It’s no secret that many people have made a lot of money—fortunes, even—by investing in real estate. This is not to say owning rental property is a surefire path to riches, but real estate has always performed very well when compared to other investments.
There is a lot to know about investing in residential income property. Here are a few of the most important aspects.
1) Real estate provides leveraged equity growth.
This simply means that using a little of your own money (the down payment) and a lot of someone else’s money (a mortgage), you can multiply the effect of the property’s appreciation over time. With a mortgage, your equity will increase at a rate faster than the property’s value.
Here’s a simple example: you buy a rental house for $400,000 with a 25% down payment—$100,000 cash and a $300,000 mortgage. Over some period of time, the property’s value increases to $450,000—an increase of 12.5%. The equity has increased by a little more than $50,000, as well, growing from $100,000 to $172,000—an increase of 72%. Here’s what it looks like year-by-year:
2) Even a “break-even” property can provide income.
When you buy income property, the rent paid by the tenant offsets some or all of the mortgage payment, taxes and other expenses. With today’s low rates, it is possible to have a comparatively small down payment (25%) and still collect enough rent to cover the mortgage payment and expenses.
When you file your tax return, you will claim the income and expenses on Schedule E of your return. The rents you collected for the year, minus operating expenses, mortgage interest and depreciation, will give your Total Rental Real Estate Income (or loss). That’s what you’ll pay tax on.
You will be able to claim a type of expense called “depreciation.” This is the theoretical loss in value over time. For residential rental property, you can claim that “paper loss” over 27 ½ years. You depreciate only the building, not the land, so if you buy a rental house for $400,000 and the building is worth $300,000 (the appraisal will tell you the value), you will depreciate the building by $10,900 per year. This will turn your “break-even” rental house into a positive cash flow investment, because you will now show a paper loss, even though the rental income paid for the mortgage and all the expenses of the property. Here’s what that looks like on paper:
In this example, the property had a “paper” loss of $5,613 because of depreciation, even though it actually broke even during the year. For most people, that negative income—even though it is NOT an out-of-pocket loss—will reduce their taxable income from other sources, like wages.
3) Real estate is a long-term investment.
Even though cable television is full of programs showing people making supposed fortunes by acquiring houses, fixing them up and “flipping” them, these programs are edited for entertainment, and they seldom show the whole story. Real estate works best when we hold it for a longer time frame to allow natural appreciation to do its job for us.
4) Owning a rental home is not just an investment; it is also a business.
Income-producing real estate requires some level of management. A successful landlord must be good at selecting tenants who will take care of the property and pay the rent on time. Owning one or more small properties may also involve repairs and maintenance.
While some choose to farm these kinds of jobs out, many landlords prefer to do the work themselves to save money. You should ask yourself whether you have the skills and temperament to do these tasks yourself. You may decide that hiring a management company is a good move. Having an experienced professional do the work for you could avoid a lot of problems, but be prepared to pay around 10% of the rental income for those services.
5) Get professional counsel.
We have given you some very general, simplified examples in this article. Before you make any decisions that are likely to have tax consequences, you should spend some time with a good tax advisor. They will be able to give you advice and information that is specific to your unique rental property situation.
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