What is an Investment Property?

An investment property is like renting your car out on a carsharing app…

If you own a car but don’t use it a lot, you might want to rent it out on a carsharing app. People will pay you to use your car for a while, then return it to you. You turn a personal possession into an investment that generates cash flow. Investment properties are similar in that you turn real estate that you own into an investment that creates cash flow.

An investment property is a piece of real estate that someone purchases for the primary purpose of turning a profit. People often buy real estate so they can live in it or make use of it. However, people who cannot afford to purchase a home still need a place to live. This opens up an opportunity for those with the funds to purchase homes and rent them to tenants. The landowner doesn’t personally use the real estate. Instead, they try to profit off their ownership of the land.

Investment properties can include things like single family homes, large apartment complexes, or commercial real estate. The determining factor is that the primary goal of the owner is to profit off their property rather than to use the property.

Rent isn’t the only way that people make money from investment properties. Sometimes, people attempt to “flip” properties. This involves buying real estate, making improvements to it, and trying to sell it at a higher price to produce a profit. Again, the owner does not plan to make use of the property. Instead, they aim to profit off their ownership of it.

The IRS treats investment properties differently than other investments and other forms of real estate. Understanding how that tax treatment impacts the returns an investment property offers is an important part of successful property investment. Anyone considering buying an investment property should probably consult a tax professional.

There are a few common types of investment property.

Residential investment properties include single and multi-family homes.

Single-family homes are one of the lower initial cost types of investment properties, and they are often the easiest type of an investor to purchase. Some real estate investors turn their homes into residential investment properties when they move to a new house. Condos are also popular because of the local homeowner’s associations which may handle upkeep.

Single-family homes also have fewer maintenance requirements and simpler financing than larger properties, such as multi-family homes. Property flipping is most popular with residential properties, because investors can more easily improve the property and more easily find buyers than for larger properties.

Investors can earn a profit by receiving rent payments from their tenants. The real estate can also gain value over time, generating a profit for the owner when they sell.

Commercial investment properties include things like retail locations, large apartment complexes, offices, and industrial buildings.

Unlike residential investment properties, the primary tenants of commercial real estate are businesses. Commercial real estate tends to be more expensive than residential real estate and has higher ongoing costs, such as maintenance.

People also typically need higher levels of experience and expertise to invest in commercial properties. Investors in residential properties may have learned general home maintenance from owning or living in a home, but few people acquire the same knowledge about commercial real estate without specialized study.

Like residential real estate, commercial properties can produce profit for investors through rent payments from tenants and through the appreciation of the property over time.

Mixed-use real estate is property that includes both residential and commercial components. Picture an apartment complex with a coffee shop on the ground floor or a development that has apartments or condos mixed with retail and restaurants.

These projects can range from single buildings to blocks to full neighborhoods. Most mixed-use investment properties are owned and managed by large real estate companies rather than individuals.

Mixed-use properties have many investment advantages. Businesses receive a built-in population of customers, while tenants may view easy access to the businesses as a major perk of living in the property. It also provides diversification between commercial and residential properties.

There are many ways of financing investment properties, and the available methods can vary with the type of property involved.

Typically, lenders are stricter with offering financing for investment properties compared to offering a mortgage to someone who intends to live in the home. Financing for residential investment properties typically comes in the form of a mortgage from a typical bank or lender. The lender may impose higher requirements for down payments or loan-to-value ratio, but the process is similar to getting a mortgage for a primary home.

Some individual real estate investors use a practice called house hacking to make financing easier. For example, someone who purchases a two, three, or four family home can live in one unit and rent out the others. Because they occupy one unit, the property qualifies for loans designed for owner occupants rather than investment properties.

Others buy a property using a conventional mortgage, live there for a full year, then move to another home with another conventional mortgage, renting out the first house. Some mortgages have longer requirements. This strategy also lets investors use conventional mortgages to purchase investment properties.

Investments in commercial or mixed-use real estate typically require specialized loans designed for commercial and mixed-use land. These loans often differ from mortgages in the terms offered, as well as the interest rates. Lenders typically target these types of loans at larger businesses that focus on real estate investing.

Real estate investors have to pay taxes on their income from investment properties.

