Investing in Real Estate:        The Quest to Invest

      Let's face it-in a hot real estate market, most U.S. investors add property to their portfolio for one reason: to make a profit. But investing in real estate is also a great option when interest rates are low. And the odds are in your favor, given that houses have been appreciating by an average of 4 percent a year or more, with some areas showing a 40% annual increase. The higher the stakes, the higher the risk-so start here to learn what it's all about, and be prepared to hire some expert help.

Basic property types

      Single-family residence. Single-family residences come in many forms, but first-time real estate investors are usually advised to buy a detached  residence and rent it out as its market value appreciates. Why are these so popular? Because they're "easy." They're easy to find and easy to buy,  relative to other types of properties, and they hold appeal both to renters and to buyers at resale. Mortgage brokers know this-so these properties are also usually easier to finance and refinance.

      Vacation property and second homes. Investment options in this category are myriad, from outright purchase to fractional-interest contracts and timeshares. Even if the property isn't income producing, it can appreciate into a worthy investment, and mortgage interest is fully deductible. If you do rent the property when it's not in use, realized income and tax obligations depend on what percentage of the year it's kept for "personal use"-a tightly defined term you should discuss with a real estate attorney.

      Apartment properties. Apartment properties require a long-term commitment, as well as a substantial investment of borrowed and equity capital, but due to the availability of professional managers they often don't demand a lot of personal time. They can have mortgage loans of up to 100% of value, while other investment types may require all cash. Loans can be amortized or paid with the income generated by rents.

      Condominiums. Condominium investments provide a bit of extra risk. Their  market value appreciates more slowly than for detached single-family residences, and rental rates usually aren't high enough to cover mortgage,  property tax, and maintenance fees.

      Vacant land:   Vacant land is probably the least liquid and therefore usually the weakest choice for a profitable shorter-term investment. While undeveloped land is easy to maintain, it nearly always takes longer to  appreciate and longer to sell.

      Commercial property. To reduce personal liability and offset the greater expense of these properties, some investors form or join a limited liability company. Because of the extremely high risks involved with this type of agreement, consulting a real estate attorney is essential before taking this step. You probably shouldn't consider this arrangement if you  aren't personally familiar with the other partners and their business  expertise.

      Financing and Tax Facts

      Buyers of residential investment property often finance all or part of a  down payment or renovation by opening a home equity line of credit, using their primary residence or another rental property as collateral. Lines of credit are also a great way to expand a down payment to receive a lower interest rate or to avoid paying private mortgage insurance.

      Qualifying for a residential investment property loan generally depends on your income, income and debt ratio, reserves, and credit scoring. Lenders will take some of your future rental income into account when scoring your credit. How much influence this has depends on the investment property and its appraisal, your lender, your financial obligations, and your down payment. Because loans for rentals carry a higher risk of default, expect to pay about 1.5 more points in interest.

      Some buyers form a limited-partnership agreement with friends or other investors to afford higher-ticket properties. Often the only person who makes a profit in these situations is the managing partner, who takes on the lion's share of buying, selling, and managing day-to-day aspects of ownership.

      There are plenty of creative financing options, including seller financing, to help a novice investor, but before you get down with the details, hire a tax advisor and a real estate attorney to advise you on the best approach for your particular situation.

      Tax Facts

      There are exceptions, but long-term investments usually don't provide a       significant gain in income or market value for at least five years. In many cases rental income will cover the property's mortgage, taxes, and insurance, but the greatest gain is usually realized upon resale. How the sale is conducted determines how you'll be taxed, affecting how much gain you'll realize.

      General tax wisdom.  All investment property expenses, including mortgage       interest, property taxes, repairs and utilities, and maintenance fees, are tax-deductible, usually resulting in a taxable loss. When an investment property is sold outright, any gain made on an investment of 12 months or more is subject to a capital gains tax. The rate of taxation ranges from 10% to 20%, depending on your tax bracket. Capital losses can be deducted from capital gains and possibly from other income as well.

      Owner occupancy. The best way to save money on taxes for long-term rental       property is to spend some time living there. If you occupy your investment property as your principal residence for an "aggregate" two of the preceding five years, when you sell the property you'll receive the personal property exemption on $500,000 (married, filing jointly) or $250,000 (separate or single returns) in capital gains.

      Tax-deferred exchanges. Tax-deferred exchanges, as described in Internal       Revenue Code 1031 and the Starker delayed tax-deferred exchange, are the only way to avoid paying capital gains taxes on investment property until you sell it outright-as long as you keep exchanging it for "like kind" property. Note that IRC 1031 tax-deferred exchanges limit your ability to deduct for depreciation.

      With IRC 1031, investors can defer capital gains tax on profits by a direct "equal or up" trade for another property held by another investor. All properties involved have to be used for trade, business, or investment; personal-use property doesn't qualify. The properties need not be similar except in value. You can even exchange multiple       properties--say, a rental property and vacant land for a commercial building of equal or greater value.

      The popular Starker exchange goes a step further. Rather than a direct trade, you can sell any qualified property and use the proceeds toward purchase of another qualified property. You have 45 days to designate the replacement property, and you must close on that property within 180 days to qualify for the deferral. To exchange an investment property for a personal-use property, to qualify you must first use that property as a       rental.

      Depreciation allowance. Depreciation, or cost recovery, is essentially a tax deduction for estimated obsolescence and wear and tear. Claimable even if the property itself has appreciated, this deduction can be taken for up to 27.5 years for residential rental properties or 31.5 years for nonresidential real property (vacant land is excluded).

      Installment sales. In this situation, you finance the buyer of your investment property, and gains are taxed over the life of the loan rather than all at once. The advantage to this approach is that you're taxed only over the years you're receiving the buyer's payments on the principal; you retain title to the property until the buyer has paid in full.

      Second or vacation homes. If you buy a second property for personal use only, mortgage interest is deductible, as with a primary residence. But you can use this benefit only once; if you own more than two such properties, any debt above the $1 million cap on the first two properties, as well as interest on additional properties, is considered nondeductible  personal interest. (Property tax, however, is deductible for and unlimited       number of properties.) Deductions for points paid on a vacation-home mortgage are prorated over the life of the loan.

      If you rent the home for 14 days per year or less, that income is  tax-free. If you rent it for longer, the income must be reported-but you can deduct rental expenses. If the property is held for personal use for more than 14 days, or over 10% of the number of days it's rented annually, it's considered a personal residence and you can't claim a tax loss. You can, however, write off the full interest, partly as a rental expense, with the remainder as personal mortgage interest.