Real estate investing (unlike many other investments) has four levers to make you money: appreciation, cash flow, debt pay down, and its tax benefits. Let’s dive into each of the return levers:
Appreciation is how much the property value increases over time.
1. According to Case-Shiller Home Index, real estate has appreciated 3% a year in the U.S. over a 100-year time frame.
2. In some markets like Denver, homes went up in value by 6.5% annually from 1974 to 2018.
Generally, cities that have population growth see annual appreciation rates between 3-5%. You can see a list of these cities here.
2. Cash Flow
Cash flow = Rent –Mortgage Payments – Expenses
Property expenses can include repairs, property taxes, insurance, utilities, and management fees. If you have a property that can be rented out for $1,800 a month, expenses of $500, and a $1,000 mortgage payment, you will have $300 in extra cash directly into your pocket every month.
3. Debt Pay Down
Below is an amortization table. It shows the first few payments on a $400,000 mortgage at a 4% interest rate over 30 years.
When you pay down principal, you are building equity in your property. Every time you pay down the principal and build equity, you are getting a return.
It gets even better. Who is paying down your loan? It is your tenant! The tenant is buying YOU more of your property by building YOUR equity.
4. The Tax Benefits
Whenever you buy a property, you can reduce your annual tax burden because depreciation is treated as an expense for tax purposes. When you purchase a rental property, you are buying the land, improvements, and the structure.
Purchase Price = Land + Improvements + Structure
The land does not depreciate, but the improvements and structure do.
The last rental property I purchased is a duplex in Nashville for $280,000. I will use this as an example to differentiate between land and improvements.
Land assessed value = $30,000
Improvements + Structure = $250,000
The government allows you to depreciate the property over 27.5 years. My annual tax benefit is therefore $250,000 / 27.5 years = $9,090. Just for owning a property, the IRS is giving me a $9,090 tax deduction for the next 27.5 years!
In my personal case, my duplex brings in $1,500 a month. Expenses (including property taxes and mortgage interest) are $1,100 a month. Depreciation is $9,090 / 12 = $757 a month.
$1,500 – $1,100 – $757 = -$357
If your rental property does show a net loss, federal tax law allows you to deduct up to $25,000 of losses to offset your other income. In my case, my Nashville property reduces my annual taxable income by $357 x 12 = $4,284. Since I am in the 35% tax bracket, my total tax savings are $4,284 x 0.35 = $1,499.
The bottom line is that there are some pretty nice tax benefits for landlords. This allows you to collect rental income without paying much (if any) taxes on it.
When You Sell
If you lived in the home for at least two years and rented it out for no more than three years, you can exclude $500,000 in capital gains when you sell it. In addition, you will owe income tax on the amount you claimed as depreciation throughout the years. This is actually taxed at your ordinary tax rate, which is higher than the capital gains tax.