Buying a place of your own

During your adult life, you’re going to need a roof over your head for many decades. And real estate is the only investment that you can live in or rent out to produce income. A stock, bond, or mutual fund doesn’t work too well as a roof over your head!

Unless you expect to move within the next few years, buying a place may make good long-term financial sense. (Even if you need to relocate, you may decide to continue owning the property and use it as a rental property.) In most real estate markets, owning usually costs less than renting over the long haul and allows you to build equity (the dollar difference between market value and the current balance of the mortgage loans against the property) in an asset.

Under current tax law, you can also pocket substantial tax-free profits when you sell your home for more than you originally paid plus the money you sunk into improvements during your ownership. Specifically, single taxpayers can realize up to a $250,000 tax-free capital gain; married couples filing jointly get up to $500,000. In order to qualify for this homeowner’s gains tax exemption, you (or your spouse if you’re married) must have owned the home and used it as your primary residence for a minimum of 24 months out of the past 60 months. The 24 months don’t have to be continuous. Additionally, this tax break allows for pro-rata (proportionate) credit based on hardship or change of employment. Also note that the full exemption amounts are reduced proportionately for the length of time you rented out your home over the five-year period referenced above.

Some commentators have stated that your home isn’t an investment, because you’re not renting it out. We respectfully disagree: Consider the fact that some people move to a less costly home when they retire (because it’s smaller and/or because it’s in a lower-cost area). Trading down to a lower-priced property in retirement frees up equity that has built up over many years of homeownership. This money can be used to supplement your retirement income and for any other purpose your heart desires. Your home is an investment because it can appreciate in value over the years, and you can use that money toward your financial or personal goals. The most recent version of Home Buying For Dummies (Wiley), which Eric cowrote with residential real estate expert Ray Brown, can help you make terrific home buying decisions.

Converting your home to a rental

Turning your current home into a rental property when you move is a simple way to buy and own more properties. You can do this multiple times (as you move out of homes you own over the years), and you can do this strategy of acquiring rental properties not only with a house, but also with a duplex or other small multi-unit rental property where you reside in one of the units. This approach is an option if you’re already considering investing in real estate (either now or in the future), and you can afford to own two or more properties. Holding onto your current home when you’re buying a new one is more advisable if you’re moving within the same area so that you’re close by to manage the property. This approach presents a number of positives:

• You save the time and cost of finding a separate rental property, not to mention the associated transaction costs.
• You know the property and have probably taken good care of it and perhaps made some improvements.
• You know the target market because the home appealed to you.

Some people unfortunately make the mistake of holding onto their current home for the wrong reasons when they buy another. This situation typically occurs when a homeowner must sell their home in a depressed market. Nobody likes to lose money and sell their home for less than they paid for it or sell for a good deal less than it was worth several years ago. Thus, some owners hold onto their homes until prices recover. If you plan to move and want to keep your current home as a long-term investment (rental) property, you can. If you fully convert your home to rental property and use it that way for years before selling it, after you do sell you can either take advantage of the lower long-term capital gains rates or do a tax-deferred exchange. For tax purposes, you get to deduct depreciation and all the write-offs during the ownership and you can shelter up to $25,000 in income from active sources subject to income eligibility requirements. (Or even more if you or your spouse happen to qualify as a real estate professional. Please see Chapter 18 for more details.)

Turning your home into a short-term rental, however, is usually a bad move because

• You may not want the responsibilities of being a landlord, yet you force yourself into the landlord business when you convert your home into a rental.
• You owe tax on the sale’s profit (and recaptured depreciation) if your property is classified for tax purposes as a rental when you sell it and you don’t buy another rental property. (You can purchase another rental property through a 1031 exchange to defer paying taxes on your profit. See the discussion in Chapter 18.)

You lose some of the capital gains tax exclusion if you sell your home and you had rented it out for a portion of the five-year period prior to selling it. For example, if you rented your home for two of the last five years, you may only exclude 60 percent of your gain (up to the maximums of $250,000 for single taxpayers and $500,000 for married couples filing jointly), whereas the other 40 percent is taxed as a long-term capital gain. Also be aware that when you sell a home previously rented and are accounting for the sale on your tax return, you must recapture the depreciation taken during the rental period.

Investing and living in well-situated fixer-uppers

Serial home selling is a variation on the tried-and-true real estate investment strategy of investing in well-located fixer-upper homes where you can invest your time, sweat equity, and materials to make improvements that add more value than they cost. The only catch is that you must actually move into the fixer-upper for at least 24 months to earn the full homeowner’s capital gains exemption of up to $250,000 for single taxpayers and $500,000 for married couples filing jointly (as we cover in the “Buying a place of your own” section earlier in this chapter).

Be sure to buy a home in need of that special TLC in a great neighborhood where you’re willing to live for 24 months or more! But if you’re a savvy investor, you would’ve invested in a great neighborhood anyway.

