpenAI, was released to the public in 2022, people scrambled to see what it could do. Turns out, quite a lot. ChatGPT can write a love story in the style of Shakespeare, offer rudimentary therapy and almost everything in between.
AI engines can also generate personal finance articles. The news and advice website CNET used its own AI tool to write content about basic financial concepts like compound interest and cashing checks — but it then had to issue corrections to some of those articles to address mistakes ranging from computation errors to plagiarism.
After testing out ChatGPT for themselves, a few of our Nerds offered this assessment: ChatGPT can give you general financial information, but it won’t always be accurate. And it cannot replace a real financial advisor who can understand the nuances of your unique financial situation, or a Nerd who knows what questions and additional info to surface to you.
Our take on investment properties
Rental properties can generate a steady stream of passive income, but as with most investments, they come with inherent risk and upfront costs. For example, you might want to hire a property manager or purchase umbrella insurance for coverage beyond your homeowner’s policy. These expenses are, of course, on top of the cost of the property itself.
There are plenty of ways to lose money on rental properties, too. Vacancies, tenants who don’t pay rent and home repairs can eat into your profits.
Know what you’re getting into. Rental real estate can be a good investment, but the returns depend on many factors and how hands-on you want to be.
Vacancies are expensive. Make sure you have cash reserves or a line of credit if your rental property is empty for a few months.
Consider alternatives. If you decide being a landlord isn’t for you, there are other ways to invest in rental real estate, including real estate investment trusts.
More about investment properties on NerdWallet:
Liz Weston: As artificial intelligence takes over the world, where do the Nerds and financial planners fit in? We start the conversation with our robot overlords in this episode.
Sean Pyles: Welcome to the NerdWallet Smart Money podcast, where you send us your money questions and we answer them with the help of our genius Nerds. I'm Sean Pyles.
Liz Weston: And I'm Liz Weston. This episode, regular Smart Money host Sara Rathner and I answer a listener's money question about how to make money from investment properties, including whether this is really a way to earn passive income.
Sean Pyles: But first, Liz and I are joined by other Smart Money regular Anna Helhoski to see if we are all out of jobs as AI, specifically one called ChatGPT, consumes the world. Welcome back to the pod, Anna.
Anna Helhoski: Thanks for having me, Sean and Liz, and yeah, let's hope not.
Sean Pyles: Yeah, well, time will tell. So Anna, AI and ChatGPT have been in the news a lot lately, especially when it comes to giving personal finance advice. So for those who may not be as familiar, can you explain what ChatGPT is and why people should care about it?
Anna Helhoski: ChatGPT is an artificial intelligence chat bot search from the company OpenAI. The company has other AI tools, like DALL-E 2, which creates incredible and very disturbing, bizarre images based on your inputs.
Sean Pyles: Yeah, it has a tendency to add extra fingers and teeth ...
Anna Helhoski: Yeah.
Sean Pyles: … to images of people, very disturbing.
Anna Helhoski: Very frightening faces. It's all around very scary stuff, but fun to play with. But ChatGPT launched for the public in November 2022 and has been making waves ever since.
It's an interactive chat bot programmed by machine learning. That means it scours the internet and pulls from language patterns and information to produce all sorts of things. It's incredibly versatile. It can chat, explain basic concepts, compose letters and emails, write everything from scripts to jokes to computer code, poetry, song lyrics and college essays, and it all appears to be practically human. It can even modify answers based on follow-up questions and hints.
Liz Weston: Are there concerns about how this technology is being used or misused?
Anna Helhoski: It's fascinating technology, but there are concerns about the implications it and other AI could have for workers, writers and creators, as well as its use in schools. Recently, ChatGPT even passed an MBA exam at the Wharton business school, which has frightened a lot of people and might say some things about MBA programs. And it's also going to be used by Buzzfeed to create content and quizzes. The news ended up sending Buzzfeed stock soaring, so people are pretty excited about the potential here.
Sean Pyles: Well, my main question on that is can an AI sort me into the right house in Hogwarts? I'm just not confident that it can do that, and part of it is because AI software isn't infallible. Recently the website CNET got into some pretty hot water when it came out that some of their personal finance content was written by an AI and their articles had some pretty glaring inaccuracies.
