6 Reasons Owning Rental Property is a Smart Decision

How would you like to become a millionaire? There is a reason more millionaires either hold their wealth in real estate or made their wealth in real estate than any other investment vehicle. It may not be fast, and it may not be sexy, but it works! Anyone can become a millionaire in real estate with a plan that is executed. Here are 6 reasons owning rental properties is a good idea if you want to be wealthy.

1. Earn Consistent Income

I was on a trip with my family a few months ago and we were gone over the first week of the month. When I got back home, I noticed that my bank had a much higher balance then when I left. I was making money while I was spending time with my family on a trip. Real estate can provide a consistent and mostly passive return which is the main reason I love to invest in it. Each month, your tenants are expected to pay you for the benefit of living in one of your properties. The beauty is that the benefit you are providing is a clean and safe place to live not an exchange of your time for money.

2. Take Advantage Of Tax Benefits

Outside of the consistent and mostly passive cash flow that you will grow to love, real estate offers many other benefits to the investor. One of the biggest and often overlooked is the tax benefits. I am not a CPA and these benefits are how I understand them. I would recommend getting your own tax advice as each individual situation may be different.

Deferred Taxes

Much like stock, or other investments, you will not pay any gains on the increase in value until you sell. That means you can be earning money each and every year through appreciation with no tax liability. With real estate this often overlooked benefit gets even better! With real estate you can sell the asset capture the gains from the appreciation and still not pay the taxes. This is called a 1031 exchange because it is section 1031 of the tax code. This tax loophole allows investors to defer gains on real estate that they sell as long as they buy another property as an investment. This works perfect when you have equity in a house that can be moved into a new property with better returns.

Deferring again has multiple benefits but one of the biggest is that it increases the size of your investment. For example if you have a $100,000 gain and need to pay taxes at a rate of 15%, you will pay $15,000 in taxes which reducing the amount you can invest in another property to $85,000. If you are using a loan to buy the new property, you would need to borrower the $15,000 that is not available to invest. That increases the size of the loan and your monthly payment which hurts your cash flow. Do two or three exchanges and you can see how this becomes one of the biggest benefits available to real estate investors.

It is important to note that the 1031 is a tax deferral, not a forgiveness. This means you are going to be expected to pay those taxes at some point in the future with two exceptions. First if you wanted to donate the house there will be no tax on the gain, mostly because this is no gain if you don’t sell it. Second, if you die. I know that is terrible to think about but stick with me here. If your plan is to pass your estate on, you may never want or need to cash in the equity in a property, and if you did you can always borrow against the property because a loan is not taxable either. When you are gone and pass the property onto your heirs the get to experience what the IRS calls a “step up.” A step up means that the basis in the property steps up to the current value. That means your heirs would only pay taxes on anything they sell the house for ABOVE the new basis or the value at the time of your death. If they inherit the property and sell it immediately, any money they get from that sell will be tax free.

Depreciation Deduction

Another huge benefit to real estate is the phantom loss. A loss that shows up on your tax return but not in your pocket is called a phantom loss. In the case of depreciation, the IRS allows you to deduct a little of the property value each year because it considers the property diminishing in value over time. The way this works is the IRS accounts for a useful life of the property and then allows you to deduct a little of its value each year over that expected life. In its simplest form, residential property depreciates over 27.5 years or 3.636% a year. If you own a $200,000 house, you will get a tax deduction of $7,260 each year. Once you own a handful of rental properties this tax benefit really starts to add up!

This benefit gets even better! We used a simple example of a $200,000 house but different parts of the house can be depreciated at different rates. For example, personal property depreciates over 5 years. This could include things like the appliances. Breaking out or segregating the costs of the real estate allows the investor to depreciate different parts of the house at different rates which give the investor control on how much tax or a tax advantage they can take now and how much they can use later. This is a complicated strategy and beyond this article but it is a good idea to at least be aware of this possibility because of its power to increase your wealth. Please check with your own tax advisor.

Deprecation, much like the 1031 exchange, does need to be recaptured when you sell the property. This assumes you sell without a 1031 and before you pass the asset to your heirs. Passing the property after death or the 1031 would avoid, at least temporarily, the need to pay taxes on the amount you depreciated.

Other Deductible Expenses

All the basic expenses that come with operating the rental property are also deducted from your income, lowering your tax liability. Deductible expenses include mortgage interest, insurance, maintenance, legal fees and more. Other items that may be deductible include:

  • Repairs – repairs can mostly be deducted they same year the repair was made with some exceptions. If the IRA considers a repair an improvement they prefer you add the amount of the repair to your basis and deduct it over the useful life (depreciate it) In this case it will lower your tax benefit in year one by spreading it out over several year. This may benefit you if you don’t need th full benefit in year one.
  • Travel – If you are actively looking or property, travel to see your property, travel to learn about investing, or any other legitimate travel that improves your rental property business, you can deduct those expense. This includes airfare, hotel, rental car, gas, and some meals.
  • Gifts – I would be careful year but legitimate business gifts are deductible. For example if you provide gift cards to people who help you or help find deals or you provide a gift to your tenant, you should deduct those expense on your tax return.

