Expert: Gina Boykin - 5/27/2008

Question
I want to know of the prudence of purchasing a second home as income property in this economic climate.  I have an existing 100,000 mortgage and a credit rating near 800.  I have money available in a non-funding 401k that is now losing capitol.  I am interested in purchasing a $200,000 home to rent.  What kind of tax benefits or punishments can i expect from this type of transaction?  Is there anything that i must do to rent property in arizona?  what kind of money will i need to have to make the purchase, and will it be prudent to take the money from the 401k account?  what kind of problems can i expect in securing a loan for the property?

Answer
•Money that is in a 401K account is there for retirement, and really should not be taken out for any reason.  You would not qualify for a hardship withdrawal, so if you take money out, there will be a penalty + you will have to pay ordinary income taxes on it.  This money was deposited pre-tax, so withdrawals are considered income, just like your regular pay.  Your company may withhold a certain percentage for these penalties and taxes before you even see the money.  So, for example, if you took out $20,000 (which is 10 percent of the price of the home), you would end up with only $12,000 if they withhold 40 percent.  Even though your 401K is decreasing right now, I’m guessing it is not at a 40 percent loss.  If you are concerned about the value of your retirement account, you could move some of the money over to a money-market fund, which should not go down in value, but will only give you about a 1-3 percent return.

•Another alternative you may hear about is a loan.  People can take loans out on their 401K, but I would not suggest that either.  It is a much better solution than a withdrawal, but if you ever leave, or are laid-off from your company, your loan will be due immediately.  

•A longer-term alternative is to rollover 401K funds into an IRA, then into a Roth IRA.  You will still have to pay taxes on the entire amount of the rollover, but withdrawals from a Roth (after the account has been open for 5 years) are penalty free.  Note: This applies to the deposits only, not any gains after the Roth has been opened.  This, of course, means waiting 5 years, but if you want to purchase another rental property in the future, or you decide to wait, it’s worth the effort now.

•The best way to purchase a home (for living and for investments) is to save up for the downpayment, closing costs, and a cushion for periods when you cannot rent the property and maintenance expenses.  The downpayment amount will be based on what you can qualify for with a lender.  With tightening credit standards, you may be looking at a requirement of 10-20 percent of the property value, even with your credit score.

•Points to consider: average rent amount in the area, how many other homes are empty and seeking renters already, the cost of property taxes and insurance, upcoming large maintenance amounts (air conditioner/heating/roof) over the next couple of years, ongoing maintenance (will you be paying someone to mow the lawn? You will also need to steam clean the carpets and pay a maid service to thoroughly clean before/after each tenant.).  Also, look at the trend of the neighborhood.

•Do you want to be a landlord?  If you don’t want to be responsible for answering tenant calls, and following up when the payment is late, you will also need to factor in the cost of a property manager.  Property managers usually charge roughly 10 percent of the rent.  So if your rent agreement calls for rent of $1,500, they will take out the first $150 and give you $1,350.  Make sure to factor that into the rent you will be asking.

•Lastly, I can’t speak to Arizona real estate law, so I can’t tell you about any of their requirements.  You may want to research this on the web (tenant and landlord rights).