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Investment Property is a wealth building tool. The amount of wealth one can gain over time through an investment in rental property is primarily a function of leverage & appreciation. Investment property can also provide cash flow & a nice tax shelter. To ensure the longevity of an investment, one must also pay attention to a few important factors. Lets discuss the long-term advantages of investment property and then cover the specific topics to make investment properties work for you. At anytime you are welcome to skip ahead. Use the bold words at the beginning of each paragraph to navigate your way through the material.
Leverage & Appreciation, in the long run, will be the most important factors that determine the amount of wealth one gains through their investment property.
Leverage is the technique of borrowing money to finance an investment property. What is the advantage of leverage? By using leverage, one can purchase an investment property without paying the full cash amount. (i.e. You invest $20,000 (10% down payment.) You purchase a duplex for $200,000. You have just leveraged your $20,000 into a $200,000 investment.
Appreciation is simply the increase in value over time. (i.e. The market value of your investment property was $200,000 last year. Your investment property appreciated 10% this year. The market value of your investment property today is $220,000.) The true power of appreciation is that the market value will grow at an exponential rate over time.
Now that we can see the long-term rewards of investment in rental property, lets go over what needs to be done to make it all work.
Make a budget for your investment in rental property. First, you need to decide what your investment base is going to be. Your investment base is simply the cost of acquiring the investment property. Investment Base = Down Payment + Closing Costs
Define your Purpose. What are your goals & intentions? Your goals are going to have a strong influence on what type of investment property is right for you. (i.e. I have an investment base of $20,000 & would like to maximize my equity over the next 15 years.)
Finding the Right Investment Property is the next step. You know how much money you can spend. You know what you want your money to do for you. Now it is time to find the best property investment for you. There are two basic types of investment properties; residential property & commercial property.
Commercial property Commercial property is the type of investment property typically leased to businesses. For simplicity, lets focus on residential investment property.
Residential Investment Property can also be broken down into two types. For real estate & tax code purposes, residential investment property is defined by the number of residential units on the property. Properties with 4 or less units are treated differently than properties with 5 or more units. Both types have advantages. There is a higher risk involved with large multi-unit properties. Thus, the possibility of higher revenues exists as the number of units increases.
Investment Properties with less than 4 units have a very distinct set of advantages. First, financing investment properties with less than 4 units is similar to financing single-family homes. Second, tenants typically tend to stay longer than in larger apartment complexes. Third, residential investment properties with less than 4 units cost less to acquire than larger complexes. This lower cost of acquisition is what makes this type of property attractive to first-time investors.
Selecting the Investment Property that will work best for you, will be answered by the numbers. Unfortunately, some of the numbers needed will not be available to you (even if the numbers are provided, they may not be correct.) The method for revealing the potential of an investment property is fairly simple, but you will need some information about the local rental market. Find out what the rental rates & rental vacancy rates are. Organize your data by the month. This will give you an idea how much money your investment will bring in each month. Next, you need to figure the expenses. Determining the actual expenses over the life of the investment is impossible. A good estimate for expenses is 30% of the gross income. (i.e. If the property rents for $1,000/mo. you can figure it will cost you $300/mo. in expenses over the life of the investment.)
What is Cash Flow? Cash flow is the difference between gross income (minus expenses) & debt service. The debt service is just the mortgage payment (plus taxes & insurance.) If you have a positive cash flow, that means that every month after paying off your investments debt service & expenses you still have a little money left over. Depending on the purpose of your investment this may be a good or bad thing.
Tax Benefits are a major advantage to owning investment property. What can you deduct from your taxes? You can deduct; expenses, depreciation, interest & points. A helpful way to remember the tax benefits of an investment property is by remembering to "D.I.P." The "D" stands for depreciation. The improved portion of your residential investment property can be fully depreciated over 27.5 years. The "improved" portion refers to everything except the land & the personal property. The "I" stands for interest. The portion of your mortgage payment that pays off interest is tax deductible. The "P" represents points paid to the lender. When purchasing real estate, there will be closing costs that need to be paid at the time of purchase. Sometimes the lender will cover these costs in exchange for points. Points are cash paid to the lender for underwriting the loan (1 point represents 1% of the loan amount.) Points paid to the lender can also be depreciated over 27.5 years. It is important to note, while points can be deducted, the remainder of your closing costs cannot.
The Flexibility of Your Property Investment is expanded by the use of IRC 1031, known as a "1031 Tax Deferred Exchange." IRC 1031 allows investors of real estate to defer the capital gains tax when exchanging "like-kind" property. The investor must exchange for real estate of equal or more value and needs to follow a number of rules & guidelines. The 1031 Tax Deferred Exchange can be used anywhere in the country & even between states.
1031 Tax Deferred Exchange
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