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Sheltering Your Assets

Buying a second property to rent
By EMILY FREEMAN |

IF YOU THINK you were eaten out of house and home this April 15th, it’s probably time to seriously consider building a shelter that will keep Uncle Sam out. Putting your money into a physical shelter-a house, condominium or duplex that you rent out-is a good way to hold on to your income. Over the years, in fact, real estate has proven itself to be one of the most reliable investments you can make, if not the most reliable.

The market may have its slowdowns, as it has recently, and its times of rapid appreciation, as we experienced only a few years ago, but the overall trend has been upward. As one local developer describes it: “It’s kind of like bouncing a yo-yo up the stairs. We may be on a landing now, but the yo-yo will bounce back up again.” With real estate-except for the most speculative kind-your yo-yo rarely bounces back down to the floor.

You probably won’t make a million dollars by investing in real estate part time in Dallas; but you don’t have to be a millionaire to get into the market, either. With some types of investments, you put up a chunk of money and then control an investment that’s worth an equal dollar amount. But with real estate, you can use leverage. Just as a lever allows you to move far more weight than you could lift alone, borrowing money for real estate investment allows you to lay out in cash a relatively small amount while reaping the benefits of a property that may be worth many times your initial investment.

But real estate investment isn’t for everyone. If you need money quickly, consider investments that are more liquid. If you can’t afford to carry the costs for a few months while the property isn’t occupied, other alternatives might better suit you. And if the thought of holding real estate raises your blood pressure, you might feel better with a federally insured investment. One cardinal rule of investing: You should be comfortable with the investment you choose.

But if you find the prospect of owning real estate exciting and you’re in a high tax bracket, real estate investment may be for you. As your tax bracket moves upward – particularly as it reaches 35 to 40 percent – the tax benefits of property investmentincrease dramatically.

Investing in real estate is not without effort and risk, though. As a part-time investor, you’ll probably want to steer clear of traditionally high-risk investments such as raw land speculation or commercial development and choose a more predictable investment such as a house or condo that you can buy and then rent out. Although it’s in your best interest to spend time researching the market for a good property, you don’t have to devote all your free time to managing that property. Many companies are available to take over the day-to-day operating responsibilities. They’ll take a cut of the rent you’d be receiving-approximately 5 to 10 percent – but freeing your own time may be wellworth the cost. Then, assuming thatyou’ve selected a good property, youshould be able not only to shelter any cash flow from your investment and from some of your regular job earnings, but to earn money on your investment to boot.



BEFORE YOU get out your calculator to figure out how much money you’re going to make in real estate, you’ll need an overview of the areas of Dallas you’re considering. The Dallas rental market is changing, and location is more crucial than ever.

“I think the entire rental market – whether single-family houses, condominiums, duplexes or whatever – has certainly benefited from 1980 to 1982 by high mortgage rates that have kept many people in the rental market,” says Ron Witten, president of M/PF Research, a real estate consulting and analysis firm. “That situation is changing. We’re finding that more renters [have become] able to buy over the last six months. We now see a large number of new apartments under construction, which is another reason to be cautious.”

The rental market downturn must be put in perspective, says Witten, who isn’t glum about the potential for residential real estate investment. “I think we’re getting back to a normal market situation. And as the economy grows, there will be more newcomers, more in-migration. What I’d be looking for as a small investor is a residential area where you can pretty well limit the competition.” He points to close-in areas such as East Dallas that are already built up so that new apartment construction is unlikely. “Another opportunity is to lease to somebody that others don’t want to lease to, such as families,” he says.

Every investor, like every gambler, has his own formula for selecting a location. Jim Fite, president of Judge Fite Co. Inc., says he looks for new to 35-year-old houses with concrete foundations in fairly stable neighborhoods for long-term appreciation and low maintenance. If you get into a neighborhood with 50 percent or less owner-occupied houses, you put yourself in a higher risk situation, he says.

You’ll pay more for a house in a predominantly owner-occupied area, says real estate developer and syndicator Roland Freeman of American Republic Realty Corp., because people who buy houses to live in may pay more because they like a particular characteristic of the house and choose to ignore the hard financial facts. But on the flip side, he says, there is a far greater potential for resale in these areas.

The construction quality of the house should be no less important in an investment purchase than in the house you live in. Although you may choose to buy a somewhat run-down house at a low price and fix it up yourself in hopes of bringing in higher rents and a good profit when you sell, you don’t want to be surprised by needed repairs. Too many investors are swayed into buying when the owner’s papers show a good cash flow; they don’t realize that the return is so high because no significant maintenance work has been done on the property in years.



YOU CAN get ahead of the real estate game in a number of ways. A house, con-do or duplex that you rent out can offer a way -through tax deductions -to keep more of the money you earn in your pocket. Just as with a house that you own and live in, you can deduct mortgage interest and property taxes that are paid on your rental property during the year. You also get a depreciation deduction -no small chunk of change, particularly during the initial years. The IRS assumes that, over a number of years, the usefulness and value of a property declines, so you can deduct some of that assumed loss (depreciation) in value each year. Nine times out of 10, this “loss” is only an on-paper accounting calculation because your property should be increasing (appreciating) in value in the real marketplace. For tax purposes, however, the initial depreciation deductions are usually so large that you should be able to show a loss on your investment and thus reduce your taxable income.

