Just bought another 12% yield!

[amarowsky]

It's a little early to tell yet, but it looks like 12 to 13% annual yield.

Can you explain how you save on taxes and if/how you depreciate on your rental homes? (or point me to a place that explains it more simply).

I have been listening to Clayton Morris's podcast about RE investing. And they have a lot of tax information on there, but I was hoping there would be a more simplified method to research it visually and explain the process a bit better.

Congrats on the new property acquisition!

[TexasHusker]

Can you explain how you save on taxes and if/how you depreciate on your rental homes? (or point me to a place that explains it more simply).

I have been listening to Clayton Morris's podcast about RE investing. And they have a lot of tax information on there, but I was hoping there would be a more simplified method to research it visually and explain the process a bit better.

Congrats on the new property acquisition!

Great question!

I am no tax expert but here is what I have learned:

1. All items related to the running of the rental property - utilities, lawn mowing, repairs, maintenance, insurance, taxes, etc. - are tax deductible. So if you have $20,000 in rents, but $6000 in expenses, you report a net of $14,000 on your tax return.

2. Depreciation isn't a way to avoid taxes, but to defer them. Kind of like an IRA or 401K. People mistakenly refer to their contributions as "pre tax", when in fact they are tax deferred. Meaning Uncle Sam is going to get what he has coming, pay me now, or pay me later.

When you depreciate a property, you are electing to pay Uncle Sam later.

Here is how it works for a residential property:

You can depreciate the DWELLING value (not the land) over a 27.5 year period. To calculate your allowable depreciation, you take the DWELLING value and divide it by 27.5. That is your yearly depreciation, and you deduct it from your current taxes.

Let's say you own a rent house that you paid $200,000 for. The dwelling itself is worth $150,000. Divided by 27.5, that equals $5455 per year in depreciation that you can deduct.

BUT...beware the recapture! When you sell that home in 10 years for $300,000, your BASIS in the home has been LOWERED from $200,000 to $145,450 because you took the depreciation. So...your gain isn't $100,000....it's $154,550. So you're going to pay long term capital gains tax on that amount.

The nice part here is that you are paying LONG TERM CAPITAL GAINS TAX instead of INCOME TAX. That rate is around 50% less +/- of the income tax rates, so that is a big deal.

Real estate is the ONLY investment where OTHER PEOPLE are paying for YOUR investment. Every other investment, YOU are funding the investment. Folks brag a lot about an employer doing a 50% match on their 401K, and that's REALLY nice! But when you own a rental property, your tenants are paying 100% of the investment for you, plus putting some cash in your pocket, and they'll keep doing it from now on! That's the kind of match I'm looking for!

It's a cool deal. Even if you make a rotten buy (which I have done a time or two), you still come out way ahead in the end, because real estate just goes up over time, and YOU'RE NOT PAYING FOR IT.

[james.hendrickson]

Great question!

I am no tax expert but here is what I have learned:

1. All items related to the running of the rental property - utilities, lawn mowing, repairs, maintenance, insurance, taxes, etc. - are tax deductible. So if you have $20,000 in rents, but $6000 in expenses, you report a net of $14,000 on your tax return.

2. Depreciation isn't a way to avoid taxes, but to defer them. Kind of like an IRA or 401K. People mistakenly refer to their contributions as "pre tax", when in fact they are tax deferred. Meaning Uncle Sam is going to get what he has coming, pay me now, or pay me later.

When you depreciate a property, you are electing to pay Uncle Sam later.

Here is how it works for a residential property:

You can depreciate the DWELLING value (not the land) over a 27.5 year period. To calculate your allowable depreciation, you take the DWELLING value and divide it by 27.5. That is your yearly depreciation, and you deduct it from your current taxes.

Let's say you own a rent house that you paid $200,000 for. The dwelling itself is worth $150,000. Divided by 27.5, that equals $5455 per year in depreciation that you can deduct.

BUT...beware the recapture! When you sell that home in 10 years for $300,000, your BASIS in the home has been LOWERED from $200,000 to $145,450 because you took the depreciation. So...your gain isn't $100,000....it's $154,550. So you're going to pay long term capital gains tax on that amount.

