What kind of real estate is both a home and a passive income stream? We’re talking about the multi-family house, which presents a unique opportunity to live and generate profit within the same structure.
There are a variety of multi-family dwelling types, financial considerations, and pros/cons inherent to this type of arrangement. Let’s learn.
What Is a Multi-Family House?
Are you thinking that a multi-family home means three floors with a generation living on each floor? Possibly, your view of a multi-family home is one where the grandparents live in a self-contained apartment connected to the main house in which their daughter lives with her children.
The examples illustrate situations with relatives living together, but in the world of real estate, neither fits the definition of a multi-family house.
Let’s start with a simple definition: A multi-family house is a property that is divided into separate residential units.
Typically, the following conditions also apply:
1. The property has a single owner (an individual or a business) that makes the units available by leasing or renting them (e.g., an apartment complex).
2. If there is not a single owner as described above, the individuals each own an independent unit within one building (e.g., condominium).
3. Each residential unit independently meets the needs of its inhabitants. Thus, it has a kitchen, bathroom(s), bedroom(s), appliances, utility meter, a separate entrance, and address.
With those things in mind, let’s examine each type.
A duplex is a residential dwelling comprising two standalone units that exist within one structure. They can sit next to each other, like books on a shelf, but each has its own entrance. Alternatively, the units can be stacked. One residence is on the first floor (accessed by a front door) and one is on the second floor (accessed by an outside set of stairs leading to the entryway).
Similar to the duplex, a triplex is a single building divided into independent living units. That there are three residences under one roof instead of two is the key difference. (We know, it may seem obvious, but we promised to start with the basics and build!) In a triplex, the configuration may be a row of side-by-side living units or a three-story building.
Spoiler alert! A quadplex is akin to its twin and triplet cousins, but it contains four independent residences in one structure. Quadplex units can stand side-by-side, or the two lower units may be topped by two upper units.
An apartment building typically is owned and managed by one entity, whether an individual or a corporation. In the US, apartment units are rented rather than sold.
If there are four or fewer individual units, an apartment building is considered a multi-family house. Buildings with five or more independent units are classified as commercial—not residential—real estate.
Condominiums are residential dwellings that are clustered together in one or more buildings. Condominiums have common outdoor spaces and share amenities. Amenities may include pools, visitor parking, and a community center.
The interior of a condominium belongs to the owner; they are responsible for its maintenance. The exterior, along with the outdoor space and amenities, belongs to the condominium association or is owned equally among the condominium owners.
Thus, an owner may choose to paint the living room walls or replace the kitchen cabinets. An owner may not change the siding, remove the greenery, or put in a windmill.
Townhouses are like condominiums as individual units are clustered together in a communal setup. Typically, a townhouse shares a common wall with its neighboring townhouse.
Unlike owning a condominium, where the property owner does not own the exterior features, a townhouse owner does. This allows the townhouse owner to have more freedom with decisions about landscaping and patio furniture.
The Multi-Family House for the First-Time Buyer
Now that we understand what a multi-family house is, you may be excited at the idea of putting your real estate to work for you. You may be thinking, I can buy a duplex, live on one side, and rent the other! What a brilliant strategy!
Many property buyers agree with you. Are you thinking of buying a multi-family house and are you also a first-time home buyer? You will want to familiarize yourself with the unique aspects of this type of property purchase.
Location, Location, Location, Location
A common phrase in real estate is “location, location, location,” employing repetition to emphasize the relevance of a home’s location. We added a fourth “location” to the phrase as extra emphasis for first-time home buyers who are considering a multi-family house.
With a first home, prospective buyers are apt to be extra particular since they are new to the process. Also, a house is one of the most significant expenditures one makes.
As such, they will want to be sure the location suits their needs. Often, first-time buyers are starting out in their careers or expecting their first child. Is the location of their home close to public transportation and nearby reputable daycare facilities?
In addition to suiting their own needs, a first-time home buyer of a multi-family residence must consider the location’s appeal to potential renters who will occupy the other units. Often, renters can be in various phases of life, each with their own set of concerns.
If you’re a first timer looking at a multi-family house as a first home, be sure that you’re willing to make tradeoffs. Striking a balance between your preferences and the preferences of anticipated renters is key.
You may have been told that buying a multi-family property can be a financial windfall for the homeowner just starting out. Specifically, the promises of a low down payment and tax breaks are cited. While both aspects can be benefits of owning a multi-family home, they are not guaranteed.
Depending on the state in which you live, you can benefit from a lower down payment. You may be required to use one of the units as your primary residence as opposed to living elsewhere and using the multi-family house as an investment property.
Often, this type of real estate purchase can offer tax benefits. Renting a property involves expenses that can be written off as business expenses.
As a first-time home buyer keen to save money, a lower down payment and tax breaks sound wonderful! The question is this: as a first-time property owner, is your financial situation flexible?
A lower down payment means less money leaving your bank account upfront. However, it often means you’re taking out a bigger loan.
As loans are interest-bearing, you will want to take that into account for monthly and yearly budgeting. As the year rolls onward, can you afford the higher monthly mortgage?
Expenses related to the business of renting can be written off. An example of this is the annual heating, ventilation, and air conditioning (HVAC) service that is provided to ensure the systems are functioning as they should be.
A single-family homeowner can’t write off HVAC maintenance service. An owner of a multi-family home may be able to, since a functioning HVAC system is part of the service they provide to their tenants.
Writing off the cost of a maintenance service is helpful insofar as it decreases the amount of your income that is taxed. At the time the service is performed, you still have to pay the individual who performs the service. Will you be able to pay for all home maintenance bills at the time the maintenance is performed?
