Choosing the Right Mortgage

With favorable appreciation rates, low interest rates and Wall Street in the grip of a bear, a second home is an appealing investment right now. Deciding what mortgage you'll need to swing the deal, however, isn't quite so clear.

The Office of Federal Housing Enterprise Oversight's Second Quarter House Price Index says the nation's housing market has enjoyed a nearly 39 percent rate of home price appreciation since 1997, with more the half the states and the District of Columbia enjoying a 5 percent growth in price appreciation during past year.

Second home values jumped 26.8 percent since 1999, according to the National Association of Realtors (NAR).

Meanwhile, the DOW Jones average has plummeted more than 29 percent since the end of 1999.

"Regardless of whether or not bubbles occur in given areas, housing has still generally been a good long-term investment," OFHEO reported.

While it may be a no-brainer deciding where to put investment dollars these days, determining what kind of mortgage to use takes a bit more gray matter.

First, consider your plan.

Do you plan to 'fix and flip', rent it out, or sell the property to another investor? Subtle differences in your loan could cost or save you thousands.

Consider the variables.

Which loan is best? It all depends upon your personal financial position, how soon you pay off the loan, either by refinancing, selling or cashing out, and it depends upon what happens to interest rates over this period of time.

And then consider your options.

Your options are also limited by income, down payment and creditworthiness. Owning an existing home, for example, is likely to push your second home loan cost up by about an extra point and a half.

A mortgage broker or lender can help you compare and contrast loan programs, but you will also need a financial or investment counselor and a tax professional to sort through the complexities.

A real estate investment is a highly leveraged investment. To cash in, relatively little up front money, in the form of a down payment, is required.

Greater leverage can come with a smaller down payment, especially in fast-appreciating markets where you plan to sell or trade your property in a few years.

If I was buying today and not concerned about a monthly cash flow and turning the property over in a couple of years, I'd be all over 5 percent down. Even though I'd have the private mortgage insurance, it would be tax deductible to some extent.

However, don't neglect to consider that the tax write off isn't always a sure thing.

An area tax professional says deductible passive losses are limited to $25,000 and that's phased out if your modified adjusted gross income (AGI) reaches $150,000. At a modified AGI of $100,000, your permitted deductible passive losses are halved and phase out more until you reach the $150,000 level.

Lower down payments also can be a better deal for working investors.

If you make a large down payment on an investment property, it's more likely to produce a taxable profit, which isn't great for people during their working years. It's taxed as ordinary income.

Unfortunately, low down payments may not get you the lowest interest rate. The less you put down, the higher up the interest rate goes.

You can also leverage your investment with an adjustable rate mortgage (ARM), interest-only mortgage or even negative-amortized mortgage. Such mortgages are typically best for short-term investments. Otherwise, you risk rising interest rates or a growing principal, either of which can eat into your return.  It's less risk if you get 3-year fixed or a 5-year fixed.  Less risky, fixed rates are at historic lows and if you've got the extra cash a larger down payment is one of the best ways to invest the cash in today's market.

If you can do better somewhere else by not putting more money down, okay, but when you have enough money to go in and get a reasonable deal and avoid PMI and avoid future trauma it's hard to pass on the rates as low as they are right now.

Mortgage Rates and Investment Property

Investing in real estate, huh? All the infomercials finally gave you the bug, didn't it? Surely if all those funny-looking people sitting on a beach chair flashing fake $100 dollar bills can make money in real estate then you can too, right? But this week's column isn't about touting a proven method for investing in real estate. It's about if you're thinking of buying investment property then why you should do it now and not wait for your "How To Get Rich in Real Estate" cassette tapes to arrive in the mail. Why?

We're all aware of rock bottom rates. It's hard not to notice when nearly every other spam you get is wanting to refinance your mortgage. Is it getting all a little too redundant to read something like "Interest Rates at Historic Lows?" How many times can we make history, anyway? The problem with such headlines is that soon we become somewhat immune to the news. Low rates, yeah, what else is new?

