The Value of Rental Real Estate



 

Like most people, I want to be financially successful.  As a tax practitioner with a number of financially successful clients, I have the unique ability to see what traits they have in common.  One particular trait stands out to me: they diversify their investments among stocks, bonds, and rental real estate.

 

What makes rental real estate an attractive investment to the wealthy?

 

It could be the simple business model.  Person A needs a place to live.  Person B owns an extra house.  Person A pays Person B to live there.

 

It could be that it is a tangible investment.  An investment simply feels more real if you can see it before your eyes.

 

Or it could be that the investor expects the property value to rise and wants to finance the property through others paying rent.

 

In addition to all those reason, I think the tax incentives that the government gives rental property owners is a big factor. 

 

 

There are a number of tax advantages to owning rental real estate.

• Depreciation.  When you are renting out real estate, you are entitled to depreciate the full value of the building over a number of years (how many depends on whether it is a residential or non-residential property).  This means that you can depreciate both the amount of cash you paid plus the amount that you borrowed on the property.  Note: Only the building is depreciable, not the value of the land.
• Expenses are deductible.  All the expenses you incur in renting the property are deductible.  This includes mortgage interest, property taxes, a property manager, HOA fees, utilities, etc.  Of particular value is the mortgage interest deduction.  As I mentioned above, you are already allowed to depreciate the mortgage, but this deduction allows you to deduct the interest paid as well.
• Capital Gains.  When you eventually sell the property, assuming that you purchased as a rental and operated it in that manner, any gain will be taxed at capital gains rates which are significantly lower than ordinary income tax rates.

Taking advantage of these incentives means that in some years investors may have a positive cash flow but little to no taxable income.

There are some limitations on these benefits.  Because of tax games that were played in the 1980s, Congress has categorized all rental income as "passive income" and only allows passive losses to offset passive income.  There are two exceptions. 

The first is for real estate professionals, which we will not discuss here.  The second exception allows individuals to deduct up to $25,000 of rental losses if they actively participated in the real estate activity.  This exception phased out for individuals with modified adjusted gross incomes of greater than $100,000.

Some successful investors choose to participate in real estate investment groups instead of purchasing properties themselves.  In addition to all the tax benefits, this lets the investors avoid the traditional landlord responsibilities, gives them access to professionals to select the best investments, and allows them to invest smaller amounts.  For example, I know of one San Diego-based real estate investment group that allows investors to join for as low as $10,000.  This is significantly less than the 20-30% downpayment that a bank may require to finance a rental property.

I would love to get your feedback and answer any questions you may have.  If you want to ask me a question privately, please send me an e-mail.

Also, please let me know if you would like a referral to any of the following professionals:

• Real Estate Agent
• Property Manager
• Mortgage Broker
• Home Owners Insurance Agent
• Real Estate Investment Group