The first (and one of the best) real estate investments for many people is a home in which to live. In this section, we cover the investment possibilities inherent in buying a home for your own use, including potential profit to be had from converting your home to a rental or fixing it up and selling it. We also give you some pointers on how to profit from owning your own vacation home.Buying a place of your own
During your adult life, you’re going to need a roof over your head for many decades. Moreover, real estate is the only investment that you can live in or rent out to produce income. A stock, bond, or mutual fund doesn’t work too well as a roof over your head!
Unless you expect to move within the next few years, buying a place probably makes good long-term financial sense. (Even if you need to relocate, you may decide to continue owning the property and use it as a rental property.) Owning usually costs less than renting over the long haul and allows you to build equity (the difference between market value and mortgage loans against the property) in an asset.
Under current tax law, you can also pocket substantial tax-free profits when you sell your home for more than you originally paid plus the money you sunk into improvements during your ownership. Specifically, single taxpayers can realize up to a $250,000 tax-free capital gain; married couples filing jointly get up to $500,000. In order to qualify for this homeowner’s gains tax exemption, you (or your spouse if you’re married) must have owned the home and used it as your primary residence for a minimum of 24 months out of the past 60 months. The 24 months doesn’t have to be continuous. Additionally, the IRS now provides for pro-rata (proportionate) credit based on hardship or change of employment. Also, note that the full exemption amounts are reduced proportionately for the length of time you rented out your home over the five-year period referenced above.
Some commentators have stated that your home isn’t an investment, because you’re not renting it out. We respectfully disagree: Consider the fact that many people move to a less costly home when they retire (because it’s smaller and/or because it’s in a lower cost area). Trading down to a lower priced property in retirement frees up equity that has built up over many years of home ownership. This money can be used to supplement your retirement income and for any other purpose, your heart desires. Your home is an investment because it can appreciate over the years, and you can use that money toward your financial or personal goals.
Converting your home to a rental
Turning your current home into a rental property when you move is a simple way to buy and own more properties. This approach is an option if you’re already considering investing in real estate (either now or in the future), and you can afford to own two properties. Holding onto your current home when you’re buying a new one is more advisable if you’re moving within the same area so that you’re close by to manage the property. This approach presents a number of positives:
✓ You save the time and cost of finding a separate rental property, not to mention the associated transaction costs.
✓ You know the property and have probably take good care of it and perhaps made some improvements.
✓ You know the target market because the house appealed to you.
Some people unfortunately make the mistake of holding onto their current home for the wrong reasons when they buy another. This situation often happens when homeowners must sell their homes in a depressed market. Nobody likes to lose money and sell their home for less than they paid for it. Thus, some owners hold onto their homes until prices recover. If you plan to move and want to keep your current home as a long-term investment (rental) property, you can. If you fully convert your home to rental property and use it that way for years before selling it, after you do sell, you can either take advantage of the lower long-term capital gains rates or do a tax-deferred exchange. For tax purposes, you get to deduct depreciation and all of the write-offs during the ownership and you can shelter up to $25,000 in income from active sources subject to income eligibility requirements. (Please see Chapter 18 for more details.)
Turning your home into a short-term rental, however, is usually a bad move because:
✓ You may not want the responsibilities of being a landlord, yet you force yourself into the landlord business when you convert your home into a rental.
✓ You owe tax on the sales’ profit if your property is classified for tax purposes as a rental when you sell it and don’t buy another rental property. (You can purchase another rental property through a 1031 exchange to defer paying taxes on your profit. See the discussion in Chapter 18.)
Effective tax year 2009, you lose some of the capital gains tax exclusion if you sell your home and you had rented it out for a portion of the five-year period prior to selling it. For example, if you rented your home for two of the last five years, you may only exclude 60 percent of your gain (up to the maximums of $250,000 for single taxpayers and $500,000 for married couples filing jointly), whereas the other 40 percent is taxed as a long-term capital gain. Also, be aware that when you sell a home previously rented and are accounting for the sale on your tax return; you have to recapture the depreciation taken during the rental period.
Investing and living in well-situated fixer-uppers
Serial home selling is a variation on the tried-and-true real estate investment strategy of investing in well-located fixer-upper homes where you can invest your time, sweat equity, and materials to make improvements that add more value than they cost. The only catch is that you must actually move into the fixer-upper for at least 24 months to earn the full homeowner’s capital gains exemption of up to $250,000 for single taxpayers and $500,000 for married couples filing jointly (as we cover in the “Buying a place of your own” section earlier in this chapter).
Be sure to buy a home in need of that special TLC in a great neighborhood where you’re willing to live for 24 months! However, if you’re a savvy investor, you would’ve invested in a great neighborhood anyway.