Anna Helhoski: That's right, Sean, and that's true of all AI software platforms. They do have their limitations. For example, ChatGPT's knowledge base is limited. It'll also refuse any inappropriate requests as a safety feature to avoid offensive outputs.
Right now ChatGPT is free, but it's not always available, so sometimes you go on the website, you try and load it up and it says it's busy. Too many people are on it. The company is planning to offer a paid version in the future and there's already a wait list for it.
Liz Weston: Wow. OK. Well, let's see how good this ChatGPT really is. And I believe you have the platform pulled up. So how about we ask it some common questions that we get at NerdWallet and see what it says. And just a note that ChatGPT doesn't actually talk. Sean used some text-to-speech software to give it that wonderful robot voice.
Anna Helhoski: OK, I am typing into ChatGPT, "Am I able to buy a house?"
ChatGPT: Buying a house is a significant financial decision and one that should be made with care and consideration. To determine if you are able to buy a house, there are several factors to consider, including your credit score, income, debt-to-income ratio and savings.
Your credit score is an important factor in determining your ability to secure a mortgage loan. A good credit score can help you qualify for a better interest rate, which can save you thousands of dollars over the life of the loan. You will need to demonstrate that you have a stable and sufficient income to make your mortgage payments. Lenders will typically look at your income and debts to determine your debt-to-income ratio.
Sean Pyles: All right, that is a pretty decent answer. And thinking of this software as a service that essentially scrapes and synthesizes content across the internet, I think that we can say it does a pretty decent job at doing that. There aren't any huge inaccuracies. But it doesn't really give the full picture, right?
Liz Weston: Yeah, it seems really general and it almost seems like it raises more questions than it actually answers.
Sean Pyles: Yeah. But for a starting off point to figure out whether you can buy a house, it's not totally wrong. So that's something at least.
Liz Weston: Yeah.
Sean Pyles: OK. Well, Anna, let's throw another question at it and maybe do it in the voice of NerdWallet and see what it spits out.
Anna Helhoski: All right, so I'm typing, "Write financial advice for the question ‘What's the best way to get out of debt?’ in the style of NerdWallet."
ChatGPT: NerdWallet suggests taking the following steps to get out of debt. One, create a budget. Understand your income and expenses to identify areas where you can cut back on spending, such as dining out or subscriptions, and redirect that money towards paying off debt.
Two, prioritize high interest debt. Focus on paying off high interest debt, such as credit card balances, first as they accrue interest faster and cost more in the long run.
Three, consider debt consolidation. If you have multiple high-interest debts, consider consolidating them into one loan with a lower interest rate. This can simplify your payments and save you money on interest.
Four, make more than the minimum payment. Pay more than the minimum payment each month to reduce the principal faster and pay off the debt quicker.
Five, seek professional help. If you are struggling to get out of debt, consider seeking the help of a financial advisor or a credit counselor. They can help you develop a plan to get out of debt and provide guidance on budgeting and managing your finances.
Sean Pyles: Again, this answer is pretty clear and efficient, but I find it lacking a human quality. For example, the emphasis on paying off high-interest debt versus paying off the smallest balance: That's what we often talk about as the debt avalanche versus debt snowball methods. I think focusing on absolute efficiency versus building on positive reinforcement is something that we talk a lot about in figuring out what's the best way for you personally to pay off debt, and this answer doesn't really get into that.
Liz Weston: Well, I like that it recommends a credit counselor, but we would also recommend talking to a bankruptcy attorney because credit counselors try to keep you out of bankruptcy. Bankruptcy attorneys know the advantages. You really need to have both perspectives to understand what to do when you're overwhelmed by your debt. And again, this is very general. It's not a bad start, but people need more information.
Sean Pyles: Yeah. One thing that strikes me as I heard this answer is that I feel like I can see the articles that it scraped this information from, and that feels a little bit creepy, especially because I wrote some of these articles. So I feel like I'm being plagiarized from in real time. But also they kind of remind me of those summary boxes that you get at the top of Google occasionally where they hit the high points but maybe don't go too into depth.
Anna Helhoski: Right. It feels like one long featured snippet without any kind of human quality behind it. That was definitely what struck me about these answers, is they seem technically correct, that seems like a fine starting point. They're really lacking nuance and it just is lacking some kind of a human quality to it.
