10 Apr What to consider when buying investment property
Q. My husband and I are thinking about a rental home at the Shore as an investment property. We have a 20 percent down payment and good credit, so we think we can get a mortgage, and the past rental history of the house has covered the annual cost of what a mortgage should be. What should we think about, and what costs are we forgetting?
A. Investment properties can be great for income, but with the wrong tenants, it can be a financial nightmare.
Before we get to the tenants, let’s talk money.
First, you’d have upfront costs as part of your home purchase, said Jim McCarthy, a certified financial planner with Directional Wealth Management in Rockaway.
Those include the down payment, inspections fees, attorney fees, closing costs and a home warranty, which is optional, but McCarthy recommends you get one.
Then there are the long-term carrying costs.
Those include the mortgage (principal and interest, property taxes and insurance. McCarthy recommends you include extra umbrella coverage, too.
Then there’s the utility cost (if not covered by the tenant), vacancy costs, and property management costs.
“Managing it yourself could be a viable option if you live in close proximity to the property,” said Mary Pucciarelli, a certified financial planner with the MetLife Premier Client Group in Piscataway.
You should also keep extra cash in reserves, McCarthy says, generally 5 percent of the annual gross rental income.
McCarthy said you should calculate the Net Operating Income (NOI) and figure out the capitalization rate, or your return on investment. You do that by taking NOI divided by purchase price.
Then ask yourself: Is the return on investment better than what you could get with another type of investment?
McCarthy said you should also remember the tax implications of owning rental real estate.
“Are you planning on using the property personally? If so, to be treated as a rental property for tax-loss purposes, your personal use can’t exceed 14 days or 10 percent of the days the unit is rented during the year, whichever is greater,” McCarthy said.
As a general rule, rental properties are, by definition, passive activities and are subject to the passive activity loss rules, he said. The passive activity rules limit your ability to offset other types of income with net passive losses.
“But the good news is there is an exception: If you actively participate in a rental real estate activity, you can deduct up to $25,000 of your rental loss even though it’s passive,” McCarthy said. “These rules are quite complex and I strongly recommend discussing your plan with a qualified tax professional.”
Also make sure you’re aware of the rules when you eventually sell the home.
Even if the finances work out, you want to make sure you’re mentally and emotionally ready to be a landlord.
“Owning rental real estate can be a financially rewarding experience or it can be a nightmare. Many of the issues that determine what kind of experience you have are not economic,” McCarthy said. “How do you handle 2am calls because the power is out?”
Also be sure tenant/landlord rights and obligations. McCarthy said New Jersey courts generally enforce tenants rights quite strictly.
For more information, check out the state’s Truth in Renting brochure.
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This story was first posted in April 2015.NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.