Since 1981, a depreciation deduction schedule has made it possible for investors to automatically take depreciation at a fast rate without the complicated procedures that were necessary in the past. Rather than taking equal deductions each year (called straight-line depreciation), you can now take higher rates of depreciation in the early years. After 15 years, you’d get no tax benefit from depreciation. For instance, if you bought a house on January 1, 1982, for $72,000 (land costs aren’t considered in depreciation), you would have been able to deduct $8,640 (12 percent) from your taxable income this April 15th. By the 10th year, your depreciation deduction would be only $3,600, or 5 percent of the house price.

Many first-time investors look immediately to the cash-flow possibilities of an investment -the day-to-day money you earn from the property on rentals. While it’s possible to make money through cash flow, experienced investors warn that putting money in your pocket each month from rental money is not very likely during the first years. “All rules of thumb are fraught with exceptions, but it’s a common first-year occurrence for operating expenses and mortgage costs to equal 125 percent of the rent received,” says Freeman. There is an up side to the coin: As long as the tax benefits you receive from your investment outweigh any costs not covered by rent, you’re still ahead in the overall picture. In addition, if you plan carefully and reduce your withholding taxes (or if you’re self-employed and pay less in quarterly payments), you shouldn’t be out-of-pocket those cash expenditures during the year, says John S. Pinkston Jr., a certified public accountant with Pinkston & Associates. Of course, you must keep an eye on your tax situation throughout the year, he says, so that you don’t pay less than 80 percent of this year’s tax liability and less than last year’s tax, which would trigger a penalty for underpaying your estimated taxes.

If you’re looking for a good cash flow from the property-say, you’re nearing retirement and the tax benefits won’t mean much to you -there are ways to increase the regular income possibilities. If you’ve selected a property in an area that’s stable or rising in value, you should be able to increase rents over a period of time. You can also put down a large down payment in order to decrease your monthly mortgage payments. But remember that a large down payment will decrease your rate of return since you’re not leveraging your money as fully as you could. Or, as one local investor does, you could buy only properties that have low-rate assumable mortgages. It doesn’t make good business sense, however, to try to increase your cash flow by neglecting needed repairs on your rental property.

In recent years, a key to making money on real estate has been to take advantage of the fast-increasing value -or appreciation. Stories abound about people who bought a house at $60,000, then sold it a few years later at $85,000. Inflation has slowed, but prices are still rising even if to a lesser degree. Several area real estate agents predict that the appreciation rate will be approximately 8 percent this year.

The point at which you sell your investment and realize the benefits of appreciation is also the time that Uncle Sam comes around with his hand extended. The tax shelter you’ve been enjoying has only put off the inevitable: sharing a piece of the pie with the IRS. Through another tax benefit – the capital gain deduction – that piece of the pie can be reduced. Although a number of adjustments are made, you’ll essentially pay tax on only 40 percent of your capital gain from the sale at your ordinary income bracket rate. If you reinvest in another property during the same year, you may be able to protect some of this income through the tax benefits of the next investment.



LIKE PIECES in a puzzle, you need to see the distinctive shape of each benefit – cash flow, tax deductions and appreciation – to see where they fit in the picture. But unless you put all three together, you won’t be able to see the whole picture. One of the most common mistakes that new investors make is zeroing in on only one aspect of an investment.



CASH FLOW



First, figure your maximum rental income. Generally, rents are equal to between .8 and 1.25 percent of the purchase price. But since you could have vacancies, you should lower that amount so that you don’t overestimate your potential income. Some investors reduce their expected income by the percentage of vacancies in the city (6 percent at the end of 1982, according to M/PF Research). Ed Boudreau of Capital Consultants Management Corp. says that an investor with a single property should estimate a slightly higher percentage of vacancies, since there’s no chance to offset losses by at least having income from other properties.

Next, estimate your day-to-day operating expenses (such as fixing plumbing lines or painting a few rooms when a new tenant moves in). These expenditures generally fall between 35 and 50 percent of your rental income. Be aware, though, that an old structure with tenants who abuse the property may cost more than 50 percent of the rental income to maintain, while a new place with good tenants may cost only 15 to 20 percent.

Finally, look at how much your annual mortgage payments will be.

Total possible rent for the year (assuming a $60,000 house with amonthly rent equaling 1 percent ofpurchase price, or $600 a month) $7,200

Less anticipated vacancies (assuming you won’t have income for 10percent of the time because of vacancies) – $720

Anticipated yearly income fromrent $6,480

Less day-to-day operating costs(assuming expenses are 35 percent ofyour rental income) – $2,268

Less yearly mortgage payments(assuming you put down $ 12,000 andhave a $48,000 mortgage at 12.75percent with monthly payments of$521.61 – $6,260

Annual cash flow – $2,048



In this case, your operating expenses and mortgage payments exceed your income from rents. In other words, you must come up with $2,048 to keep the rental property running. The picture doesn’t look promising from this perspective, but look at what happens when you consider the tax situation.