Sean Pyles: And one thing in general around these answers that I think is lacking is that these ChatGPT bots aren't really going to be able to surface things that you don't know that you don't know. And that's one of the main benefits of talking with a trusted financial advisor or a knowledgeable Nerd. You will be able to get insights from someone who can show you different things that you hadn't even thought of yet.
Liz Weston: Actually, what it reminded me of more than anything was reading an intern's work. Like somebody that's new to journalism, their first pass through a story tends to be very simple, very general. So I have hopes that it's going to get better. Obviously, that's what machine learning is all about. It's getting better and better and more specific. So already it's better than the chat bots we have to deal with when we're trying to get through to customer service. So that's good.
Sean Pyles: Yes, that's for sure.
Liz Weston: At some point I think we'll get to where artificial intelligence can actually have a conversation with you. In other words, it can ask you questions like, in terms of the “Am I ready to buy a house” question, they can ask, "Well, what are your other goals? Are you saving enough for retirement? Do you really want to be a homeowner? Are you prepared to stay put for five years?" Things like that.
Sean Pyles: And eventually, I think we may get to a point where this can supplement the work that we do in trying to help people make smart financial decisions, but maybe it's just my own bias here, but I don't think that we're fully out of a job.
Anna Helhoski: I agree. I think especially editors definitely won't be out of a job because that's something that's going to definitely be needed. I also see ChatGPT and other AI like this becoming part of how we work rather than completely replacing the work that we're doing. But I again might be a little biased.
Sean Pyles: Yeah. We'll see. OK. Well, Anna, thank you so much for talking with us about ChatGPT.
Anna Helhoski: Absolutely. Thanks for having me.
Sean Pyles: Before we move on to this episode's money question segment, I have a quick call out for our listeners to send us your tax questions. We are working on an episode all about the 2023 tax season, so help us help you. Hit us up on the Nerd hotline at 901-730-6373. You can text us or leave us a voicemail there. You can also write us or send us a voice memo at [email protected].
Liz Weston: All right, now let's get into this episode's money question. This episode's question comes from Daniel who wrote us an email and who uses he/him pronouns. Here it is.
"Hey, guys. First, I love the podcast. Thanks for all the great insights into better ways to work with my money. I'm a white-collar professional in my mid-30s and trying to think of ways to increase my income outside of my job. I'm thinking about getting a second property and using it for rental income, whether for long-term or short-term rentals. My question is, what are some factors I should consider before going down this path? I know I need to consider mortgage, down payment, insurance and upkeep costs, but what else should I know or think about? Would I be better off just sticking with the stock market or other forms of investing? Thanks, Daniel.
Sara Rathner: To help us answer Daniel's question, on this episode of the podcast we are joined by Lisa Green, a content Nerd who has many rental properties of her own. Welcome to Smart Money, Lisa.
Lisa Green: Thank you, Sara and Liz, and thank you for having me on this podcast today. This is a topic that I love to talk about.
Liz Weston: Awesome. So rental real estate can really offer some decent returns over the long run, depending on where you are and how you invest. But being a landlord isn't for everyone. Obviously, it's been a good fit for you, Lisa.
Lisa Green: Absolutely. Right now we have 27 rental homes. These are all single-family that we use for long-term rentals. We're still interested in acquiring more, currently looking at a potential 28th. And we got started in this 20 years ago, believe it or not, by buying a couple of foreclosed properties right off of the Multiple Listing Service.
Liz Weston: People who aren't familiar with real estate, that's where most properties are listed, right?
Lisa Green: Yes.
Sara Rathner: So here's the number one question for me, and probably a lot of people who are listening in, including Daniel. How did you get the money to get started?
Lisa Green: We were fortunate to already live in a home that we owned and we had some equity in that home. And we had already set up a home equity line of credit so that we were able to borrow against that equity, and that gave us the funds to get started by using the home equity line of credit to fund a new purchase.
That's not the only way to get started. I know of other folks who've gotten started through what's commonly known as house hacking. This means renting out part of the property that you live in. This could be anything from a room in your house to buying a duplex or quadplex and living in one unit while you rent out the others. And essentially letting the tenants in the rest of the property pay your mortgage for owning the property.
Liz Weston: Interesting. OK. And what are some other ways?
