Unlocking the Potential of Rental Property Investments for 3M Employees: A Guide to Building Wealth

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What Is It?

Many of our clients from 3M have been interested to know more about purchasing rental properties. Purchasing a rental property is one way of investing in real estate. Rental property is typically a multifamily dwelling that you purchase with the intention of renting out individual units. However, you might also purchase single-family homes as rental properties. Most real estate investments are growth-oriented, meaning that the return on your investment is based on how much your property increases in value from the time you purchase it until the time you sell it.

However, when you purchase a rental property, your focus will typically be on current income and cash flow. Although you may someday sell the property at a profit, the greater part of your return will likely come from rental income. It's important that the 3M employees who are looking into investing in rental property note that for this reason, rental property is typically a long-term investment.

What Are The Risks?

It's also important that these 3M clients are aware of the risks that come with it. Although rental property is not as speculative as some real estate investments, substantial risks are associated with investing in rental property. In particular, rental property investments are subject to market risk and liquidity risk. Your tenants could run into financial difficulties and become delinquent with their rent payments--or not pay them at all and require eviction proceedings.

Political or economic changes in the area could affect your occupancy rates and property values. Changes in tax laws could reduce or eliminate the favorable tax treatment of rental property. Changes in zoning laws could have a positive or negative impact, as could changes in traffic patterns. Should you find yourself with an unexpected cash need, you will probably not be able to quickly liquidate your rental property. Before considering getting into the rental property business, these 3M employees should evaluate their ability to deal with these risks.

Caution:  We'd like our 3M clients to be aware that there are inherent risks associated with real estate investments and the real estate industry, each of which could have an adverse effect on the financial performance and value of a real estate investment. Some of these risks include a deterioration in national, regional, and local economies; tenant defaults; local real estate conditions, such as an oversupply of, or a reduction in demand for, rental space; property mismanagement; changes in operating costs and expenses, including increasing insurance costs, energy prices, real estate taxes, and the costs of compliance with laws, regulations, and government policies. Real estate investments may not be appropriate for all investors.

When Can It Be Used?

You Have the Knowledge and Attributes Required to Be Successful

In order to be successful with any type of real estate investment, it's essential that these 3M employees have (or be willing to work on acquiring) knowledge of the real estate business as a whole. Books and seminars are a good start. You might also want to talk to others who have made successful investments in the type of real estate you are considering--in this case, rental property. In particular, investing in rental property requires common sense, in that you must have the foresight to find the right location.

Finding good properties in up-and-coming neighborhoods takes more than just luck. It is a product of knowing an area and recognizing its trends. You must also be a good judge when it comes to choosing tenants and/or professional property managers. However, one of the most important factors is determination. You may not realize it if you are just starting out, but it takes a serious commitment to keep your rental property in top condition, so you can continue to attract quality tenants and increase your property value.

You Understand the Risks and Responsibilities Inherent to Real Estate Investing, and You Are Comfortable With Them

Like all real estate, rental property is a risky investment. Before considering this type of investment, these 3M employees must evaluate their ability to deal with the risks and responsibilities associated with rental property. In addition to measuring your risk tolerance, asking yourself some of the following questions may help you evaluate the appropriateness of this investment:

•  Do I have the financial backing required to purchase investment property?
•  If not, is my credit rating good enough to secure financing?
•  Do I have the ability and the resources to use my own money if necessary to help the investment survive?
•  Would my life's savings be in jeopardy if I needed cash to help pay bills for the investment property?
•  If there were vacancies or delinquencies, would I have sufficient income to pay the expenses until the rental income returned to normal levels?
•  Can I keep my current job or business and invest in real estate on a part-time basis?
•  Would worrying about my rental property interfere with other aspects of my life?
•  If I decide to go into this business and it fails, would I be all right financially? Emotionally?

