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What should I consider before converting my home into a rental property?

- How do you feel about being a landlord? Managing a rental property takes time, patience, and knowledge of local rent-control laws. Some tenants are a pain, and premises occasionally need repairs. You can hire a property manager, but this service costs money, and finding a good one can be a challenge.

- What about wear and tear? If you've gone to great lengths to make your house immaculate, realize that renters aren't going to treat your home with the same loving care that you gave it. Although you can protect your interests somewhat by securing from your tenants a large security deposit (at least one month's rent), you can't expect them to pay for the inevitable and gradual wear and tear. For documentation purposes, you may also videotape the interior of the rental, including the condition of floors, walls, and so on. Beware, though; you may find that, at the end of the lease, your tenants disagree with you over what you think is unreasonable wear and tear.

- What's the cash flow? Tally up all the monthly property expenses that you anticipate and compare that amount with the expected rental income. If you've recently bought your property or have little equity in it, you may be unable to turn a profit. The worst case scenario is that the additional monthly cash drain cramps your budget and causes you to accumulate consumer debt.

What are some of the tax implications of renting my home?

If you are considering renting your home, even for just a short time, after you move out of it and before you sell it, tread very carefully! After you've converted your house into rental property, you can't avoid taxation on the profits from that property simply by purchasing another primary residence.

- If you do decide to turn a property into a rental and then later sell it, you can roll over your capital gain into another "like kind" investment real estate property. Currently, the IRS broadly defines what a "like kind" property is. They allow you, for example, to exchange undeveloped land for a multi-unit rental building. Just remember that the IRS does draw a sharp line between a primary residence and a rental property, and they won't let you roll profits over that line.

- The rules for rolling over a gain from one rental property to another (called a 1031 or Starker exchange) are strict. To begin with, you are allowed little time to complete the rollover -- only 6 months -- and you must also identify a replacement property within 45 days of the sale of the first property. You are not allowed to handle the proceeds: They must pass through an account. Because of the complexity of the transaction, it makes sense to find an attorney and/or tax advisor who can guide you through the process and ensure that you do it right.

How important is it to defer my investment property profits?

Taxable profits on the sale of an investment property are often much greater than on a comparable residential property. That difference is because the IRS lets you depreciate investment property while you own it and deduct the depreciation amount from your income taxes every year. However, when you sell the property, you must factor the depreciation you took on the property into the property's adjusted cost basis.

- Suppose that you buy an investment property for $150,000, and many years later you sell it for $300,000. During your years of owning the property, you claim a total of $50,000 in depreciation on your tax returns. The amount of depreciation reduces your cost basis from the original $150,000 purchase price to $100,000, thus making your "taxable profit" that much larger. You owe capital gains tax on $200,000 -- the difference between the sale price of $300,000 and the adjusted cost basis of $100,000.

- Fortunately, you can defer taxes on these gains by rolling over your profits into another investment property. If you simultaneously sell an investment property and buy another, that one exchange is called a 1031 exchange. If the exchange is not simultaneous -- that is, if you delay your purchase of the second property -- you must meet some very specific requirements (called the Starker rules, after a famous tax case).

- If you're going to do a Starker or a 1031 exchange, be sure to enlist the help of an attorney or tax advisor who's an expert at these transactions to ensure that you do it right. You need an experienced professional to help you jump the many legal hoops (such as filling out special tax forms like Form 8824, which tells the IRS that you bought a "like kind" investment property).

What are the tax implications of having attached rental units?

The IRS makes a distinction between property a taxpayer lives in and property he or she rents out to others, even if both are within the same building. You need to understand this distinction and its tax implications (enlist a tax account and/or attorney).

For example, suppose that you've owned and lived in a home for a number of years. Your house has an attached rental unit that you rent out. You've claimed depreciation deductions for the rental portion of your property on your annual income tax return. Suppose further that the rental unit accounts for about 25 percent of the total living space of the building. When you sell the property, the IRS treats the sale as two separate transactions -- the sale of your primary residence (the 75 percent portion of the property) and the sale of a rental property (the other 25 percent portion of the property). Therefore, 75 percent of your profits are subject to the primary residence capital gains exclusion rules.

As for the profits on the rental portion of the property, you will owe capital gains tax on those profits unless you buy another building with a rental unit that meets the particular requirements that we discuss in the know how to defer your investment property profits section (see link below).

If I rent my house while trying to sell it, do I risk converting my house into an income property?

