Q. I want to buy an investment property in a beach area about an hour from my house. The summer rents would cover the mortgage and taxes and then some. What do I need to know before I do it?
— Wanting to buy
A. An investment home is an exciting idea, but it’s a big commitment.
Let’s first take a step back and look at your overall financial situation.
First, assess if you have an adequate emergency reserve of six months to one year of personal living expenses, said Michael Maye, a certified financial planner and certified public accountant with MJM Financial in Gillette.
“The reason I point this out is it doesn’t make sense to take or use all of your cash reserve to make the down payment for an investment property,” he said.
Assuming you have the foundational emergency savings, take a look at whether you’ve properly addressed your other goals such as retirement, college and others.
Maye said you need to remember the actual investment property, while generating income, is itself illiquid. Compared to liquid investments, the home would take time to sell.
If you have the cash reserves and you’re addressing your other goals, it’s time to consider the investment property.
The first thing to consider is while the mortgage and taxes are the major expenses, they are not the only costs of owning an investment property.
“Do not forget to take into account insurance costs, utilities, rental advertising/marketing, cleaning, ongoing repairs and maintenance, legal expenses, and potential vacancies,” Maye said. “From a qualitative perspective how are you going to feel when you get the call on the 4th of July weekend that your rental properties toilet is broken?”
The next area to consider are the income tax rules regarding investment properties, and these are anything but simple, Maye said.
“While investment property can in theory be depreciated, this often turns the income negative for tax purposes,” Maye said. “Unfortunately, since this is considered a `passive activity’ for tax purposes, the losses may not be currently deductible for tax purposes.”
He said there can be exceptions for someone classified as a “qualified real estate professional” or someone under certain income levels.
To get straight on what it all means, he recommends you hire a tax professional who is well-versed in the tax intricacies of owning an investment rental property.
You’ll also need to understand the tax rules regarding “personal use” of an investment property.
“If you use the property more than a certain amount then the property becomes `mixed use’ and income/expenses will need to be pro-rated for income tax purposes,” Maye said. “I think this reinforces the idea of working with a qualified tax professional as well as maintaining good records.”
The final area to consider is risk management.
Maye said if things go awry with your rental property and you get sued, you don’t want it to put your other assets at risk.
He recommends you speak with an attorney about placing the rental property in a Limited Liability Company (LLC) to provide separation between this asset and your other assets.
And you need to know as a rental property, your current insurance policies are unlikely to provide you with an liability protection, Maye said. Be sure to speak with your insurance broker to make sure you have the correct coverage.
“While there can be money to be made in rental real estate one needs to be fully aware of all the costs and risks associated with owning investment property,” Maye said. “Remember, do your full due diligence before buying an investment property i.e. all the costs/risks and then make an informed business decision.”
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