Investment Property

What Is an Investment Property?

An investment property is real estate property purchased with the intention of earning a return on the investment either through rental income, the future resale of the property, or both. The property may be held by an individual investor, a group of investors, or a corporation.

An investment property can be a long-term endeavor or a short-term investment. With the latter, investors will often engage in flipping, where real estate is bought, remodeled or renovated, and sold at a profit within a short time frame.

The term investment property may also be used to describe other assets an investor purchases for the sake of future appreciation such as art, securities, land, or other collectibles.

Understanding Investment Properties

Investment properties are those that are not used as a primary residence. They generate some form of income — dividends, interest, rents, or even royalties — that fall outside the scope of the property owner's regular line of business. And the way in which an investment property is used has a significant impact on its value.

Investment properties generate income and are not primary residences.

Investors sometimes conduct studies to determine the best, and most profitable, use of a property. This is often referred to as the property's highest and best use. For example, if an investment property is zoned for both commercial and residential use, the investor weighs the pros and cons of both until he ascertains which has the highest potential rate of return. He then utilizes the property in that manner.

An investment property is often referred to as a second home. But the two don't necessarily mean the same thing. For instance, a family may purchase a cottage or other vacation property to use themselves, or someone with a primary home in the city may purchase a second property in the country as a retreat for weekends. In these cases, the second property is for personal use — not as an income property.

Types of Investment Properties

Residential: Rental homes are a popular way for investors to supplement their income. An investor who purchases a residential property and rents it out to tenants can collect monthly rents. These can be single-family homes, condominiums, apartments, townhomes, or other types of residential structures.

Commercial: Income-generating properties don't always have to be residential. Some investors — especially corporations — purchase commercial properties that are used specifically for business purposes. Maintenance and improvements to these properties can be higher, but these costs can be offset by bigger returns. That's because these leases for these properties often command higher rents. These buildings may be commercially-owned apartment buildings or retail store locations.

Mixed-Use: A mixed-use property can be used simultaneously for both commercial and residential purposes. For instance, a building may have a retail storefront on the main floor such as a convenience store, bar, or restaurant, while the upper portion of the structure houses residential units.

Financing Investment Properties

While borrowers who secure a loan for their primary residence have access to an array of financing options including FHA loans, VA loans, and conventional loans, it can be more challenging to procure financing for an investment property.

Insurers do not provide mortgage insurance for investment properties, and as a result, borrowers need to have at least 20% down to secure bank financing for investment properties. 

Banks also insist on good credit scores and relatively low loan-to-value ratios before approving a borrower for an investment property mortgage. Some lenders also require the borrower to have ample savings to cover at least six months' worth of expenses on the investment property, thereby ensuring the mortgage and other obligations will be kept up to date.

Tax Implications

If an investor collects rent from an investment property, the Internal Revenue Service (IRS) requires him to report the rent as income, but the agency also allows him to subtract relevant expenses from this amount. For example, if a landlord collects $100,000 in rent over the course of a year but pays $20,000 in repairs, lawn maintenance, and related expenses, he reports the difference of $80,000 as self-employment income.

If an individual sells an investment property for more than the original purchase price, he has a capital gain, which must be reported to the IRS. As of 2020, capital gains on assets that are held for at least one year are considered long-term gains and taxed at 15%, except for those who are married and filing jointly and have taxable income exceeding $496,600 or single and have income exceeding $441,450. In these cases, the rate is 20%.

In contrast, if a taxpayer sells his primary residence, he only has to report capital gains in excess of $250,000 if he files individually and $500,000 if he is married and filing jointly. The capital gain on an investment property is its selling price minus its purchase price minus any major improvements.

To illustrate, imagine an investor buys a property for $100,000 and spends $20,000 installing new plumbing. A few years later, he sells the property for $200,000. After subtracting his initial investment and capital repairs, his gain is $80,000.