Four
Ways Residential Real Estate Investors
Build Wealth
Lower Your Taxes
Investor tax incentives can be substantial.
Some investors can use deductions from
rental property to offset some of their
wage income. Other investors, while not
eligible for the offset, can avoid owing
taxes on their rental income by showing
adequate expenses and deductions. Even
if rental payments do not cover the investor's
expenses, tax breaks may actually make
up the difference—or more.
As an investor, you can claim deductions
for actual costs you incur for financing,
managing and operating the rental property.
That means mortgage interest payments,
real estate taxes, insurance, maintenance,
repairs, property management fees (if
any), travel, advertising, and utilities
(if the tenant doesn't pay them) may be
subtracted from your adjusted gross income
when figuring your personal income taxes
up to the amount of real estate income
you receive.
Also, don't forget deductions for depreciation.
The tax code assumes buildings and improvements
"wear out" over time. These
"losses" are deductible from
income, regardless of the property's actual
market value.
Depreciation is a "non-cash"
expense; that is, no actual payment needs
to be made out of pocket. Although the
government collects deferred taxes on
the income sheltered by depreciation when
you eventually sell, you've gotten "free"
use of the money in the meantime. And
if you do a tax-deferred exchange by purchasing
a replacement property, you can defer
taxes on the depreciation and on any profit.
(Ask your tax advisor about Section 1031
of the US Tax Code.)
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Have a Positive Cash Flow
A positive cash flow results when the
rent you receive exceeds the total you
pay for the mortgage, taxes, insurance,
maintenance and other carrying costs.
That's not as hard as it sounds. First,
decide whether you need a positive cash
flow before or after taxes. A pre-tax
positive cash flow translates into current
income, a goal of many retired investors
and others with current expenses. Properties
yielding a pretax positive cash flow are
harder—but certainly not impossible—to
find.
If this is your goal, you need to buy
widely. Not all properties will yield
high enough rental income to cover expenses.
Make sure you know how much rent to expect
by finding out about rents for similar
units nearby, the property's current rental
fee, and date of last rent increase. Keep
in mind you may need to purchase with
a large down payment so your mortgage
payments are smaller.
A positive after-tax cash flow can come
from a negative pretax cash flow. Generally,
the depreciation deduction makes the difference.
If you meet the eligibility test, you'll
be able to use the depreciation to shelter
some of your taxable income and reduce
your tax bill.
Second, you'll want to ensure your tenants
make timely rental payments and take care
of the property. Of course, a positive
cash flow is impossible without rental
income. A thorough credit, employment,
and landlord check on applicants will
help you find good renters, and a strong
lease combined with a required security
deposit will help put you ahead.
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Use Leverage
As an investor, you magnify the return
on your investment by borrowing a large
part of the purchase price. That is, by
limiting the amount of cash you invest,
you make your cash go a long way.
Leverage means using borrowed money to
increase equity. And equity—the difference
between what a property is worth and the
balance owed on the mortgage—is what's
important when figuring whether your dollars
are invested wisely.
Assume you bought a $100,000 rental property
with a 30% down payment, and after several
years the home is worth $135,000. The
$35,000 return on your $30,000 investment
is more than 100%. (Several factors will
actually lower your profit, but to illustrate
the principle of leverage we're keeping
the numbers simple.) If you bought that
same $100,000 property with all cash,
the return on your investment would be
35%. Leverage puts other people's money
to work for you.
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Benefit from Growing Equity
Even at a modest rate of appreciation,
real estate may well yield a higher return
on the cash investment than would some
other financial investments, such as bonds
or long-term CD's. Each mortgage principle
payment you make is a payment to yourself.
You build equity as your mortgage principle
shrinks, even if your investment property
doesn't change in value.
Although homes in different parts of
town may appreciate at entirely different
rates, the key is shopping carefully for
a purchase guided by a knowledgeable professional.
Review your expectations and think about
how long you plan to hold onto your investment.
When you reach your predetermined "equity
target", it's time to sell or refinance—and
perhaps use the cash you receive for other
investment properties.
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10 Proven
Secrets to Success
There are nearly as many investment-hunting
strategies as there are investors. Yet
experience provides some universal truths
that pay off.
- Compare Comparables
Fast-and-loose rules-of-thumb to estimate
value, such as 6 or 8-times annual gross
rent or 10-times net operating income
or 100-times monthly rent, may not reflect
an area's values. Use comparable sale
prices of nearby properties to get the
truest sense of market value. Do the
same for area rents. A low price can
be supported by reasonable rent; remember,
renters who can afford a high rent can
afford to buy instead.
- Tax Laws Change
A good investment is a good investment
before it's a good tax shelter. Tax
laws change. The right property in the
right place with the right financing
and management will weather inevitable
tax code changes.
- Specialize
Start in a market segment you know.
Whether you focus on fixer-uppers, foreclosures,
starter homes, low-down payment properties,
condominiums, or small apartment buildings,
you'll benefit from experience by specializing
in one aspect of investment real estate
properties.
- Run the Numbers
Operating expenses from repairs and
maintenance, loan payments, taxes, vacancy
costs and more will determine the difference
between smooth sailing and a sinking
ship. Upfront number crunching is your
best strategy. Run before-and after-tax
cash flow statements with confirmed
figures.
- Determine Last Rent Increase
If the rents were recently increased,
your future income may be limited and,
worse still, tenants might move. Check
the date of the last increase to know
where you stand. Also, make sure current
tenant doesn't have short-term lease,
living there simply to tempt the unsuspecting
buyer. Examine existing leases and be
sure to get tenant's security deposits
from seller at closing.
- Check Tax Assessment
A current assessment that will increase
after your purchase—because it
is old or doesn't include unrecorded
improvements—could change your
property tax expenses.
- Investigate Insurance
If seller's coverage is based on lower-than-current
replacement value, your insurance cost
may increase when you pay a higher purchase
price.
- Confirm Utility Costs
Ask the local utilities to verify recent
utility expenses, especially if any
of these costs are included in your
tenant's rent.
- Ask Your Accountant
Especially on the tax questions, as
well as your basic investment analysis,
be sure to get a second opinion from
your tax advisor or CPA.
- Inspect, Inspect, Inspect
Never buy a property sight unseen. Nothing
replaces on-site inspection and nosing
around the property like a bloodhound.
Hire professional inspectors for structural
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What to
Look For
You'll want to look for what's good—a
good property in a good neighborhood with
a good price and good financing. As an
investor, you may start looking in or
near your own neighborhood so you can
"keep an eye" on the property.
That doesn't mean, however, investors
should look for the best home in the best
neighborhood. You'll find rents often
don't cover the higher mortgage payments.
Look for a home in a neighborhood where
renters want to rent, not where you want
to live.
Look for:
A well-maintained neighborhood / Ready
access to public transportation, highways
/ A style of home that appeals to the
most renters in the price range / A property
that fits comfortably into the neighborhood,
is "typical" rather than unusual
/ A property that doesn't require a lot
of maintenance or repairs, unless your
objective is to find a "fixer-upper"
/ A property whose carrying costs you
can afford during a temporary vacancy
/ Preferably an undervalued home listed
by motivated sellers
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Consult
a Professional
Your best asset in choosing investment
property—whether a rental property
or a vacation home—is your real estate
professional. A knowledgeable realtor
can locate prospective properties, provide
information and perform a market analysis,
investigate local ordinances and regulations,
and assist in finding the best available
financing.
Remember, you'll also need the professional
assistance of a real estate attorney,
a tax advisor, and possibly a property
manager.
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