If you want to buy a rental property, make sure that you do it with your eyes wide open.
Besides making a big financial commitment to a single asset, rental property can require more time and money than mutual funds or your 401(k) account.
First, make sure you’re buying the right property for a rental. Virginia Johnson of ERA Shields recommends researching rents in the area where you’re looking for a property. You want a property in which the potential rents will at least cover any mortgage payment, as well as regular maintenance on the property.
If the property is in a homeowners association, make sure to include those fees in your rent and read the covenants to know any restrictions on the property. Johnson also says, “Scrutinize the neighborhood. Think about resale — someday you probably will want to” sell.
Become aware of what landlords do.
Hiring a property manager may be a good idea. A person with expertise in screening potential renters and keeping a property in good repair will save you time and money, even after paying management fees. You’ll also need to pay for materials and labor for repairs and upgrades. Having a buffer between landlord and tenant can avoid frequent calls and requests for rent concessions.
Rental properties have specific tax issues. Rental property owners can depreciate buildings and improvements, an accounting method for owners to recover the cost of a property over the time it’s owned. Depreciation is an annual tax-deductible expense that doesn’t require a cash outlay.
Many investors own rental properties to benefit from depreciation, but they must “recapture” depreciation when the property is sold. That means owners must declare all depreciation as income in the year of sale, which is subject to ordinary income tax. You can’t avoid recapturing depreciation by not taking it as an expense. You also must pay capital gains tax on the increase in the property’s value.
If you don’t need cash from selling a property, there are some alternatives. That can include owning the property the rest of your life or making a tax-free property exchange. We’ll explore both next week.