Buying real estate for rental income
Rentals can be an excellent way to build wealth, but there are many aspects to understand before you start.
How's your credit?
Put your own finances into shape -- the less debt you have, the better deal you'll get for a property loan. In addition, have a large cash reserve (at least the total of all the rents for the individual units for one month) and a credit line for large emergency costs, secured by the value of your own home.
What's the ending?
How long will you own the property? When will you sell it? These answers will determine your long-time tax strategy, your short-term tactics for managing, maintaining, and improving the property, and your acquisition of both short-term and long-term tenants.
Who do you know?
To find properties to buy, build a network of resources: foreclosure lists from city hall or local banks, listings from real estate agents, contacts in a local property owner or landlord association.
What should you pay?
Never pay too much. If you do, you'll never make back what you paid because the income generated from the property will never add up to enough to meet your purchase price. The key is to figure out the total rental income for the property for your time horizon you've planned for selling the property, and make that the price you're willing to pay. Also, make sure the annual income from rentals matches the total of your mortgage payment for the property, the related property and school taxes, and costs of maintenance, insurance, and repairs -- and figure in a 5% vacancy rate.
Who'll take care of the property?
You should hire a rental property manager to be on-call for problems with the property. If you don't hire a rental property manager, build a list of on-call workers who can perform specific repairs.
Who are the tenants?
When you receive responses to your newspaper ads for tenants, be sure to investigate references, and credit and job histories. Have your tenant sign a lease or property rental agreement that explains the length of the rental, the rental amount, the due dates, and penalties for late payment. Get a security deposit and the last month's rent, and give a receipt., Be sure the tenant understands all the stipulations within the lease (such as 'no pets' or 'no smoking') before they sign the lease/agreement.
How's the books?
Check with your own financial advisor about the requirements for bookkeeping in your locality, and remember that an investment in rental property means tax regulations you're not likely to know. One of those things you must know inside and out is the difference between a 'repair' and an 'improvement.' A repair, such as fixing a leaky roof, should be deducted in your bookkeeping as an expense in the year it was done. An improvement, such as a new roof, however, cannot be deducted as an expense, but must instead be added to the cost basis for the property (see below), which is used to figure profit or loss when you finally sell the property.
What's in the books?
A landlord of a rental property must keep accurate records about income, expenses, and cost basis. Tax authorities usually provide tax breaks to a person who acts as a landlord for the property used for rentals. But there are bookkeeping requirements of such tax breaks. Amounts that must be tracked are :
- Purchase price
- Accumulated depreciation
- Current annual depreciation
- Rental income
- Security deposits received
- Expenses directly associated with the rental property
You'll have to pay taxes annually, and perhaps even quarterly, depending on whether you're realizing a profit or loss for the year.
What's the final sale?
When you've reached the end point of your plan for a particular piece of rental property, and are ready to sell,
you must follow certain rules related to gain or loss. The overall concept is that the owner must subtract the cost basis (figured over the years of ownership) from the price for which the property is sold. The formula for figuring out the cost basis of a rental property is:
Purchase price
+ Purchase costs
+ Improvements
+ Selling costs
- Accumulated depreciation
= Cost Basis
The calculation of profit or loss is: selling price, minus the calculated Cost Basis for the rental property.
If the result is positive, then the sale created a profit for you, and must be reported as such on your tax forms for the year. If the result is negative, then you have incurred a loss, and must follow the tax rules at the time of the sale for a loss.