3 Financial Planning Considerations for Investment Property
Key Points:
Real estate is an asset class many individuals consider for diversification within their overall investment portfolio.
In addition to a primary residence, many individuals look to invest in other real estate properties during their lifetime.
Acquiring and managing an investment property involves a variety of unique planning considerations. Interested investors should take a comprehensive approach to their investment decision in order to avoid unexpected complications or costly oversights.
Real estate is an appealing asset class for many investors. Over half of all investors that make a purchase cite the appeal of passive income streams and price appreciation potential as primary motives to make an investment.¹ In addition to owning a primary residence, many investors have or will consider purchasing an investment property of some sort over the course of their lifetime.
According to the National Association of Realtors, throughout calendar year 2017, 1.14 million homes were sold as investment properties, making up 18% of all home sales. An additional 12% of home sales were made up through vacation home purchases, many of which are utilized for seasonal rental through online platforms.¹
Despite being a fairly common asset class, however, there are three planning considerations unique to investment property that one should include in their evaluation process, beyond basic cash flow considerations.
Depreciation Planning
Unlike a primary residence, an investment property will need to be depreciated annually over its useful life. The accounting for this depreciation adds an additional layer of deduction on the property for tax reporting purposes. For investors that must report and pay taxes on profits, depreciation is often looked at favorably, as writing down the property over time through depreciation reduces the present-day tax obligations on the income from the investment.
In evaluating an investment property purchase, however, investors should be mindful of the long-term impacts of that depreciation. Upon sale, depreciated property requires that a calculation be done to determine the amount of “depreciation recapture”-- gain realized by the sale of depreciable capital property that must be reported as ordinary income for tax purposes-- that may be required on the disposition of the property. This recapture, which can result in ordinary income to the seller in addition to the potential long-term capital gain on the sale, can add material and often unforeseen costs to the investor when the property is sold.
Mixed-Use Considerations
Investors that approach real estate with part-time or seasonal vacation rental aspirations also need to be mindful of the planning and tax considerations that come along with mixed-use tax reporting requirements. The amount of days the property is used personally, as compared to the number of days rented, needs to be closely monitored and reported on the tax filing.
Generally speaking, the more time spent in the home personally throughout the year, the more likely the income tax treatment of the investment property will be similar to that of a personal property, and vice versa. In addition to impacting the income reporting requirements, the level of mixed-use rental will also impact the level of deductions that can be taken on the property as well. Therefore, too much personal use time for a property can result in not seeing any tax benefit from the property, as most expenses would no longer be deductible.
Activity Types
In addition to the number of days used, investors may also need to monitor the amount of time that is spent actively managing the property by themselves or others. The amount of time spent managing can determine whether an investor is considered to be active or passive in that investment activity, or whether it is considered a qualified trade or business.
At a level above 250 hours managed annually, an investor may potentially be eligible for additional tax deductions through the use of the Qualified Business Income deduction, which came about as a result of the Tax Cuts and Jobs Act passage at the end of 2017. Another critical time threshold for investors occurs at 750 hours annually. If the time spent actively working in real estate is in excess of 750 hours per year, a person may be considered an active real estate investor, rather than just a passive investor. The passive/active tax reporting implications are complex and also have material impacts on both the short- and long-term planning considerations for the investor.
Conclusion
Whether enthusiastic about investing in a certain geographic locale, enticed by the appeal of passive income, or interested in diversifying your investment portfolio, property investors need to be cognizant of several planning considerations. In addition to personal planning objectives, any feasibility analysis done ahead of purchasing an investment property must also look at several other considerations. Investors should also be mindful of the extra time commitment and the unexpected issues and expenses that could occur during the life of the investment.
The expectations for personal use of the property, the time spent on management and maintenance, as well as the impact of expected taxes due on a sale of the property all need to be evaluated alongside other day to day considerations before choosing to make an investment. Despite the surface appeal and popularity of investment property, the nuances within the planning can dramatically alter the expectations and impact of making an investment over time.
Sources:
² https://www.irs.gov/publications/p544