Here’s a simple example to illustrate the potentially significant benefits of this strategy. You purchase a fixer-upper for $275,000 that becomes your principal residence, and then over the next 24 months you invest $25,000 in improvements (paint, repairs, landscaping, appliances, decorator items, and so on), and you also invest the amount of sweat equity that suits your skills and wallet. You now have one of the nicer homes in the neighborhood, and you can sell this home for a net price of $400,000 after your transaction costs. With your total investment of $300,000 ($275,000 plus $25,000), your efforts have earned you a $100,000 profit completely tax-free. Thus, you’ve earned an average of $50,000 per year, which isn’t bad for a tax-exempt second income without strict office hours. (Note that many states also allow you to avoid state income taxes on the sale of your personal residence, using many of the same requirements as the federal tax laws.)

Now, some cautions are in order here. This strategy is clearly not for everyone interested in making money from real estate investments. In our experience, this strategy is not likely to work well for you if any of the following apply:

• You’re unwilling or reluctant to live through redecorating, minor remodeling, or major construction.
• You dislike having to move every few years.
• You’re not experienced or comfortable with identifying undervalued property and improving it.
• You lack a financial cushion to withstand a significant downturn in your local real estate market as happened in numerous parts of the country during the late 2000s and early 2010s.
• You don’t have the budget to hire a professional licensed and insured contractor to do the work, and you don’t have the free time or the home improvement skills needed to enhance the value of a home.

One final caution: Beware of transaction costs. The expenses involved with buying and selling property — such as real estate agent commissions, loan fees, title insurance, escrow or closing costs, and so forth — can gobble up a large portion of your profits. With most properties, the long-term appreciation is what drives your returns. Consider keeping homes you buy and improve as long-term investment properties.

Purchasing a vacation home

Many people of means expand their real estate holdings by purchasing a vacation home — a home in an area where they enjoy taking pleasure trips. For most people, buying a vacation home is more of a consumption decision than it is an investment decision. That’s not to say that you can’t make a profit from owning a second home. However, potential investment returns shouldn’t be the main reason you buy a second home.

For example, we know a family that lived in Pennsylvania and didn’t particularly like the hot and humid summer weather. They enjoyed taking trips and staying in various spots in northern New England and eventually bought a small home in New Hampshire. Their situation highlights the pros and cons that many people face with vacation or second homes. The obvious advantage this family enjoyed in having a vacation home is that they no longer had the hassle of securing accommodations when they wanted to enjoy some downtime. Also, after they arrived at their home away from home, they were, well, home! Things were just as they expected — with no surprises, unless squirrels had taken up residence on their porch.

The downsides to vacation homes can be numerous, as our Pennsylvania friends found, including

• Expenses: With a second home, you have the range of nearly all the costs of a primary home — mortgage interest, property taxes, insurance, repairs and maintenance, utilities, and so on.
• Property management: When you’re not at your vacation home, things can go wrong. A pipe can burst, for example, and the mess may not be found for days or weeks. Unless the property is close to a good neighbor or other kind person willing to keep an eye on it for you, you may incur the additional expense of paying a property manager to watch the property for you.
• Lack of rental income: Most people don’t rent out their vacation homes, thus negating the investment property income stream that contributes to the returns real estate investors enjoy (see Chapter 1). If your second home is in a vacation area where you have access to plenty of short-term renters, you or your designated property manager can rent out the property (note that using a service like Airbnb assists with finding people to rent your property but doesn’t help with the arrival/departure and security deposit issues nor applicant screening and keeping your property maintained, plus many other similar services a property manager performs). However, this entails all the headaches and hassles of having many short-term renters. (But you do gain the tax advantages of depreciation and all expenses as with other rental properties.)
• Obligation to use: Some second homeowners we know complain about feeling obliged to use their vacation homes. Oftentimes in marriages, one spouse likes the vacation home much more than the other spouse (or one spouse enjoys working on the second home rather than enjoying the home itself).

Before we close out this section on vacation homes, we want to share a few tax tips, as found in the current tax code:

• If you retain your vacation home or secondary home as personal property, forgoing the large income streams and tax write-offs for depreciation and operating expenses associated with rental properties, you can still make a nice little chunk of tax-free cash on the side. The current tax code permits you to rent the property for up to 14 days a year — and that income is tax-free! You don’t have to claim it. Yes, you read that right. And you can still deduct the costs of ownership, including mortgage interest and property taxes, as you do for all other personal properties.
• If you decide to maintain the property as a rental (you rent it out for more than 14 days a year), you, as the property owner, can still use the rental property as a vacation home for up to 14 days a year, or a maximum of 10 percent of the days gainfully rented, whichever is greater, and the property still qualifies as a rental. Also, all days spent cleaning or repairing the rental home don’t count as personal use days — so that’s why you paint for a couple of hours every afternoon and spend the morning fishing!

Before you buy a second home, weigh all the pros and cons. If you have a partner with whom you’re buying the property, have a candid discussion. Also consult with your tax advisor for other tax-saving strategies for your second home or vacation home. And please see Chapter 18 for more tax-related information on rental properties.

Paying for timeshares and condo hotels

Timeshares, a concept created in the 1960s, are a form of ownership or right to use a property. A more recent trend in real estate investing is condo hotels, which in many ways are simply a new angle on the old concept of timeshares. A condo hotel looks and operates just like any other first-class hotel, with the difference that each room is separately owned. The hotel guests (renters) have no idea who owns their room.

