The Good, Bad and Ugly of My First Rental Property
Note I am not a CPA, lawyer, or financial advisor. All information below is for informational purposes only. Please consult with a professional prior to making investment decisions.
Real estate is my weakness in the world of investments. My real estate experience started at a young age. My dad owned several units growing up, including a quadriplex and several rental houses. That was back in the day when you could get a 100% loan for a property just walking in off the street. How times have changed!
That experience growing up was invaluable for me. My dad let me ride along on any real estate related trip he took. By the time I reached high school, I had seen all sorts of things. I watched my dad collect rent from someone screaming profanities at him. I watched a tenant get evicted. I’ve even seen a tenant arrested for dealing drugs out of the house!
Most importantly, I watched what a down market and bad partnerships can do to a real estate portfolio. Fortunately, my dad had the means to get through this and has liquidated most of his portfolio now, but I learned invaluable lessons watching.
Many years later now, I have now owned and sold my first rental property. I am currently without any real estate investments as TheBossMD household focuses on student loans, but I plan to get back in the game.
My experience thus far has convinced me that real estate is an excellent asset class but it is just like any other investment or business. You need to understand it to profit. I have added to my real world education with other resources like BiggerPockets and numerous books.
For those of you wondering if this is something you can include in your portfolio as a working physician, I’d like to walk you through the story of my first rental property. I did some really smart things and really dumb things along the way. Hopefully, you can learn from my experience and apply it to your own portfolios.
A Physician Loan
My first renal property was actually my wife and I’s first home. We used a physician loan to buy it. We put nothing down and got a 30 year mortgage at 4.75% (obviously not today’s market). When you add in insurance, taxes, etc, our monthly payment came out around $1150.
After living in the house for 5 years, we decided to move a little closer to family. I had toyed with the idea of renting the house for a few years, but I didn’t realistically think it would work out. Most physician loans stipulate that the home has to be your primary residence.
I decided it couldn’t hurt to ask and called up the bank to see what they would say. My jaw about hit the floor when she said,”We don’t care if you rent your house.” I almost followed up with asking if there was a limit on the number of physician loans they would give me, but I figured that was too aggressive.
Armed with this knowledge, I went to my wife to pitch the idea to her. My idea was simple. The house was located in a good community with strong economic growth. If we could rent the house to good people at a good rate, then we could make a few bucks each month. After a few years, we could decide if we want to keep it long term or sell it, depending on how the market is doing.
Finding a Good Tenant
I then proceeded to make my best decision of this entire process. I determined my criteria for potential tenants and I stuck to them. Here were my criteria below:
- Monthly income must be 3x monthly rent
- Solid prior landlord references
- No criminal history
- No eviction/foreclosure history
- Credit score>700
- Must return communications promptly
I told every applicant up front that those were the criteria. I got a generic paper application and charged an application fee to cover the credit check. A lot of people didn’t make it past the first phone call! I had a few people beg me to bend the rules, but I didn’t budge.
After listening to a lot of rambling phone calls and getting stood up for showings several times, I finally struck gold with a young professional moving to the area. She had a great job, solid references, and returned any email or call immediately.
I celebrated finding my excellent tenant by promptly doing something stupid. The home commanded a rent of $1500-$1550 easily. I was so excited that I had found a trustworthy tenant that I got talked into undercharging her. We settled on a lease for $1350 a month. Yep, you read that right. I left at least $200 per month on the table. Like I said, stupid.
I also compounded my mistake by not raising the rent after the initial one year lease expired. I actually renewed at the same rate and did an eighteen month lease the second time! The only upside was that I minimized my vacancy and turnover costs.
Managing the Property
Given that I only had one property, I elected to manage it myself. This decision also got a lot easier when I left too much money on the table with my lease to pay for property management! I think it’s excellent experience for anyone that wants to really get involved in real estate to manage a rental yourself. No one cares more than you about your property, and experience is the best teacher for what good property management looks like.
