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Once you’ve obtained and started managing your first rental property, you’ve learned a thing or two about the business. From buying a second home, you’ve discovered what works and what doesn’t work for you.
Now that you’re savvier about real estate investing, you likely feel more confident about buying rental property. Although you may know significantly more now than you did before you owned an investment property, there’s always room to learn more, especially if you want to maximize your returns. Here are 5 things to know before investing once again in rental properties to help ensure you’re making the best decisions.
1. Whether You Can Afford to Invest Again
Contact a mortgage broker to determine whether you’re in a position to be pre-approved for a mortgage. The numbers get more complicated the more properties you own, especially when you have a mortgage on your first rental home and are seeking to take out a mortgage on your second rental property.
Lenders consider debt-to-income ratio when making the decision on whether to approve you. Even if you have a mortgage and expenses on one rental property, as long as your overall income compared with your overall debt is enough to afford a second rental property, you should be able to get a loan.
Be prepared to document your positive cash flow after all your costs. Once you can show two years of tax returns that show your positive cash flow, you’ll have an easier time getting a loan since you probably won’t need to provide as much documentation to get approved. But even if you don’t have two years of tax returns that show positive cash flow under your belt, there are still many scenarios for lenders to approve loans.
2. How to Pick a Deal That Makes Sense
Evaluate the risk level you’re comfortable with. Some investors get in the game early with the goal of making real estate investing their sole source of income, while others might already have a steady job and consider this a side hustle. The first group is probably more comfortable using leverage to obtain more properties (although no one should over-leverage themselves), and the second group might want to remain more conservative, buying at a slower rate and putting more money down when they do.
Another consideration is cap rate. You’ll want to determine what your rate of return will likely be before you invest in any property. You determine cap rate by dividing net operating cash flow by the property’s purchase price. Let’s say your net cash flow is $18,000 and you paid $250,000 for the property. Your cap rate would be 7.2%. The higher the cap rate, the better.
While most investors strive for 8% or more, the highest cap rates may come with higher risk, such as a high-cap-rate property in a low-income area with older homes and low-performing schools. While you may purchase the house at a low price and be able to charge a decent rent, you could have trouble collecting that rent or have renter instability.
3. How to Choose the Right Location
In real estate, the “location, location, location,” phrase doesn’t only apply to your primary residence. It’s just as important when choosing a rental property. You want to buy in a place desirable to renters and you want to invest in an area that makes sense as an investment.
You are likely to set high rents in San Francisco, for example, but at a median home price of $1.63 million (and that’s down slightly from last year!), it probably doesn’t make sense to buy there. You want to buy an affordable house in an area with low unemployment, decent incomes, good schools, and a high number of owner-occupied homes.
Visit sites like Realtor.com® to find properties for sale near you.
4. Whether to Hire a Property Management Company
You’ll save money by managing your own properties since property managers typically charge between 8% and 12% of the monthly rent. However, managing your own property isn’t always feasible. If you don’t live near the property, if you have numerous rental properties, or if you don’t have the time to manage your rentals, then a property management company is for you.
If you decide to use a property manager, make sure they will find quality tenants for you, collect the rent, handle maintenance and repairs, be the contact for your tenants, and handle evictions.
5. Avoid Real Estate Seminars
The ads you’ve probably heard on television or radio touting free real estate seminars to teach you how to “earn real money” through real estate investing might sound attractive. You might learn something from attending one of those events but beware: At some point, you’ll be asked to spend real money first. Many of these seminars try to get you to pay for coaching, which can cost thousands of dollars.
Once you’ve been successful with your first rental property, you’ll likely want to buy another. To find the best properties in your area, visit Realtor.com® to get connected to local Realtors, find available properties, get pre-approved for a mortgage, and more.
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Most investment property owners have heard of a 1031 exchange, but many might not know what it is or its significance. That’s understandable, seeing as 1031 exchanges are only relevant when investors are thinking about selling investment property.
If you’re ready to sell an investment property, it’s imperative to understand the ins and outs of a 1031 exchange because using this vehicle can save you a lot of money in taxes.
To help you better understand 1031 exchanges and when you would benefit by using one, we’ve asked Logan Allec, CPA, at Money Done Right. Allec specializes in taxes for real estate investors and works on 1031 exchanges on a near-weekly basis.
