Buying Rental Property Is A Great Way To Round Out Your Investments

What To Know About Buying a Rental Property

Photo credit to Clayton WIN

Owning real estate rental property is good — it can do the two things that are characteristic of performing investments.  A rental house can pay you monthly cashflow, in the form of collecting rent that is more than your expenses.  And, a rental house can grow in value, in the form of the sale price being more than the purchase price.  Yippppeee, good real estate can pay you these two ways.

I bought a rental house after attending a real estate class and wanting to know more about the ins and outs of owning rental property.  I bought a fixer-upper, yes, it needed a lot of work.  I expected that I would fix it up and then sell it for more than my total cost.  You guessed it, I made the house lovely, just as I would like to live in it, and then I couldn’t sell it for what I had in it. 

Beware The Pitfalls Of Buying Investment Properties

Change of plans — then I decided I would rent the house instead of sell it.  In the first couple of years, I collected the rent each month but my expenses, including debt service and insurance where more than the rent I collected. 

Then I began to realize in this learning process that cash for this project included:  the down payment to get the mortgage, the remodel costs, the shortfall that I was experiencing each month and oops….the month or so of lost rent when a tenant moved out before another one moved in.  Suddenly I had a project that I was feeding. 

That worked out though, and several years later, my rents exceeded my expenses, the property had gone up in value — and whoopee!, I was making monthly income plus enjoying the appreciation of the worth of the house.  It was just good that I’d had the cash flow to survive the early years.

Even in recessionary times, rents have been holding up because there is currently a shortage of Buying Rental Propertyapartments for middle-income renters— according to the National Association of Realtors. With student loans up, the difficulty of qualifying for a mortgage, and just plain lifestyle choices for financial flexibility….more young people are renting.  Of course, it depends upon where your rental property is located but rents can be a stable source of income from an investment.

And then I learned the third great thing about investing in rental property:  there was income, appreciation, and third, tax benefits!  Rental property is one of the best tax deductions in America.  That means that you can save more of what you earn.

Deductions Against Rental Income Is Sweet

Soon I learned that I could deduct expenses against the rental income that I was making, like the gardening, and other maintenance, and also depreciation.  It was fun to learn about owning rental property, everything from buying the property, to remodeling it, the income and expenses, and the tax consequences.

I learned that if you make $150,000 or more you can’t deduct rental losses.  Well, what else could I do, I wondered because, in the early years, I had rental losses?  There is a solution, I discovered. 

This is fundamental.  Always keep this in mind.  When you have a business, for whatever you do, you can always take more deductions.  And more deductions means that more coin is left in your purse!

Buying Rental Property and Tax DeductionsI like that because I am thinking about growing my Money Machine.  That imaginary thing that houses my investments, and grows with greater and greater potential to pay me a sum of money to replace me working.  When my real estate pays more monthly income, when the rental house grows in value, and when I can preserve more of the income with tax deductions — I win — and my Money Machine is growing larger.  All good.

Also, if one of these three things is not working as well, it’s time to tweet.  Perhaps you have a rental and it’s time to raise the rent.  Rents have been going up on a national basis.  Perhaps the accountant that you are using is not familiar with all the deductions that you can take on the rental property, or you are doing your taxes personally, and now it’s time to move up to a new tax person who can help you oil your Money Machine. 

Here’s the scoop!  When you are classified as ‘active’ as a real estate woman, in other words, you are running your real estate as a business, you can deduct much more than you can as a passive investor. 

For instance, you can deduct a portion of your home office, cleaning, office furniture, educational seminar programs and travel, and a $2500 write-off for equipment.  These are just some examples to say that it is sexier to be a real estate business and sharpen your tax strategies with the help of a good tax person.

To make your real estate efforts into a business, there are certain qualifications that good ole Uncle Sam will be considering.  Did you spend 750 hours in your real estate business that you have accounted for in a log?  Now this might sound like a lot of hours, but it includes drive time to your rental property, meeting with tenants, organizing repairs etc.  I was really surprised when I lined out the time that I spent for my rental property and all of the different ways that I could account for the hours spent.  There was running an ad in the newspaper, collecting the rent, doing the accounting — and before long, 750 throughout the year was attained!  A good accountant will tell you more about being a real estate business.  Here I want to introduce the concept. 

I still have that piece of rental property and that’s a good thing too.  If I were to sell it now, I would pay between 155 and 20% (depending upon my tax bracket) in capital gains taxes, because I have held the property for longer than two years.  If I sold the property in the first year, just after I had finished remodeling it, I would have paid ordinary income taxes at a rate much higher than the capital gains rate.  That’s was a big motivation for holding on to the property at that time, and deciding to rent it. 

Another option is something called a 1031 Exchange.  If you sell one piece of property and quickly buy another one, you can bypass paying taxes.  This also helps your Money Machine to grow bigger.  It has to be carefully done though.  First, you need an Accommodator, funny sounding word, huh?  That’s just a professional company that immediately gets and holds the proceeds of the sale for you.  If you touch the sale proceeds, by putting them into any account you own, you spoil the 1031 Exchange.

