Buy, sell & rent: managing investment property takes a keen understanding of housing laws and regulations

Black Enterprise, July, 2004 by Donald Jay Korn

Here's what you need to know before you take the plunge.

Steven Perkins had been in court the day before. "I was involved in a dispute involving my rental property in Southfield," he recalled, referring to the Detroit suburb where he lives and works. "An oak tree by the driveway had been damaged by someone I'd hired to do some cutting, I've owned that house more than 20 years, and I've been in court olden enough to have learned quite a bit about how to make a suitable case."

Have such trips to the courthouse sapped his desire to be a landlord? Not really. "Even with the hassles, it's worth it," says Perkins, 52, a psychologist with a private practice as well as a position with the local school district. "Over the years, I've added other properties, such as two lakefront houses, one in Canada and one in Holton, Michigan, that I use myself when they're not rented out, and a co-op that I just bought in downtown Detroit. Some of those properties have appreciated a great deal, and I'm counting on them for my retirement funds."

Perkins' experiences illustrate both the highlights and pitfalls of owning residential real estate that you rent to tenants. While there are certain risks and obligations potential landlords need to be aware oil the financial rewards can be ample.

There's no denying the benefits of owning rental properties, especially when real estate values almost consistently trend upward. Among the perks are:

Current income: Landlords collect rent from tenants; over the years, increasing rents can provide another source of cash flow. "I receive about $1,000 a month from the house I rent in Southfield, or $12,000 a year," says Perkins. "After expenses, I probably clear about $6,000, which I consider 'play money.'"

Appreciation: Perkins says that the Southfield house, originally bought for around $30,000, is now worth more than $200,000. "My lakefront properties have gone up even more, in a few years, and the Detroit co-op I just bought has already jumped in value." Perkins bought his Holton property for $180,000, with a $40,000 down payment. The property has nearly tripled in value in six years, to $500,000, giving him an eightfold return: a $320,000 gain on a $40,000 outlay.

Daryle Jordan, "15, an attorney in Alexandria, Virginia, also relates a tale of success in rental real estate. "I owned a property in Georgia for a year and another in Virginia for about 10 years," he says. "Even though I had some negative cash flow, I wound up selling the properties for a substantial profit. I've been using those proceeds to invest for my daughters' college education."

Leverage: Rental property can be bought largely with borrowed funds, increasing the effective return if the property gains value. "When you borrow money to buy investment property, it's typically on a 'qualified non-recourse' basis," according to Larry Torella, tax partner at Eisner L.L.P., a New York accounting firm. "The property secures the debt., not your other assets, which limits your downside if things don't work out."

Tax advantages: "The tax laws are very favorable to real estate investors," says Torella. "If you do receive net cash flow from the property, after expenses, some or all of that income may be tax-free."

Whether or not you have positive cash flow, you may wind up with a loss, for tax purposes, and such a loss might provide you with a tax deduction [see sidebar, "Tax Tips for Landlords"]. Torella points to other tax advantages: you can pull out tax free cash by refinancing your loan if the property appreciates, you can enter into a tax-free exchange if you want to switch investment properties, and you can eventually sell the property and pay tax at favorable long-term capital gains rates.

That's the good news. The bad news? Becoming a landlord is no easy path to profits. "I've probably heard more horror stories than success stories." says Frank S. Arvai, a CPA and certified financial planner in Troy, Michigan. "Some very smart people have bought rental property and suffered through late payments and bounced checks, only to wind up selling the real estate at a loss, Midnight calls from tenants with problems can drain you after a while."

There's no magic formula that can guarantee success in rental real estate, but there are some steps you can take to tilt the odds in your favor:

Have reasonable expectations. "Some people expect to buy a property and enjoy positive cash flow right away," says Wallace Gibson, who heads a property management company in Charlottesville, Virginia. "That probably won't be the case unless you're making a very large down payment. Often, you'll go three to five years before cash flow turns positive."

Positive cash flow--meaning that the rent you collect from tenants exceeds all of your out-of-pocket expenses--is critical for real estate investors. Gibson says that in her experience, this usually happens when the investor makes a large down payment and has relatively low mortgage costs. Most investors prefer to maximize leverage with a large mortgage, so it may take years for rental increases to grow enough to outstrip fixed mortgage interest costs.