Both timeshares and condo hotels typically involve luxury resort locations with amenities such as golf or spas. The difference between the traditional timeshare and condo hotel is the interval that the unit is available — condo hotels are operated on a day-to-day availability, and timeshares typically rent in fixed intervals such as weeks.

Some of the most popular projects have been the branded condo hotels such as Ritz Carlton, Four Seasons, Trump, W, Westin, and Hilton located in high-profile vacation destinations like Hawaii, Las Vegas, New York, Chicago, and Miami. You can also find many foreign condo hotel properties in the Caribbean and Mexico, and the concept is expanding to Europe, the Middle East, and Asia.

Two types of individuals are attracted to investing in condo hotels and timeshares. One group is investors who believe that the property will appreciate like any other investment. The other group is people who use the condo hotel or timeshare for personal use and offset some of their costs.

We don’t see timeshares or condo hotels as worthy real estate investments as they don’t appreciate and they don’t generate income. But they are often presented as a viable alternative real estate investment and millions have been purchased. You will likely be solicited to consider this opportunity during an upcoming vacation, so we want to share our concerns.

Single-family homes

As an investment, single-family, detached homes generally perform better in the long run than attached or shared housing. In a good real estate market, most housing appreciates, but single-family homes tend to outperform other housing types for the following reasons:

• Single-family homes tend to attract more potential buyers — most people, when they can afford it, prefer a detached or stand-alone home, especially for the increased privacy and less noise from neighbors.
• Attached or shared housing is less expensive and easier to build and to overbuild; because of this surplus potential, such property tends to appreciate more moderately in price.

Because so many people prefer to live in detached, single-family homes, market prices for such dwellings can often become inflated beyond what’s justified by the rental income these homes can produce. That’s exactly what happened in some parts of the United States in the mid-2000s and led in part to a significant price correction in the subsequent years. To discover whether you’re buying in such a market, compare the monthly cost (after tax) of owning a home to the monthly rent for that same property. Focus on markets where the rent exceeds or comes close to equaling the cost of owning and shun areas where the ownership costs exceed rents.

Single-family homes that require just one tenant are simpler to deal with than a multi-unit apartment building that requires the management and maintenance of multiple renters and units. The downside, though, is that a vacancy means you have no income coming in. Look at the effect of 0 percent occupancy for a couple of months on your projected income and expense statement! By contrast, one vacancy in a four-unit apartment building (each with the same rents) means that you’re still taking in 75 percent of the gross potential (maximum total) rent.

With a single-family home, you’re responsible for all repairs and maintenance. You can hire someone to do the work, but you still have to find the contractors and coordinate and oversee the work. Also recognize that if you purchase a single-family home with many fine features and amenities, you may find it more stressful and difficult to have tenants living in your property who don’t treat it with the same tender loving care that you may yourself.

The first rule of being a successful landlord is to let go of any emotional attachment to a home. But that sort of attachment on the tenant’s part is favorable: The more they make your rental property their home, the more likely they are to stay and return it to you in good condition — except for the expected normal wear and tear of day-to-day living. (We discuss the proper screening and selection of tenants in Chapter 15.)

Making a profit in the early years of ownership from the monthly cash flow with a single-family home is generally the hardest stage. The reason: Such properties usually sell at a premium price relative to the rent that they can command (you pay extra for the land, which you can’t rent). Also remember that with just one tenant, you have no rental income when you have a vacancy.

Attached housing

As the cost of land has climbed over the decades in many areas, packing more housing units that are attached into a given plot of land keeps housing somewhat more affordable. Shared housing makes more sense for investors who don’t want to deal with building maintenance and security issues.

In this section, we discuss the investment merits of three forms of attached housing: condominiums, townhomes, and co-ops.

Apartments

Not only do apartment buildings generally enjoy healthy long-term appreciation potential, but they also often produce positive cash flow (rental income – expenses) in the early years of ownership. But as with a single-family home, the buck stops with you for maintenance of an apartment building. You may hire a property manager to assist you, but you still have oversight responsibilities (and additional expenses).

In the real estate financing world, apartment buildings are divided into two groups based on the number of units:

• Four or fewer units: You can obtain more favorable financing options and terms for apartment buildings that have four or fewer units because they’re treated as residential property.
• Five or more units: Complexes with five or more units are treated as commercial property and don’t enjoy the extremely favorable loan terms of the one- to four-unit properties.

Apartment buildings, particularly those with more units, generally produce a small positive cash flow, even in the early years of rental ownership (unless you’re in an overpriced market where it may take two to four years before you break even on a before-tax basis).

One way to add value, if zoning allows, is to convert an apartment building into condominiums. Keep in mind, however, that this metamorphosis requires significant research on the zoning front and with estimating remodeling and construction costs. You also may be exposed to litigation brought by your individual unit buyers who within a few years become disenchanted with their investments and find an experienced attorney and a team of experts to make claims of construction defects or allege that you failed to have adequate reserves at the time of the conversion.