Lisa Green: Well, another common way is to keep your first house as a rental when you move to a new house. Some people do this by accident because they can't really sell the property because of the market conditions, and so they end up an accidental landlord. But some people become a deliberate landlord this way, and we've done this too. When we moved to a new property, we simply held onto the property that we already had. The mortgage is already in place and you're already familiar with the home, you just keep it and turn it into a rental.
Liz Weston: Actually, I was one of the accidental landlords. That's something that happened to me. So I have a tiny bit of experience with this.
Sara Rathner: A lot of people I know keep their starter home or condo, and then once they graduate to a bigger house, or they relocate because of work or other reasons, it's just a matter of holding onto the original house and renting it out.
Liz Weston: Lisa, have you only used HELOCs or have you gotten other types of loans?
Lisa Green: Oh, we've definitely gotten other types of loans. The HELOC helped us get started, but we could quickly see that we were going to need a better source of funding, and I was very nervous. We're like, OK, we're going to have to ask a bank for a loan. But actually getting a local banker to give us the loans was a lot easier than I thought it would be.
We were just starting out, but we tried really hard. We made a business plan and explained what we were going to do, and we took all this to the bank and the banker looked at it and said, "Well, OK." And I know that at least once, he actually came to see one of the properties while we were there working on it, because he wanted to make really sure that we were on the up and up. Saw it with his own eyes, and after that our banker was all in, and pretty soon we could just fund our next acquisition with just little more than a phone call. "Hey, we found another property we want." "OK."
Liz Weston: Oh, nice. That's great.
Sara Rathner: So Lisa, what's your approach to investing in rentals?
Lisa Green: Well, the method that we use is commonly called BRRRR, B-R-R-R-R, and it stands for buy, rehab, rent, refinance and then repeat. So I can kind of walk you through each one of those steps.
First, you try to buy a property at below-market value, you want to get a good deal as much as possible. So here's where you can use funds such as a HELOC or a short-term loan from the bank. I've even known of people who use credit card advances to just get your hands on the property.
Liz Weston: Ooh. That sounds risky.
Sara Rathner: Whoa.
Lisa Green: Yes, I have never ever tried that, but I have heard of people doing that.
Sara Rathner: That comes with a whole lot of potential downside, so I would caution against that particular route versus a HELOC, which would be a significantly lower interest rate, most likely.
Lisa Green: I agree. I agree.
Sara Rathner: Wow.
Lisa Green: But the second step is now that you have the property, you rehab it to bring it up to market value. In our case, we typically gained more value from this rehab than we spent on doing the work.
Liz Weston: And it sounds like you two do the work yourselves, you and your husband?
Lisa Green: We did a lot of the work ourselves. Yes, we did.
So once you have the property rehabbed, you rent it to a tenant to establish an income stream on that property. Now that you've got a fully functioning rental, now you go back to your lender or perhaps a different lender and you refinance the property as a fully functioning rental property that has been rehabbed and brought up to market value. When we did this, we almost always got back more money than we had spent on buying and rehabbing. So our out-of-pocket investment was zero.
Liz Weston: Nice.
Lisa Green: You can't even calculate the return on investment when your out of pocket investment is zero.
Liz Weston: That's a good point. And then the final R is repeating the process.
Lisa Green: It's repeat the process. You've refinanced, you have the money back in your pocket, now you can go buy another one and do the same thing over and over, and you build your portfolio this way.
Liz Weston: Now, people can think of rental properties as passive income, but I have a feeling that they are anything but. How much work goes into this?
Lisa Green: A lot of that, Liz, is up to you. Rental properties can be very hands-on, as they were in my case, or they can be mostly passive. It's your choice. You can buy fixer-uppers, where you have a lot of opportunity to increase the market value with the work that you put in, or you can choose turnkey properties that are already rehabbed, fixed up, ready to go. You just put a tenant in it and move forward. If you're handy and if you have time, you can do a lot of work yourself, but if you don't want to do that you can hire property managers, you can hire renovation crews, you can hire bookkeepers to do a lot of this work for you.
I mean, a key factor for me is whether your income will continue if you personally stop doing all the work. I mean, that's the goal, right? We all would like to retire someday and stop doing all the work. So to me, this is a key difference between working a job, even if you're self-employed, versus owning an investment. And I tend to compare the type of rental investing that we do against … what you hear so much about on a lot of the television programs about real estate is flipping. People are flipping houses to make a profit, and you can do that. You can flip a house and you can make a quick profit, but once you sell that flip, you've got all the income you're going to get from that house, the income stops, and now you need to find another house to flip again. This sounds a lot like work to me.
