The following is a guest post written by Terry Sprouse, author of “Fix em Up, Rent em Out: How to Start Your Own House Fix-up and Rental Business in Your Spare Time” – Find out more at Fixemup.org
In my opinion, the two safest ways to get started in real estate, are: 1) buy a home, rent it, then do it again, and/or 2) buy a home, live in it 2 years, then sell it without paying any federal taxes using the “homeowner’s tax break.” Over the past six years, my wife and I have used both techniques. We have several properties that we keep as rental properties and provide us with cash flow. In addition, we also buy houses in need of repair with the intention of selling them and utilizing the “homeowners tax break” to pay no federal taxes.
Turn Your Residence into a Rental Instead of Selling It
A system that I like to use is to refinance my residence six months to a year before I plan to buy a new residence. This gives me enough money for a down payment on the next house that I will purchase. When I locate a good fixer-upper I can quickly purchase it. During the 3-4 weeks it takes to close on the new house, I prepare the old house so it will be ready to rent. This usually involves some painting and landscaping. Then, before I close on the new house, the “for rent” sign goes up on the old house.
The 3 steps in this technique: 1.) refinance your residence. 2.) use the refinance money as a down payment to buy a new house. 3.) move into the new house and rent out the old house Instead of refinancing your residence, you can use savings or a loan from a relative as a down payment. As mentioned, an advantage of refinancing your residence while you are still living there is that you get a lower interest rate on your loan than if you were refinancing a rental property. Under this technique, you get the lower “primary residence” interest rate for both the old property and the new one, since each property is your primary residence at the time that you take out the loan.
Did you know that you can own real estate in your IRA?
Sell a House that You Live in For Two Years and Pay No Income Tax
The 1997 Taxpayer Relief Act was a great boost for average people who wanted to sell their home and buy a new one. It was also a great boost for investors. Couples are allowed to exclude up to $500,000 of the capital gain on the sale of their primary residence. Single individuals can exclude up to $250,000. In other words, the sale of the house is never reported on your federal IRS forms if the capital gain is less than the $500,000 and $250,000 limits.
This exclusion is based on compliance with two requirements: 1. The home must have been the primary residence for both spouses during two of the last five years. The two years do not have to be consecutive but if you rent out the primary residence for more than three years you would be required to occupy it again for two years. 2. The exclusion is available only once every two years. Utilization of this tax exemption is the safest investment strategy for the conservative investor who wants to take few risks. This is the type of investor who wears both suspenders and a belt to hold up his pants. They like to play it safe.
Under this strategy, the investors can quality for the least expensive loan, the owner-occupied loan. There is no need to worry about tenants destroying your rental property or not paying the rent. You completely control the investment by living in the property yourself. When you sell, you have the opportunity to bring in up to $500,000 tax-free money every two years. My wife and I didn’t sock away much money for retirement, but with our rental houses, we have a flow of income that will last as long as we keep the houses.
Many people stay away from rental properties because they don’t want to deal with renters. However, with practice anything is easy, including dealing with renters, and the rewards far outweigh the difficulties. If you really don’t want to deal with renters, just use technique #2, where you buy and sell every two years. Technique #2 is for people who like to play it safe. I have made real estate investing my hobby, as have many others, and you can do it too. For anyone who wants to learn there is plenty of room in the fix-up business. Grab a hammer and join me.
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{ 21 comments… read them below or add one }
Should a Christian build wealth off of people who cannot buy a home?
Ultimately we all build wealth from people less fortunate than us. The fact that you can buy a shirt for $10 made by a low-wage Indonesian instead of $80 made by a low to mid income American, contributes to your wealth. The system is the system. Just try not to make it worse than it is. And live frugally, not to get rich, but to spend your life helping those less fortunate than you.
My wife and I are planning to employ both strategies. We are in the middle of a fixer upper and are looking at foreclosure properties near college campuses for rentals (constant flow of tenants). Overall I think this will be a winning strategy for long term financial success.
But is it a winning strategy for your tenants’ long term financial success?
@minimum wage
Regarding your first comment, I don’t think the article suggests taking advantage of anyone or doing anything unBiblical – do you see something I missed?
I don’ think landlords need to take advantage of renters to get ahead. Just the opposite is true. If you treat renters with respect, and help them to meet their needs and goals, they will treat you the same way. One thing that makes life easier for both parties is when a renter stays in a rental property for many years.
