Owning rental homes has historically been a great vehicle for generating passive income and building equity but it’s been unclear exactly how. Here are the four reasons we love rental property investing:
- Cash flow
- Equity build-up
- Tax benefits
Investopedia defines cash flow as “the net amount of cash…moving into and out of a business”. AKA passive income. Broken down, cash flow is the difference between the monthly rental income and total expenses (mortgage, taxes, and insurance).
Cash flow produces a flow of income without trading time for money. This frees you to do other things (work a full-time job you love, travel the world, spend time with family, start a new business venture, etc)
Here’s is an actual example of cash flow for my first rental property:
Equity build-up refers to your residents helping to pay down your mortgage which increases your equity (or ownership) of your home.
When you’re purchasing a home with a mortgage, the bank owns a portion of your home but this diminishes as the mortgage loan is paid down. The beauty of owning rental real estate is not only the cash flow but that your residents gradually pay down your loan!
Typical mortgages last thirty years (assuming you don’t pay extra towards the mortgage) so it’s safe to say once the mortgage is entirely paid off, your cash flow increases significantly.
In the above example, once the mortgage is fully paid, your cash flow would increase to $1,022/month!
At a high level, the government understands that it doesn’t do a great job of providing affordable housing and therefore gives tax incentives to investors in order to encourage rental housing.
Some of the most common are:
Each rental home that’s owned receives business-like tax treatment meaning you’re able to deduct all expenses against your income. Some common deductions are mortgage interest, travel/accommodations, insurance, management fees, and repairs.
When owning a rental home, your best deduction is typically depreciation. The IRS depreciation period for rental homes is 27.5 years. For example:
- 60% is allocated to the land which isn’t deductible
- 40% is allocated to the structure which is deductible
- 40% * $200,000 = $80,000
- $80,000 / 27.5 years = $2,909/year depreciation
The $2,909/year and any other expenses would then be subtracted from your cash flow leaving you with an income figure for the IRS which you’d then pay your normal taxes on. Oftentimes, this figure becomes negative which could you use to offset other income.
Finally, once you’ve made capital gains on the home and want to move on to larger investments. The IRS allows you to reinvest your profits into a larger investment and defer paying capital gains taxes.
The last one is appreciation. As defined by Investopedia, “Appreciation is an increase in the value of an asset over time”. Over the long-run, the single-family residences have increased on average 2% per year.
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