Some people think their primary residence IS their real estate investment. They look at their home as part of their retirement, security in case of an emergency and maybe something to leave to their children if they don’t drain all of the equity themselves before passing away.
Although your primary residence is an investment you are building, it should not really be viewed as such because it will not generate income for you unless you convert it into a reverse mortgage. Converting your primary residence into a reverse mortgage will drain the equity and ultimately leave you with nothing, not to mention your children.
A true real estate investment is a property that is either providing a monthly rental income for you or is increasing in value over the long term. Land is one type of property that will always only increase in value over the long term. It is a good idea to have at least one land property in your real estate investment portfolio.
Rental Property Investment
Rental property is an excellent investment. As with most investments there is risk that you need to calculate in and determine if rental property is a good fit for you.
The first assessment is how long do you plan on having the rental property. The longer you plan on owning, the more flexibility you have with the purchase price. The longer you own the rental property the more the monthly rental income will pay for the purchase price, increasing the profit you will make if you ever sell.
If you plan on a quick turn over then you will want to be very careful with getting a discounted purchase price. Discounted purchase prices typically are obtained by buying through an action or buying a distressed property. If you are willing to invest in a distressed property to renovate it before renting it you may just get the best deal so long as you account for the time and budget needed to rehab the property.
Be aware that your risk increases the most when you purchase rental property at or near your cash thresh hold. If you don’t leave cash in your repair and emergency reserves then unexpected repairs, difficult tenants and a market down turn could spiral you into a situation where you are forced to sell high without a profit, at a loss or losing the property altogether.
Key tips when buying a regular rental property
- Buy local.
- Have an emergency cash reserve that is at least 20 percent of the purchase price.
- Be ready to take care of repairs or legal evictions quickly without delay.
In general, there are two approaches to take with rental property management; hands on or delegated. Obviously, you as the property owner are the property management in both scenario’s. However, it’s up to you how much month to month hands on maintenance you want to perform yourself or delegate.
If you have a low number of rental properties you may want to consider maintaining it yourself to learn the ins and outs of maintaining a rental property and to save money as you get started in the rental business. If your schedule has other priorities then it would be a good idea to delegate this task right away.
Depending on what type of rental property will determine how much and what type of maintenance is required. If it is a residential rental property that has a minimum year lease then the maintenance event typically occurs annually with a few repair exceptions mixed in. If it is a VRBO property this is a completely different scenario with at least weekly maintenance events if not daily.
You will want to review your budget and schedule to determine the best course of action and how hands on you want to be with the maintenance. Many times, hiring a team to perform this for you pays off in time saved and being more proactive when maintenance is needed.
Taxes on Rental Properties
You will want to consult with a tax professional on how best to structure your residential rental property assets. You may want to consider forming a separate entity such as an LLC to place the rentals under. This won’t get you out of the Capital Gains tax event should you sell the property but does provide a way to maintain control, reduce liability and give shares to those you want to inherit the asset if retained.
Whether the rental property is placed under you individually or in an LLC, the profit is still considered personal income and will be taxed accordingly depending on what tax bracket you are categorized under. In the event that you sell the property you will get hit with Capital Gains Tax unless you sell within the 1031 Exchange requirements in which case you are moving funds from one asset into another and avoid the Capital Gain Tax because you do not receive taxable cash profit.
For a short term sale that is under a year of ownership the Capital Gains Tax will equal your personal income tax bracket percent. If it is sold after a year of ownership it is considered a long term sale and becomes a lesser percent of your personal income tax bracket and filing status. The rates are 0%, 15% or 20%.
Long-term capital gains tax rate table
Filing Single
Tax Your income
0% $0 to $39,375
15% $39,376 to $434,550
20% $434,551 or more
Filing Married Jointly
Tax Your income
0% $0 to $78,750
15% $78,751 to $488,850
20% $488,851 or more
Filing Head of Household
Tax Your income
0% $0 to $52,750
15% $52,751 to $461,700
20% $461,701 or more
Filing Married Separately
Tax Your income
0% $0 to $39,375
15% $39,376 to $244,425
20% $244,426 or more
Tips on how to minimize capital gain taxes
Wait to Sell
Retain your real estate investment property for at least more then one year. This avoids the full matching personal income tax bracket tax you would assessed and gives you the discounted tax rate.
Profit Allocation
You can shift dividends from a profitable asset and invest it in an unprofitable asset. In this way you avoid the capital gain tax, retain the performing asset and invest to repair an under performing asset.
Place Assets in Tax Deferred Accounts
If you place investment property into a 401(k) plan or a 529 college account that is tax-deferred, if you sell the property it will not receive the capital gain tax at the point of sale.
Deduct Expenses Before Capital Gains Tax
- Closing Costs
- Real Estate Commission Fees
- Real Estate Taxes
- Repair Costs/Non-Decorative Improvements
How to get started buying a rental property
If your credit score is at least above 680 you may qualify for a rental property loan. The loan would most likely be tied to your primary residential property for collateral.
You could check with your local credit union for good rates or go online to apply to the various marketplace lenders that are available. If you don’t like the rates you receive or don’t quiet qualify then use the delay to save up 25% as a down payment. By the time you save up the money you most likely will have received an offer that is more favorable. If not, apply again. Your down payment will put you in a better position to receive more favorable terms.
Another finance options is owner financed. Similar to a bank, you make monthly mortgage payments to the owner. The property title remains with the owner until paid in full at which time it is transferred to you.
Finally, gathering a group of investors to share a property purchase is a great way to obtain a property without a bank loan. If it is a rental property you will want to determine the ownership percentages based on how much each investor provided and then separately, the operating budget that includes an amount paid to the manager of the property. If that is yourself then you would receive the percentage of ownership along with a salary for the management work.
In general, owning rental property is a great investment, especially if you are careful to seek out a property that is offered at an auction or is distressed when you have the ability to renovate and convert it into a money making asset. Roadblocks to financing can be overcome with a solid contract agreement. Building in an emergency fund into your purchase budget to cover unexpected items that may arise will protect you and your asset. Gather up a good team and get started!