Non-Taxable Security Deposits

There are two instances when a security deposit is not taxed the year you receive it. If the security deposit is refundable, you will not pay tax on it until you retain it. In this case it is used to repair the property from damage caused by the tenant so you will have no taxable income from retaining the deposit. In the second case you can defer the tax on non-refundable deposit until a later date.

One of my favorite ways to manage property is to “sell” the house on a rent to own. I like this because the tenant believes they will buy the house and they take care of the home as it they already own it. They are also responsible for the maintenance, so it becomes much more passive to me. Over 90% of the time they do not buy so I consider this a property management technique and expect to retain ownership of the home. I always set the price at an amount I would be happy selling at in case they do actually buy the home. In the case of a rent to own, a large portion of their deposit is non refundable and will be applied to the property purchase. Since that money is not refundable for any reason, it is mine and I can do with it what I please. I do not pay taxes on it because it is going to be credited to the home when/if they buy. I only pay tax on it when they buy the property or when they move out and decide not to buy the property.

Losses from Natural Calamities or Thefts

Obviously anytime you take an actual loss you can deduct that loss. In the case of damage to the property or theft you will deduct the amount of the loss which is the amount to repair or the actual costs of lost items to theft. In these cases it is expected that you will receive insurance proceeds from a claim so the deduction for tax purposes will be the total loss minus the gain from the insurance claim.

Distinguishing Between Passive & Professional Investors

This benefit is not going to be available to everyone, but it is worth mentioning as certain people will see tremendous benefit. In general passive losses can only offset passive gains. So if you have a W2 income, you cannot use passive losses to offset that income. The exception to this is a real estate professional designation. If you qualify as a real estate professional, you can deduct your real estate losses against any other kind of income. With the huge tax benefits of real estate, like depreciation, you can quickly see how this can be advantages. Qualifying for this benefit is not easy however. You must meet two criteria.

  • More then half of your time must be in real estate. This can be managing your rentals, looking for property, trading properties, or a number of other things that would be viewed as real estate business.
  • You must work at least 750 hours in a year in that line of work. That means about 14 hour a week.

3. Property Value Appreciation Over Time

Although I much prefer the benefits of cash flow each and every month, wealth is truly accomplished through the appreciation of the property. Appreciation is the value increasing over time. Sometimes property goes up in value and sometimes it goes down in value but if you look at a long enough period, it always goes up. This again is why I love the cash flow. If we do experience a correction and a reduction in value, we can decide not to sell as long as the property makes enough money to pay the expenses. Investors get into trouble when they cannot afford to hold a property and are forced to sell it during a time of weakness in the housing market. As long as you are able to hold on until you are ready to sell, you will make money and see appreciation which increases your returns.

4. Portfolio Diversification

Diversification is the number one way to reduce risk. If you have a balanced portfolio you should expect to see some assets doing well when others are not. Having all your assets in one class, like stocks for example, would leave you exposed to a crash in that asset class. Many investors believe that they can obtain diversification in the stock market by buying stocks in different sectors. Although I would agree to some extent, true diversification will include investments outside the stock market. Real estate is a great way to diversify your portfolio.

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5. Hedge Against Inflation

Any real asset is a hedge to inflation, and believe me, inflation is coming. There is no way the government can spend money like they do and not see the value of the dollar erode. Real assets tend to increase in value with inflation which is why you see investors run to gold and silver in high inflationary times. If you think about it, real estate is both a real asset and finite, there is a limited about of land. As the value of the dollar decreases during inflation, it takes more dollars to buy goods and services. That includes rent and home prices.

6. Leverage Rental Properties For Additional Investments

Leverage is one of the main reasons mane investors choose to invest in real estate. You can control millions in assets for a fraction of their value. It is common to see conventional loans on rental properties with a 20% down payment when you buy. If you use a simple example of a $200,000 house, that means you would have a down payment requirement of $40,000. Not including any other costs in buying a home to keep this example simple, if the home increasing in value 5% which is close to average, the appreciation return on your investment would be 25%. I calculate that by first coming up with the gain and then dividing that by the investment. A 5% gain on $200,000 is $10,000 divided by $40,000 down payment. 10,000 / 40,000 = 25%

That is considering appreciation alone and does not account for any other benefit we have discussed. Those returns are hard to beat!

Because real estate is easy to leverage you can grow your portfolio at a rapid pace. As your properties increase in value you can refinance those properties to free up the equity and use that money to buy more properties. Remember loans are real estate are not taxable, so it is a great way to tap into your equity. I know many investors that have become wealthy with this strategy.

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With a little diligence, some cash reserves, and a long time horizon, rental real estate is a low risk investment with huge benefits.

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