Strengths

Rental Property May Receive Favorable Tax Treatment

Because rental property is considered business property, mortgage interest, property taxes, insurance, advertising, maintenance, and other expenses are typically tax deductible. These deductions can be used to offset some or all of your rental income.

Property depreciation is also deductible. However, remember that net rental income (income minus expenses) and net capital gains from the sale of rental property will be included when calculating whether your total investment income is subject to the 3.8% tax that applies to the investment income of individuals with an adjusted gross income (AGI) above $200,000 and couples filing a joint return with more than $250,000 AGI.

Rental Property Provides Both Current Income and The Potential for Capital Gains

As mentioned, most of the return on your rental property investment will be current income in the form of rent payments. However, rental property also has the potential for capital gains because there is a chance that you can eventually sell the property for more than your original purchase price. By contrast, other types of real estate investments (e.g., raw land) provide an opportunity for capital gains, but little current income.

Variety of Property Types and Locations Provides Flexibility

When you purchase rental property, you can choose from a wide variety of property types and locations. Your choices range from urban high-rises to small apartment buildings, to suburban duplexes and townhouses, to single-family homes in the country or at the seashore.

Tradeoffs

Like All Real Estate, Rental Property Can Be a Highly Speculative Investment

It is imperative that these 3M employees understand the risks they are undertaking when they invest in real estate. There is no guarantee you will realize a profit on a real estate investment. In fact, there is no guarantee your property will even retain its current value. What makes real estate investing so hazardous is that so many of the factors that determine the success or failure of a given real estate investment are outside of the investor's control.

Changes in the tax code could reduce or eliminate the tax advantages of real estate investing. Economic changes in an area (e.g., the failure of a major business or the closing of a military base) can adversely affect property values and put many of your tenants out of work, creating the possibility of delinquency. Financial markets can also affect the value of real estate investments as interest rates fluctuate. These are just a few of the many risks for our 3M clients to consider if they are thinking about investing in real estate.

Rental Property Requires Personal Involvement and Constant Management

Regardless of whether you choose to manage the property yourself or hire a property management professional, your involvement doesn't end with the purchase of rental property. You will need to interact with tenants and/or property managers throughout the life of the investment. These interactions can be rewarding, but they can also be highly stressful. Before investing in rental property, these 3M clients should consider whether they would be emotionally capable of firing a manager or evicting a tenant if the need arose.

For our 3M clients who are considering self-management of the property, consider whether you are willing to deal with tenants' complaints and problems, which may come at all hours of the day and night. These 3M employees should keep in mind, too, the numerous day-to-day tasks necessary to keep the rental property operating smoothly. In addition, there are many liability issues you probably haven't even considered, such as building security and codes, anti-discrimination laws, the possibility of lead and/or asbestos in the building, and ADA (Americans with Disabilities Act) accommodations, to name a few.

Investing In Rental Property Typically Requires a Large Outlay of Capital

Many investors do not even consider getting into real estate because of the relatively large sums of money necessary to acquire and maintain property. This capital requirement also contributes to real estate's poor liquidity. This disadvantage works in two ways: first, by making it difficult for you to enter the real estate game yourself, and second, by making it difficult to find a buyer who can get you out of the game when you're ready to quit. If you are not prepared to lay out a significant amount of money for an individual real estate investment (or you are not willing to secure the necessary financing), you might want to consider a different type of venture, such as a real estate investment trust (REIT) or a real estate partnership.

Political And Economic Changes In the Area Can Affect Occupancy and Property Values

Since the majority of your return from an investment in rental property comes from rental income, it is important to keep your occupancy rates as high as possible. Of course, many factors might make this more difficult. Political changes (e.g., a tax hike) can adversely affect the residents of a given community, making them less likely to upgrade to a nicer apartment or rental home.

Economic changes (e.g., a factory closing) can create high unemployment, making it difficult for your tenants to pay their rent. Rezoning, relocation of roads, and other unexpected events can also affect your property value and could be devastating when you eventually decide to sell the property. In fact, if property values decline enough, you may find yourself unable to sell the property at all.