If you are planning to rent the self-contained units to tenants and choose to manage the property yourself, being flexible is critical. We don’t mean you need to sit in a pretzel-like configuration to discuss the water heater. We mean you need to be willing to be available for your tenants.
The exact terms within rental agreements vary widely, but the basic premise is that you are providing both a physical location and a set of services to your tenants. If the water temp plummets, the power goes out, or a window becomes stuck, you may be responsible for providing a prompt resolution.
If you have another job, you will need to be able to juggle its requirements along with being the owner/manager of a multi-family home. Whether you have dependent children or care for a relative these are situations to consider, as well.
We aren’t discouraging a first-time home buyer from purchasing a multi-family unit. Instead, we are encouraging you to give due consideration to the location’s relevance and the types of flexibility needed.
Real Estate as a Source of Passive Income
According to Investopedia, the U.S. Internal Revenue Service (IRS) defines passive income as money and losses derived from an entity with which one is not actively involved. The act of providing living space and collecting a fee from its occupant qualifies as passive income, with these exceptions:
1. The individual who is renting the living space is not a real estate professional.
2. The property is not being rented to a corporation or business in which the individual has business dealings.
3. Income generated by leasing tracts of land is not considered passive income.
Maybe you’re wondering how renting can be a form of passive income if the act of renting relies on you performing actions such as fixing leaky faucets and flickering light bulbs? Your actions do not generate a living space nor do your actions keep the living space in existence. Your actions maintain and uphold the living space.
Think of it this way. If you’re a teacher, you instruct and guide. If you’re an architect, you perform calculations, measurements, and drawings that become blueprints. You may rent a living space as a form of shelter, but you do not shelter people. The multi-family house provides shelter and you’re involved peripherally.
The Pros of Buying a Multi-Family Home
We’ve looked at the multi-family home from multiple standpoints. We’ve addressed the types that exist, their potential for a first-time buyer, and the nature of the income they generate.
Now, let’s do a deep dive into the positive and negative attributes of a multi-family home. Bear in mind, as with many things, what are considered pros and cons vary from individual to individual.
A multi-family home can be a winning solution for families who have more than one generation that wants to live near each other without necessarily sharing a bathroom.
You may be caring for an aging parent or supporting a sibling with special needs, who is mostly self-sufficient. Perhaps you’re a newly married couple with the goal of saving money. A multi-family structure offers physical and metaphorical boundaries with your extended family.
Redirect Rent to Minimize Mortgage
Envision a situation where you are living in one unit of a multi-family structure while renting the others. Theoretically, you can use the monthly rent amounts to pay off the mortgage on the entire structure.
The solution sits on three assumptions:
1. You own the entire structure.
2. The other units within the structure are not vacant.
3. The tenants pay the monthly rent in full.
Let’s throw in some numbers to make the abstract idea more concrete. Presume you own a triplex. You are approved for a loan and the monthly mortgage amount due is $3,600. If you have two tenants paying $1,000 each, you will collect $2,000 per month. If you direct the rental payments towards the mortgage, that is $1,600 out of your own pocket instead of $3,600.
Behold Business Expenses
We discussed the idea of first-time home buyers purchasing multi-family units. We noted the appeal of tax breaks associated with this kind of property purchase while recognizing that the benefit to the property owner comes via deductions and they still pay for the expenses themselves.
Owners of a multi-family structure should understand which expenses associated with renting qualify as deductions. For federal tax purposes, expenses incurred in order to maintain and manage the property qualify. Tangible items, such as tools and supplies that are used in aid of maintenance and management, may be deducted.
As the owner, you can add to and upgrade the structure. Add-ons like wrought-iron rails to replace warped wooden ones or private decks boost the appearance and versatility of tenants. Upgrades like smart appliances will make your tenants’ lives easier or more efficient.
What do you get from that? Add-ons and upgrades may mean you can charge more for monthly rent. The greater the rent that is paid, the more you have towards the mortgage. Do you see where this is going?
The Cons of Buying a Multi-Family Home
The number of single-family homes and multi-family homes available at any one time can vary. However, outside of the simple number of structures available, one also must consider that multi-family structures have characteristics that affect their availability.
Some multi-family units are considered commercial, not residential, real estate. There are zoning laws and tax treatments unique to commercial real estate, which vary by state and municipality. If you’re new to property management and renting, give careful consideration to how the structure is classified.
Any shared space reduces privacy. Proximity can result in knowledge. For some people, having their neighbors know they do yoga on the patio is not a big deal. For others, a neighbor living within yelling distance is a neighbor that lives too close.
Living in a duplex provides more privacy than living in a triplex. A common area in a condominium complex offers less privacy than a yard surrounding a single-family dwelling.
Individuals need to know their level of comfort with proximity to others, well in advance of putting a down payment on a multi-family unit.
The Fluctuating Facets of Property Management
When you decide to rent property, unless you hire a property management company, you take on many tasks. We see five facets involved with property management.
Some of these include:
1. drafting and reviewing leases (or hiring an attorney)
2. learning the tax implications unique to rental properties
3. repairing and maintaining physical structures
4. screening potential tenants
5. managing risk through insurance policies
Evaluating a multi-family home as an option requires research, financial analysis, and an assessment of one’s interpersonal and management skills. Accompanied by the premises and pointers presented in this post, you are on your way to determining whether a multi-family house is your place to call home.
If you have more questions on the wide world of real estate (and who doesn’t), you’ll find a wealth of answers in my books and blog!
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