Then within 45 days, you have to tell the Accommodator what property or properties that you have earmarked as your possible purchases.  And then, within 180 days, you have to close on the new property you are purchasing.  This is all to avoid paying taxes in the process. 

If you want to gain some cash out of this series of transactions, then the best bet is to finish this process of selling and buying, and then borrow cash on your new property.  Thing is, you can’t sell and buy with your favorite Aunt or family member — Uncle will be looking to see that it’s a transaction that is ‘arms length’.

When you buy a piece of rental property, and you get a mortgage on it, the banks will usually want you to own the property personally to make the loan.  Once you own it though, that’s not the best way to handle it.  It’s often better to retitle the property into a limited partnership which you set up legally, and have the limited partnership own the property for you. 

I went on from owning the rental house to owning an office building.  There were 10 offices in this magnificent old Victorian building.  Although, this is funny.  I was traveling in Europe and I was describing the magnificence of this building to a person that I met there.  I said, ‘and the building is over a 100 years old’, with great glee.  The person looked at me and said, ‘My grandmother is older than that!’  We think a 100 year old building in California is really old, and not so in Europe, I was told!

Limit Your Exposure, Protect Your Other Assets

One of my tenants in the building was a therapist and her office was on the second floor.  Her client left her office and proceeded down the stairs.  Since it was an older building the stairs were narrow and a little awkward to get used to.  I could keep them this way because the building was on the Historic Register and I didn’t have to bring it up to current building standards because the Register preserves buildings as they were built.  Also, the stair railing was very low (people must have been smaller back in the 1900’s when the building was built).  She started down the first step and took a tumble — yikes — rolling down the stairs and landing at the bottom.  We called the paramedics and she had broken her foot. 

While I felt badly for this sweet woman, she was also very kind.  She didn’t sue me.  If she had, I owned the building in a limited partnership and this would have limited her recourse to the building itself.  In other words, my other personal assets were protected from some mishap at this rental property. 

Did you know that you can also buy rental property with moneys that you have accumulated in your IRA account?  Yes, you can!  It takes a little maneuvering to do so, and it may be worth your while to consider this.  Since IRA accounts already are protected from taxes when you earn income, the magic of tax deductions on our personal tax return is not applicable here. 

Self Directed IRA Mean You Can Direct What Goes In It

You can set up something called a Self Directed IRA.  This is a special IRA account that is not generally found at your regular brokerage firm.  There are special companies that specialize in self directed accounts because these have different governing rules than traditional IRA accounts.  A Self Directed IRA means that you can self direct it, and in it you can by many things like: real estate, mortgages, trust deeds, tax liens, options, real estate investment trusts — a whole bunch of stuff.  What you can’t own in them is your office, your personal or vacation home. 

If you go this route of the Self Directed IRA, you’ll want to look closely at the structure of the account so you understand how it works.  Sometimes the company will charge a fee on the back-end if you sell the real estate in this type of an account — you just want to make sure that you understand how it works for you.

These days, do you hear the talk of people renting their home or part of their home on the internet?  It’s possible to be very creative.  Only problem for me is that my extra bedroom’s closet is stuffed full of clothes — and where would I put them to rent the room?  You can rent out your house for 14 days a year and the income is not reportable on your taxes, but if you’ve cleaned out the closet and rented the room more than this on AirBnB, it is reportable income.

And here’s the last and most important thing to say about buying rental property.  When it goes into your Money Machine and it’s an investment — buy it right.  I spent many career years as a trader in the markets, and traders will tell you that the profit is in the purchase price, not in the sale price.

In other words, when people are gleeful about how much the market has gained in value, and it feels good to everyone, and you think of the prospects of jumping in — it’s probably the wrong time to do it.  That’s a time to hold your cash and be patient.

When everyone is groaning about their losses and about how the market has turned sour and people are shunning the opportunity — that’s the time to buy.  It’s tough to will yourself to do it by parting with your cash but that’s when the best deal is made.  When your whole body is resisting the purchase because there is no indication of immediate success, and it’s a leap of faith — it’s a go. 

When your whole body is ready to run after the herd — that’s a stop.

You might be saying, ‘well, the stock, bond and real estate markets have been running up for nearly a decade now’.  Isn’t that assurance for me to buy, and maybe these markets will just never go down again. These long run up should tell you that it is not the time to buy.  Markets always through history have gone up and then down, then up and then down. 

Pick your buying time when the market dips, people are ready to part with property at discounted prices (not premium prices).  It’s like going to your favorite store and finding a sale.

My friend told me that she was cruising a favorite shopping area the other day and wandered into the Donald Pliner Shoe Store.  To her amazement there were gorgeous blue boots that had been more than $400, and were now on sale for less than $150.  She was so happy to get them, and another pair at bargain prices.  She was feeling really good that she scoped out the perfect buying opportunity!

This is how your Money Machine will grow with your purchase of rental property.

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