In this series of blog posts, I will be discussing the powerful benefits of owning rental real estate. My strength is in single family rental homes, so my examples will reflect my current knowledge and expertise.
Real estate investments have gotten a bad rap since the real estate market crashed back in 2006. However, when done properly, rental real estate is an excellent investment to own. Real estate investments return cash in three ways: Tax Benefits, Operating Income, and Capital Appreciation. Stocks and bonds only have two ways of earning cash: stocks through dividends and appreciation; bonds through interest payments and appreciation. Stocks and bonds do not have any tax incentives, only potential tax liabilities.
When I invest in real estate, I focus on tax benefits and operating income. I do not focus too much on capital appreciation because I view rental properties as long term investments that will be able to weather the ups and downs of the real estate market. Lets take a look at the first of three ways rental real estate earns a return – Tax Benefits.
The IRS allows owners of rental properties to write of the depreciation of the “improved value” of the property. When looking at a property tax bill, the property is divided into land value and improvement value. The improvement value usually refers to the value of the building on the property. Rental real estate is depreciated over 27.5 years. To determine how much of the property is depriciatied every year, simply take the improvement value of the property and divide by 27.5 years. Here is an example from a property that I actually own:
Total market value: $122,000
Land Value: $22,000
Improvement Value: $100,000
Depreciation amount: $100,000/27.5 years = $3636.36 per year.
I am able to write off $3,636.36 every year from my income due to depreciation. Other expenses such as HOA dues, property taxes, mortgage interest paid, insurance premiums, and any other operating expenses are also written off. In the end, you end up with what looks like a loss on paper but is actually a gain. Here is the full breakdown of a rental property that I currently own:
Total Value $122,000
Land Value $22,000
Improvement Value $100,000
Depreciation amount $100,000/27.5 years = $3,636.36
Total Rental Income: $14,400
Mortgage interest: $6,286.21
Property Taxes $3,384.66
Property Management: $660
HOA dues $325
Total Taxable Loss: -$954.23
Actual Annual Phantom Cashflow: $2,682.13
When preparing my tax documents, in the eyes of the IRS, it looks like I lost $954.23. In reality, my gain was $2,682.13 (-$954.23 plus depreciation of $3,636.36). This is a win win situation. I have a net loss on paper that reduces my taxable income by $954.23 plus I actually gained $2,682.13 without paying any taxes on that money, and this is completely legal! Don’t believe me? Ask a CPA!
There are a few items to mention though. In order to write off that $954.23 against my W2 income, I must actively participate in the operations of the property. I can have a property management company handle the property, but as long as I make decisions regarding the property, I am actively participating. Also in order to write of the full amount of that loss, I must either be a full-time real estate professional or have an Adjusted Gross Income less than $100,000. If my adjusted gross income was $150,000 or more, I would not be able to write off the loss at all (unless of course, I was a full time real estate professional).
Lastly, one must be careful when deciding to sell a rental property. Remember that depreciation write off? Well, when a property is sold, the IRS adds back in all the depreciation so you will be taxed on the property appreciation plus the depreciation recapture. This can be avoided by using what is called a 1031 exchange. Please consult a CPA before selling a rental property. The CPA will be able to save you lots of time, money, and frustration when it is time to sell that rental.
Next blog post I will be discussing another way rental real estate earns money: Through operating income.