The nice part here is that you are paying LONG TERM CAPITAL GAINS TAX instead of INCOME TAX. That rate is around 50% less +/- of the income tax rates, so that is a big deal.

Real estate is the ONLY investment where OTHER PEOPLE are paying for YOUR investment. Every other investment, YOU are funding the investment. Folks brag a lot about an employer doing a 50% match on their 401K, and that's REALLY nice! But when you own a rental property, your tenants are paying 100% of the investment for you, plus putting some cash in your pocket, and they'll keep doing it from now on! That's the kind of match I'm looking for!

It's a cool deal. Even if you make a rotten buy (which I have done a time or two), you still come out way ahead in the end, because real estate just goes up over time, and YOU'RE NOT PAYING FOR IT.

Very nice explanation Texas.

[amarowsky]

Great question!

I am no tax expert but here is what I have learned:

1. All items related to the running of the rental property - utilities, lawn mowing, repairs, maintenance, insurance, taxes, etc. - are tax deductible. So if you have $20,000 in rents, but $6000 in expenses, you report a net of $14,000 on your tax return.

2. Depreciation isn't a way to avoid taxes, but to defer them. Kind of like an IRA or 401K. People mistakenly refer to their contributions as "pre tax", when in fact they are tax deferred. Meaning Uncle Sam is going to get what he has coming, pay me now, or pay me later.

When you depreciate a property, you are electing to pay Uncle Sam later.

Here is how it works for a residential property:

You can depreciate the DWELLING value (not the land) over a 27.5 year period. To calculate your allowable depreciation, you take the DWELLING value and divide it by 27.5. That is your yearly depreciation, and you deduct it from your current taxes.

Let's say you own a rent house that you paid $200,000 for. The dwelling itself is worth $150,000. Divided by 27.5, that equals $5455 per year in depreciation that you can deduct.

BUT...beware the recapture!

The nice part here is that you are paying LONG TERM CAPITAL GAINS TAX instead of INCOME TAX. That rate is around 50% less +/- of the income tax rates, so that is a big deal.

.

My current strategy with my rental (and future rentals) will be to buy and hold until death. At that point I'll plan to 1031 the value to my beneficiaries, (I'm told this will allow them to acquire the inheritance at current value and trigger no additional taxation that I accrued with my depreciation).

I have 3 questions that seems fairly simple to answer,

1)Once a rental house is paid for, then I will only pay capital gains on my rent income less operating expenses, correct?

2) If I am claiming depreciation, is there anyway to replenish that value? Like say I replace a roof for $10k, that is necessary to maintain the home. I get to claim the tax deferment on the "roof repair" % of the $10k, but will that also increase the dwelling total value (that can be depreciated), so the depreciation will be either higher value or longer duration?

3) If my depreciation tax deferment amount is higher than the income (less operating expenses) for the house, does that spill over to defer my other capital gains income? Or even federal income tax? (say I depreciate 6000 a year and income after taxes is only 2400, can I use that extra 3,600 of tax deferment towards securities capital gains or other federal income taxes?)

I really appreciate you information TexasHusker, this is a great way to get my understanding straight.

[TexasHusker]

My current strategy with my rental (and future rentals) will be to buy and hold until death. At that point I'll plan to 1031 the value to my beneficiaries, (I'm told this will allow them to acquire the inheritance at current value and trigger no additional taxation that I accrued with my depreciation).

I have 3 questions that seems fairly simple to answer,

1)Once a rental house is paid for, then I will only pay capital gains on my rent income less operating expenses, correct?

2) If I am claiming depreciation, is there anyway to replenish that value? Like say I replace a roof for $10k, that is necessary to maintain the home. I get to claim the tax deferment on the "roof repair" % of the $10k, but will that also increase the dwelling total value (that can be depreciated), so the depreciation will be either higher value or longer duration?

3) If my depreciation tax deferment amount is higher than the income (less operating expenses) for the house, does that spill over to defer my other capital gains income? Or even federal income tax? (say I depreciate 6000 a year and income after taxes is only 2400, can I use that extra 3,600 of tax deferment towards securities capital gains or other federal income taxes?)

I really appreciate you information TexasHusker, this is a great way to get my understanding straight.

