2 Half-Truths About Investing in Real Estate

Half-Truth #1: The longer you hold on to a rental property, the better an investment it becomes.

The true half: When you buy a property with a fixed mortgage, your payments will stay the same while, hopefully, rent will go up over time. In addition, the amount of your payment going toward equity increases over time, as well, and, when the market is good, the property’s value should be appreciating.

The other half: There are some obvious concerns that come up as a home ages, of course. Roofs need repairing. Wear and tear gets worse. That alone is a good reason to plan to get out of an investment before it hits certain age milestones, but those are reasons that can be overcome with good planning.

If you turned your previous residence into a rental property, remember that every two years you can claim a sold property as a primary residence (if you have lived in it two of the last five years) and not pay capital gains tax. If you intend to keep rolling that investment equity into other properties, though, you can also avoid those taxes through a 1031 exchange.

The big consideration that is overlooked is simply this: at your property’s current value, it may no longer be a good investment property. When the market soars, rental rates cannot keep up. You may be surprised to realize that you would not buy your property now as a rental. It would not make enough money to justify the investment. At this point, the wise investor asks himself if he could do better with that investment capital elsewhere.

Half-Truth #2: Unless you forfeit equity or a stable payment plan by using “creative financing”, your rental property will run a negative cash flow for the first couple of years.

The true half: It is rare that current rental rates are profitable against current home prices. That is why the tax benefits are so important.

The other half: Beware of the risks inherent in creative financing, and consider the alternative. Rent your current home.

The best loan you will ever get on a property is for the house you intend to live in. Interest rates are simply higher for investment properties. Shop for your next home and then turn you current one into a rental property. Within three years you can still sell it without paying capital gains tax, you’ll get the lower interest rate, and you’ve already soaked up enough time to let rental rates catch up. If you have lived in your home two years, chances are that rental rates have risen to the point that you can rent the property at a positive cash flow.

It is possible, however, that you currently live in a house that out prices the rental market. Nice, big, expensive homes do command higher prices, but usually the market is small, vacancies are higher, and the return on investment is lower. If you live in a more modest house that would rent at a price that targets the main rental market, then this is a strategy to consider.

Conclusion: A robust way of getting into rental properties is to convert your personal home. Live in the home two years and sell it less than years after you move. You may avoid the expense of large repairs, depending on the age of the home, and you will avoid capital gains tax. Unless the market has been stagnant, you should be able to generate a positive cash flow.

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