Fritz and Company - Investing in Real Estate

 

Should you invest in rental real estate?

If you want to make a profit by investing in rental real estate, you must be willing to commit more resources to this property than you would to an investment made at your bank, through a broker, or in a mutual fund.

Someone has to collect rents, find good tenants, and maintain the property. If you hire help to do these tasks, your profits shrink.

Also, if you borrow money to buy the property, you have to pay the mortgage whether or not the property is rented. You should have emergency funds so that you will not lose the property to foreclosure if you lose your tenant.

If you decide to invest in rental property, you may need professional help to match your resources to property that will meet your goals. Some of the questions you should consider before you invest:

  • What can you afford? Determine the highest price range you can sustain, given your present resources and the projected cash flow from the property.
  • Is the property fairly priced? Get a list of comparable listings and recent sales from a real estate company. Make any purchase offer contingent on the results of structural and pest inspections. Check local records to verify that additions and major improvements were made in compliance with building codes.
  • Are there any restrictions on the property? Rent control will lower the price that you can afford to pay for a property.
  • Who will be your tenants? Evaluate the likelihood of non-payers, transients, and untidy housekeepers and adjust your price accordingly. If you are buying a condominium in a building populated with young people, you may find it difficult to interest a retired couple (if that's your market) in living in the unit.

Investing in rental property can be very profitable, but you should be fully informed before you invest, or you could end up with more work and less return than you anticipated.

How to calculate cash flow from rental property

Now that real estate tax breaks have been cut significantly, it's more important than ever to see good economic reasons for owning rental property. Here's how to calculate the cash flow from an investment in rental property.

First, calculate taxable income or loss from the property. Taxable income or loss is rent received minus three types of expenses: operating expense, depreciation, and mortgage interest expense.

Assume the purchase of a single-family house for $125,000, of which $25,000 applies to the land and $100,000 to the building. Depreciation of the cost of the building is a tax deduction even though depreciation is not paid out in cash each year. However, the deduction must be spread over 27.5 years. Divide the $100,000 cost of the building by 27.5 years. Your depreciation expense is $3,636 per year.

Assume a cash down payment of $30,000 and a mortgage loan of $95,000 for 25 years at 10%. The first year's payments would be $10,359 including about $9,459 of tax-deductible interest.

Suppose the property is rented for $12,000 a year, and the total of operating expenses paid by the owner, such as property tax, insurance, and repairs, is $2,500. Subtract from rental income of $12,000 the three types of expense: depreciation ($3,636), interest expense ($9,459), and operating expense ($2,500). The result, for tax purposes, is a rental loss of $3,595.

The tax rules on rental losses are different if you're a real estate professional. But if you're not a professional, here's how your rental loss could affect your income tax.

If you actively manage the property and your adjusted gross income does not exceed $100,000, the rental loss (up to a maximum of $25,000) could be deducted from other income such as salary, interest, and dividends. Multiply the rental loss by your federal income tax rate (in our example, 31%). The federal tax avoided as a result of this deductible rental loss is $1,114.

 

Rental income   $12,000
 Plus: Tax savings + 1,114
 Less: Operating expense - 2,500
 Less: Mortgage payments - 10,359
CASH FLOW + $255

 

The investment just about "breaks even" on cash flow. The owner's equity in the property increases each year as the mortgage loan is paid down. Any increase in the value of the property during the years of ownership will increase the owner's ultimate return. The owner's ultimate return on the property will be affected by any taxes paid on the gain when sold.

Calculating the cash flow on a rental property investment you're considering will help you decide whether the investment is a good one. You may want to avoid investments with a negative cash flow because you'll have to come up with additional money to cover operating costs and debt payments.

Call us for assistance in evaluating rental property investments.

We are here to help.

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