Sara Rathner: Yeah, it seems like the process of buying the new property and fixing it up is a heck of a lot more work than having a fixed-up property that you currently own and just taking in income from a tenant and then maintaining the property over time, but not doing anything major to it. That's what it sounds like.
Lisa Green: Exactly. What I favor is more “buy and hold.” This gives you an income stream for a lifetime. Over the course of our investing, I probably sold a half a dozen properties and I wish I had every one of them back.
Sara Rathner: Wow.
Lisa Green: Here's an example. We saw all the hype about flipping. So we thought, OK, we can try that. And so in 2015 we did a flip and we made about $22,000 in profit on that flip. That sounds nice, it wasn't too bad. I mean, it wasn't a huge amount of work, and we had $22,000 in profit. OK. Then we had to pay short-term capital gains tax on this amount because we had not held the property for more than a year. Today that house is worth $120,000 to $140,000 more than we sold it for. If we had still owned it, we probably could have had some small positive cash flow over the past seven years, plus we would still own the house and we could borrow against it or sell it at this much higher value. So to me, this is an illustration of why buy and hold has more value to me than flipping.
Sara Rathner: So you mentioned the cost of hiring professionals versus doing things yourself, but I think something that needs to be pointed out is when you do things yourself, you're using your time. And time has value, too. So when you hire somebody else to handle something, you're buying back your time in exchange for your money. But when you do things yourself, you're not exactly saving money 100% because you're giving up time that you could spend in other ways.
I feel like that's something that kind of scares me. What time do I have available to dedicate to this? So that's something I think everybody should think about. Oh, I'll just paint the house myself. I'll just put in new floors myself. I'll just tile the bathroom myself. OK, but that takes hours if not days and sometimes weeks. So always something to think about if you're going to do the DIY route.
Lisa Green: Absolutely agree. When we were starting out, we did do a lot of the work ourselves because we had more time than money, and partway through we switched to having a property management company that now does that work for us and finds subcontractors to do the fix-up and handles all of that for us, which is much more pleasant in terms of your day-to-day life once you get to the point where you can afford to do that.
Sara Rathner: So our listener is wondering what he should consider before getting into the rental property game. So what would you tell him?
Lisa Green: Well, I think that Daniel has already nailed a lot of the factors to consider. Your mortgage, your down payment, the insurance, and the cost of upkeep of the property.
So here are a few more things to be aware of: First of all, vacancies are very expensive. When a tenant moves out, the income stops and the expenses soar at the same time because you have to rehab the property to get it ready for the next tenant. You may have to go in and paint. You definitely have to go in and clean. You may have to replace flooring or appliances or other elements. You need cash reserves for this or access to funds through a line of credit.
Now, this actually gets easier as you acquire more and more properties because they aren't all likely to be vacant at the same time. If you only own one rental and there's a vacancy, now you have zero income coming in. If you own 10 rentals and you have one vacancy, nine of them are still bringing in an income to you and so it's not as much of a blow.
Liz Weston: Now I live in California, which is considered a pretty litigious state, and it feels like being a landlord would kind of make you a lawsuit target. So how do you deal with that?
Lisa Green: Well, you will want an umbrella liability insurance policy. And let me explain a little bit of what that is. Let's say someone is injured at your rental property and they file a lawsuit against you. You might be held liable for the damage to that person. This has not happened to me, but if it did my umbrella liability insurance policy could help pay a legal judgment against me. It's called umbrella insurance because it goes over and above the liability coverage that's already included in your typical homeowner's insurance policy. It just adds more liability coverage. And this coverage is typically not very expensive and can give you a lot of peace of mind.
Sara Rathner: So we mentioned a couple of times hiring different professionals who can help you as a property owner, and one of those professionals is a property manager. So what can a property manager do for you and how much do they cost?
Lisa Green: Yeah, we were very grateful to finally decide to put our properties under a property manager. The property manager will screen potential tenants and find someone to rent your property for you. They will answer the urgent calls about clogged toilets in the middle of the night so that we don't have to.
Liz Weston: There you go.
