Rental properties aren’t only about the leftover cash at the end of each month. I mean, sure, that’s the easiest one to understand. You charge so much rent each month, subtract all your expenses and whatever you are left over with each month is what you get to keep. There’s so much more!
I just wrapped up my first year tax year as a real estate investor. As I was wrapping up my taxes (boy was that a learning experience!) I realized that my finances benefited from my first rental property from more than just the cash in my bank account.
The best news? It’s really not that complicated and I’ll walk you through the basics of each of these in this post. Most of these you are already familiar with you’ve just never contemplated them from the standpoint of a real estate investor.
In this post, I’ll start out with a hypothetical real estate purchase and then explain each of the four ways real estate adds to your net worth.
A hypothetical real estate purchase
I think the best place to start will be a hypothetical example. Let’s assume we buy a rental home for $100,000 and we put 20% down. We finance this with a 30 year, 4% loan.
I won’t do a deep dive on property analysis but the simple explanation below will give you an idea of the cash flow a home like this may see.
Take a look and familiarize yourself a bit because this is the key to all the numbers that we’ll discuss later.
The 4 types of returns from real estate
From here we’ll take a look at each of the four types of returns you’d get if you purchased this rental property. To make it simple we’ll take a look at each of the types of returns on an annual basis.
A few key assumptions to point out before we dive in:
- Our downpayment was $20,000
- we also had $3,000 put towards repairs and closing costs
- The monthly rent is $1,050
- The cash flow each month is $133.07
This is the first one everyone thinks of and the easiest to grasp. This one is the simplest. If we get $133.07 in monthly cash flow we’d have $1,596.04 (133.07*12) in cash at the end of the year.
Total Cash flow: $1,596.04
The other beautiful thing about owning a home and having someone pay rent is that they’d be paying the mortgage down for you. Below is a screenshot of a mortgage calculator with the inputs provided above.
If you look at the bottom of the “Cumulative Principal” column you’ll see that in the first year of the mortgage there was $1,408.83 paid off on the loan. With each passing year, this number will increase which means we’ll “make” more money each year. For now, lets stick with year 1.
Total Principal Paydown: $1,408.83
The third type of return that you get on your rental property is appreciation. I’ll caution you right now, never buy a home for appreciation only. Make sure you going to get sufficient cash flow.
You never want to buy a home that doesn’t cash flow only betting on appreciation. However, if you have a home thats spits off cash each month the appreciation truly is the icing on the cake.
According to this site, homes have appreciated 3.8% a year on average. I’m an engineer by nature so lets divide that by two to give us some cushion (3.8%/2 = 1.9%).
So in the first year the home will appreciate by taking the home purchase price times half the reported annual appreciation (100,000 * 1.9%).
Total Appreciation: $1,900.00
I’ll be the first to tell you I’m no accountant or tax expert. However, after just wrapping up my taxes for the first tax season as a real estate investor I have learned a ton.
There are two tax benefits of being a real estate investor. The first is that now you are a business owner. Therefore, some of your personal expenses MAY now become business expenses. Some of the easy ones maybe a home office, some of your phone bill, your internet, things like that.
Again, talk to your accountant about those items but they are all things to consider.
The more set in stone tax benefit is something called depreciation. Essentially, the government assumes the value of your home is decreasing in value each year so you get to put an expense on your books that doesn’t take a dime out of your pocket.
The calculator (for estimation purposes only) is pretty straightforward.
According to the IRS, the building value of a rental property can be depreciated over 27.5 years. So to calculate this you take the purchase price minus the value of the land and divide that by 27.5.
The value you just calculated then goes on your books as a fictitious (may be a strong word) expense.
In our example, let’s say our $100,000 home assessed for $15,000 land value and $85,000 for the value of the building.
So you’d take $100,000 minus $15,000 and divide by 27.5.
Total Depreciation: $3,090.91
Now that isn’t necessarily a straight return you are getting. Instead, that expense is keeping you from paying taxes on that income.
Because rental income is taxed at 15%, that depreciation is essentially helping you avoid paying taxes on your rental income.
So the actual return we are getting is taking the total depreciation and multiplying by 15%
Total Tax Benefits: $463.64
Adding this all up
Now that we’ve gone through each type of return you get from a rental property let’s add them all up:
That’s not a bad return. As a reminder, we invested $23,000 into this which means we got a 23.3% return on our investment. That type of return is great.
One thing to keep in mind when comparing that return to other asset classes is that a good majority of the returns, primarily principal paydown and appreciation, aren’t liquid. Those two pieces are just equity you are building up in your home.
There are ways to take advantage of these but it isn’t as simple as just clicking sell.
For instance, if you had an index fund that returned 23.3%, your balance would go up by that amount.
Wrapping it up
I hope you’ve learned a lot going through this exercise. I can’t emphasize enough that I am not a tax or legal professional. The first time I realized all four types of return I had to do the math again to do it.
If there’s one thing I have learned about real estate is that it’s not complicated. Sure, there are things you need to learn but it’s not rocket science.
The key to something like this is that you are patient. Investing in this asset class isn’t going to be a get-rich-quick type of thing. However, real estate can create an immense amount of wealth over time if simply taken care of and left alone.