Here’s a simple example to illustrate the potentially significant benefits of this strategy. You purchase a fixer-upper for $275,000 that becomes your principal residence, and then over the next 24 months, you invest $25,000 in improvements (paint, landscaping, appliances, decorator items, and so on) and you invest the amount of sweat equity that suits your skills and wallet. You now have one of the nicer homes in the neighborhood, and you can sell this home for a net price of $400,000 after your transaction costs. With your total investment of $300,000 ($275,000 plus $25,000), your efforts have earned you a $100,000 profit completely tax-free. Thus, you’ve earned an average of $50,000 per year, which isn’t bad for a tax-exempt second income without strict office hours. (Note that many states also allow you to avoid state income taxes on the sale of your personal residence, using many of the same requirements as the federal tax laws.)
Now, some cautions are in order here. This strategy is clearly not for everyone interested in making money from real estate investments. We recommend that you bypass this strategy if any of the following apply:
✓ You’re unwilling or reluctant to live through redecorating, minor remodeling, or major construction.
✓ You dislike having to move every few years.
✓ You’re not experienced or comfortable with identifying undervalued property and improving it.
✓ You lack a financial cushion to withstand a significant downturn in your local real estate market as happened in numerous parts of the country during the mid- to late-2000s.
✓ You don’t have the budget to hire a professional contractor to do the work, and you don’t have the free time or the home improvement skills needed to enhance the value of a home.
One final caution: Beware of transaction costs. The expenses involved with buying and selling property — such as real estate agent commissions, loan fees, title insurance, and so forth — can gobble up a large portion of your profits. With most properties, the long-term appreciation is what drives your returns. Consider keeping homes you buy and improve as long-term investment properties.
Purchasing a vacation home
Many people of means expand their real estate holdings by purchasing a vacation home — a home in an area where they enjoy taking pleasure trips. For most people, buying a vacation home is more of a consumption decision than it is an investment decision. That’s not to say that you can’t make a profit from owning a second home. However, potential investment returns shouldn’t be the main reason you buy a second home.
For example, we know a family that lived in Pennsylvania and didn’t particularly like the hot and humid summer weather. They enjoyed taking trips and staying in various spots in northern New England and eventually bought a small home in New Hampshire. Their situation highlights the pros and cons that many people face with vacation or second homes. The obvious advantage this family enjoyed in having a vacation home is that they no longer had the hassle of securing accommodations when they wanted to enjoy some downtime. In addition, after they arrived at their home away from home, they were, well, home! Things were just as they expected — with no surprises, unless squirrels had taken up residence on their porch.
The downsides to vacation homes can be numerous, as our Pennsylvania friends found, including
✓ Expenses: With a second home, you have the range of nearly all of the costs of a primary home — mortgage interest, property taxes, insurance, maintenance, utilities, and so on.
✓ Property management: When you’re not at your vacation home, things can go wrong. A pipe can burst, for example, and the mess may not be found for days or weeks. Unless the property is close to a kind person willing to keep an eye on it for you, you may incur the additional expense of paying a property manager to watch the property for you.
✓ Lack of rental income: Most people don’t rent out their vacation homes, thus negating the investment-property income stream that contributes to the returns real estate investors enjoy (see Chapter 1). If your second home is in a vacation area, where you have access to plenty of short-term renters, you, or your designated property manager can rent out the property. However, this entails all of the headaches and hassles of having many short-term renters. (However, you do gain the tax advantages of depreciation and all expenses as with other rental properties.)
✓ Obligation to use: Some second homeowners we know complain about feeling forced to use their vacation homes. Oftentimes in marriages, one spouse likes the vacation home much more than the other spouse (or one spouse enjoys working on the second home rather than enjoying the home itself).
Before we close out this section on vacation homes, we want to share a few tax tips, as found in the current tax code:
✓ If you retain your vacation home or secondary home as personal property, forgoing the large income streams and tax write-offs for depreciation and operating expenses associated with rental properties, you can still make a nice little chunk of tax-free cash on the side. The current tax code permits you to rent the property for up to 14 days a year — and that income is tax-free! You don’t have to claim it. Yes, you read that right. Moreover, you can still deduct the costs of ownership, including mortgage interest and property taxes, as you do for all other personal properties.
✓ If you decide to maintain the property as a rental (you rent it out for more than 14 days a year), you as the property owner, can still use the rental property as a vacation home for up to 14 days a year. Alternatively, a maximum of 10 percent of the days gainfully rented, whichever is greater, and the property still qualifies as a rental. Also, all days spent cleaning or repairing the rental home don’t count as personal use days — so that’s why you paint for a couple of hours every afternoon and spend the morning fishing!
