An investment property is real estate purchased with the intention of earning a return on investment through rental income, future resale, or both. The property may be owned by individual investors, groups of investors, or corporations.
An investment property can be a long-term endeavor or a short-term investment. In the latter, investors may engage in flipping, where real estate is bought, remodeled or renovated, and sold at a profit within a short time frame.
The term “investment property” may also apply to other assets such as art, securities, land, or collectibles, all purchased for future appreciation.
Key Takeaways
- Potential Profit: Investment properties are purchased with the goal of earning returns through rental income, future resale, or both.
- Low Primary Residence Impact: These properties are distinct from primary residences or second homes, often making financing more challenging.
- Tax Implications: Selling an investment property needs to be reported, which may result in capital gains, affecting an investor’s tax situation.
Understanding Investment Properties
Investment properties generate income and are not primary residences. They can earn dividends, interest, rents, or royalties outside the property owner’s regular line of business. How an investment property is utilized highly affects its value.
Investors often conduct studies to determine the property’s highest and best use, balancing between commercial and residential options to maximize returns.
An investment property can often be mistaken for a second home, but the two are not synonymous. For example, a vacation home is typically used for personal rather than generating income.
Types of Investment Properties
Residential
Residential rental homes offer a common pathway for investors to supplement their income. These can include single-family homes, condominiums, apartments, townhomes, or other residential structures rented to tenants.
Commercial
Commercial properties used for business purposes can also be investment properties. These might involve higher maintenance and improvement costs but can offer greater financial returns through higher rental incomes compared to residential properties.
Mixed-Use
Mixed-use properties blend commercial and residential uses. For instance, a building could have a storefront on the ground floor and residential units above.
Financing Investment Properties
Securing a loan for an investment property can be more challenging compared to primary residences. Insurers do not provide mortgage insurance for these properties, requiring investors to have at least 20% down for bank financing. Additionally, banks typically demand good credit scores and low loan-to-value ratios.
Banks often expect borrowers to maintain some savings to cover at least six months of expenses on the investment property.
Tax Implications
The IRS requires investors to report rental income but allows deductions for related expenses. If an investor collects $100,000 in rent over a year but incurs $20,000 in expenses, only $80,000 needs to be reported as self-employment income.
When selling an investment property, capital gains must be reported. The gain is calculated as the selling price minus the purchase price and any major improvements. For instance, if an investor buys a property for $100,000, spends $20,000 on improvements, and sells it for $200,000, the gain is $80,000.
Related Terms: ROI, Capital Gains, FHA Loans, VA Loans.
References
- Internal Revenue Service. “Topic No. 409 Capital Gains and Losses”.
- Internal Revenue Service. “Topic No. 701 Sale of Your Home.”