TAXES



When your cash flow is in the red (as above), you create a tax loss -a reduction in the amount of income on which you have to pay taxes. To get the actual amount of your taxable income on the investment, you must first add the principal you paid on the mortgage back into the cash flow (in this case, your tax loss).

Even the most uncalculating individual will enjoy the next step: figuring the deduction you take for depreciation. If you use the accelerated schedule, you can deduct 12 percent of the cost of the house during the first year. You can take the depreciation deduction only for the cost of the house because land doesn’t depreciate (or lessen in value), according to the IRS. So be sure you subtract the cost of the land in figuring the depreciation deduction.

Finally, add the tax loss from your cash flow and the depreciation deduction to see what your taxable income is.



Cash flow during the year – $2,048

Add back in annual principal paidon the mortgage + $147

Taxable income on the investmentbefore depreciation (in this case, it’sactually a tax loss since the number isnegative) -$1,901

Add the deduction for depreciation (assuming that the price of the house was $51,000 of the $60,000 purchase price and that you took accelerated depreciation of 12 percent – $51,000 x .12) -$6,120

Your taxable income from the investment (again, it’s actually a tax loss) -$8,021

Multiply by your income-tax bracket (assuming you’re in the 40 percent bracket) x .40

Tax benefit from your investment(money in your pocket because you don’t have to pay taxes on it) $3,208

Notice that, because of your tax benefit, you’re ahead by $3,208 – more than the amount you were down as a result of your problems with cash flow from your investment.



APPRECIATION



To make the picture complete, let’s assume that you sell your rental property after five years. Also picking a number out of the air, assume that the house went up in value (appreciated) 8 percent each year. Now it’s time to pay the piper -give Uncle Sam his cut of your profits. Here’s a rough idea of what happens.

You should be aware that all those depreciation deductions you took weren’t really “free.” In essence, all you did was defer some taxes. So, for tax purposes, the depreciation you paid will increase the gain you got on the sale of the house.

On the other hand, you’ll be able to take a capital-gain deduction. You won’t have to pay any taxes on 60 percent of your profit (which has been adjusted for depreciation deductions). You’ll pay at your regular income tax rate on the remaining 40 percent.

There’s one more calculation that must be made. Since you took the accelerated depreciation deduction rather than just straight-line depreciation, you’ll have to pay taxes on the difference between those two amounts. Add the 40 percent of the profit on which you must pay taxes to this depreciation amount (called recaptured depreciation), and you’ve got your taxable income on the sale of your house.



Capital gain on the sale (the profit adjusted for depreciation deductions you took) $38,630

Multiply by the amount you must pay taxes on (because of the capital gain deduction, 60 percent is tax-free) x.40

Sum of your taxable income from the sale $15,452

Add the recaptured depreciation + $6,460

Taxable income from the sale $21,912

What you owe Uncle Sam (assuming you were in the 40 percent bracket; however, because the sale increased your income, part of thetaxable amount will be in the 44 percent bracket) $9,073



But keep in mind that you have two options other than paying Uncle Sam. You could invest in another property with the possibility that its tax benefits will lower the amount you must pay, or you could swap properties with another investor, which will allow you to defer all or part of your gain on the transaction.



LIKE POKER, the key to real estate investing is knowing when to hold and when to fold. How long you keep an investment property depends upon a number of factors. Since mortgage interest and depreciation deductions both decline over the years (especially with the accelerated schedule), your tax benefits become smaller each year. At the same time, your cash flow position generally increases, particularly if you’re able to gradually raise rents and hold costs in line.

Many investors stay with a property only as long as it yields tax benefits, then sell it once those benefits provide little shelter. This usually occurs between the fifth and seventh years of ownership. Others may hang onto a property for several years to receive the regular cash flow. Still others may buy in a rapidly appreciating market, hold the investment for a few years, then sell it for a whopping profit in appreciation.

But adhering to predetermined formulas of when to sell has some pitfalls. “You can’t have a nice, neat set of rules for the time to sell a property,” John Pinkston says. “They completely ignore the market conditions or personal situations at the time. For instance, if you bought the property when you were 58 and now you’re 65, don’t sell it because you don’t need the tax shelter anymore. Why pay Uncle Sam a bunch of dollars on the gain? By the same token, if you bought a property and within a short time its value was pushed up 50 percent because a major new company moved into its area, sell it and get out. Your appreciation has reached its peak.”



TO BE successful in rental properties, you’ll need to do your research: Learn how to choose a property with good potential, figure out the intricacies of cash flow, tax benefits and appreciation, and learn whenit’s time to get out. On the other hand, ifyou’ve done your homework, you probably won’t feel quite so much like grumbling when you have to pay Uncle Sam hisdue on some future April 15th. At leastyou will have gotten use out of your hard-earned money before Uncle Sam takes hisslice of the pie.