Many of us dream about someday buying a second home as an investment—and possibly for family vacations as well. Before you do, be sure to know what you are signing up for.
To start, calculate the expected income and total return, as well as understand the tax benefits and costs. You’ll want to decide whether to use a mortgage and set aside money for maintenance and repairs as well. This blogs shares information to help you determine if you should pursue a second home as an investment today, if you need to wait a little while, or if you should look elsewhere for an investment.
Big questions to answer
Marla Mason, CFP® is a former owner of a bed and breakfast. The big picture questions prospective buyers should ask before making a purchasing decision include:
- Would you want to own this property—even if you cannot rent it?
- Is it attractive to a large audience, not just you and your family?
- What are the pros and cons of the location, including distance to transportation and surrounding local businesses?
- Toilets, tenants and trash. Who will deal with these?
- What’s the exit plan?
- And, of course, how will you make money on this investment?
To answer the last question, you need to do some math.
Calculate your income
To calculate your income from the property, take your expected monthly rent and multiply by 12. Then, divide that number by the price you paid for the property. This is called your “gross cap rate.”
For example, if you buy a property for $100,000 and your monthly rent will be $500, then your gross cap rate is 6% (12 x $500 = $6,000 / $100,000 is 6%).
However, a gross cap rate does not include your expenses. If you are going to pay for the HOA dues, electricity, water, heat, trash removal, property management company, etc., you want to include these monthly expenses in your calculations. For example, if your utility, property management and HOA expenses total $200 per month, or $2,400 per year, then your net cap rate drops to 3.6% ($6,000 less $2,400 = $3,600 / $100,000 is 3.6%).
Additionally, it’s easy to overlook the annual expenses of real estate ownership. Two of the largest expenses are property taxes and homeowner’s insurance, don’t forget to calculate those costs before you buy.
These costs can reduce your annual income and the cap rate by about one-half of one percent. If your property taxes total $300 and your insurance totals $250, then your net cap rate dropped to 3.05% ($3,600 - $550 = $3,050 / $100,000 is 3.05%).
Set aside one percent of what you paid for an emergency
Real estate requires maintenance. Unlike buying an equity or a bond, buying a property requires spending money to fix the things that break, such as windows, water heaters, toilets and anything else mechanical. For some mechanically inclined investors, fixing things is fun, but for most of us, it’s just an added expense. As a general rule, set aside at least 1% of the purchase price, per year, every year, for maintenance. If your property is older, set aside more. You’ll have a little peace of mind in case of an emergency.
Tax benefits of real estate
The IRS provides significant tax breaks to real estate investors. Even though the taxation of rental property quickly gets complicated, and sometimes we miss the long-term costs for the short-term tax benefits.
There are two 15-day rules to remember:
- Rule #1: If your personal use of the property is 15 or more days per year, then the property is a residence and the income is considered passive income, making your income tax deductions limited. Rule #2: If you rent your vacation home for fewer than 15 days during the year, you don’t report rental income and therefore can't claim offsetting rent-related deductions.
It is important to note that upon the sale of a property, a real estate investor pays “recaptured depreciation.” This is not dependent on whether or not they took the tax benefits while renting the property and means that taxes that otherwise would have been paid over several years are paid in a single year. Mike Miller, CPA, says, “The only recourse this leaves you with is amending the past 3 years of returns to claim it but lose out on all years prior. Yes, you can choose to not to take depreciation, but tax law requires you to recapture it as if you had.”
To defer this tax, the real estate investor may roll the proceeds into yet another real estate investment property, called a 1031 exchange, but there are strict rules and a time frame. There are some real estate investors who choose to “defer taxes until they die.” Their children or other beneficiaries are left to deal with a tax burden—if there is one.
If you expect the property to grow in value and plan to sell it for a profit, you may want to move into the rental home to save on your taxes. If you lived in the home for at least two years before it is sold, you may be able to claim it as your primary home and exclude capital gains taxes, which can total up to $250,000 per person.
Real estate that transfers after death, and then is sold by the inheritor, may completely avoid taxes. Under today’s tax laws, real estate is marked up to fair market value upon death and in 2019, total estates under $11.4 million pay no estate taxes.
One final note: tax rules are subject to change. Various members of Congress and the White House often talk about revising rules so your best advice is to create a plan. Talk to a CFP® professional or other real estate expert about the benefits, and possible long-term costs, of offsetting your current income from a real estate investment. Because despite the complexity, the real estate tax benefits are real.
How to handle a mortgage
In today’s low-interest rate world, mortgages are a popular way to purchase real estate. Borrowing money reduces the amount of money you have at risk, but a mortgage payment decreases your net income.
As a general rule, a mortgage is most appealing for real estate investors who expect their real estate to appreciate at a fast pace. A mortgage payment will reduce—if not completely eliminate—your monthly income, so it’s important to do the math before you buy.
In our example, you would improve your gross cap rate with a $50,000 mortgage. Putting in half the cost of the purchase price and receiving the same rent will double your cap rate ($6,000/year / $50,000 is 12%).
However, a mortgage payment reduces the net income, sometimes by a lot. Based on today’s average costs associated with a 30-year mortgage—4.5% rate, 4.7% APR, $1,300 closing costs and $250/monthly payment for 30 years—a mortgage reduces investment real estate income by the monthly payment. If you receive $6,000 in rent annually, but are paying $3,000 to a mortgage ($250/month x 12 months) and $2,400 in other costs, then your net annual income is only $600.
If you decide to move forward with a mortgage, pay attention to both the “rate” and APR. Mortgage rates are the annual percentage cost of borrowing money and an APR is the rate plus the up-front loan costs, which are usually at least $1,000. Thus, for small loans like this one, the closing costs can be a large percentage of the loan. For larger real estate purchases, the difference between the APR and rate will be smaller.
To make sense of a mortgage, your future success is determined by the growth in the property value plus the future growth of income that comes from raising rents.
For an easy-to-implement second home purchase calculator. For more personalized, independent assistance, visit www.letsmakeaplan.org and find a CFP® professional in your neck of the woods.