It pays to own rental real estate

On a recent flight from San Francisco to Chicago, I sat nextto a talkative businesswoman. After we exchanged pleasantries and she learned Iinvest in and write about real estate, she asked, “What type of realestate should my husband and I invest in?”

Rather than give a direct answer, I replied, “Well, doyou have any realty investments now?” Just our townhouse, she replied.”Has that been a good investment?” I asked.

Purchase Bob Bruss reports online.

She said they bought it about four years ago and since thenit has more than doubled in market value. I responded that was extraordinary,but it can happen for well-located homes.

Then I asked her, “How much of a cash down payment didyou make?” She replied, “Ten percent down. We got one of those PMI(private mortgage insurance) mortgages for 90 percent financing.” Next,she launched into a rant about what a ripoff her $124 per month PMI premium is.

After I politely explained how she could cancel the PMI withan on-time payment record for at least 24 months by asking the lender to cancelthe PMI based on a new appraisal, she was very grateful. “Why didn’t thelender tell me?” she asked.

Then I tactfully redirected the conversation to make twopoints: (1) She and her husband wisely bought for 10 percent down, and (2) Theyare profiting from the benefits of leverage by controlling the entireproperty-value increase with just a small cash investment.

IF ONE HOME IS GOOD, WOULDN’T TWO BE BETTER? Duringthe conversation, my seatmate said she and her husband want to buy a largerhouse. I congratulated her on that wise decision, especially in the current”buyer’s market” in most cities.

Then she asked if they should keep or sell the townhousewhen they buy a larger home. Since she mentioned the townhouse is located in agood neighborhood and there seems to be strong rental demand, I suggestedkeeping the townhouse as a rental.

When my new friend asked about losing the $500,000principal-residence home-sale tax exemption for a married couple filing jointly(up to $250,000 for a single homeowner), I explained the townhouse can berented as long as 36 months before losing this benefit of Internal Revenue Code121.

“That’s presuming you and your husband owned andoccupied it at least 24 of the last 60 months before the home sale,” Ireminded my seatmate. If the townhouse continues to go up in value over the 36months after you move out, I continued, then you get to enjoy even moretax-free market-value appreciation up to $500,000.

Then I asked, “If one home is good, wouldn’t two bebetter?” She got the point real fast. Next, I briefly explained the taxadvantages of keeping the townhouse as a rental property for a few years beforedeciding to keep or sell it.

I explained the benefits of the noncash depreciation taxdeduction for rental property, but I don’t think I did a very good job. Savingtax dollars didn’t seem to interest her.

PROS AND CONS OF OWNING RENTAL HOUSES. Althoughthere are many tax advantages of owning rental houses, especially tax-freeincome deductions up to $25,000 if you earn less than $100,000 annual adjustedgross income, there are a few possible disadvantages.

The primary negative to owning rental houses is called”tenants and toilets.” By carefully selecting quality tenants who arelikely to pay the rent on time (based on their credit report and FICO score),the management problem can be minimized. Good-quality house renters often staymany years.

Another possible negative is maintenance. Periodically,house components need repair or replacement. Rental-house owners should haveaccess to quick cash for an emergency, such as a roof replacement. A homeequity credit line is the best source because it costs nothing (except a $50annual fee) until it is used by writing a check.

PROFESSIONAL PROPERTY MANAGEMENT ISN’T CHEAP. Althoughowner management of rental houses is recommended to save costs if the propertyis located within an hour’s drive, sometimes landlords either don’t want to orare unable to manage their rental houses.

When that happens, there are professional propertymanagement firms available. Before hiring such a firm, investors should obtainclient references and check out the firm extremely carefully.

Most professional property management firms charge fees of10 percent to 15 percent of the gross rental income for houses. They oftencharge additional fees for supervising repairs and for renting vacancies. Thebest firms provide monthly computer printouts to owners showing rentcollections and expense payments, along with a monthly check to the owner.

ARE APARTMENTS GOOD INVESTMENTS? Myairline seatmate had one more important question: “Wouldn’t apartments bea better investment since my husband and I travel a lot?”

Then I explained large apartment buildings can be goodinvestments because the landlord can usually hire an on-site resident managerto collect the rents and manage the property. But I quickly added, “Thenyour job is to manage the manager.”

My personal experience has been apartment buildings …(1) usually don’t appreciate in market value as fast as single-family housesand (2) problems with apartment buildings are usually big problems, such asmalfunction of a key component or the need for an expensive repair, such as anew roof.

Also, if the local apartment rental market is soft, with toomany vacancies, that severely hurts the rental cash flow.

Apartment buildings and commercial properties are valueddepending on their capitalization or “cap rate,” which depends on thenet operating income. However, single-family rental-house market values dependon recent sales prices of comparable nearby houses rather than rental incomeand expenses.

BONUS ADVANTAGE OF RENTAL HOUSES. An extraadvantage of investing in rental houses or any other type of real estateinvestment or business property (but not your personal residence) is it can beexchanged — tax-deferred — for other investment or business real estate ofequal or greater cost and equity.

Internal Revenue Code 1031 makes it possible to pyramidrealty investments from a small rental property into investment property worthfar more, without the erosion of capital gains tax. Full details on this andother tax benefits are available from your tax adviser.

(For more information on Bob Bruss publications, visit his
Real Estate Center

Copyright 2007 Inman News

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