But let me remind you of something. Way, way back, say two years ago, rates were in fact about 2% higher than where they are now. That can mean more than just a small difference in payment. It can mean whether or not your rental unit will ever cash flow and how much real estate you can buy.

Let's look at an example of a rental property selling for $180,000. It's rented, always has been. Great tenants. Shoot, the tenants even mow the yard and do minor repairs themselves. Property is immaculate. It's a nice little house and rent in the area for similar properties goes for about $1,500 per month. Now let's do some math.

A 30 year fixed rate in January of 2001 of 7.50% (yes, rates were very high back then) on a $150,000 note gets you a mortgage payment of $1,050 per month. You're showing a gross monthly profit of $450. Factor in hazard insurance and property taxes each month and maybe you're walking away with a couple of hundred bucks. Remember, these tenants do all the repairs and never complain.

Fast forward to today. A competitive investment rate could be found at 5.75%, the monthly mortgage payment drops to $878. This nearly doubles your net income. And this is a fixed rate for as long as you own the property. It will never change unless you tell it to.

Lets' look at it another way. Instead of looking at that cute little house on the corner, you spotted a duplex closer to the college campus. A 2% increase in interest rate erodes your buying power. How much? By nearly 20%, that's how much. If you can afford a $250,000 loan today and rates go back up to 2000 levels, you may only qualify for a $200,000 loan. That's huge. And that difference is something no Real Estate Investing Seminar can ever change.

This column is not an attempt to convince you to buy real estate of any sort. I'll leave that to you and your real estate agent. But if you have already decided to buy and are shopping, shop a little harder. You don't want your cost of funds to rise any more than they have to.

Let Renters Pay for Your Second Home

If you buy a second home now for retirement later, you could give yourself a hedge against home price hikes as well as a relatively low-cost retirement shelter with an equity cushion.

That assumes during ownership you can find tenants who'll pay enough rent to cover your investment costs. You'll also have to be able to actually use the property when you retire.

"Buying a retirement home while you're still employed is a wise investment, if you can keep it rented until you're ready to move in," says Valerie Patterson, senior producer of RealEstateJournal.com.

That means you'll have to find a property you can rent for an amount that will cover not only the principle and interest but also the bulk of property taxes, insurance, property management and maintenance costs, home owner association dues and any other costs, actual and estimated, associated with property ownership.

Patterson says if you can't secure a tenant, or if the rent you collect doesn't cover your monthly payments, even locking in a low interest rate now may not be wise unless you've got the extra income to cover the difference.

Don't forget to consider tax benefits that can help offset costs.

In addition to mortgage interest deductions on owned home values up to $1 million, tax deductible passive losses on rental properties are as much as $25,000. The passive loss amount does begin to phase out once your modified adjusted gross income reaches $150,000, says an area tax professional.

He says don't overlook non-financial considerations related to buying a retirement home now to live in later. Your heath, the climate, some unforeseen event or change could prevent you from moving into your second home at retirement time.  You would have to sell and pay taxes on the gain, but you could take any passive looses you had not been able to take advantage of. You could do a tax-free exchange of like property somewhere else. You would have some options, but I would be leery of buying a retirement home way in advance of retiring. That's just my opinion.

Patterson said the upside to buying your retirement home now is that you can count on having someone else paying your mortgage for as long as you rent it. You'll inherit a home with at least a part of the mortgage already paid-and a relatively low interest rate locked in.

It's a good idea to get a head start on retirement living. Your favorite location might be a lot more expensive in 10 to 15 years when 73 million baby boomers begin retiring.

Appreciation may also help off set some of your costs, but to maximize your investment as a retirement nest egg, you probably don't want to tap your home's equity unless it absolutely necessary for some dire financial need.

However, if home prices fall, you might wind up paying more for your house than you needed to," Patterson cautions. "But it's far from certain that prices will fall, and even if they do, they could easily run up again in the future.

In any event, buying a retirement home now to live in later begins with even more considerations.

·  Investors should shop for a second home much in the same way they shopped for their first home. Buy the cheapest home in the best block or buy into the cheapest neighborhood in the best community, both to give the home's value room to grow. However, if such a home doesn't garner rent sufficient to cover the cost of ownership, look in areas where rents have been established.