Due to my excellent tenant choice, I received minimal phone calls for the entire time my tenant occupied the property. She even asked if she could do some things herself, like paint a few rooms to better match her furniture. Sure, no problem!
Another mistake I made, however, was trusting too much and not doing periodic inspections. I was lucky because my tenant never caused any major damage to my property, but in retrospect, I would have done inspections every six months to make sure everything was on the up and up.
If I had, then I would have noticed that the carpet was wearing out. I could have avoided rushing to replace it right when I was trying to sell the house later. In the future, I’ll be checking in more.
Deciding To Sell
As we passed the two year mark of being a landlord, I began to ponder what my end game was. Interest rates had dropped by then, and I had a decision to make. Do I try to see if someone will refinance at a lower rate to keep the property long term, or do I sell the property? I ultimately chose to sell for two reasons.
First, Mrs. BossMD and I decided to focus on paying off our student loans. It might have been the better financial move to keep the property, but we wanted the student loans off our plates and out of our lives.
Second, by selling before the three year rental mark, we could avoid some of the associated capital gains via the section 121 exclusion. Section 121 of the IRS code states that you can exclude capital gains from the sale of any primary residence as long as you resided in it for two out of the past five years. Single folks can exclude up to $250,000 of gains while married couples can exclude up to $500,000. Not a bad deal. There is some fine print associated with exactly how much capital gains you can avoid, so your tax professional will be helpful here.
Note, the section 121 exclusion does not prevent you from depreciation recapture, which you will still have to pay. For those that don’t know, depreciation is this wonderful real estate tax perk, where you can write off a portion of the purchase price of the asset every year for a certain amount of years (27.5 years for homes). This a large part of what makes real estate income tax advantaged. Depreciation often wipes out a large chunk of the income on your taxes.
Depreciation recapture is the process where the IRS “recaptures” some of that benefit when you sell the home at a gain (i.e sell it for anything higher than the current adjusted cost basis). In general, the depreciation is recaptured at your marginal tax rate, i.e if you’re in the 33% bracket, then it will be taxed at 33%. This is probably where you need a tax professional to assist you again. Best to figure out exactly what you will be paying Uncle Sam before you decide to sell.
Missing A Tax Opportunity
One opportunity that I missed was to do a 1031 exchange. A 1031 exchange is named for Section 1031 of the IRS code which allows for property owners to do a “like-kind” exchange of their property for another of equal or greater value. There are a few other rules surrounding this, but in general, you can avoid taxes on the sale of your property through this mechanism if you stay within the parameters of the code.
I could have potentially traded up from my house to a quadriplex with higher value, while avoiding the tax man for now. Stupid! I didn’t consider this at all when making my hold vs. sell decision. I had several tax friends later say I should have considered it, but it was too late by then.
This is something I’ll definitely consider in the future and also why I’ll involve my accountant much earlier in my sell vs. hold decision process.
Given the whole experience, I have to say I was pleased with my first rental property. I made a nice chunk of change, had minimal stress, and learned some good lessons. I plan to dip my toes in the water again once Mrs. BossMD and I reach our student loan goals and agree to diversify our portfolio a bit more.
Here are my takeaways from the experience:
- Quality tenants reduce headaches
- Desirable properties in good locations attract good tenants
- Tax advantaged income
- Average physician should have multiple financing options
- Long term leases can be good…until they’re bad
- Don’t forget about trading up
- Consult professionals when needed so you don’t miss opportunities
- Don’t cheat yourself out of rent!
Overall, I think maintaining a real estate portfolio is a great way to build wealth as a physician, and it’s definitely possible for a working physician. If I scale to more properties in the future, then I’ll definitely expand my team so I can remove myself from the day to day. Here’s hoping I can convince Mrs. BossMD to get started soon!
Do you have a good real estate story? What was your first rental property like? Tell me about it in the comments!