A good rental property strategy will not only build immediate cash flow and provide a long-term retirement strategy, but it can also create some incredible tax benefits if you plan wisely.
I’ve identified the following key benefits:
1. Property appreciation
I’m not advising a “fix and flip” strategy. You should plan on keeping your rental property for at least seven to 10 years. As such, appreciation is one of the key benefits in your ROI. In fact, the National Association of Realtors (NAR) has reported that real estate nationwide has averaged more than 6.74 percent appreciation annually during the past 50 years.
This rate of return outperforms the S&P 500 and most Wall Street investments. I realize that not all property in every market will experience this type of growth, but this average is definitely something to consider. Don’t discount the power of property appreciation.
2. Mortgage reduction
This is an oft-overlooked benefit to owning rental property. If you purchase wisely, the property should be at least breaking even in cash flow if you have tenants because the renter is essentially paying the mortgage for you.
This principal reduction within the mortgage is an ongoing tax-free benefit, along with appreciation, that you can calculate and count on over time. Keep this in your spreadsheet as you calculate your total ROI.
3. Tax savings and deductions
It’s no secret that rental properties lose money on paper. But with the power of depreciation, the fact that you get to deduct the mortgage interest your renter is essentially paying for you and the additional deductions you can take for travel, property taxes, HOA fees, repairs, maintenance, home office, supplies, cell phone, etc., the tax benefits add up very quickly!
However, how you’re classified as a real estate investor is absolutely critical. The IRS may classify you as passive, active or professional unless you take proactive steps to understand and elect the best classification for your situation on your tax return. The benefits vary widely. Here are the basics:
- Passive investors. Anyone qualifies, but losses are only deductible against other passive income.
- Active investors. To qualify, you simply need to make decisions — buying or selling property or hiring a property manager — regarding your properties and check the proper box on your tax return. However, losses are limited annually to $25,000 and phase out completely at $150,000 of adjusted gross income (AGI).
- Real estate professionals. All real estate losses are deductible against any type of income. However, you must meet a two-part test (your primary occupation is real estate, and you spend 750 hours per year working on it) and materially participate in the management of the property under one of another seven tests.
It’s very important to understand these options and discuss them with your CPA. Remember, even if you aren’t able to deduct losses immediately against your other income, you’ll eventually realize the write-offs, and the tax benefits can be phenomenal.
4. Cash flow
Simply stated, good rental property creates cash flow; bad property does not. Purchasing good cash-flow property causes the other benefits to fall right into place. If the economic downturn and the drop in real estate values have taught us anything, it’s that we must analyze and purchase property based on cash flow above all.
Cash flow is also a part of your ROI when you analyze a property. You’ll need to consider all of your cash expenses to determine what your cash-on-cash rate of return is as you try to minimize cash expenses related to the property. Conversely, you’ll want to maximize your tax write-offs in order to enjoy the most tax benefits.
In summary, many savvy investors realize these four quadrants or benefits work together and can produce double- if not triple-digit rates of return on their leveraged rental properties. Your overall ROI analysis of any property will include cash flow, the mortgage principal pay-down, property appreciation, and tax benefits. With these benefits and the substantial ROI, it’s no surprise that the wealthiest and most successful people in America hold rental property as a large part of their portfolios.
So many people ask me, “What are your successful clients doing, Mark? How are they surviving the economy?” And I tell them: Almost every one of my wealthy clients owns rental real estate. Granted, rental real estate isn’t all it takes, but it’s certainly a key factor in the equation. If you want to build wealth, give your CPA something to work with on your tax return, and feel like you are more in control of your retirement money, please consider rental real estate.