Real Estate Is Not a Liquid Investment

Like all real estate, rental property is relatively difficult to sell in a hurry, and there is little certainty about the selling price you will receive if you do manage to find a quick buyer. Unlike the stock market and many other securities markets, there is no established national exchange for real estate trading. If you choose your property wisely and manage it well, you may have a steady stream of rental income, but you will probably not be able to sell the property quickly if an unexpected cash need arises. Other types of investments, such as stocks, bonds, and other short-term securities, should be included in a balanced portfolio to provide adequate liquidity.

How to Do It

Select the Rental Property You Want to Purchase

Selecting the appropriate rental property can be a daunting task. Many first-time real estate investors choose to start small, choosing a duplex or similar property as a starter. Although it is not the most glamorous type of property, a duplex provides many advantages over other types of rental property, especially if you are just getting into the landlord business. Duplexes are affordable--prices are typically comparable to single-family homes.

They also provide you with personal housing, should you decide to live on-site and manage the property yourself. You can rent out one side of the duplex and live in the other, using the tenant's rent to help make your mortgage payments. Other options for starting small include single-family homes, triple-deckers, and brownstones. If you are an experienced landlord, you might consider a large apartment building or complex. Although the following list is not exhaustive, some important things to consider when choosing property include:

•  Number and size of units
•  Fair market rents in the area
•  Location of property
•  Availability of parking
•  Proximity to schools, shopping, public transportation, and other amenities
•  Quality of local school system
•  Commuting time to major business districts
•  Crime levels in the area
•  Police and fire protection in the area
•  Amount of property taxes
•  Costs for adequate insurance

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Arrange Financing for the Purchase (If Necessary)

If you are purchasing rental property, you will probably need a mortgage. Even if you have resources available to make the purchase, taking a mortgage is typically advantageous because the mortgage interest is usually tax deductible as a business expense. There are many different types of mortgages to suit your specific needs, although not all types of mortgages are available from all lenders, and many are not appropriate for investment property. These 3M employees should remember that choosing a mortgage can be a complex process, and making an inappropriate choice can have consequences later.

Decide on form of Ownership

How should you own your home? That depends. If you are purchasing property by yourself, your only real choice is sole ownership (unless you incorporate). However, if you are buying property with another person or persons (e.g., your spouse, your children, or a group of associates), you have several options with regard to form of ownership. You may choose to own the property as joint tenants, as tenants in common, or, if married, as tenants by the entirety. Each of these forms of ownership has certain advantages and disadvantages, depending on your situation.

Tip:  It is also possible to form a business entity (e.g., partnership, limited liability company) to own property.

Arrange for Ongoing Management and Maintenance of Property

You might decide that you can handle management duties yourself, especially if your investment is limited to only a few units and the properties are located close together. For any of our 3M clients who choose to manage your property themselves, be sure you understand the magnitude of the task you are undertaking. Many would-be managers have found that their schedules cannot accommodate the time commitment. Some of the necessary duties include:

•  Placing ads as rental units become available
•  Interviewing prospective tenants
•  Performing credit checks and contacting references on prospective tenants
•  Sending and receiving correspondences
•  Setting and collecting rents
•  Following up on delinquent rent payments
•  Keeping books and paying bills
•  Cleaning common areas such as hallways and laundry rooms
•  Making safety and maintenance inspections
•  Mowing lawns/landscaping
•  Shoveling and plowing snow
•  Arranging for all repairs and maintenance
•  Making improvements to the property as necessary

Professional management may be necessary if you don't have the time or inclination for these necessary activities, or if you own many properties in diverse locations. Professional managers may also be useful if you are uncertain about fair market rents in the area where you have purchased property. Hiring professional managers means you don't have to do as much to keep your rental property functioning, but it also requires you to give up a certain degree of control over the property, and the salaries of property managers will need to be paid.

