Why you shouldn’t own rental real estate in retirement
About 23 years ago, I was living in Las Vegas where I started working with some new clients who had decided to partner up and invest in a bunch of rental properties in Montana. They had formed various LLC’s used to hold ownership to the properties, and each LLC was owned 50% by each partner. One of the partners was a married couple, and the other partner was a single individual. Now for the sake of this story, I’ll call the married couple the Joneses, and I’ll call the single individual Mr. Smith.
At the time of the original investment, all three of these individuals were in their mid 50s, and they were all in good health. Therefore, they would spend much of their free time doing their own repairs and helping to build sweat equity into their investment. Each of them also had other income, so they were very happy to be able to enjoy the tax benefits of the depreciation that came from each of these rental properties.
Over the years, these three individuals have continued to work with me. However, the Joneses decided to take a much different real estate investment path than what Mr. Smith decided he would do. As the Joneses got closer to retirement, they decided to completely divest themselves from the real estate holdings. Whereas Mr. Smith continued to own many of these properties, and he continues to own them even to this day.
Now, at this point, some of you may be asking yourself, why is Dave telling me this story? And what does it have to do with my retirement? Well, the reason I’m telling you this story is because I believe you should not own rental real estate in retirement if you’re trying to get to a tax free and risk-free retirement. As I share my concerns, I think we will start to see why it’s my opinion Mr. Smith did not make the right decision by holding on to all of these real estate investments.
I’m going to share with you my top five reasons I believe you should not own rental real estate in retirement if you’re trying to get to a tax free and risk-free retirement.
My number one reason for not investing in rental real estate in retirement is your rental income is going to be 100% taxable. We’re currently living in a period of time with historically low tax rates, and every economic indicator points that tax rates have to go up in the future, or the country will not be able to continue to provide all the benefits they’ve committed themselves to.
Therefore the best thing you can do for your retirement is to transition your assets from the taxable and tax deferred buckets into the tax free bucket before taxes go up. This includes your rental real estate property. By doing this, you can have more control over what your retirement income is going to look like because you take Uncle Sam out of the equation.
Let’s look at it from a different perspective. Let’s say you want to buy a new property, but you need a loan in order to help you finance the investment.You decide your local bank is the best option. So, you jump into your car and head down to talk to the local branch manager. After listening to your situation, the branch manager throws his hands in the air and says, “Congratulations! You may not believe this, but I have some great news for you. I’m going to give you every penny you ask for today.” Upon hearing this, you throw your arms in the air as well, and you proceed to give each other virtual high fives since we’re still experiencing COVID restrictions.
As you sit back down and get comfortable in your seat, the banker says the process for the loan is very simple. All you have to do is sign your life away on this stack of documents. And then once you’ve signed all the forms, he will reach out to you personally and let you know what interest rate the bank has decided to charge you for your loan. As you listen to this sentence, your excitement quickly turns into outright concern.
So, you ask for clarification. Are you really going to have to sign your life away before knowing the interest rate? The banker replies, ”Yes, that is exactly what I said.”
Now, I don’t know about you, but I would never take this loan. Yeah, signing your life away is exactly what you’re doing. When you have rental real estate and retirement, you are invested in an asset that’s going to create a future tax liability. And you’re at the mercy of the government to determine what rate they’re going to charge you on the income you receive each year from this investment.
My second reason for not investing in rental real estate in retirement is because your rental income will probably cause your social security to be taxable.
In 1983, Ronald Reagan signed into law a change to the social security program that allowed the government to tax a portion of your Social Security benefits if your provisional income was above a certain threshold.
Provisional income is calculated by adding your regular taxable income, which includes any rental income, your tax exempt interest income, and one half of your Social Security. Once you combine all these amounts together, if the total exceeds $34,000, for a single individual, and $44,000, for a married couple, then 85% of your Social Security benefits are going to be taxed.
There are two main issues if your Social Security is taxed first. I find that when people have their Social Security taxed, they often end up paying twice as much in tax as they otherwise would. The biggest reason for this is the Social Security income gets added on top of all the other income that is being reported on your tax return, which means it’s going to be taxed at the highest tax bracket you’re in.
