Choosing An Area - Where to Buy Rental Property?

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Reprinted with permission

When choosing an area where to buy a rental property, there are several things to consider including, distance from your home, supply of potential tenants, average rents you can collect and the ability of tenants in that area to pay you.

I would choose property where people want to live, close to shops, parks and decent schools, and in a well-kept neighborhood. There's nothing worse than owning a rental property without any renters. In addition, check out any restrictions on renting with the home owners association, which, if there is one, can have a say in any rental agreements.

Plan on spending time and money advertising for and interviewing potential renters. Have a contingency plan in place if a unit remains vacant for a few months.

Determine what a competitive rental rate is for your property by asking rental agents what they would expect to charge, by reviewing area rentals, and by personally visiting rentals available in the neighborhood.

Run the numbers. Make certain that whatever income you derive covers your costs of owning the property, plus a profit.

Check to see whether the value of other area properties have increased or decreased in the past five years. Try to buy in an area that's on the way up.

Be on the lookout for any hazards common to older properties, such as asbestos, lead-based paint and electrical systems that are not up to code. Budget in reconciling these problems.

Discuss any tax benefits with a tax specialist. There may be local tax incentives for renovating your property as well as advantageous approaches to declaring your expenses.

In Summary

Income produced meets financial goals Suitable property
Appealing location
Vacancy rates
Neighborhood rental rates

Now you need to know the cash flow

First, calculate taxable income or loss from the property. Taxable income or loss is rent received minus three types of expenses: operating expense, depreciation, and mortgage interest expense.

Assume the purchase is $92,500, of which $15,000 applies to the land and $77,500 to the building. Depreciation of the cost of the building is a tax deduction even though depreciation is not paid out in cash each year. However, the deduction must be spread over 27.5 years. Divide the $77,500 cost of the building by 27.5 years. Your depreciation expense is $2,818 per year.

Assume a mortgage loan of $92,500 for 25 years at 10%. The first year's payments would be $10,152 including about $9,270 of tax-deductible interest.

Suppose the property is rented for $13,800 a year, and the total of operating expenses paid by the owner, such as property tax, insurance, and repairs, is $2,500. Subtract from rental income of $13,800 the three types of expense: depreciation ($2,818), interest expense ($9,270), and operating expense ($2,500). The result, for tax purposes, is a rental loss of $788.

The tax rules on rental losses are different if you're a real estate professional. But if you're not a professional, here's how your rental loss could affect your income tax

If you actively manage the property and your adjusted gross income does not exceed $100,000, the rental loss (up to a maximum of $25,000) could be deducted from other income such as salary, interest, and dividends. Multiply the rental loss by your federal income tax rate

Cash flow can now be calculated:

Rental Income - + $13,800
Plus: Tax savings - + 788
Less: Operating expense - (2,500 )
Less: Mortgage payments - (10,152)
CASH FLOW = $1,936

Calculating the cash flow on a rental property investment you're considering will help you decide whether the investment is a good one. Avoid investments with a negative cash flow because you'll have to come up with additional money to cover operating costs and debt payments.

Your offer needs to be based upon your current income level, the cash flow of subject property and most importantly the motivation of your seller mixed with your title research.