When I was a Peace Corps Volunteer in Honduras, I worked with rural schools, teaching science classes, developing gardening projects and helping to build classroom. I found that when I first came into a new community, people were suspicious of me because I was different and they didn’t know me. So, to help me fit in, I was extremely friendly to everyone I met, particularly those who appeared to be most suspicious of me. I’d ask questions about their lives and their family, tell little jokes, and try to get to know them. What has stuck with me after all these years is that when I was friendly with suspicious people, they responded the same way to me.
People who rent houses also have their defeneses up until they get to know me. I use the same technique that I used in the Peace Corps to make them know that I’m their friend. And, I’ve made a lot of good friends over the years.
Not all renters will be good renters, and in those cases you have to deal with them so that they pay the rent on time, take care of the property and don’t disturb the neighbors. But you can still do it in a professsional way. It can be difficult at first, but the more you do it the better at it you get, until finally, dealing with problem tenants is just routine.
I think this strategies is not as easy as many years back. Rental nowadays has been quite hard to cover the load repayments.
But no doubt it’s a great strategies my father use to be a developer in 3 years. He use this strategies to cause himself into the biggest debt in his history and make the most money in his history as well.
He told me “The key is find a good location with great informations source.” He also told me that “If you can find a great location with underpricing houses, you can get a house for free and have cash flow from there monthly.”
Good job on the posting I can see quite a number of people benefit from it!
Alex Liu
SecretsOfUnlimitedWealth.com
I have always shied away from rentals due to some of the potential headaches associated with them. I think it takes a certain temperament to be a landlord, unfortunately I don’t have it.
Best Wishes,
D4L
I used to work with a group of landlords in opposition to excessive local regulation (for example, it became illegal to rent a dwelling to more than two unrelated individuals, regardless of the property’s carrying capacity – this effectively stopped rental conversions), and I got to hear a lot of horror stories – it seems like every landlord who’s managed at least a few properties for a few years has at least one.
So I have at least an imperfect sense of the risks involved. But in my position as a low-income renter living on the margin in a high-turnover market, I found myself facing five rent increases in five years because the high turnover mitigated against the usual market restraints keeping rent increases in check. (If new tenants are moving into the area every year, you don’t need to worry about keeping your old ones.)
Finally I found a buy-and-hold landlord (a retired teacher who had previously lived in the house and was keeping it to leave to her sons with the basis step-up, and was more interested in keeping low-maintenance tenants than in maximizing cash flow (as the other landlords in town were). I stayed there 13 years until illness and loss of income forced long-distance relocation. If I had had to move locally I doubt I would have been able to find anything affordable.
As for having to live somewhere, I find the finances of renting intriguing. Since landlords are in business to make a profit, and since most landlords succeed in making a profit, on average a renter must be carrying the operating costs and perhaps even then some. So I ask, if I’m paying enough to meet the cost, shouldn’t I be able to own rather than rent? For a lifetime renter, the premium they pay for not being able to buy is staggering (in my case, I view it as the difference between being able to enjoy a modest retirement and never being able to retire at all).
I’m not suggesting every renter should be able to afford a conventional single-family home, but couldn’t the market meet low-wage ownership demand? I’ve seen cottages and guest houses used as rentals; I see ownership opportunities there if some enterprising developer were interested.
“Minimum Wage” makes a lot of sense in asking why renters can’t get help to purchase houses. It must be a frustrating situation to want to buy a house and not have the ability to do so. I’ve done some work with Habitat for Humanity which provides houses for people with incomes insufficient to qualify for a normal loan, but I know that they cannot meet the demand for this type of housing. There are also city programs that help low income people get homes. My wife has a friend, an unmarried woman with 2 children who works as a maid, who qualified for one these programs and wound up with a modest house. I wonder, do these programs work, or what type of program would be needed to allow perennial renters who desire houses to be able to buy one?
As you know, state governments float bond issues to raise money which they then use to subsidize low-income homebuyers, e.g. the interest is subsidized to afford the buyer a low rate, or the buyer is provided down payment assistance in the form of a grant or a loan which is typically forgiven if the buyer lives in the home for so many (often five) years.
These state programs are very limited in the number of homebuyers they can assist. I learned only recently that program size restrictions are handed down from Washington. So state and local governments appear limited in what they are allowed to do.
I think governments and developers need to think outside the box to innovate affordable housing solutions. NIMBY and “smart growth” attitudes and policies are major obstacles here. As I say more generally, whenever the interests of the poor are actively opposed by any other interests, the poor almost invariably lose.
