The Nine Amazing Benefits of Owning Rental Property
Many people have thought of buying rental property yet only a small percentage actually follow through and make it happen. Part of the reason is that if it were easy to do and to make it profitable, everyone would be doing it. Another reason is that many people, even with the means, do not know how to do it right. In addition, some people are afraid of being a landlord or feel that they don’t have the time or expertise. Here are nine reasons why people who can swing it without great risk of overextending themselves should do it.
Residential real estate tends to appreciate over time, other than special cases like increasingly blighted areas or one-industry towns which lose that business. While we’ve seen eye-popping gains in real estate values in the past few years (10%, 20% or more per year in some areas), typically one can expect about 3%-5% yearly appreciation on average historically. When you consider that most real estate purchases are leveraged – in other words the investor puts a small amount of their capital into it and borrows the rest – this increases the effective return on their investment as a result of appreciation.
A quirk of the tax code that remains a benefit for investment property owners is the ability to deduct depreciation on their tax return. It seems counterintuitive when real estate, in reality, tends to appreciate not depreciate. The depreciation deduction is a great benefit because it is a non-cash expense. One can deduct the purchase cost of the “improved” value of the property typically over 27.5 years. For example, if you bought a single family rental for $400,000 and you estimate that the improvements are 65% of the total value (land being the other 35% which is not depreciable), you can deduct as an expense $260,000 over 27.5 years, or $9,454 per year. This reduces your taxable gain on the rental income, and in many cases the depreciation helps you report zero taxable gain, yet depreciation is not cash out of your pocket. The downside is eventually when you sell the property you will need to “recapture” everything you depreciated at 25% federal tax. Yet, this tax is deferred, and deferral of tax is another incredible benefit…
3) Tax Deferral
Tax deferral is one of the greatest wealth-building benefits of real estate investing, because as your real estate appreciates, you do not pay tax until you sell. You can hold indefinitely and refinance the property to invest elsewhere, all tax-deferred. Now, since real estate is illiquid and requires a good bit of capital, many investors need to sell to take advantage of other investing opportunities. In this case, the tax code still allows them to do what is called a Starker Exchange, or a “1031 exchange”. You can sell a rental property and roll over all the proceeds to a new investment property and defer all capital gains and depreciation recapture taxes, within strict IRS guidelines on procedure and timing. An investor who uses this strategy methodically could defer taxes forever. In practice though, most people find a need for the proceeds and decide to take the tax bite instead.
4) Tax Rate
Federal state and local regular income taxes can cost you 30%, 40%, 50% or even more in certain high-tax states on regular earned income. Real estate sales are taxed at long term capital gains rates (if held for more than a year), which is 15% typically, and 20% or 23.8% for certain high income earners on federal taxes, plus smaller amounts varying by state. In addition, you can deduct from your gain any improvements made to the property, like a new kitchen. While your rental income is subject to regular income tax rates, you can deduct almost every expense related to the property (unlike the home you live in), plus depreciation as mentioned above, which significantly reduces or even eliminates in some cases taxable rental income.*
5) Your Tenants Pay Your Way
Think about paying rent – your money goes to someone else and you get no tax benefit on your payments. A landlord who has prudently invested for positive cash flow (rent exceeds the total of the mortgage payment plus taxes and maintenance, but not including depreciation) effectively pays off their mortgage with the rent money. While the property is appreciating, the landlord in building additional equity by paying down the mortgage balance with no out-of-pocket cash! Eventually, if the investor holds long enough, the property is mortgage free and worth much more than the purchase price. Often this is a great strategy for a retirement nest egg.
6) Tax Elimination
Let’s say that you are getting up there in age and you’ve been holding your investment property for decades. You have a huge taxable gain if you sell and facing full depreciation recapture. You figure you don’t really need to money anymore as you are financially secure and you would rather leave your asset to your heirs than spend it all yourself. Real estate that transfers to your heirs when you die gives them a “stepped up basis” for the property. For example, if you paid $100,000 two decades ago and now it is worth $500,000, and the heirs decide they will sell your property and get $500,000 for it, their capital gains tax will be zero because their stepped-up cost basis is $500,000. This assumes your estate would not be subject to high thresholds for estate taxes, which is a different consideration.
7) Passive Income
If you are a wage earner and you don’t have tenure at a university, or a sweet executive golden parachute, or you are not a Supreme Court justice, likely you are to some degree at risk of losing your job. Having income from rental property is excellent security as another source of income in case you lose your primary source. You cannot get fired from your investment property. Yes, you can have your income reduced based on economic downturns, or from vacancy for one reason or another, but with prudent management of your property and your tenants, a knowledge of the best areas to invest and an investment criteria of positive cash flow, you will be much more secure.
8) Inflation Hedge
This one is a timely benefit of owning a rental property now that we are seeing reported inflation at 8-9% across the country, while many are experiencing significantly higher cost of living inflation. Property values during this inflationary period have soared. Rents are rising almost everywhere. Who is benefiting? The investment property owner. Who is suffering? The renters living paycheck to paycheck. Real estate tends to be an excellent inflationary hedge.
9) Financial Options
If you have an investment property which appreciates over time and you have positive cash flow each month on the rent which pays down your mortgage, you are much more financially free than those living paycheck to paycheck and trying to save money to invest. Saving after-tax wages with the hope of eventually becoming financially independent tends to be a challenging strategy for all but the highest 1% of earners. Rising taxes, economic downturns, job losses, inflation and personal setbacks all tend to work against the wage earner seeking to get to financial freedom eventually. For all the reasons above, owing rental real estate is one of the best paths to financial security and the freedom to do what you want with your life.
* Note that the tax code restricts certain deductions such as depreciation and taxes based on the filer’s tax status, whether they are a “real estate professional” and their individual scenario. Any investment strategy which incorporates a tax strategy should be reviewed with a tax professional to evaluate your specific situation.