1. Rental income is taxed as ordinary income. Sorry if I confused this. Capital gains tax applies only as it relates to the basis and gain (or loss) of the underlying investment.

2. Certainly, there are durable items such as appliances, HVAC, new roof, etc., that you can depreciate. However, their schedule is a much shorter term than 27.5 years. This is an accountant question.

3. This is very definitely an accountant question, although right off hand, losses can be carried over.

Good luck - it appears you have a sound strategy!

[amarowsky]

1. Rental income is taxed as ordinary income. Sorry if I confused this. Capital gains tax applies only as it relates to the basis and gain (or loss) of the underlying investment.

!

I looked into this more, because I believe I am still confused.

It looks like I'm in the 25% tax bracket @ $67k for earned income.

So based off of this information, I would be federally taxed 25% of my profits for my rental.

On biggerpockets blog, I saw someone (who claims to work as a CPA) say "rental income is classified as passive income for tax purposes and is treated the same as any other form of business income except not subject to self employment taxes". From what I can see this is 15.3% (self employment taxes).

Q: Lets say my rental is earning me $100/mo $1200/year as profit. Would you (or someone) be able to explain how that would be taxed? (feel free to include my 67k income @25% tax as part of this hypothetical situation).

[TexasHusker]

I looked into this more, because I believe I am still confused.

It looks like I'm in the 25% tax bracket @ $67k for earned income.

So based off of this information, I would be federally taxed 25% of my profits for my rental.

On biggerpockets blog, I saw someone (who claims to work as a CPA) say "rental income is classified as passive income for tax purposes and is treated the same as any other form of business income except not subject to self employment taxes". From what I can see this is 15.3% (self employment taxes).

Q: Lets say my rental is earning me $100/mo $1200/year as profit. Would you (or someone) be able to explain how that would be taxed? (feel free to include my 67k income @25% tax as part of this hypothetical situation).

1. You are correct - your rental income is taxed at your applicable tax rate.
2. It is considered passive income. If you have losses, they are passive losses.
3. Rental income IS NOT subject to self employment tax.

[amarowsky]

1. You are correct - your rental income is taxed at your applicable tax rate.
2. It is considered passive income. If you have losses, they are passive losses.
3. Rental income IS NOT subject to self employment tax.

I believe I understand now.

So if I was at 25% level, and I make $1000 after my expenses, it'll just be a straight $250 going to Uncle Sam.

It seems like though depreciation I will still be receiving an advantage for quite some time. So I can't really complain.

Thanks a bunch for the info T-Husker, I appreciate the effort you provided to support my questions. I'm excited to pick up another rental.

Although, in the area I'm looking around my average ROI will only be between 8 - 11% (this is under the assumption that my net income will only be 60% of my gross rent). So 12%+ doesn't seem so viable in my planned purchase area for new properties. Still, it's hard to say no to such a high ROI.

Congrats again on your new purchase!

[TexasHusker]

I believe I understand now.

So if I was at 25% level, and I make $1000 after my expenses, it'll just be a straight $250 going to Uncle Sam.

It seems like though depreciation I will still be receiving an advantage for quite some time. So I can't really complain.

Thanks a bunch for the info T-Husker, I appreciate the effort you provided to support my questions. I'm excited to pick up another rental.

Although, in the area I'm looking around my average ROI will only be between 8 - 11% (this is under the assumption that my net income will only be 60% of my gross rent). So 12%+ doesn't seem so viable in my planned purchase area for new properties. Still, it's hard to say no to such a high ROI.

Congrats again on your new purchase!

Thank you. In the real estate world, ROI is called the "CAP" rate. So if you have a $100,000 piece of real estate that yields 10%, that is a CAP rate of 10%, etc. So the higher your CAP rate, the higher your return.

Generally, though not always, the higher the CAP rate, the higher the risk and/or time investment. As an example, I know a fellow here who holds a large portfolio of lower-income housing. The types where folks pay by the week, and often in cash. His CAP rate exceeds 20 percent. On the other hand, it takes a lot his time and energy - chasing rents, fixing lots of things, and so forth.

