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Is it worth building an in-law suite in your house to rent out?

In-law suite in the basement

We recently bought a house that has a 3-bedroom rental suite in the walk-out basement (aka mortgage helper).  In our neighborhood, it could fetch $2,500 to $3,000 per month.  That’s a nice chunk of income given it’s turnkey; we don’t have to invest a nickel into getting it ready to rent.  Despite the potential revenue (upwards of $36,000+ per year), we are NOT going to rent out the in-law suite.  It’s just not worth it.  Let me explain.

Before I explain, I should also point out that I’ve been a landlord in the past so I’m familiar with the gig.  I owned a four-unit building. I lived in one unit.  Now we own a house with an in-law suite but this time we’re not renting it out.  Here’s why.

Why is it not worth renting out our basement in-law suite?

Taxes.  The long and short of it is that thanks to the insane amount of taxes we would have to pay on rent revenue received, it’s not worth giving up all that finished basement space.  The tax rate on all that income would be 53%.  I’m not joking.  That means if we managed to rent it out for $3,000, we’d only put $1,410 into our pocket each month.  While $1,410 is not chump change, we would be giving up over 1,700 sq. ft. of finished space.  Included in that space are a sauna, bathroom, kitchen and three large bedrooms.

But that’s not all.

Landlording can be a huge headache

Being a landlord isn’t without hassle.  We could end up with nightmare tenants.  We’d have to promptly deal with complaints.  We have young kids and would probably have to do our best to ensure they weren’t so loud upstairs… and trying to keep young kids quiet isn’t easy or fun.  We’d give up a parking spot in our driveway or on the road in front of our house.  Here’s a quick list of many hassles you get to deal with

  • Noise: You might end up with a tenant who likes to blast music, has tons of people over all the time partying, etc.  You never know until they’re in.
  • Having to be more quiet than you’d like: This is a bigger issue for us. We have young kids who are loud. The last thing I want to do is police that more than I do… and I know if we had tenants, we’d have to get on our kids to keep it down.
  • Give up a lot of premium space: I’ve discussed this already but it’s also worth mentioning that you give up privacy in the yard as well.
  • Parking issues: We have two cars already. One fits in the garage. One is on the driveway. If we have a tenant, they either take up a great spot on the driveway or the premium spot in front of the house.  Mostly it’s not a big deal but guests would have to park further away.
  • Eviction takes forever (assuming you win): If you end up with a nightmare tenant, it’s not like you can evict them inside 24 hours.  It’s a long, drawn-out process. If you hire a lawyer, it’s costly.  We know folks who went through a three-month nightmare trying to get rid of noisy tenants who refused to pay rent.
  • Finding good tenants is no picnic:  Finding tenants is like hiring employees.  It’s a process.  You have to take up valuable time vetting applicants.  It’s not the worst task in the world but it does take time.
  • Potential damage to your home: Tenants will cause wear and tear and may actually cause a lot of damage.  It’s definitely a risk and a cost.
  • Have a stranger in your house:  Although I know folks who have ended up good friends with tenants so it can work both ways. I also know people who have ended up with difficult tenants.  You never know.

It’s not all doom and gloom… having a tenant offers some benefits other than monthly income:

House-sitter: If you travel a lot, having a tenant can provide peace of mind that there’s someone at your house.

Could become great friends:  If you end up with a great tenant, you might become great friends. I know someone who is great friends with a former tenant.  It’s a good collateral benefit.  I would never count on it, but it happens.

At the end of the day, the benefit of the space to us is worth far more than the after-tax revenue we’d get renting it out.  I understand that we could deduct various expenses such as a portion of property taxes, improvements, utilities, etc. but it still wouldn’t make much of a difference.

Is it worth building an in-law suite to rent out in your house?

Again, it totally depends on your situation.  It clearly isn’t for us. We have one so we don’t have to spend a nickel on it yet aren’t going to rent it out.  However, it depends on your household income and whether you don’t need the space.  You need to crunch the numbers.  If it costs $50,000 to build a suite that will rent for $2,000 per month, you’ll pay the construction expense off in two years.  You’d want to ask an accountant whether the cost to build it could be deducted from the taxes owing on the rental income in your jurisdiction.

So in two years, your in-law suite is paid for; going forward, the after-tax revenue is all profit in your pocket.  If you have no other income, most of that $2,000 would go into your pocket. If you’re a high-earning household, a sizeable chunk of that $2,000 will not go into your pocket.

Part of the analysis requires what kind of returns you could earn from alternative investments.  There may but much better investments with better tax treatments than plowing it into a rentable suite.  For example, in Canada, we have an investment vehicle called a TFSA account.  Once funded, all income and capital gains generated from those investments are tax-free forever.  For example, if the $50,000 turned into $150,000 over the next 20 years, the $100,000 increase is tax free.  All revenue generated by the $150,000 is also tax-free.

