Real estate as retirement income

By Jill Schlesinger

(iStockphoto)

(MoneyWatch) Is the real estate market a good investment for retirement? I haven't fielded that question in at least five years, but over the past six weeks, I have been pleasantly surprised by the number of people who are reconsidering real estate as a source of steady income.

Let's start with the numbers. After experiencing a massive bubble from 2000-2006 (no, it's not normal for prices to double over the course of seven years), real estate cratered. Prices dropped almost 35 percent from peak levels, and in some areas, like Florida and Las Vegas, the damage was far worse.

Now, a full six years from the peak, recent housing data indicates that a bottoming process is occurring across the country. Existing home sales in April rose 3.4 percent from the previous month to the highest level in almost two years and 10 percent above year-ago levels. Adding to the case that the market is bottoming, inventory is down 20.6 percent from a year ago. In Econ 101, reduced inventory means less downward pressure on prices.

Similar results were seen in new home sales, which rose 3.3 percent from the previous month, almost 10 percent from year-ago levels and 25 percent from the lows. Still, there's still a long way to go before we see a "normal" housing market. The total level of sales is historically weak and 2012 will probably be the third worst year on record after 2011 and 2010. However, historically low mortgage rates are helping the market by making the cost of ownership more affordable, assuming that the buyer can qualify.

Sensing this opportunity, many are wondering whether a jump into the rental market can boost retirement savings and income. The answer is yes, with a few important caveats. Buyers must have realistic expectations, starting with a long-term time horizon and recognition that the days of "flipping" a house to score a big profit are gone. In fact, in the early going, many properties may just break even. The goal is for the owner to be mortgage-free and to collect a steady stream of income.

Additionally, securing a mortgage for rental property has changed dramatically since the bubble years. "No money down" loans are nonexistent; today, lenders generally require a deposit of 30 percent. Even with that chunk of equity, mortgage rates for rental properties are higher than for owner-occupied residences.

One way to defray some of the cost of owning income-producing properties is to use their favorable tax treatment. The Internal Revenue Service allows you to claim depreciation on your property over 27.5 years, which is a way to spread the cost of an asset over a period of time. Here's how it works: You can offset a portion of your rental income by the cost basis of your rental property (what you paid for the property plus improvements, but not the land) divided by 27.5. While this is just one way to defray taxable income, note that depreciation is a way to defer taxation, not escape it.

The IRS imposes taxes on depreciation when you sell the property, which is known as "recapture." You can defer recapture by using proceeds from the property to purchase a new one via a 1031 exchange but you must follow strict rules to comply. Additionally, if you own the property until death, your heirs will not be subject to recapture.

If the ability to create a steady stream of income with favorable tax treatment seems too good to be true, it is. Being a landlord requires hard work. No amount of screening will prevent you from encountering a horrible renter or a midnight call about some problem. If you don't want to be involved at that level, you'll have to hire a management company, which will obviously eat into your cash flow.

Finally, remember that real estate is an illiquid asset. Be sure to have access to sufficient liquid assets before you become a landlord.

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