Lisa Green: And they will track down tenants who are late on the rent to get them to pay, which was actually one of the more annoying parts of managing our own property. And typically they might take 8% to 10% of the gross rent for handling this all for you. But then it becomes much more of a hands-off operation where you simply sit back and wait for the check to come in.
Sara Rathner: Yeah. As somebody who doesn't want to unclog somebody else's toilet at 3 o'clock in the morning, that sounds pretty nice. That's just not the kind of investment I want to make.
Liz Weston: And Lisa, I mentioned that I live in California, which has a very different attitude towards landlords and debtors. So the landlord tenant law and the creditor debtor law are very different from the way that they are in the South. So could you talk a little bit about what you need to know in terms of your state and local laws?
Lisa Green: Absolutely. And you are so right, Liz, that some areas are more favorable to landlords and others to tenants. This can be true on a state by state basis. It can also vary from one city to the next. Some cities will have lots of restrictions, particularly on short-term rentals. And lending practices can also vary by location.
You may have heard that it's better to hold title to your properties, for example, in a business entity like an LLC. But in other places it may be fine to hold properties in your own name. In fact, that's what we are able to do where I live.
So I think that the important thing to know here is that you just have to investigate what the state and local laws are in the area where you live and in the area where you plan to invest. Joining a local real estate investors association can be a great way to learn from other people who are already in this business.
Liz Weston: And Lisa, you and I talked before we started recording about some of the differences in getting a bad tenant out. If you have a problem with a tenant and need to do an eviction, here in California, even an uncontested eviction, in other words when they're not fighting back, can cost thousands of dollars and it can add up really quickly. And I think the attitude in your area is a little bit different.
Lisa Green: It is. We have found that most tenants don't want to be evicted any more than we want to evict them. And so a lot of times if you can work with them to help them make up the rent that they are falling behind on; you can help them work their way out of a tough situation.
But we did have one family, over 20 years, that stopped paying rent and just refused to leave, and we did end up in front of a judge with an eviction case. Now, before this particular judge, the case was pretty cut and dried. The judge says, "Do you owe these people money? Can you pay it? Nope? Then get out of their house."
Liz Weston: Oh my.
Lisa Green: But that judge did order us to put the tenant's belongings into a storage unit and pay the storage bill for a month out of our pocket.
We also have had about a thousand dollars in legal expenses and several months of lost rent that we couldn't recover because the tenants just didn't have the money. They left the house in bad repair, and we had a lot of fix-up costs before we could rent it again. So I think we ended up with a loss of about $8,000 on that house for that year. And this is in a state that's considered fairly landlord-friendly.
Sara Rathner: That's absolutely something to think about. I mean, you mentioned one bad tenant in 20 years where it got to this point. So really if you think about over 20 years, the loss kind of gets spread out. But definitely something to think about: What if your really bad nightmare tenant is your first tenant? So you're pretty new to this. You don't have as much money saved up to handle these unexpected emergencies. But yeah, I mean that's why it's really important to screen tenants well and have a lawyer on your side.
Lisa Green: Absolutely.
Sara Rathner: Know what your rights are as a landlord and what their rights are as the tenant and what you might be able to do if you're faced with a tenant who is not paying their rent.
Lisa Green: Absolutely, Sara. I think that the importance of screening your tenants cannot be over-emphasized.
You're looking for three different things in a tenant. You want someone who, number one, will take great care of your property. Number two, will pay the rent in full, on time every month. And number three, will keep living there for a long time because turnover is expensive. And it can be hard to find applicants who meet all three of these criteria. Meanwhile, your house is sitting there vacant, there's no rent coming in, and you're really eager to get someone into it.
For us, the temptation was always to compromise on our standards so we could get someone into the house quickly. This is a mistake that can lead to the eviction issue that we just previously discussed.
Liz Weston: But I imagine on the other side, sometimes you get a really, really good tenant.
Lisa Green: Yes, you do. Sometimes you get a superstar tenant. We had one family that took great care of the property, always paid the rent on time, stayed in that house for eight years and then bought the house from us.
Liz Weston: Wow.
Lisa Green: It was a win-win. We used the proceeds from the sale of that one property to purchase two others, and they got the property that they really loved.
Sara Rathner: So it wouldn't be a conversation about real estate without conversation about taxes, because they really touch everything in our lives, don't they? So what are some of the tax advantages to investing in rental homes?