·  Look for appreciation potential, typically found in areas where demand eventually will exceed supply. Avoid heavily marketed, but unproven areas. Property with future marketability for you should you need to sell or your heirs also should be considered.

·  Find a home in close proximity to as many preferred activities, attractions and events as possible. The more of these area features the better the potential for renting the property at a decent rate and selling at a high price later.

"We recommend that prospective buyers identify a gated, master-planned community -- for security and peace of mind -- with the amenities, such as golf, tennis, fitness, clubhouse, etc. that they would enjoy years from now," said Elisabeth Miller-Fox, president of PrivateCommunities.com.

·  Consider "try-before-you-buy" mini-vacation getaways offered by timeshare developments in potential investment home purchase areas. For no more than a nominal fee, if any, the trips come with an obligation to tour the development, but the rest of the two-to-three day jaunt provides plenty of time to check out the community and potential investment homes -- at the developer's expense.

"We urge prospective buyers to go through the rental process themselves before taking the step of second-home ownership," said Miller-Fox.

·  Get professional representation for the search, mortgage and property management.

"An equally important factor for this type of purchase is the existence of a rental department that is associated with that community's sales department since people who have rented in a community are often the best source of new sales for the community," said Miller-Fox.

"The rental department is a strong marketing tool for the developer and they typically do a good job of keeping the property rented at the highest market rates," she added.

Pulling Equity from Rental Properties

Question: I own two rental townhouses worth about $140,000 each, thanks to skyrocketing property values. The mortgage balances are only $50,000 each at 7.50 percent. With today's low rates, I think it's foolish to tie up so much money in the equity in these homes and I'm considering buying another property that's on the market for $100,000. It needs quite a bit of cosmetic work but it's well priced. In fact, you could say that the property has been "trashed."

Do you think it's a good idea to refinance my two rentals so I can pay cash for the third property? I'm worried that I won't be able to get a loan on the property until I fix it up. The only other property I own is my primary residence that's worth over $500,000. I have a $150,000 mortgage balance with a 6.25 percent fifteen year loan and I'm accelerating the payments in hopes of paying it off early. Thank you for your comments.

Answer: A lot of folks who own rental property like to keep these properties completely separate from their primary residence. The primary residence is a home -- a "nest egg." I've never understood this logic. As a mortgage broker, it's my job to advise my clients in the matters of optimizing the allocation of mortgage debt.

Here's what I mean. You currently have a 6.25% fifteen year loan on your primary residence. Presumably, your goal is to pay off this loan as soon as possible so that your "nest egg" will be free and clear of debts.

That's a great goal. But when establishing a financial objective, such as paying off the loan on your house, you need to consider your entire financial picture. For example, you are accelerating the payment of a mortgage loan that carries an interest rate of 6.25 percent. Meanwhile, you have $100,000 of additional mortgage debt that carries an interest rate of 7.50 percent.

Rule number one: If you're going to pay off debt early, pay off the expensive debt first. I've had clients who have $60,000 in high interest credit card debt (that's not tax deductible) who wanted to refinance to a 15 year loan so they could pay off their house early. And at the same time, these folks acknowledge that the higher mortgage payments resulting from a 15 year loan would prevent them from paying down their massive credit card bill.

Go figure. It just makes no sense unless you're planning for bankruptcy.

But let's get back to your situation. You are right to be concerned about the ability to obtain a mortgage secured against a property that's "trashed." Lenders like the property to be in marketable condition.

But refinancing your two rental properties will be expensive for several reasons. Statistically, investor loans carry a higher risk than loans secured against a primary residence. That's reason number one why the lender's going to jack up the rate. Compounding the problem is the fact that you're seeking "cash out" from the rental properties. Expect the lender to raise the rate a bit more.

And finally, you're taking out two loans. Two loans mean two sets of closing costs. Double county recording fees, double appraisal fees, double settlement fees, etc.

You get the idea.