Don't inadvertently convert your house into income property. Suppose that you list your house for sale and it sits and sits for months on end without any offers. You need to move, and you can't afford to leave the house vacant while making your mortgage payment, paying property tax and insurance payments, and simultaneously shouldering the cost of renting or buying another home. So you rent out your difficult-to-sell house for a number of months while still on the market.

If you cease seriously trying to sell your house while renting, the IRS deems that you've converted your home into rental property, and you owe capital gains tax unless you buy a replacement rental property. If you have any doubts about running afoul of the tax laws, please consult with a good tax advisor.

Is rental real estate a good long-term investment?

Suppose that you made a killing when you sold your house, or you're simply a good saver, or you're the beneficiary of a nice inheritance. If you've got some extra cash burning a hole in your pocket, consider investing in some rental real estate. Real estate is a good long-term investment. Historically, real estate investors have enjoyed average annual rates of return (in the range of 9 to 10 percent) comparable to stock market investors' returns.

Part of the reason for those healthy real estate returns comes from the fact that land is in limited supply so the price of land -- and the property on it -- generally faces upward price pressure as the economy and population expands. And, because you can borrow upwards of 80 percent of the purchase price of a property, you leverage your invested capital to work harder for you; you earn returns not only on your down payment but also on the borrowed money.

Looking ahead to your golden retirement years, rental real estate not only should appreciate in value but also provides you with rental income for living expenses. And, when you eventually decide to sell your rental real estate to tap into the equity in your property, under current tax laws, the maximum federal income tax rate you pay on your capital gain is 28 percent, which may be less than the tax rate you pay on your employment or investment income.

And, last but not least, if you have a great deal of your retirement nest egg stashed in the stock market, rental real estate can help you diversify your investment portfolio. Of course, when you consider how diversified your investments are (or aren't), don't forget all the money you may have "invested" in real estate by virtue of owning your home.

What drives the amount a rental property is worth?

The income and resulting cash flow (income less expenses) that a property can generate drive the amount a rental property is worth. Suppose that you could purchase a 4-unit building in a rural area or you could buy a similar 4-unit building in an upscale suburban community just a half-hour commute from an economically robust city.

- If each unit in the rural building rented for just $250 per month whereas those near the city rented for $1,000 per month, which building do you think would be worth more money? Or, looking at it another way, which building would you prefer to buy if both buildings were for sale for the same price? Higher rents translate into a much higher property sale price.

- Suppose that property like yours typically sells for 10 times the property's gross annual income. For example, each unit rents for $1,000 per month x 4 units x 12 months = $48,000 x 10 (gross multiplier) = $480,000 market value.Suppose that, through property improvements, you can increase the unit rents by 10 percent. Now the building is worth $1,100 per month x 4 units x 12 months = $52,800 x 10 = $528,000 market value. Thus a mere $100 per month per unit increase results in a $48,000 increase in the building's value.

Plan for the sale of your rental property as far in advance as possible so that you can be sure that your rental incomes are maximized. If any units are coming vacant, examine what upgrades can be done to boost the rent you can charge. Also consider what enhancements you can make to the building. Survey the local rental marketplace to ensure that you're not underpricing units.

How do I minimize my property's expenses?

In addition to maximizing income, you can also increase a property's cash flow by minimizing its expenses. Planning at least a couple of years in advance for the sale of your building should give you enough time to make your property more cost efficient to operate and therefore more profitable and appealing to the next buyer.

For example, although you have to shell out some money up-front, investing in energy efficiency by insulating your property and installing modern appliances can really slash your operating costs. If you haven't evaluated your insurance for at least a couple of years, also shop around to be sure that you're getting the best insurance value you can.

How important is zoning when considering a property for purchase?

Before you bought your property, you should have taken the time to research and understand the effects of zoning or possible rezoning on your property's use. A surprising number of real estate buyers, however, neglect this important step. Even if you did understand the zoning of the property before you bought, the mood of your local planning department, which interprets zoning laws and approves building projects, may have changed in the meantime.

So before you consider listing your property for sale, be sure that you know how you can improve its use and value. Even if you don't want to do significant renovation or contracting work, you should at least understand how you can further develop the property so that you (and your agent if you're selling through one) can sell for a higher price by promoting the opportunity to add value.

What is cash flow?

Cash flow is the amount of money that a property brings in and the amount you have to pay out for expenses. Some homeowners-turned-rental-property-owners can't cover all the costs associated with rental property. In the worst cases, such property owners end up in personal bankruptcy from the drain of negative cash flow (that is, expenses exceed income). In other cases, the negative cash flow hampers people's ability to accomplish important financial goals such as saving for retirement or helping with their children's college costs. Before you consider becoming a landlord, make some projections about what you expect your property's monthly income and expenses to be.