Vacation rentals can certainly have a CAP rate of 12%, but how do you feel about owning a rental 1,100 miles away? There's a diarrhea factor in there. Is it worth it to you? On that front, I decided to either "go big or go home." In other words, if I was going to take that risk, I was going to get set up to better manage the risk: Start my own management company, buy more properties, etc.

I have also owned rental properties locally - single family homes - that had a CAP rate of around 9-10%. That's not that hard to achieve.

[amarowsky]

Thank you. In the real estate world, ROI is called the "CAP" rate. So if you have a $100,000 piece of real estate that yields 10%, that is a CAP rate of 10%, etc. So the higher your CAP rate, the higher your return.

Generally, though not always, the higher the CAP rate, the higher the risk and/or time investment. As an example, I know a fellow here who holds a large portfolio of lower-income housing. The types where folks pay by the week, and often in cash. His CAP rate exceeds 20 percent. On the other hand, it takes a lot his time and energy - chasing rents, fixing lots of things, and so forth.

I have also owned rental properties locally - single family homes - that had a CAP rate of around 9-10%. That's not that hard to achieve.

Thank you for more clarity on CAP rate.

I have been lurking all over bigger pockets, REIclub.com, and listening to Clayton morris's podcast (focus on class C (cheaper single family homes in working neighborhoods)).

Clayton has a CAP rate calculation that I like.
Take annual total income from rental X .6 (40% Fees subtracted for PM +Vacancy + Repair + taxes ) / Home purchase price. He would refer to that as ROI (seems very similar to cap rate, just adjusted for fee's).

So the houses I'm looking at are in the 65-80k range, and rent for $950-1150/mo.

So my CAP rate would be (in the middle) = 1050*12 = 12600 / 75k = 16.8%

His ROI would be = 12600 * .6 = $7560 / 75k = ROI 10%.

I guess as long as that remaining $7560 is over the financing cost, then you're in the black. It seems like a good conservative yardstick to measure.

Would there be a standard real estate term for CAP rate minus Fees?

Also I'd like you to comment on his basic formula (and I'm also posting a question in the property management thread I would love for you to respond to!)

[TexasHusker]

I think his formula is sound.

I do add back in the taxes I am saving from depreciation as part of my ROI or CAP rate.

For residential residences, I also budget 1 month per year vacancy just to be conservative.

So if monthly rent is $1000, I figure $11,000 per year. If it's rented all year, that is a bonus.

Houses of that rental amount are generally going to have higher turnover, just because you are dealing with lower-income folks. I don't know why, but it's true. You may need to budget 2 months of vacancy per year.

[bjl584]

Bigger Pockets has an excellent series of podcasts. There are several hundred of them and counting. They are also on YouTube.

I know a gentleman here locally that buys rehabs for cash. Fixes them, rents them, refinances them with a lender, takes the cash out from the reappraisal and uses it to buy another property. In two years he has created a portfolio of 13 houses. Sometimes it's as easy as a coat of paint and new carpet. The bank will reappraise at $30K higher than purchase price. Just be mindful of the area you are buying. The best deals aren't on the MLS. Pound the pavement, look for places that look vacant and track down the owner, talk to family and friends. Some of the best deals are buying from other landlords that are tired of it or who don't know what they are doing. They might be willing to offload their portfolio at a discount just to get rid of it.

[TexasHusker]

I actually have found that MLS is my best tool. And I'm not swayed by an over-priced house.

Back in 2006, there was a nice 3/2/2 house near me that they were asking $179,900 for. That was around FMV for the house, but I offered $150K and closing in two weeks and they accepted. It's been rented for $1500 a month every month since, to the same renter - though I personally don't own it any more - I sold it to use the funds to open another business.

I asked the sellers later why they accepted the offer, and they said "we were moving three states away, owned it outright, and were just ready to be done with it."

I've been there!

[LivingAlmostLarge]

Interesting how sometimes you just want to get out.

[amarowsky]

I do hear that a lot of R/E investors use the 1% rule as the roughest calculation for a viable property. 1% rule being, as long as you can rent the house for 1% of total value, then you should be able to rent at a profit.

TH above situation follows this. $150k house, rents for $1500/mo.

There are a LOT more calculations that can skew this (taxes, area, x, y, z, etc..)

But it is a pretty good jumping off point for considering a property.