Buying your first rental property can be one of the best investments you make to help earn passive income. While there are many benefits to owning a rental property, there are also many challenges. We’ve put together a summary that goes over the main things to know when buying a rental property.
Here is a step-by-step guide to buying your first rental property:
1. Set Up Your Team
Surrounding yourself with a great team helps to make the rental buying process much smoother than if you were to go at it all alone. A real estate agent should be the first professional that you look to bring on your team. Not only would they have the expertise with the real estate market but they would be a great resource for finding other professionals for your team, which include a real estate attorney, appraiser, home inspector, contractor, and more. Adding a tax accountant to your team is also advised as they can help lessen the stress of year-end tax reporting and understanding your financials.
2. Secure a down payment for the rental property
Purchasing an investment property is different from purchasing a personal home. You will need to put down at least 20% of the investment property value as the down payment. If you’re unable to come up with the 20% down payment, financing through a bank to obtain a personal loan would be a secondary option.
3. Location, location, location
When it comes to buying a property, especially a rental property, the location where you purchase it is of great importance. It’s essential to do your research so that the investment property you buy is in a location that is getting more popular and highly sought along with low rates of crime. Areas where new developments and construction of shopping, restaurants, parks, and schools can give you a good indication that the neighborhood has potential to attract individuals and families to move there.
4. Purchase With Cash or Finance the Property?
One of the biggest questions that first time rental property buyers have is: Should I buy the property with cash or should I finance the investment property purchase. The answer is that it depends. If you have the cash on hand to buy the property, it would allow you to have higher earnings per year. However, if you don’t have enough cash on hand to buy the property outright, financing is still a great option. There are various ways to finance the purchase, including conventional bank loans, hard money loans, and home equity loans. Please keep in mind that the interest rates on investment properties are higher than those for a traditional home mortgage. Shopping around for the best investment interest rates is highly recommended.
5. Cash Flow and Expense Budgeting
Purchasing a rental property is great, but if you don’t have an idea of how much the rental expenses will be, you’re setting yourself up for failure. Information is essential when it comes to business, so the more information that you have, the better you’ll set your rental property up for success. Some of the biggest expenses that you will need to budget for include:
- Maintenance costs
- Mortgage payments
- Property taxes
- Homeowners insurance
- Homeowners association fees
Also, factoring in unexpected expenses to your budget is highly recommended. A good rule of thumb would be to set aside 5%-10% of the property value for unforeseen scenarios, such as needing a new roof or replacing the A/C and water heater.
6. Purchase the Property Personally or Set Up an LLC
Generally, most people purchase the rental property personally and under their own name. In those situations, the property would be owned by the owner and the deed would list the owner’s name. However, if you wanted to purchase the property through an LLC, that would give you additional liability protection. If you decided to go the route of setting up an LLC, the deed to the property would reflect the LLC as the owner.
7. Landlord Insurance
Legal liability is of great importance for rental property owners. With that in mind, purchasing landlord insurance would be a good idea. Not only does this type of insurance give you liability protection, but it helps to cover property damage and unforeseen loss of rental income. Quick note: prior to purchasing any landlord insurance, it’s a good idea to check with your insurance company to see if they can bundle landlord insurance with an insurance policy that you already have with them.
8. Find a Tenant and Sign the Lease
Once your property is set up and ready to be rented, you would need to advertise to find prospective tenants. Some of the most common ways to advertise would be on rental websites, Craigslist, social media, and by word of mouth. Schedule a showing for prospective tenants who are interested and reach out to you. After the showing, you should have them fill out a rental application and as well as run a background check on them. The final step would be to have the tenant sign a lease. The lease will serve as the legal agreement between yourself and the tenant. It will reflect the length of the rental agreement, the monthly or yearly rental payments, how rent will be collected, any utilities the tenant is responsible for, and the rules that the tenant must follow while under lease.
9. Prepare For Tax Reporting
Similar to reporting income from your wages or contracting work, you will need to report your rental income and expenses on your tax return every year. Rental activity is reported on Schedule E of your personal tax return. This is true regardless of whether you personally own the property under your name or if you set up an LLC to own the rental property. Keeping track of your income and expenses each month will help you save time and avoid a lot of headaches that you would have by waiting until the end of the year. Using accounting software such as QuickBooks or FreshBooks would make income and expense tracking very simple and easy. Another option would be to record income and expenses on a spreadsheet like Microsoft Excel or Google Sheets.
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