A good rental property strategy will not only build an incredible long-term and sometimes immediate tax strategy, it will build wealth for your future and produce consistent cash flow if done properly!
Rental properties save taxes. They either produce losses you can deduct now, or they allow you to defer the gains until a future date.
If you’re trying to build wealth and create a thriving financial future, it’s critical that you understand the power of owning rental property.
Rental Property Comes in all Shapes and Sizes
When you think of owning rental property, what comes to mind?
An apartment complex? a single family home? storage units? farm ground? vacation home? tiny houses? camping resort? RV park? commercial real estate? office building? Venue?
There are so many different types of rentals you can own. The key is to figure out what you would like to own, how that fits into your lifestyle, and then understand how it helps you build wealth and save on taxes.
There are 2 types of Rentals – Long-term & Short-term
Short-term rentals are properties that are rented for 7 days or less. Think of Airbnb or VRBO vacation rentals. There’s a loophole you can take advantage of with this type of rental. See my blog How short-term rentals are taxed
Long-term rentals are properties that are rented for more than 7 days at a time. This is the majority of all rentals.
There are 4 Main Benefits to Rental Property
This is a rental property you are keeping for at least 7-10 years. This is not a fix-and-flip strategy. The National Association of Realtors (“NAR”) has reported that real estate nationwide has averaged over 6.74% appreciation during the past 50 years.
This rate of return outperforms the S&P 500 and most Wall Street investments. Now I realize not all properties in every market experience this growth. However, some do even better than the national average.
To calculate the ROI on the appreciation, divide the appreciated growth by the amount of your down payment.
You are using the down payment instead of the purchase price because the down payment is what you have in out of pocket cost.
Ex: Purchase Price $100,000 | Down payment (20%) $20,000 | Mortgage Bal $80,000
If the annual appreciation is 6.74%, your appreciated value the first year would be $6,740. ($100k x 6.74%)
Your ROI is calculated by dividing the appreciated amount by your down payment. ($6,740/$20,000).
Your ROI on the appreciation is 34%.
This is often an overlooked benefit to rental property. The rent you collect each month should cover at minimum PITI (principle, interest, taxes, insurance). At the end of the year, your mortgage balance will be lower because you made payments towards the loan.
Here’s how to calculate your ROI on the mortgage reduction using the example above.
Beginning mortgage balance $80,000
Mortgage balance after 1 year $77,000
Your ROI is 15% the first year. ($3,000/$20,000) The ROI percentage will increase every year because the amount paid toward principle gets larger each year as you pay down the loan.
Rental properties lose money on paper. The benefit of deprecation, the fact that you get to deduct the mortgage interest, taxes & insurance that your renter is basically paying for you, and not to mention all of your tax write offs like; travel, HOA fees, repairs, maintenance, home office, supplies, cell phone, etc… The tax benefits can add up quickly!!
How you are ‘classified’ as a real estate investor (Passive, Active or Professional) will determine the tax benefit you will get. (To be discussed in a future blog post)
At the very least, you will be able to carry these losses forward to write off against future property that you sell if you aren’t able to deduct them immediately against your other income.
Here’s how to calculate your ROI on the tax benefits using the previous example.
Let’s assume that after you deduct the interest, taxes, insurance, repair/maintenance, travel expenses, supplies, depreciation, etc. you have a $7,000 loss on the property. Let’s also assume that you’re in the 22% income tax bracket.
$7,000 x 22% = $1,540 in tax savings (the $7,000 loss is deducted from your other income, thereby saving you $1,540 in taxes).
Your ROI is 8% for the first year. ($1,540/$20,000)
Good rental property cash flows…bad rental property does not.
It’s critical that you purchase a property that is going to give you cash flow! You need that cash to build a reserve for future expenses and to purchase other properties.
Here’s how to calculate the ROI on cash flow using the example above.
If your PITI (principle, interest, taxes, insurance) totals $800 a month and the amount of rent collected each month is $1,100, you have cash flow of $300 a month, which totals $3,600 a year.
Your ROI on cash flow is 18%. ($3,600/$20,000) As rent rises, so will your ROI percentage.
When you consider all 4 benefits of owning rental property and calculate the ROI as a whole, your total ROI equals 75%.
Where on Wall Street are you going to get that kind of return on your $20,000 investment?
Savvy investors know how to create tax-free cash flow and have double-digit rates of return on their leveraged rental property.
When it comes to building wealth, it’s no surprise that the most wealthy and successful people in America hold rental property as a large part of their portfolios in one form or another.
Talk with your tax advisor to analyze your tax position. Knowing how the tax code applies to your rental property provides multiple benefits.
A little bit of planning can go a long way in making sure you save on your taxes and build a thriving financial future.
If you would like to schedule a consultation with one of our tax professionals, we encourage you to book an appointment.