One of the most common forms of income from an investment property is rent. Investors must report rent on their income tax return and pay taxes on that rental income. Investors can deduct some of the costs of owning and maintaining an investment property to reduce their tax burden. This includes things such as:

• Interest on the mortgage
• Maintenance
• Utility costs
• Insurance

Investors can’t deduct costs related to making improvements to a property. For example, repairing a broken deck may be deductible, while installing a deck where there was not one may not be deductible.

When investors sell a property, they may have to pay capital gains taxes if they sell the real property for more than they paid to purchase it. The tax rate varies with how long the owner held the property. Property held for less than a year is taxed at the normal income tax rate (10% to 37%), while the capital gains tax rate for property held longer than a year is less (0% to 15%, rarely higher). The investor may also be able to deduct certain things, such as depreciation, to reduce the taxable gain. You should consult a tax professional given the complexities.

Whether rental property is a good investment varies with many factors. As with all investment opportunities, due diligence is important to make sure you understand the potential risks and rewards.

One popular rule used by real estate investors when analyzing potential purchases is the one percent rule. This rule states that an investment property may be a good deal if you can generate one percent of its cost in rental income each month. For example, if you purchase a home for $200,000, you should be able to rent it out for $2,000 per month, by this rule.

Properties that provide a rent below the target one percent may be a bad deal, while those that provide more rent may be a good deal.

When investing in a rental property, it’s essential to consider all of the costs. Even if you avoid costs such as property management or maintenance by doing the work yourself, this involves an opportunity cost — You are spending time compared to a passive investment portfolio or owning shares in a real estate investment trust.

One thing that beginners should know before investing in real estate is that investment properties tend to be more hands-on than other types of investments, which makes them best-suited for people who enjoy hands-on investing.

Another thing to consider is that real-estate investment tends to be long-term. Buying an investment property means taking out a large loan that often has a term of 15 to 30 years. During the life of the loan, a majority of the rental income may go toward paying down the mortgage. The property may only produce significant cash flow after the debt is repaid or as rents increase and mortgage payment stays the same. Similarly, it can take years for a home’s value to appreciate.

It can also be helpful to establish a separate business entity to purchase the investment property. This can reduce the investor’s personal liability for things that happen on the property.

The exact amount that you need to buy an investment property varies with the real estate market in your area. In high-cost areas, homes can go for hundreds of thousands or millions of dollars while other markets have homes that cost just tens of thousands.

Generally, lenders are more restrictive when lending to real estate investors. While someone purchasing a primary residence may be able to do so with a small down payment, most lenders require 20% down payments for investment properties.

You should also have some extra money in reserve to handle things like insurance, maintenance, property management costs, and vacancies. Many lenders require that you have six months of reserve cash before they will offer a loan.

For example, if you want to buy a $100,000 investment property, you’ll need a $20,000 down payment plus extra in reserve cash. Also bear in mind there are closing costs and repairs necessary both before and after you rent the property.

If you want to get into real estate investing, you may be tempted to buy rental property before buying a home for yourself. There are pros and cons to this strategy.

One advantage is that it gets you into the real estate investment market sooner. If things go well, it leaves more time for your investment to gain value and produce cash flow. It also gives you more flexibility in where you live because it’s easier to move out of a rented apartment than a purchased home.

Another advantage is that you may be able to leverage your investment property to buy a home for yourself down the line.

A drawback of purchasing an investment property before your first home is that it may become more difficult to qualify for a mortgage if you already have one for an investment property.

Another drawback is that buying investment properties delays purchasing a home. If property values are increasing in your area, you may wind up paying more for your home.

The first step is to save up a down payment and reserve funds. Once you’ve done that, you can get pre-approved for an investment property loan. This will give you an idea of your potential budget and can help you target the correct properties.

Then, you need to research potential properties. Look for properties that you can buy at a reasonable cost and that will produce enough cash flow to cover expenses. Alternately, look for properties that have the potential to appreciate quickly, such as property in a promising location or real estate market. Many real estate investors aim to buy properties that will rent for 1% or more of the purchase price each month.

Once you’ve found a property, you can make an offer, finalize your loan details, and purchase the real estate. Make sure to get the property inspected and assessed, just as if you were buying the property to live in.