Military Financial Advice - Military Times

Make rental property part of retirement plan

If you are fairly sure where you want to relocate after you leave the service, purchasing a home in that area and renting it out until you retire can be an excellent strategy.

Many people plan to move when they get out, and it is often better to own a home than to pay rent. Since house prices tend to increase over time, it makes sense to buy early if you have a good idea where you want to be in the future.

There are significant financial and tax advantages to buying a home that you will live in after renting it out. If you live in a home that you own, repairs and maintenance are not tax-deductible. If you are renting the home to someone else, those expenses and others are deductible, and additions to the home can be deducted through depreciation over 27½ years.

It will be necessary in most cases to hire a good property manager to find a tenant and take care of repairs and maintenance. Property managers usually charge 10 percent of the rent each month and may charge an additional fee to find a tenant.

Rental property should pay for itself each month. However, if you plan to live in the house in the future and will be doing significant repairs or additions over time, the amount of positive cash flow each month is less important. If your rental income pays for the repairs, maintenance, mortgage, insurance and property manager, and you plan to live in the house in the future, it is not necessary for the rental income to be significantly greater than the total annual cost of ownership.

If you own this property for a longer period, as local rents increase, you may have extra income to start paying off a 30-year mortgage early. You should have a 30-year conventional fixed-rate mortgage for rental property. Fancy financing using adjustable-rate mortgages with a low initial rate or interest-only mortgages where you make no principal payments do not make sense for a longer-term investment. If you cannot afford the property with a fixed-rate mortgage, do not buy it.

In the last five years of your active-duty service, start to aggressively make repairs and replace appliances that you will not keep when you move in. Since you can depreciate the cost of these appliances over five years, they will still be usable when you occupy the house. Repairs are deductible in the year they are done, so do maintenance such as painting in the last three years of the rental period. Avoid extensive repairs in the last year.

It is necessary to hire a good tax preparer to be sure that you are properly accounting for the rental property’s income and expenses. If the property is not in your state of residence, you will need to file a nonresident tax return in the state where it is located. In most cases, no tax will be due, but it is a good idea to file the return even if there is no taxable income from the property after expenses and depreciation. Income and expenses from rental properties are reported on federal Schedule E and depreciation on the property is reported on Form 4562 and Schedule E.

Many people have asked me: “What if I move into this house and I don’t like it and want to live in a different location?” In that event, you have to live in the house for only two years before it can be sold as your personal residence. After two years, a married couple may exclude $500,000 in capital gains from the sale of their principal residence; a single person may exclude $250,000.

You can use those two years to find where you really want to live. When it’s time to sell the first home, most or all of the gain will be untaxed. This will give you money to purchase a new home more to your liking. If the area is less expensive, you may be able to buy a home with no mortgage or a smaller mortgage.

If you have no idea where you want to live after retirement, this strategy can still work. Buy a rental house in a growing area with positive cash flow. When you have decided where you want to relocate, sell the rental house and do a 1031 exchange (called a Starker exchange) so that your gain is not taxed. Then, buy a new rental property in your selected retirement location.

Continue to rent out the new property for two years or more. Then, you can move in; if you want to sell the house later, be sure to wait at least five years from the date of the sale of your original rental property or you will lose the tax advantages of the 1031 exchange. Rules for 1031 exchanges are complex. Be sure to get professional help before you sell your rental property.

Tagline: Barbara H. Pietrowski is a licensed certified public accountant, certified financial planner and personal financial specialist. Her practice includes tax preparation, fee-only financial planning and investment management.