Choose Your Tenants Carefully

Ultimately, the success of your rental property investment relies heavily on the quality of your tenants. Thus, finding and keeping good tenants is extremely important, so take your time. Make sure you screen all prospective tenants carefully. Get as much information as possible, including credit, employment, and personal history. Ask for references and contact them for more information.

If you discover undesirable information, you are not obligated to rent to that person. You are within your rights as a landlord to set rules regarding pets, smoking, noise, and so on, and you can reject any prospective tenant as long as your decision complies with fair housing laws and are based on legitimate business criteria. Making your rules known to prospective tenants at the outset (and including them in the rental agreement) can protect you in the long run. You can protect yourself further by requiring a security deposit and the first month's rent before signing the rental agreement, if local laws allow you to do so.

Tax Considerations

Rental Expenses (Including Mortgage Interest) Are Typically Tax Deductible

Income-producing real property, including rental property, is considered business property. As such, it receives certain favorable tax treatment in that your expenses are typically deductible. The general rules regarding deduction of rental expenses are as follows:

•  All expenses (including mortgage interest, property taxes, insurance, utilities, advertising, maintenance, and so on) can be deducted against rental income received on the property
•  If the total expenses are less than the gross rental income, the resulting profit is taxable income
•  Rental activities are considered passive activities. Losses from passive activities that exceed income from passive activities are disallowed for the current year but may be deducted from passive activity income in future years. However, if you materially participate in those rental activities, you may deduct up to $25,000 of any excess passive losses against income from other sources. This $25,000 amount begins to phase out when your modified adjusted gross income (MAGI) exceeds $100,000 and is eliminated entirely for incomes exceeding $150,000. Rental expenses include a wide variety of items that you might not ordinarily consider. However, as long as they are truly used in the course of business, these items are perfectly legitimate deductions. The following are a few examples of items you might be able to deduct as business expenses:
•  Tools and hardware
•  Cleaning supplies and expenses
•  Lawn equipment
•  Office supplies
•  Office machines (e.g., typewriters, fax machines, copiers)
•  Computers and management software
•  Postage
•  Salaries
•  Payroll taxes
•  Books and subscriptions
•  Seminars and meetings
•  Legal fees
•  Travel costs to and from the property

Rental Property Depreciation Is Also Deductible

Another tax benefit of rental property is the deductibility of depreciating assets. Rental property is assumed to decrease in value over a period of years, due to wear-and-tear and other factors. Although this is not necessarily the case, you are allowed to deduct depreciation as a way to recover this assumed loss of value. Rental houses and apartments placed in service after January 1, 1987, depreciate on a straight-line basis over 27.5 years (approximately 3.63 percent per year). Thus, if you purchase rental property this year for $275,000, your depreciation deduction would be $10,000 per year for the next 27.5 years.

Tip:  We'd like our Fortune 50 clients to note that  c ertain qualified property may be entitled to a special 30 percent first-year depreciation deduction (in addition to the normal first-year depreciation deduction).

Repairs And Improvements Are Not The Same In the Eyes of the IRS

It is important to understand all of the tax deductions associated with rental property. One subtle but important rule to know is that repairs and improvements are treated differently in the eyes of the IRS. Repairs keep your property in good working order but do not materially add to the value of the property or substantially prolong its life. Repairs are considered expenses and may be deducted like any other business expense. Improvements, on the other hand, add to the value of the property, prolong its useful life, or adapt it to new uses. Improvements are classified as capital investments and are thus recovered through depreciation.

Capital Gains Tax Liability May Result From The Sale of the Property

We'd like to remind our 3M clients that because your rental property is a capital asset, you may be required to pay capital gains tax when you sell it. In general terms, if you sell the property for more than you paid for it (or your basis in the property), you have realized a capital gain. If this gain cannot be offset by capital losses, you will have to pay capital gains tax on this amount. Capital gain income and loss can have a significant impact on your net return on your investment.