When you acquire investment real estate, you have two basic ways to make money from it. The first is to rehab and flip it for a net profit. The gain in value is capital appreciation. The other alternative is to invest in a property that generates rental income, a long-term strategy. Of course, there is no reason why an investor can’t eventually sell a rental property and also reap capital appreciation. The differences in the two strategies can affect the type of investment property, the type of loan, and possible tax effects.
If you are seeking short-term capital appreciate via a fix-and-flip strategy, you will probably be looking to buy a property selling for significantly less than its neighbors. This can arise from foreclosures, short sales, auctions or direct purchases of run-down properties. A small flipper operation might only be able to handle one property at a time, so it must be very careful in its selection process. The deal makes sense if you clear a sufficient profit after paying for the loan interest, closing costs, rehab costs, insurance and so forth. It depends on your belief that the neighborhood will maintain its value over the life of the project (not much of a risk) and that the economy won’t have a sudden shock (a la 2008-09).
If you want to pursue a rental strategy, you want properties that will likely rent out quickly and remain rented. The properties might require some degree of rehab. If so, you will have to evaluate the payback period in which rental income compensates you for the cost of the fix-up. You will likely choose properties in stable neighborhoods or gentrifying ones that exhibit a low rental vacancy rate. You also might want to diversify your rental properties across several neighborhoods to reduce your overall risks. This is a long-term buy-and-hold strategy that will generate cash flows to augment any other income you may have.
Most fix-and-flip projects are short-term, i.e., completed within one year. Hard money lenders like Specialty Lending Group specialize in short-term loans, though it does offer longer-term ones as well. As a flipper, the property is considered inventory, so any profits are taxes as ordinary income. That is, even if you hold the property for more than one year, you can’t take advantage of the lower long-term capital appreciation rates.
Rental strategies are by nature long-term. It makes sense to pursue a rental strategy on properties that produce a sufficiently high net rental yield – annual rental income minus annual expenses, all divided by the total cost of the property. Rental income is always taxed at ordinary rates. However, a little-known feature of individual retirement accounts allow your IRA to own passive rental properties as long as you don’t participate in the management of the property (and don’t live in your own rental). This makes the rental income tax-deferred, a significant benefit. Rental properties are usually financed by mortgages, although ones requiring prior rehabilitation might be purchased via a hard-money or bridge loan that is eventually replaced by a conventional mortgage. When eventually sold, any capital appreciation will be taxed as ordinary income. Unless shielded in an IRA, you will have to pay self-employment tax and quarterly estimated tax payments on your rental income.
Contact Specialty Lending Group to learn how we can help you finance your investment property strategy in the Washington D.C. region, whether it’s geared toward capital appreciation or rental income.