Before you buy a second home, weigh all the pros and cons. If you have a spouse or collaborate with whom you’re buying the property, have a candid discussion. Also, consult with your tax advisor for other tax-saving strategies for your second home or vacation home. Moreover, please see Chapter 18 for more tax related information on rental properties.
Paying for condo hotels and timeshares
Timeshares, a concept created in the 1960s, are a form of ownership or right to use a property. A more recent trend in real estate investing is condo hotels, which in many ways are simply a new angle on the old concept of timeshares. A condo hotel looks and operates just like any other first-class hotel, with the difference that each room is separately owned. The guests have no idea who owns their room.
Both timeshares and condo hotels typically involve luxury resort locations with amenities such as golf or spas. The difference between the traditional timeshare and condo hotel is the interval that the unit is available — condo hotels are operated on a day-to-day availability, and timeshares typically rent in fixed intervals such as weeks.
Some of the most popular projects have been the branded condo hotels such as Ritz Carlton, Four Seasons, Trump, W, Westin, and Hilton located in the high profile vacation destinations like Hawaii, Las Vegas, New York, Chicago, and Miami. You can also find many foreign condo hotel properties in the Caribbean and Mexico, and the concept is expanding to Europe, the Middle East, and Asia.
Two types of individuals are attracted to investing in condo hotels and timeshares. One group is investors who believe that the property will appreciate like any other investment. The other group is people who use the condo hotel or timeshare for personal use and offset some of their costs.
From an investment standpoint, the fundamental problem with timeshares is that they’re overpriced, and like a condominium, you own no land (which is what generally appreciates well over time). For example, suppose that a particular unit would cost $150,000 to buy. When this unit is carved up into weekly ownership units, the total cost of all those units can easily approach four to five times that amount!
To add insult to injury, investors find that another problem with timeshares is the high maintenance or annual service fees. Is it worth buying a slice of real estate at a 400 to 500 percent premium to its fair market value and pay high fees on top of that? We don’t think so.
Many owners of timeshares find that they want to vacation at a different location or time of year than what they originally purchased. To meet this need, several companies offer to broker or sell timeshare slots. However, timeshare availability and desirability have so many variables — including location, time of year, and quality of the particular resort — that it has been difficult to fairly value and trade timeshares. As a result, resort rating systems have been developed (Resorts Condominiums International and Interval International are two of the most well-known) to compare resort location, amenities, and quality.
The developers and operators of condo hotels love the concept because one of the most consistently successful principles of real estate is increasing value by fractionalizing interests in real estate. As with timeshares, the developers are able to sell each individual hotel room for much more than they could get for the entire project.
Condo hotel operators are able to generate additional revenue from service and maintenance fees to cover their costs of operations. Often the owners’ use of their own rooms doesn’t negatively affect the overall revenues of the property because the rooms would have sometimes been vacant anyway. Condo hotels allow their owners to stay in their units but often impose limits on the amount of personal usage.
The purchaser of the condo hotel unit sees this type of investment as an option to direct ownership of a second home and likes the ability to generate income. The professional management is another one of the attractions to investors. The owners don’t pay a management fee to the hotel operator unless their room is rented, and then the collected revenue is split.
These properties are often hyped, and the expectations of the condo hotel investor are often much greater than the reality. Investors are lured to condo hotels by the potential for appreciation and cash flow as well as professional management. Many investors find themselves being pressured into pre-sale offering presentations even before the units are built. These events can be tempting, but savvy investors need to do their own due diligence. Therefore, when you hear a sales pitch indicating that your proposed investment in a condo hotel unit will provide significant income from hotel rentals and cover most or all of your mortgage and carrying costs, that’s the time to grab your wallet and find the nearest exit.
Many investors’ first experiences with timeshares are tempting offers of a free meal, a great discount offer to a theme park, or even a free one or two night stay at the resort, with the catch that they have to spend some time listening to an informational presentation. These offers usually come from individuals contacting you in known tourist locations or when you check into a hotel that just happens to offer condos as well. Robert remembers his first exposure to timeshares was as a child in the early ‘70s on a family vacation to Florida, when his parents got a free camera just for attending a seminar on timeshares near Orlando. Even as a teenager, Robert didn’t like the obvious pressure sales tactics he observed.
However, timeshares may make sense for you if you like to vacation at the same resort around the same time every year and if the annual service or maintenance fees compare favorably to the cost of simply staying in a comparable resort. Remember, though, that if the deal seems too good to be true, it is too good to be true. As with timeshares, the only folks who generally make money with condo hotels are the developers, not the folks who buy specific days of ownership.
