Rental property tax benefits and net worth increase - yearly
This is a continuation of the 2 articles pertaining to Tucson Arizona. In the 1st one I described the local economy using statistics and made a few predictions. In the 2nd article I had compared the benefits to the disadvantages of housing near a university or not. Almost every area investors consider will be within a stone's throw of a University, and I wanted to be clear that the decision as to whether on not purchase a place within walking distance of any campus is non-trivial.
Now the meat and potatoes of this venture. The reason to purchase a property is not simply to live off the rent once it is paid off. The reason is that over the life of the property, you will accumulate a huge amount of wealth relative to your initial investment. This comes about through handling write-offs and expenses related to the owning of a rental. Here are a list of things you will be writing off of your taxes when you get a property up and running:
- Property Tax
- Mortgage interest
- HOA fees
- House Insurance
- Property Management fees
The only thing these write-offs are offset by is the rental income. If you make a 20% down payment on a house you want to buy and rent it out, you should be approximately breaking even on a month to month basis in terms of expenses. If breaking even on a month to month basis were the end of the story, it would not be very profitable to own a rental property in this manner, because your property would just be sitting there doing nothing! The kicker here is that yearly you will also take into account the depreciation of the property, which equates to 1/27.5th of the value of the property sans land value. This easily will boost your after tax cash flow into the positive realm. All of these factors when added together create a huge reservoir of net worth increase after only a few years time.
I will go through one example with a 200,000$ house purchase of a single family residence to show you how much your ROI (return on investment) will conservatively be. For this I will be using values common to an 1800sqft house of newer construction in the Tucson, AZ northwest area. For simplicity sake we will approximate the down payment as 40,000$ and ignore appraisals and closing fees because that could get very long winded and it won't help solidify my points.
Total annual write-offs: 23,465$ (see below)
- Property Tax/Mortgage interest/House Insurance mortgage payment with escrow : 1200$ / month (assume 5% 30 yr fixed loan as an investment property)
- HOA fees: 30$ / month
- Depreciation: (200k*90%)/27.5 = 6,545$ annually
- Maintenance/Repairs: ~50$ month estimated
- Property Management fees: 10% of rent will be 130$ a month
Annual rental income: 1300$ x 12 months = $15,600
Annual Cashflow before tax: -1320$ (remember depreciation is not cash before taxes)
Annual Cashflow after tax assuming 35% tax bracket for federal/state combined: 2750$
Annual home value increase: safe to assume 4% in the long term or 8,000$ increase annually
Annual principal paid yearly (equity built): near beginning of loan approx 2300$. This will increase as the life of the property and loan continues.
Annual net worth addition: (2750$+8000$+2300$) = ~13,000$ This number will increase as the life of the property and loan continues.
Annual ROI = (40,000$ invested/13,000$ net worth yearly) = 31%
Ok now hopefully that got your attention. 31% ROI is nothing to scoff at. I don't really like to write long-winded articles because they get boring and the point I was trying to make gets diluted. In this article I feel I have to say a few words about my assumptions and the risks involved in making this kind of a decision. I don't want anybody to think that this is free money just waiting for the taking, it is in fact an investment of time, money, and intelligence which will allow you to partake of these benefits. If you are lacking in intelligence or money I will tell you right off that you won't be suited to handling a rental, even with the aid of a property management company. The undertaking of purchasing a real estate investment is not a trivial one or one for the faint of heart but done properly it can be much more rewarding than other investment classes. I don't know anybody who can make 31% every year in the stock market, but I know that any intelligent and dedicated person can do it with real estate with relative ease.
My assumptions in this endeavor create a limited area where these calculations are accurate. Because I am only focusing on one micro-economy in the US (Tucson, AZ,) which I happen to favor for various reasons, I am eliminating the many variables that come into play when other geographical locations are considered. I am also focusing on single-family homes of newer construction of which there are many in the Tucson area. Again these assumptions negate the requirement for this article to explain how the rest of the country operates with respect to housing, and shelters me from addressing issues like deferred maintenance and mechanical failures which will likely come into play with older houses.
I have made no mention of the differences between speculative investing and rental investments in general. To a degree everything is speculation but certainly some of the risk assumed on a day to day basis is very minor. A classic example of speculation is the assumption I used above about the home value year over year (yoy) increase of 4%. This could very easily be more, and it could be less, and it could even be negative! What you need to ask yourself is this: if your house lost some value would you still be ok with your rental property as a whole? If the answer is "Yes, I will be fine because this is a long term investment and the tax benefits immediately outweigh the loss of perceived value of the home," then jump on board, because this train is headed straight to stability town! However if your convictions could be swayed by the value change of the property going negative I would say be much more cautious in this investment. The good news is that the 31% a year net worth increase leaves a bit of wiggle room for property value growth to go negative. That is to say that even if you considered your house to appreciate yoy at 0%, you would still have an ROI of about 8%, which is impressive considering you are holding a depreciating asset on paper!
No financial advisor in his right mind would recommend this to everyone. If you were not employed in a high tax bracket (above 80k of so annually) then the calculations would be modified to reduce your after tax gains and ROI significantly. If that were you, I would possibly suggest getting a primary residence as that has many tax benefits and net worth benefits as well, just of a slightly different flavor. Owning a rental works best when you are trying to offset taxes incurred from your career.
Another thing worth mentioning is that the depreciation of the house must be "payed back" in a sense if you ever sell the property. An intelligent person would sell an investment property on a year when his/her tax bracket was lower to avoid the upper level tax bracket associated with being a high earner. Perhaps do it during retirement or a year of consulting that didn't go so well? This will not come into play ever if your plan is to hold the rental for the rest of your life, which many folks prefer because then they will never be forced to "pay the piper" so to speak.
With this article It was my goal to present to financial pioneers a better, smarter way to invest. I think the article should be read with a grain of salt and everything in this should be triple checked by any aspiring landlord.
I will say this again here: I don't want anybody to think that this is free money just waiting for the taking, it is in fact an investment of time, money, and intelligence which will allow you to partake of these benefits. If I were you I would calculate every single variable involved on a per property basis before you make any decisions. I would check multiple geographic areas to see if any are better suited to my needs. That's where the intelligence comes in. Also be sure you have an emergency fund which consists of 6 months available in adequate size to support yourself and your new rental property in the event that the unthinkable happens and you lose your job/tenants at the same time. Of course behind the scenes a mortgage broker would not even qualify you for an investment loan if you could barely scrape up enough for a down payment. That's where the cash comes in. Keep in mind that the ideas as presented above are best suited to obtaining long-term investment goals, and you must be prepared to dedicate yourself for many years to avoid short-changing the net worth gains. That's where the time comes in.