Top Factors in the Investment Use of Real Estate

    

The Consummate Capitalist views real estate in two broad categories: personal-use and investment-use.  The two are never mixed.  That is, if a dwelling is put to personal-use, it is not an investment.  A key criterion that distinguishes such investment assets as stocks, bonds, and investment real estate from such generic assets as personal automobiles and one or more dwellings that a person owns is the question of personal use.  The Internal Revenue Code (Tax Code) addresses this distinction well: there are three tiers of allowed tax deductions that may be taken against one's Vacation/Second Home.  However, it is the very notion of putting the dwelling to personal use, at all, that takes it out of the category of an investment property and places it into the rubric of deductions allowed for a Vacation Home.¹  A clear message is being communicated by the U.S. tax authorities: investment property is not put to personal use; and if property is put to personal use, a taxpayer cannot deduct business expenses for that use.  


The following is a list and short description of key factors that may be helpful in locating and purchasing investment rental property:  

1) Location of Property   A home that is rented out should have very easy access to shopping, dining, excellent schools, entertainment, and well-maintained commuter roads and public rails.  Location is not important in a vacuum; location is vitally important because of its relative position to many other locations that tenants will want at their fingertips.  

2) Desirability of the House   If the house has a poor floor-plan, forget it; if it has a cracked foundation, forget it; if it needs new electrical and plumbing from the start, forget it.  The "fixer upper" route is all right for the experienced contractor; but for most, it adds too many unpredictable contingencies (financial risks) to the equation.

3) Condition of the Neighborhood   Junky neighborhoods seldom perform a turnaround; and the period of time tha is necessary is unpredictable.  Also, if there appears to be shady characters roaming the streets, junky/out-of-order cars, or more than a couple of poorly maintained yards, etc., then you can expect the house that you buy and rent-out will go in the same direction as the neighborhood.  

4) Age and Condition of the House Prior to Purchase  If an investor is not comfortable with some of the technical aspects that comes with a property (heating/cooling systems, electrical condition, plumbing, condition of the water heater, foundation, structural integrity, etc.) then a state licensed inspector may help tremendously. By hiring a professional inspector, you will be more fully apprised of all the factors that contribute to the offered price.

5) Ability to Obtain a Good Manager  You can earn figurative dividends by researching, interviewing, and receiving references on property managers, particularly if your property is out-of-state.  If a property manager has your best interests in mind, cares for a property, is careful with who occupies the property, and otherwise disburses payments to you with thorough accounting, you will have done yourself a great favor in taking the time to get this aspect right.

6) Local Economy and Job Outlook   The city chosen should either be in an economic growth spurt, or best of all, there is a general consensus that it is heading that way.  And, even if a town is doing well, consider the percentage of people employed by just one or two major employers.  A town too reliant on just a couple of major employers is one that is only a couple of mergers/acquisitions from being bankrupted... and the housing prices with it.

7) Presence of an Investor Cash Cushion   A significant cash [or near-cash, like savings bonds] cushion is indispensable for a real estate investor.  Some will blythely assume that they will just be able to borrow money against real estate holdings, if a sudden cash needs erupts.  However, the lending conditions in 2008 cast a long shadow on such an assumption.  At least $5,000 to $7,000 should be standing by for a sudden major repair that may be necessary. Additionally, owners should have several thousand dollars additionally set aside to cover vacancies (thus the investor pays the mortgage while looking for tenants). When viewed comprehensively, its a good idea to have anywhere from $10,000 to $15,000 set aside for one or two properties to cover potential contingencies.  More properties would call for more cash set aside.

8) Prevalence of Bargain Houses   Among other guarantors of mortgage loans, the Department of Housing and Urban Development (HUD), the Veterans Administration (VA), Fannie Mae, and Freddie Mac all routinely offer homes at bargain prices that were previously foreclosed.  These organizations are attempting to divest themselves of ownership of homes in an effort to recoup some (or most) of their losses that accrued for having been the previous loan guarantor (and having gotten stuck with the tab... and the house). 

9) Investment Mortgage Interest Rates   Mortgage rates are very important because they can greatly improve an investors financial position on a particular property.  For example, a purchase price that does not look attractive at say, $190,000 and an interest rate of 7.5%, may be much more attractive because it is possible to get a 5.5%, 30-year fixed rate.  Typically, investment mortgage rates are between .25 and .75 percent more than a primary home mortgage rate. The difference represents the perceived risk of a person borrowning money against an asset that can be easily abandoned (or so the thinking goes).  The difference in the interest rate can potentially allow you to break even every month (using tenant rent) on a home that would have had you in the red (because of a purchase price that was a little too high for the rents that could be received).  If you are breaking even, this means that the tenant is paying down the balance on the loan (and building equity, even without any price growth).  And the house is costing you nothing out-of-pocket.

10) Income Tax Implications    If a married couple earns less than $100,000 per year, jointly, then all "tax lossess" of up to $25,000 on property held for investment income are fully deductibel against taxpayer earned income.  This means that if Mr and Mrs Taxpayer earn $90,000 in a given year, but also incur $15,000 in real estate tax losses, the couple will reduce their taxable income by an additional $15,000 more than they would have without owning the rental real estate. 

If a couple jointly earns more than $100,000, then $1 of deduction is lost for every $2 of income above $100,000.  This means that if Mr and Mrs Taxpayer earn $130,000, they will lose $15,000 of the maximum $25,000 deduction.  The $15,000 reduction is the result of it being one-half of the amount the couple earned above $100,000 ($30,000 extra); they lost $1 of deduction for every $2 of "excess" income above $100,000.  The result means that they can still deduct up to $10,000 in real estate tax losses (max $25,000 reduced by $15,000 because of excess income).

The attractiveness of deducting real estate tax losses against active income is that often there is no out-of-pocket loss to the taxpayer... but the tax benefit is received all the same.  Tax losses often occur because of allowed deductions for depreciation . . . which is an allowance for the fact that the components of a home (walls, flooring, roof, etc.) wear out over time.

^{1  26 U.S.C. (Tax Code), section 280A.}
 

 

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