Many individuals invest in residential rental property and find that with the right property and the right planning, being a landlord can be financially rewarding. The following are five financial advantages that can make investing attractive:
1. Use of Borrowing Power
With real estate investing, there is a benefit to using debt to increase the ability to purchase, especially if multiple properties are involved. One property can be leveraged to purchase the next. As additional properties are purchased, the an investor’s cash outlay can potentially decrease if the property values have increased enough to support the next purchase.
2. Cash Flow
If the rents charged exceed the cash carrying costs of the property, the result is positive cash flow. Cash carrying costs take into account real estate taxes, debt service, insurance, capital improvements, repairs and maintenance, utilities, association fees, and management fees. Many retirees use income streams from rental properties to supplement or provide for retirement income.
3. Increased Investment
If the property is mortgaged, part of the cash carrying costs noted above include the principal portion of the monthly mortgage payment. This amount is not truly an expense of the rental property, since it builds equity in the investment. Consider this the dividend reinvestment program of the real estate world. Also, the hope is always that real estate markets will flourish and the fair value of the property will grow. However, as with stock that appreciates, the only way to realize that appreciation is to sell the property.
4. Tax Deductions
While rental income is taxable, it comes with some viable potential tax deductions. Taxable rental income can be reduced by cash expenses, including some of the same costs listed under point two above – real estate taxes, mortgage interest, insurance, repairs and maintenance, utilities, association fees, management fees (or travel costs to and from the property if the property is self-managed rather than serviced by a third party manager).
5. More Tax Benefits
Depreciation – In addition to the tax deductions above, depreciation deductions can be claimed, which are essentially the write-off of the original costs of the buildings and improvements. Many landlords end up with positive cash flow investments, while reporting tax losses, because depreciation is not a cash expenditure, but still results in a tax deduction.
Qualified Business Income (QBI) – The Tax Cuts and Jobs Act now gives landlords another potential benefit. The rental activity may be considered QBI-eligible activity, which is effectively taxed at a lower rate than ordinary income. Restrictions apply here, as QBI application and calculations are complex, but many residential rental owners that self-manage their properties find that they qualify for a benefit.
Passive Losses – Rental losses that are subject to “passive loss limitation” (for those in higher income tax brackets) do not reduce current year ordinary taxable income, but the benefits of these losses are never lost. These losses carry forward indefinitely, first reducing taxable rental income in future years, and finally reducing gain (or increasing loss) at the time of disposal of a property.
Mortgage Interest – Mortgage interest deductions can be taken on mortgage amounts up to the original purchase price of a property. As a property appreciates in value, it is possible to refinance the property and extract additional equity and the interest will still be deductible. Many investors use this tool to extract equity from rental properties in order to purchase the next property, and in this way, grow their business.
Residential real estate investments are usually considered mid- to long-term types of investments, so patience is key. The industry is cyclical, the housing market tends to reflect what is happening with interest rates, and being a landlord isn’t for everyone, but real estate is, for the most part, a solid investment and ownership can be a way to increase wealth and cash flow for a savvy investor.