So my advice is to abandon the notion that your rental properties and primary residence need to be "separate." You have $350,000 in equity sitting right under your nose in your primary residence. Fifteen year loans are running around 5.50% these days, and that's with little or no fees. If the payment's too high on a fifteen year loan, 30 year products are running about six percent -- again with little or no fees.

If you want to buy this trashed rental property, my advice would be to refinance your primary residence and take out $100,000 cash. Who cares whether the hundred grand is secured to your "nest egg"? The bottom line is that it's a cheap source of money -- a lot cheaper than cashing out rental property equity or a credit card advance.

1031 Property Exchanges - Deferring Capital Gains

If you sell your home, and have lived there for two out of the past five years before it is sold, our tax laws provide you with a fabulous tax break: you can exclude up to $250,000 of any gain you have made ($500,000 if you are married and file a joint return).

But when you sell real estate which you are renting, (called "investment property") you will have to pay the capital gains tax, which for all practical purposes has now been reduced to 15 percent of profit you have made.

However, there are some creative ways in which to defer -- not avoid -- having to immediately pay any such tax. One such technique is known as a Starker (or "deferred") Exchange, named after Mr. Starker who defeated the Internal Revenue Service, although he had to go all the way to the Supreme Court to win his case.

Currently, the capital gains tax rate is 15 percent on the amount of any appreciation and -- depending on the facts and circumstances, and how and when you have taken depreciation -- 25 percent recapture on the amount you have depreciated. You have to discuss your specific situation with your own tax advisors. If you sell your investment property and buy another one within the time frames spelled out by Congress, you will defer -- not avoid -- having the pay any capital gains tax now.

Some people just do not want to continue to be landlords, and you may want to "bite the bullet" and pay the tax. Before you do so, however, you should give serious consideration to the exchange provisions contained in the Internal Revenue Code. They can be a useful device for any real estate investor -- regardless of the size or the value of the property. But, as you will see from this article, you must follow the rules -- and take certain steps before you go to closing.

The law establishing like-kind exchanges can be found in Section 1031 of the Internal Revenue Code. The rules are complex, but here is a general overview of the process.

Section 1031 permits a delay (non-recognition) of gain only if the following conditions are met:

First, the property transferred (called by the IRS the "relinquished property") and the exchange property ("replacement property") must be "property held for productive use in trade, in business or for investment." Neither properties in this exchange can be your principal residence, unless you have abandoned the property as your personal house. If you are considering going the 1031 route, you should start using the appropriate language found in the IRS regulations.

Second, there must be an exchange; the IRS wants to ensure that a transaction that is called an exchange is not really a sale and a subsequent purchase.

Third, the replacement property must be of "like kind." The courts have given a very broad definition to this concept. As a general rule, all real estate is considered "like kind" with all other real estate. Thus, a farm can be exchanged for a condominium unit, a single-family home for an office building, or raw land for commercial or industrial property.

Once you meet these tests, but before you actually move forward with the exchange, it is important that you determine the tax consequences should you just do a straight sale and not an exchange. You must calculate what you will have to pay by way of capital gains tax, and if you are not able to do this, ask your tax accountant to prepare this information for you. If the taxable consequences from a straight sale will not generate a large payment to Uncle Sam, you may just decide to forego the Starker exchange.

If you do proceed with the like-kind exchange, your profit will be deferred until you sell the replacement property. However, you should understand that the cost basis of the new property in most cases will be the basis of the old property. This is another issue to discuss with your accountant so as to determine whether the savings by using the like-kind exchange will make up for the lower cost basis on your new property.

The traditional, classic exchange (A and B swap properties) rarely works. Not everyone is able to find replacement property before they sell their own property. In the case involving Mr. Starker, the court held that the exchange does not have to be simultaneous. No time limits were imposed on Mr. Starker's exchange.

Congress did not like this open-ended interpretation, and in 1984, two major limitations were imposed on the Starker (non-simultaneous) exchange.

First, the replacement property must be identified before the 45th day after the day on which the original (relinquished) property is transferred.