The second issue is because tax on Social Security can be thousands of dollars a year. Other assets often run out five to seven years faster than they otherwise would. Because instead of being able to use these assets to cover your living costs in retirement, you’re having to use them to pay extra money to the government.
Now, reason number three for not investing in rental real estate in retirement is that by the time you get to this age, there’s a good chance depreciation will be minimal if you have any depreciation left at all.
Let’s remember Mr. Smith. His first investment in rental real estate was when he was in his 40s. Now, he’s in his early 70s, and he’s used up all of his depreciation on those original properties. This means that he, as well as you if you don’t have depreciation, will be reporting more income on your tax return than you did during those early years when you’re able to take the depreciation deduction.
The other issue you have is depreciation is not adjusted for inflation. Over time, your rent should increase with inflation. But if your main deduction isn’t adjusting with this increase in income, you’re going to have more taxable income, which means less spending income during your retirement.
Reason number four, I don’t believe you shouldn’t invest in rental real estate in retirement is because the last thing most people want to worry about during that time is dealing with more problems.
And when you own rental real estate, there will always be problems. Whether it’s a repair that needs to be done, or a tenant who has moved out and left a vacancy you need to fill, someone has to take action and solve the problem. Yes, you can hire a manager to take care of these tasks. But if you do this, you may lose as much as 10% of your income to the management company. Plus, you’ll still have to pay for the repair costs and any loss of income you have because of the empty unit.
And my last reason why I believe you should not invest in rental real estate during retirement is because it’s an all or nothing investment.
What do I mean by this? I mean, if you own rental real estate property and you need extra cash, you’re going to either have to go without this extra cash or be or be willing to sell the whole property.
I do realize some of you will argue that you can just take out a loan, but doing this is not without consequences. There will be fees for borrowing the money. Plus, you will now have to pay interest and a monthly payment in retirement.
It’s irrelevant how many assets you have if you don’t have cash flow. You can own a $3 million rental property, but if you don’t have a tenant renting that property, what good is the property? When you’re retired, you have no other income coming in.
What good would the property be doing you if you have no other income coming in besides what you would have gotten from this investment? You can also have issues with being able to properly diversify your retirement portfolio. Depending on the value of your rental property, you can have major issues with market risk as well. Rental property is a large investment for most retirees. So if the market goes down, and you end up having to sell the property, you can lose a large portion of your retirement nest egg.
Now that you know my five reasons why I wouldn’t own rental real estate in retirement if you’re trying to get to a tax free and risk free retirement, I’d like to share one more thing with you that you could do if you decide to go against everything I’ve said today and invest in rental real estate anyway.
But before I do, let me take a minute and give you an update on the Joneses and Mr. Smith. Mr. Jones has recently passed away, but Mrs. Jones is enjoying the retirement of her dreams.
When the Joneses sold out of the real estate investment as they were first approaching retirement, they took time to understand the risks facing the retirement and created a plan to where they could enjoy attacks and risk free retirement, which Mrs. Jones continues to enjoy to this day.
But not Mr. Smith, he’s still a real estate owner who’s dealing with all the issues I’ve talked about during today’s podcast.
His taxable income is higher than it’s ever been because he has less depreciation than he has ever had. He’s also paying tax on his social security benefits each year. He has continued to try to manage the properties himself, which always results in a lot of complaints and frustrations about what he’s having to deal with. Additionally, he’s stuck trying to time the market if he needs extra income because his only option for extra income is to sell a property. Obviously as an investor, he wants to be able to get the maximum dollar for his investment, so he wants to be able to sell it when the markets go up.
I did mention there’s one option if you want to continue to own rental real estate into retirement, and that option is that you place the real estate into a self directed Roth IRA or Roth 401k. These plans require you to follow very strict rules and regulations. But if done correctly, you can use rental real estate as a portion of your retirement portfolio and still be able to eliminate tax rate risk and the consequences of having your Social Security taxed.
In closing, before I get to the question and answer segment, let me remind each of you about the importance of individual retirement planning. Your situation is not going to look like my situation, nor will it look like the Joneses or Mr. Smith.