On the other hand, a savvy homeowner could take the rental income and use it to finance retirement accounts that can avoid a large tax bill. For example, in Canada we can put a certain amount each year into a retirement account and that income is not taxed.  It’s taxed when pulled out in retirement but it’s safe to assume due to lower-income at that point that it’ll likely be taxed a lower rate.  Therefore, by investing all rental income into RRSPs, homeowners avoid paying taxes in the current year from the rental income and simultaneously contribute to retirement.

An In-Law Suite MIGHT (likely) be worth it for resale

In our area where houses are expensive, some folks looking to buy require a “mortgage helper” suite.  More demand for a property means a better price.  Moreover, folks who don’t care likely wouldn’t reject a house because it has an in-law suite. We didn’t. In fact, we love the idea of a second kitchen (we’ll use it as a pantry and bar).  The additional bedrooms provide for storage and a guest room.  All-in-all the existence of the suite works just fine for us.  My point is that with respect to home value, an in-law suite will more likely help than hurt.

You also want to consider the different types of in-law suites or rental suites you could build in your house or on your property.

Maybe it’ll be worth it when we’re retired

If/when we retire, that changes things.  Our income would be less which means our tax bracket could be lower which means we’d put more of the rent into our pockets.  At the same time, we’d be empty nesters and wouldn’t need all that space; the cost of giving it up would be far less. In other words, most of our current objections to renting it would no longer apply.  Most importantly, because our household income will likely be lower, the rent income would be a bigger help than it is now.

Why don’t we rent our in-law suite out for cash (under the table and pay no tax)?

Lots of folks do and get away with it indefinitely. Perhaps we could as well but the risk is pretty high.  If caught, the penalties and interest and back-taxes owing could be crippling.  Suppose we got away with it for ten years.  The back taxes owing would come to $190,800 (53% of rent income received).  On top of that would be penalties and interest.  Moreover, we’d probably be red-flagged with the tax authorities triggering future audits.  It’s just not worth the risk.  Besides, while I’m all for taking advantage of tax avoidance opportunities, I’m not into tax evasion… and yes, there’s a big difference. Avoidance is legal. Evasion is illegal.

What about short-term rentals on sites like Airbnb and VRBO?

If you live in an area where there is demand for short-term rentals (short-term rental tips), that could be a better solution.  You can earn in a week what you’d get from long-term rentals.  In other words, if rented out consistently, it could fetch far more.  You still must pay tax on that income but if we, for example, could earn $6,000 per month via short-term rentals, that would net $3,000 in our pocket each month.  We don’t live in a high short-term rental demand area so it’s not an option.

That said, short-term rentals are a lot more work. You must market the space, deal with inquiries, clean it frequently, etc.  It’s much more hassle than having a long-term renter.

Taxes make a huge difference

Our government (Canadian government but I’m sure similar housing issues exist in many countries) talks a’plenty about the lack of housing yet fails to use tax policy to ameliorate the issue.  Not only that, the high taxes paid on in-law rental suite income means many folks aren’t declaring that income so the government collects nothing on it.  What we have is either rental suites in houses being rented under-the-table or not rented at all due to high taxes.  It’s a huge loss of revenue to the government while restricting the amount of housing.  It’s a total fail.

If the government implemented a more reasonable tax rate on in-law suite rental income, more folks would declare the rental income. Those with suites sitting empty would be more inclined to rent it out.  I know I’d give it more consideration if I only had to pay 20% on the rental income.  For example, our tax code treats capital gains differently than personal income.  Same with corporate and business income; tax rates are much lower.  The reason for different tax rates for capital gains and business revenue is to spur investment.  It works.  This means if the government would like to encourage homeowners to build/rent out suites it needs to offer tax incentives to homeowners.

Crunch the numbers

The best way to know whether it’s worth building an in-law suite is to crunch the numbers.  The main point of this entire article is that when you crunch the numbers don’t forget about the taxes.  Taxes will likely be your largest expense.  In fact, many people aren’t aware you have to declare rental income which forms part of your personal income which if already in a higher tax bracket, will end up being a sizeable percentage of the rent income you receive.

Take your tax rate and apply that to your anticipated rental income.  In fact, it’s possible that renting out your in-law suite can bump you up into a higher tax bracket.  While you’d only pay the higher tax rate on the portion of income in the higher rate, the fact of the matter is that if you have a decent household income, you’ll pay a lot of taxes on your rental income.

It’s so easy to salivate over the $1,500, $2,000 or more you could get renting out a suite but when you realize you’ll only pocket a fraction of that, it makes you (and many others) think twice about doing it.

Note, the same above applies to all types of rental suites, whether basement, carriage house, single room, etc.

Related: House floor plans with in-law suites