What You Need To Know About Real-Estate Investing

Wall Street Journal editor Dave Kansas details the tax deductions available to owners of primary and second homes, as well as how to buy a profitable rental property.
By: Dave Kansas: The Wall Street Journal Online
The new book, "The Wall Street Journal Complete Money & Investing Guidebook," by Journal editor Dave Kansas, offers personal finance strategies, including investing in real estate. Below is selection on primary homes, vacation houses and income properties.

Investing in real estate is a key part of any investor's financial planning. For most of us, our homes are a big part of our net worth. And as we grow older, we build equity in our homes that can help fund our children's college or our own retirement. Here, we'll take a look at investing in our private residences, in vacation houses and in income or rental properties.

Our Homes

Owning a home comes with tax advantages. For instance, interest paid on mortgage is tax-deductible. And in some cases, home improvements can provide tax advantages. Selling a home also has some tax advantages. If you are single and have lived in your primary residence for two years, the first $250,000 of profits from the sale of the house are tax-free. If you're married, the exemption is $500,000. And you can take that tax advantage once every five years.

Second Homes

Investors have some options about optimizing the purchase of a second home. They can use the residence as a personal property, in which case the interest payments are tax deductible. Under the tax code, taxpayers itemizing deductions can claim mortgage interest payment deductions on the first $1 million of debt incurred for the purchase of a first or second home. To qualify as a second home, an owner must use the residence for more than 14 days per year.

The other option is to rent the property when you're not using it. If you rent for fewer than 14 days, you can still qualify for the personal home deduction. If you rent for more than 14 days, the tax treatments change, because now your second home is considered an investment property. Expenses such as mortgage interest and maintenance are divided between personal and investment use, proportional to the number of days of rental use and actual use. The expenses counted as investment are deductible; the portion allocated for personal use, including mortgage interest, is not deductible, because an investment property is not considered a personal second home.

Income Properties

Investing in income property is riskier than buying a second home, because rather than having a place to visit on the weekends, an income property is purchased to deliver, well, income. A two-family home, called a "duplex" in some parts of the country, may sound easy to rent and maintain. But if one unit is empty, 50% of your rental income isn't coming in that month. And that rental income is usually aimed at paying off a mortgage used to purchase the income property. Having a 100-unit building makes it less likely that you'll face a 50% vacancy rate, but even a 10% vacancy rate means you are trying to rent out 10 units, which can take a lot of time. Investing in income property sounds glamorous, especially when you run the numbers with full vacancy rates and no turnover. But pipes break, people move out and the roof sometimes needs replacing. The landlord of an income property has to deal with all these headaches. Landlords who have a lot of money can hire other people to handle these things, but most of us investing in real estate don't start with such full pockets.

Valuing an income property is more complex than valuing a residence. When you buy a residence, you are calculating your ability to pay a mortgage out of your own earnings. When you buy an income property, you're calculating how the income (rents) will help pay the mortgage.

So how to value an income property? An income property has an annual net operating income, or NOI. This is a figure of rental income less anticipated vacancies, maintenance and other expenses, not including interest payments or other debt related to the property. Most investors divide the NOI by something called the "cap rate" to come up with the proper value for one apartment in a complex. The cap rate relates to the expected annual rate of return on the property, and most income property buyers recommend using a cap rate of 9% (0.09) or 10% (0.10) when evaluating a property. So a property with an NOI of $100,000 and a cap rate of 9% would have a value of $1.1 million. This kind of simple calculation isn't perfect, but in a real-estate market that is increasingly frantic, doing even simple math can help you understand if you're overpaying for a property. Like investing in stocks, investing in real estate works best when you don't overpay. Cap rates vary depending on all kinds of local variants, such as the proximity of good schools, safety and local economic growth.

- Adapted from "The Wall Street Journal Complete Money & Investing Guidebook" by Dave Kansas. Copyright 2005 by Dow Jones & Co. Published by Three Rivers Press, an imprint of the Crown Publishing Group, a division of Random House Inc. For more information, please visit http://wsjbooks.com.