Tired of being priced out of the market? Perhaps you should consider buying an income-producing property that you can live in, such as a duplex or triplex. The additional income could help pay your mortgage and enable you to qualify to buy a more expensive property.
Ideally, your wealth-building strategy might go something like this. You move into the property and own it long enough to accumulate equity through appreciation. Then you sell. You use the proceeds earned from the portion of the building that you occupied as a down payment on a single-family home.
You exchange the proceeds from the rental portion of the property into a larger rental property that will have more upside potential, thereby avoiding capital gains tax. Or, if you’re tired of being a landlord or need more cash for a down payment, you can pay capital gains tax on the rental portion of your proceeds and plunk what’s left into a new home.
Be aware that the tax consequences of owning a single-family residence are different than they are for rental properties. For example, an owner of a single-family residence is entitled to a capital gain tax exemption at the time of sale, under certain conditions.
This exemption doesn’t apply to owners of rental property. In order to avoid paying capital gains tax when you sell a rental property, you have to sell subject to a 1031 exchange. So, if you buy an income property to live in, you’ll be subject to two different sets of tax laws. Consult with a tax advisor who knows the ins and outs of owning real estate before embarking on a project like this.
Taxes aren’t the only issues to investigate before buying a property where you’ll simultaneously be an owner and a landlord. A primary consideration is the price you pay. In areas where single-family home prices are high, you may also have a hard time finding a small income property that makes sense financially.
Preferably, the rents on an income property should cover the costs of ownership (mortgage payment, property taxes and expenses). Otherwise, you will pay extra each month to make ends meet. There are tax benefits for income-property owners, such as depreciation, that can help offset negative cash flow.
Since you’ll be living in the property, you can afford to pay a higher price than someone who wants the property strictly as an investment. However, keep in mind that you will be reselling it someday. If you overpay today, you may be disappointed at your returns when you sell.
HOUSE HUNTING TIP: Make sure to check on the local landlord-tenant laws. Some communities in California, such as Oakland, Berkeley and Santa Monica, have rent-control ordinances. Where rents are controlled, you may not be able to raise rents to market rates. Small income properties are notorious for having low rents. Base your projections on actual and allowable, not overinflated, rents.
Find out the strength of the local rental market. The rental market, like the housing market, fluctuates over time. The most successful rental properties are often located near shopping, transportation and good schools.
Financing is usually less expensive and easier to obtain for properties with four units or less, so you may want to restrict your search to properties of this size. Also be aware that the lender may factor in a vacancy allowance in calculating how much income the property will generate. You should do the same. There will be times when you’ll be without a tenant.
THE CLOSING: Finally, carefully consider if you can handle being a landlord, with all the responsibilities that entails, and one who will live in very close proximity to the tenants.
Dian Hymer is author of “House Hunting, The Take-Along Workbook for Home Buyers” and “Starting Out, The Complete Home Buyer’s Guide,” Chronicle Books.
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