What Is a 1031 Exchange?
A 1031 exchange references the Internal Revenue Code 1031. It allows you to sell appreciated investment property and defer the gain on it — meaning you don’t have to pay taxes on any gain that you’ve realized on that property if you reinvest the proceeds into another investment property.
Can You Invest in Anything You Want with a 1031 Exchange?
You have to invest in like-kind property, and the definition of that is pretty broad. For example, if you sell an apartment building, you don’t have to invest only in another apartment building. You can invest in single-family homes, raw land, or even a bowling alley. A big “no-no” is reinvesting the proceeds into a primary residence because that’s not a business use.
Why Would Someone Want to do a 1031 Exchange?
Investors really like a 1031 exchange because they avoid paying taxes. The more taxes investors pay Uncle Sam, the less cash they have to reinvest. Investors want as much ability as they can to keep rolling more proceeds into more and more properties to expand their portfolio, and when there’s a tax drag on that — when a portion of their sale has to go to the government — it impedes their ability to keep expanding their portfolio.
Understanding Common 1031 Exchange Methods: Which 1031 Exchange Method Is Right for You?
Why Wouldn’t You Want to Use a 1031 Exchange?
There are reasons not to do a 1031 exchange. For example, if someone’s in the lowest tax bracket of their life, they might just want to bite the bullet this year and not do a 1031 exchange — rather than down the line when they are presumably going to be in a higher tax bracket. At some point, you will pay taxes when you cash out.
Another reason someone would not want to do a 1031 exchange is if they have a loss, since there will be no capital gains to pay taxes on. Or if someone is in the 10% or 12% ordinary income tax bracket, they would not need to do a 1031 exchange because, in that case, they will be taxed at 0% on capital gains.
Finally, an investor might have another investment opportunity that’s not real estate-related. In that case, that person might prefer to pay the taxes so they can invest in that other opportunity.
Is the Capital Gain Taxed at 15%, or Is There More To It Than That?
The capital gains tax rate depends on your ordinary income tax bracket. Capital gains are taxed at 0%, 15%, or 20%. The majority of mom-and-pop real estate investors, however, will pay 15%. For example, in 2019, if you’re married and filing jointly, and you make between $78,751 and $488,850 a year, you pay a capital gains rate of 15%. Married couples who make $488,851 or more a year are taxed at 20%, and married couples who make $78,750 or less pay 0% on capital gains.
Are There Other 1031 Tax Issues to Know About?
Yes, there is recapture of depreciation to be considered. One of the great things about investing in rental property is that you get to take a deduction for depreciation, which is a non-cash deduction used against your taxable income. On the flip side, when you sell that rental property, you have to pay depreciation recapture tax at a 25% rate. But that tax, along with capital gains, can be deferred with a 1031 exchange.
Learn how one investor used the 1031 exchange to scale up his portfolio.
What Are the Most Important 1031 Exchange Rules for People to Keep in Mind?
- You can’t sell an investment property, buy another, and then initiate the 1031 exchange. You have to initiate a 1031 exchange before the property sells.
- You can’t do a 1031 exchange on your own. So if you’re thinking of doing one, the first thing to do is to find a qualified intermediary, a company that facilitates 1031 exchanges. This is not something you can DIY.
- There’s the identification period rule. Within 45 days after you sell your property (called the relinquished property) you must identify potential replacement properties.
- You have to purchase and close on the replacement property within 180 days after you sell your relinquished property.
- The property that you exchange into must be of equal or greater value than your relinquished property. If your replacement property is of less value, and you’re getting cash from the deal — called a “cash boot” — you must pay taxes on that cash.
- You can sell your investment property and invest in more than one property. You can buy three different properties, for example, if you want to. There’s no limit. If you identify more than three, there are some extra rules, which your qualified intermediary will go over with you.
- Fees vary on 1031 exchanges depending on the state, but for a standard 1031 exchange expect to pay between $800 and $1,200.
Find a New Property for Your 1031 Exchange
If you’ve decided the 1031 exchange is right for you and you’re on the hunt for a new investment property, browse properties on Realtor.com to get an idea of what’s in your range to qualify for a 1031.
As you build up your investment portfolio, Avail can help you set a competitive rent price, find great tenants, and keep track of your rental property income. Learn more about managing your properties with Avail.
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