Investment Property: Definition, Financing, and Types
What Is an Investment Property?
An investment property can be a long-term endeavor or a short-term investment. With the latter, investors will often engage in flipping, where real estate is bought, remodeled or renovated, and sold at a profit within a short time frame.
The term “investment property” may also be used to describe other assets an investor purchases for the sake of future appreciation such as art, securities, land, or other collectibles.
KEY TAKEAWAYS
- An investment property is purchased with the intention of earning a return through rental income, the future resale of the property, or both.
- Properties can represent a short- or long-term investment opportunity.
- Investment properties are not primary residences or second homes, which makes it harder for investors to secure financing.
- Selling an investment property must be reported, and may result in capital gains, which can have tax implications for investors.
Understanding Investment Properties
Investment properties are those that are not used as a primary residence. They generate some form of income—dividends, interest, rents, or even royalties—that fall outside the scope of the property owner’s regular line of business. And the way in which an investment property is used has a significant impact on its value.
Investment properties generate income and are not primary residences.
Investors sometimes conduct studies to determine the best, and most profitable, use of a property. This is often referred to as the property’s highest and best use. For example, if an investment property is zoned for both commercial and residential use, the investor weighs the pros and cons of both until they ascertain which has the highest potential rate of return. They then utilize the property in that manner.
An investment property is often referred to as a second home. But the two don’t necessarily mean the same thing. For instance, a family may purchase a cottage or other vacation property to use themselves, or someone with a primary home in the city may purchase a second property in the country or in another state as a retreat for weekends. In these cases, the second property is for personal use—not as an income property.
Types of Investment Properties
Residential
Rental homes are a popular way for investors to supplement their income. An investor who purchases a residential property and rents it out to tenants can collect monthly rents. These can be single-family homes, condominiums, apartments, townhomes, or other types of residential structures.
Commercial
Income-generating properties don’t always have to be residential. Some investors—especially corporations—purchase commercial properties that are used specifically for business purposes. Maintenance and improvements to these properties can be higher, but these costs can be offset by bigger returns. That’s because the leases for these properties often command higher rents. These buildings may be commercially-owned apartment buildings or retail store locations.
Mixed-Use
A mixed-use property can be used simultaneously for both commercial and residential purposes. For instance, a building may have a retail storefront on the main floor such as a convenience store, bar, or restaurant, while the upper portion of the structure houses residential units.
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Financing Investment Properties
While borrowers who secure a loan for their primary residence have access to an array of financing options including FHA loans, VA loans, and conventional loans, it can be more challenging to procure financing for an investment property.
Insurers do not provide mortgage insurance for investment properties, and as a result, borrowers need to have at least 20% down to secure bank financing for investment properties.
Banks also insist on good credit scores and relatively low loan-to-value ratios before approving a borrower for an investment property mortgage. Some lenders also require the borrower to have ample savings to cover at least six months’ worth of expenses on the investment property, thereby ensuring the mortgage and other obligations will be kept up to date.
Tax Implications
If an investor collects rent from an investment property, the Internal Revenue Service (IRS) requires them to report the rent as income, but the agency also allows them to subtract relevant expenses from this amount. For example, if a landlord collects $100,000 in rent over the course of a year but pays $20,000 in repairs, lawn maintenance, and related expenses, they report the difference of $80,000 as self-employment income.
If an individual sells an investment property for more than the original purchase price, they have a capital gain, which must be reported to the IRS. For 2021 and 2022, capital gains tax rates are either 0%, 15%, or 20% for most assets that are being held for over a year.
In contrast, if a taxpayer sells their primary residence, they only have to report capital gains tax on a home sale in excess of $250,000 if they file individually and $500,000 if they are married and filing jointly. The capital gain on an investment property is its selling price minus its purchase price minus any major improvements.
To illustrate, imagine an investor buys a property for $100,000 and spends $20,000 installing new plumbing. A few years later, they sell the property for $200,000. After subtracting their initial investment and capital repairs, their gain is $80,000.
Source: Investopedia
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