In San Jose (and probably elsewhere) rental houses no longer have back yard green space; they have another house or two in the back yard. If zoning regs allowed it, you could put several (4-6) cottages on a standard lot, and they could be affordable to low-income singles as condos – in Portland, onsite parking requirements are relaxed in areas close to transit. (A standard lot usually cannot be split under current zoning rules, but multiple dwellings could be developed as condos; a different zoning change would be needed to split lots.)
Interesting post!
I would disagree that those two methods are the “safest” however, both involve concentrating your assets into one property which can be risky if you make a mistake (pay too much) or if the situation changes ie interest rates shoot up and the house value goes down.
I would suggest that REITs (Real Estate Investment Trusts) are a safer (and possibly better) way to invest in real estate because they are diversified and you can choose how much you want to invest. With houses you are limited to investing a lot of money unless you have find financial partners.
Mike
I like your live in then rent out strategy.
Keep in mind most mortgage comapny language states you intend to live in the property for a least a year (some companies the language says two years); if you state to the mortgage company that it’s owner occupied them rent the property, that’s what they call loan fraud (it’s a felony in most places). You may want to investigate the mortgage company policy up front, save yourself a headache down the road.
Mike,
I agree that investing in REITs reduces your risk. However, like other stock-type companies you don’t control the investment, instead you relinquish control of your money to a fund manager. Your only decision is when to buy or sell. I prefer to be in control. I want to be the one to decide when to buy, improve and sell my properties. And, I think in the long run, the more you control your investments the more money you stand to make.
Also, when you own the properties, you learn about all aspects of the business and in the process you become more self-sufficient and develop life-coping skills that can help you deal with unexpected turns down the road.
Ernesto,
Good point. You should plan to live in a house at least one year before renting it out.
@Terry
Thanks for staying on top of the comments – and thanks for the post too!! I learned a bit from the post and am learning from the comments as well…
Re: mortgages and owner occupied
Is there any problem if you live in the mortgaged property AND rent out the other bedrooms? I know someone who did this, he was effectively living in the house for free right off the bat, and as rents advanced he came out further and further ahead every month.
Minimum Wage,
I think renting out rooms in your house is a great technique. If renters are added to a house and it is handled in a subtle way (e.g., no additional cars visible from the street), and without any disturbance to the heighborhood, you probably won’t have any trouble. However, there can be neighborhood regulations or city zoning laws that might create roadblocks.
There’s a good book entitled “Creating an Accessory Apartment: for every homeowner who wants to turn extra space into extra income,” by Patrick Hare & Jolene Ostler, that describes how to add an an apartment onto an existing house. It also has some good detail on how to make new renters blend in and not call attention to the changes.
I recently got married. I own a home in FL, and my husband owns a home in GA. After we got married, I moved to GA. The market it too bad in FL, and I have been unable to sell my house. We want to start renting it out. What do I have to do to set my house up as a rental property? I want to be able to claim it as rental property on our taxes, so I want to make sure I take all of the proper steps. Since I didn’t purchase it as “rental property,” is there anything that I have to do, or can I just start renting it? I am in the process of setting up Landlord Insurance (dwelling/liability), but that is all I have done. Any and all suggestions are welcome. Thanks. Dana
How the lenders see the fact that I have a house that I’m putting to rental and ask for a loan to buy another house to live with my family?
Is it complicated to apply for a second mortgage if I already have one?
Can you give some tips on how to deal with lenders?
Thanks and congratulations for the post,
Marianna
Mariana,
Cash-out mortgage refinancing involves refinancing your mortgage for more than you currently owe and pocketing the difference. If you have been paying down your mortgage for some time, then the principal is likely to be substantially lower than what it was when you first took out your mortgage. That build-up of equity will allow you to take out a loan that covers what you currently owe, and then some.
Refinancing a loan differs from purchasing a house in that you can roll the closing costs into the loan.
That means that if you take out a $100,000 loan, and closing costs are 3%, or $3,000 dollars, your loan amount changes to $103,000 and you pay the entire amount over the 30 period of the loan. This is a big advantage because you can do the refinancing without any money coming out of your pocket. You only pay a few extra dollars every month for your loan.
I’ve never had any lenders ask me what I want to do with the money I get. They more loans they close on the more money they make.
For more information on “How to Turn Your House into a Rental Property,” I am putting the final touches on a book with that title. It should be available through Amazon.com in the immediate future.
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