If you compare the performance of the Real Estate Market to the performance of the Stock Market, investing in property can seem like a no-brainer. Using Real Estate as a money maker is not as simple as it may seem, especially if you are considering purchasing property that you would then rent out. If you have been considering buying some investment property, following is some essential information you need to know.
There are five basic types of residential investment property:
1. Single-family residence: While there are many different kinds of single-family residences, it is most common for first-time real estate investors to purchase a detached residence and rent it out as its market value appreciates. The reason this kind of investment is so popular is because these properties are the easiest to find and purchase, and they are appealing to both renters and buyers at resale. Because of their widespread appeal, single family residences are also usually easy to finance and refinance.
2. Vacation property and second homes: Your choices for investing in a vacation or second home range from outright purchase to fractional-interest contracts and timeshares. Keep in mind that even if the property doesn’t bring in any income, it can appreciate into a valuable investment, and mortgage interest is fully deductible. If you are planning to rent the property when you aren’t using it, realized income and tax obligations depend on what percentage of the year it's kept for "personal use"—a strictly defined term that needs to be discussed with a real estate attorney.
3. Apartments: An apartment property requires both a sizeable investment of borrowed and equity capital and a long-term commitment, but they often don't demand a lot of personal time if you hire a professional property manager. You may be able to finance up to 100% of the property’s value, whereas other investment types may require all cash. Loans can be amortized or paid with the income generated by rents.
4. Condominiums: Investing in a condominium brings with it more risk than some of your other options. The market value appreciates more slowly for a condo than for detached single-family residences, and rental rates aren't usually high enough to cover mortgage, property tax and maintenance fees.
5. Vacant land: If you’re looking for the most profitable short-term investment, vacant land is not for you. While easy to maintain, undeveloped land almost always takes longer to appreciate and longer to sell.
Real Estate investors often use a home equity line of credit to finance all or part of a down payment by using their primary residence or another rental property as collateral. You can also use a line of credit to expand a down payment and receive a lower interest rate or to avoid paying private mortgage insurance.
To qualify for a residential investment property loan, your income, income/debt ratio, reserves and credit scoring will all be taken into account. Some of your future rental income will also be considered when your lender scores your credit. The influence this information has will depend on the property itself and its appraisal, your lender, your financial obligations and your down payment. You can also expect to pay about 1.5 more points in interest because of the higher risk of default investment loans carry.
With few exceptions, Real Estate investors won't see a major gain in income or in the property’s market value for at least five years. While rental income will usually cover the property's mortgage, taxes and insurance, you will make most of your money is upon resale. How you’ll be taxed, which affects how much gain you will realize, depends on the way that sale is conducted.
Every expense incurred from an investment property – mortgage interest, property taxes, repairs, utilities and maintenance fees – is tax-deductible, which usually results in a taxable loss. When an investment property is sold outright, any gain made on an investment of 12 months or more is subject to a capital gains tax. The taxation rate ranges from 10% to 20%, depending on your tax bracket. You can deduct capital losses from capital gains and possibly from other income as well.
What is the best way to save money on taxes for long term rental property? Live there. If your investment property is used as your principal residence for an "aggregate" two of the preceding five years, you'll receive the personal property exemption on $500,000 (married, filing jointly) or $250,000 (separate or single returns) in capital gains when you sell the property.
Tax-deferred exchanges (outlined in the Internal Revenue Code Section 1031) are the only way to avoid paying capital gains taxes on investment property until it is sold. According to IRC 1031, gain or loss is not recognized when property held for productive use in investment, business or trade, is exchanged for "like-kind" property to be held for the same purpose. Any property held for this purpose (excluding your primary residence) is eligible for exchange. The properties do not have to be similar in any way except value.
A cost recovery deduction for depreciation provides a reasonable allowance for the exhaustion, wear and tear, and obsolescence on your investment property. You can claim this deduction even if the property itself has appreciated for up to 27.5 years for residential rental properties or 31.5 years for nonresidential real property.
If your second property is only used for personal use, mortgage interest is deductible, as with your primary residence. But you can use this benefit only once. For example, if you own more than two such properties, any debt above the $1 million cap on the first two properties, as well as interest on additional properties, is considered nondeductible personal interest. (Property tax is deductible for an unlimited number of properties.) Deductions for points paid on a vacation-home mortgage are prorated over the life of the loan.
If you rent the home 14 days per year or less, that income is tax-free. If rented for longer than 14 days, you must report the income, but rental expenses can be deducted. If you hold the property for personal use for more than 14 days, or more than 10% of the number of days it's rented annually, it's considered a personal residence and you can't claim a tax loss. You can, however, write off the full interest, partly as a rental expense, with the remainder as personal mortgage interest.