How do I determine what I can charge for rent?

On the income side, determine the amount of rent you are able to charge by taking a look at what comparable properties are currently renting for in your local market, checking out the classified ads in your local paper(s), and speaking with some leasing agents at real estate rental companies. Be sure to allow for some portion (around 5 percent per year) of the time for your property to be vacant -- finding good tenants takes time.

What kind of expenses do I need to prepare for if I purchase a rental property?

On the expense side, you have your monthly mortgage payment (of which we're sure that you're already painfully aware). And, of course, you have property taxes. Because you probably pay these expenses just once or twice yearly, divide the annual amount by 12 to arrive at your monthly property tax bill.

- You may end up paying some or all of your renter's utility bills, such as garbage, water, or gas. Estimate from your own usage what the monthly tab will be. Expect most utility bills to increase a bit because tenants will probably waste more if you're picking up the bill.

- Be sure to call your insurance company to inquire about how your property insurance premium would change if you convert the property into a rental. As with your property taxes, divide the annual total by 12 to get a monthly amount.

- Don't forget repairs and maintenance. Figure that you'll spend about 1 percent of the property's value per year on maintenance, repairs, and cleaning. Again, divide by 12 to get a monthly figure.

- Finding good tenants takes time and promotion. Rental brokers, if you choose to list through them, normally take one month's rent as their cut. If you advertise, estimate at least $100 to $200 in advertising expenses, not to mention the cost of your time in showing the property to prospective tenants. You must also plan on running credit checks on prospective tenants.

When should I sell my rental property?

If you own property that you hold solely for rental/investment purposes, you probably have a great deal of discretion about when you sell the property. As with other investments, you may be wondering when is a good time to sell.

Surely you have some sense from watching real estate prices and rental vacancy rates whether your local market is strong, weak, or somewhere in between, and your examination of some public information can help you better determine whether now is a good time to be cashing in your chips:

- Economic health: The vitality of the local employment market is crucial to a healthy local real estate market. What is the unemployment rate in your local area and how does that rate compare with prior months and years?

- New construction: If real estate prices have been on the rise, the number of new building projects may be on the increase, which can be a sign that now is a good time to sell. As more properties come onto the market and prices spiral higher and higher, eventually the increase in construction acts like water on a fire, extinguishing future strength.

- Available land: Housing units must be built on land; the less land that remains available for development, the more upward pressure is exerted on housing prices.

- Housing for sale: All things being equal, the fewer the properties for sale, the better the environment in which to be selling. In a strong real estate market, housing sells relatively quickly and the inventory of property for sale is in relatively short supply.

- Rental real estate market health: Although being a renter is tough when vacancy rates are low and falling and rental rates are escalating, being the owner of rental/investment real estate is great. Rental real estate is worth more when the local rental market is strong.

Is it important to utilize an agent with investment property experience when I decide to sell?

Be sure to hire an agent who specializes in selling your type of investment property in your area. An agent lacking experience with selling investment real estate similar to yours may misprice your property and lack the special skills necessary to market and successfully sell it. Be sure to ask agents you're interviewing for activity lists detailing each property they listed and sold over the past year.

How can I better determine the value of my investment property?

Especially if you've owned investment real estate for a number of years, your property may be very valuable. If you are going to hire a real estate agent to help sell the property, interview agents who specialize in selling such property in your area. Each agent should prepare a comparable market analysis to evaluate your property's worth. By digging into the details of each comparable market analysis the agents provide you, you can better determine your property's real worth.

For properties that have sold recently, there's no substitute for actually seeing the property. You may be surprised at how many property owners are willing to show you their property. If you have doubts about the value of your property, even after having real estate agents prepare a comparable market analysis, spring for the fee of several hundred dollars and hire a good real estate appraiser who has experience with rental properties like yours in the area.

Some rental buildings are simply difficult to find comparable sales for. Perhaps no similar buildings have sold for a long time in the area or no similar properties exist. Overprice your property and it may sit unsold for many months and end up fetching less than it otherwise could in the real estate marketplace. Underprice your property and you may leave a great deal of your money on the table.

Should I work with rental property experienced tax & legal advisors when selling my rental property?

If you're dealing with rental real estate, expect complicated and unclear tax and legal issues to get in your way. If you choose to hire advisors to help you navigate the morass, be sure that you're getting your money's worth in good advice.

Working in residential real estate is not sufficient experience for advisors to whom you're paying high fees for advice about your rental property. Tax and other laws pertaining to rental property sometimes differ tremendously from laws regulating owner-occupied housing. Hire advisors who specialize in dealing with rental property.