Second, the replacement property (or properties) must be purchased no later than 180 days after the taxpayer transfers his original property, or the due date (with any extension) of the taxpayer's return of the tax imposed for the year in which the transfer is made. These are very important time limitations, which should be noted on your calendar when you first enter into a 1031 exchange. They are mandated by Congress and cannot be extended by even one day.

In 1989, Congress added two additional technical restrictions. First, property located in the United States cannot be exchanged for property outside the United States.

Second, if property received in a like-kind exchange between related persons is disposed of within two years after the date of the last transfer, the original exchange will not qualify for non-recognition of gain.

In May of 1991, the Internal Revenue Service adopted final regulations which clarified many of the issues.

This column cannot analyze all of these regulations. The following, however, will highlight some of the major issues:

1. Identification of the replacement property within 45 days. According to the IRS, the taxpayer may identify more than one property as replacement property. However, the maximum number of replacement properties that the taxpayer may identify is either three properties of any fair market value, (called a "safe harbor") or any number of properties so long as their aggregate fair market value does not exceed 200 percent of the aggregate fair market value of all of the relinquished properties.

Furthermore, the replacement property or properties must be unambiguously described in a written document. According to the IRS, real property must be described by a legal description, street address or distinguishable name (e.g., The Camelot Apartment Building)."

2. Who is the neutral party? Conceptually, the relinquished property is sold, and the sales proceeds are held in escrow by a neutral party, until the replacement property is obtained. Generally, an intermediary or escrow agent is involved in the transaction. In order to make absolutely sure that the taxpayer does not have control or access to these funds during this interim period, the IRS requires that this third party cannot be the taxpayer or a related party. The holder of the escrow account can be an attorney or a broker engaged primarily to facilitate the exchange, although the attorney cannot have represented the taxpayer on other legal matters within two years of the date of the sale of the relinquished property.

3. Interest on the exchange proceeds. One of the underlying concepts of a successful 1031 exchange is the absolute requirement that the sales proceeds not be available to the seller of the relinquished property under any circumstances unless the transactions do not take place.

Generally, the sales proceeds are placed in escrow with a neutral third party. Since these proceeds may not be used for the purchase of the replacement property for up to 180 days, interest is usually earned on these funds.

The Internal Revenue Service permits the taxpayer to earn this interest -- referred to as "growth factor" -- on the escrowed funds. Any such interest to the taxpayer has to be reported as earned income. Once the replacement property is obtained by the exchanger, the interest can either be used for the purchase of that property, or paid directly to the exchanger.

There is an interesting loophole which may be attractive to many readers who currently own rental property. Let us assume that you have found your dream house somewhere in the United States where you want to live after retirement. If you sell your investment property, you will have to pay a large capital gains tax. If you do a 1031 exchange now, and obtain title to the replacement property where you ultimately want to live when you retire, you can rent out that property until you decide to move. Then, once you have established the new property as your principal residence, if you live in it for at least two years and more than two years have elapsed since you sold your last principal residence, once again you can exclude up to $250,000 (or $500,000 if married and you file jointly) of the gain you have made.

Although the IRS provides no guidance as to how long you have to use the replacement property as an "investment," the general consensus is that you should rent out the property for at least one full tax year.

Thus, depending on the numbers and the facts, you may ultimately be able to avoid the capital gains tax which would normally be due when you sold your investment property.

The IRS has also authorized taxpayers to engage in "reverse Starkers," where you buy the replacement property first and then exchange (sell) the relinquished property. It should be noted that quite often, a taxpayer finds the replacement property first, and the owner of that property is unwilling to enter into a long term contract whereby the sale will not take place until after the relinquished property has been sold. According to the IRS regulations, you can reverse the process. Although the basic time limitations are the same for a reverse Starker, the rules are more complex and will end up costing you more money than if you did a regular like-kind exchange.

The rules for the "like-kind" exchange are tricky. You must obtain competent, professional financial and legal assistance if you plan to go this route. Please contact me for a referral if you do not have an established relationship with a knowledgeable tax professional or true real estate attorney.

Talk to Bruce Specter about this and other Real Estate Investment ideas and programs. 

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This page was last updated on 02/14/08.