Real Estate Investments as a Second Source of Income
Many investors create supplemental income by investing in real estate. You can generate short-term income by purchasing and then selling properties for profit. You can also generate long-term income by renting out the properties that you purchase. However, as with any type of investing, there are potential pitfalls as well as rewards.
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Financing Real Estate
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You can buy stocks, mutual funds and many other types of securities with an initial investment of a few thousand dollars or less. Real estate purchases normally cost tens, if not hundreds, of thousands of dollars. You can finance a real estate purchase but most lenders require you to make a downpayment of at least 20 percent on a rental home, and that amounts to $20,000, on a $100,000, home. If you need supplemental income to cover your day-to-day expenses then you may not have the kind of cash reserves that you need to start investing in real estate. On the other hand, you could take a calculated risk and invest a large percentage of your cash reserves if you feel confident that you can quickly make a profit by reselling the property.
Market Conditions
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During economic boom times, housing prices tend to rise and homebuyers can fairly easily obtain financing. However, economic conditions can change very quickly and during a recession home prices sometimes start to fall. If you finance a home purchase you may find that the purchase loan soon exceeds the market value of the home, in which case you must pay off the residual balance if you want to sell the property. The Federal Housing Administration (FHA) only finances purchase loans if the current property owner has owned the home for a least 90 days. Such anti-flipping rules can make it even harder to sell a home for profit during tough economic times, although the FHA did temporarily drop this rule for 2011. Therefore, you may actually end up losing money when you invest in real estate.
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Inflation
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Prices including real estate listings tend to rise over time due to the effects of inflation. If you finance a rental home with a fixed rate mortgage, then you can raise the rent in line with inflation even though the mortgage payment remains the same. This means that your rental profits grow over time. Even after you have finished paying off the mortgage, inflation will enable you to increase the rent on a regular basis. However, inflation will also affect the cost of maintaining your home and the older a house gets, the more maintenance it needs.
Taxes
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As a real estate investor, you can deduct some of your property expenses from your taxes and these tax deductions help to reduce the impact of maintenance costs on your earnings. If you generate income by flipping houses, then you can sometimes avoid paying income tax on the earnings from the sale. If you sell the home after more than a year of ownership, you pay long-term capital gains tax on your earnings. If you sell an investment home within 12 months of purchase, then you pay ordinary income tax on the sale proceeds. As of the time of publication, long-term capital gains are taxed at a rate of just 15 percent while income tax rates run as high as 35 percent. However, if home prices fall within the year that you own the home then you may end up losing money on the home even if you avoid paying taxes.
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References
- Bankrate; Funding Retirement With Rental Income; January 2008
- CNN Money; Real Estate for Retirement... a Good idea?; Walter Updegrave; October 2005
- Realtor; Making Your Money Work for You; M. Anthony Carr
- Bankrate; Real Estate Investments and Capital Gaines Taxes; George Saenz; May 2005
- HUD; FHA Extends Anti-Flipping Waiver to Help Stabilize Housing Market; January 2011