Lisa Green: I think there are some awesome tax advantages to investing in rental homes, starting out with something known as depreciation. This allows you to deduct the cost of your property from your taxes over time. And that can be a nice tax break, although you might have to pay those taxes back if you sell the property.
Liz Weston: Yeah, that's something known as depreciation recapture, and it can be kind of a surprise when people don't know that it's coming.
Lisa Green: Yes. So if you are in that situation — as I saw the possibility of that when we were selling a house to our superstar tenant — you can put off the tax bill indefinitely by using something called a 1031 exchange. This allows you to defer the taxes by selling the property and investing in similar rental properties. So in our case, we sold one house, reinvested all that money into two other houses, and were able to defer the taxes so we did not have tax consequences from that sale.
Liz Weston: OK. And if you hold onto those properties until you die and then bequeath them to your heirs, then essentially nobody ever pays those taxes. Your property gets a new value for tax purposes and all the appreciation that happened over that time essentially never gets taxed.
Lisa Green: Exactly. That's known as a step up in basis. And it applies to anything you own, including stocks, bonds, your home and other real estate. But it's a really great tax advantage.
Liz Weston: Have you ever had a loss on a property?
Lisa Green: Yes. We showed a paper loss on our taxes for about the first 10 years of investing. You can end up with a loss on paper and you might be able to write that off against your regular income, even though your cash flow is positive, putting money in your pocket every month.
This happened to us for about 10 years. We had losses on paper even though we had spendable cash coming in. And we were able to write it off against our regular income.
Liz Weston: So basically the rent you were receiving was more than your expenses; it was the depreciation that was creating that paper loss, essentially.
Lisa Green: Exactly.
Liz Weston: OK. And you mentioned taxes, but there's one tax you don't have to pay on rental income or passive income.
Lisa Green: Yes. This is passive income. It's not income from a job. So you do not have to pay Social Security, Medicare or self-employment tax on it.
And the great thing for Daniel, who says that he is in his 30s, the great thing about investing now is that he has time to set up these rental properties as a great source of income in retirement. You'll pay off the mortgage over 30 years, and now just as you're reaching retirement age, you have something that is going to generate more income than ever because you no longer have a mortgage payment to make. So rather than spending down a lifetime of savings in your 401(k) or other accounts and watching those dwindle and worrying whether you're going to outlive your money, you can live off the income from your rental properties and you'll still own the assets to pass down to your heirs.
Liz Weston: Now, Lisa, I mentioned I had a brief experience as a landlord, and it was so bad that it just basically scared me off the whole process. So if you don't want to be a landlord, there are other ways to invest in real estate, including real estate investment trusts and mutual funds and exchange-traded funds that invest in rental and commercial real estate. And we will include links so that you can get more information about those in our show notes. With that, Lisa, thank you so much for taking the time to talk with us.
Lisa Green: Thank you. This has been a lot of fun, and I wish Daniel the best of luck.
Liz Weston: Great. And now let's get to our takeaway tips. Sara, do you want to kick us off?
Sara Rathner: Sure. First, know what you're getting into. Rental real estate can be a good investment, but the returns depend on many factors and how hands-on you want to be.
Liz Weston: Next, vacancies are expensive. Make sure you have cash reserves or a line of credit if your rental property is empty for a few months.
Sara Rathner: Finally, consider alternatives. If you decide being a landlord isn't for you, there are other ways to invest in rental real estate, including real estate investment trusts.
And that's all we have for this episode. Do you have a money question of your own? Turn to the Nerds and call or text us your questions at 901-730-6373. That's 901-730-NERD. You can also email us at [email protected]. Also visit nerdwallet.com/podcast for more information on this episode. And remember to follow, rate and review us wherever you're getting this podcast.
Liz Weston: And here's our brief disclaimer. We are not financial or investment advisors. This nerdy info is provided for general educational and entertainment purposes and may not apply to your specific circumstances.
This episode was produced by Sean Pyles and myself with help from Anna Helhoski. Audio wizard Kaely Monahan mixed our audio, Jae Bratton wrote our show notes, and a big thank you to the folks on the NerdWallet copy desk for all their help.
Sara Rathner: And with that said, until next time, turn to the Nerds.