3 Step Approach to Maximizing the Magic of Depreciation in Rental Real Estate

So, you have an interest in real estate and want to understand exactly how owning investment real estate can benefit your bottom line. Congratulations on taking the first steps.

Before I start, keep in mind that I am not a CPA. The numbers/assumptions below have been simplified to make the ideas easier to understand, so you are advised to run any questions by your trusted tax professional or CPA prior to any property purchase. Tax law changes often, and there are many criteria that investors have to meet to benefit from the many tax benefits of investment property ownership. I am using the following example for illustrative purposes only.

Assumptions (for simplicity):

Your annual gross income is $50,000
Your federal income tax is a flat 25% and your state income tax is a flat 10%
You purchase a modest $100,000 single-family home for rental purposes of which $10,000 is the value of the land.
Your monthly principal and interest mortgage payment on the rental home is $550, of which $450 is mortgage interest
Your property taxes are $600 per year (i.e. $50 per month)
Your insurance is $300 per year (i.e. $25 per month)
You rent the home for $950 per month
You pay a property manager $75 per month to manage the property for you and handle all tenant issues so that you don’t have to spend time on these.
You hold the property for 5 years
Appreciation in your area averages 3% per year

Your financial benefits of investment property ownership are many and can include cashflow, interest and depreciation deductions, principal payoff and appreciation. We’ll walk through each of these benefits below.

Cashflow

Cashflow is the difference between the rents you receive on a property minus the mortgage and other expenses you pay out. On this property you will receive cashflow in the amount of $950 -($550+$50+$35+75) = $240 each month. This passive income is real money in your pocket. So, to start you just gave yourself a $2880 annual raise just by purchasing this investment property. (It’s nice not having to ask your boss for a raise, isn’t it?)

Interest and Depreciation Deductions

Rental property owners can write off the amount of interest they pay on loans used to acquire or improve rental property. The IRS also requires real estate investors to depreciate their investment property. Depreciation is a “paper loss” that is required to account for estimated wear, tear and obsolescence. The value of the land that your rental home sits on, however, is not depreciable (as land rarely loses its value). In our example, residential investment property is depreciated over 27.5 years on a straight-line basis (your CPA can advise you on other methods of depreciation).

The value that you can depreciate is $100,000-$10,000 = $90,000

Therefore the annual depreciation deduction that you can take is $90,000/27.5=$3272.73

and the annual interest deduction you can take is (450*12)= $5400

So, without the rental property, you would have paid $50,000*(10%+25%) = $17,500 in taxes.

And with the rental property, you will only pay ($50,000-$3272.72-$5400)*(10%+25%) = $14,464.55 in taxes.

So, the rental property saved you an additional $3,035.45 in income taxes! (And this doesn’t take into account additional tax deductions for insurance, property management fees paid, property taxes and any allowable improvements/repairs made to the property). Imagine that; Uncle Sam requires you to pay less in income taxes as a rental property owner!

Principal Payoff

Over the 5 years that you own this property, your tenant’s monthly rent payments are paying off the mortgage for you. At the end of year 5, you should owe approximately $92,300 on your mortgage; down from your $100,000 purchase price. This is an additional $7,700 in value for you! How does it feel to make money while you sleep?

Appreciation

History has shown that over time, real estate appreciates. Appreciation rates vary by location so check with your local real estate expert (me!) for historic rates in your area. Don’t bother asking about future rates as no one has a crystal ball. (And if they give you an answer run the other way…FAST!) Just know that the historic trend over time from the early 20th century forward has been favorable. For this example, our conservative assumption of a 3% annual appreciation rate, when compounded over 5 years, gives your property a value of $115,927.40 at the end of year 5. This is an additional $15,927 in value that you didn’t have to lift a finger to earn!

Overall, your financial benefits after 5 years of ownership total:

drumroll please…

($2880 *5)+($3035*5)+($7,700 )+($15,927 )= $53,202!!! And this is from only one property. Imagine the power of these benefits with a small portfolio of properties. This is how real estate can propel you to early retirement. It doesn’t take outrageous amounts of money or huge investments. Just a slow and steady real estate investment plan that you consistently act on over time. If you’re not sure where to start, feel free to contact our office and we can work with you to create an investment plan that will work for you.

How NOT to waste $30 per day for the rest of your life

The numbers above are the very reason why many investors hold investment property in their portfolios. The $53,202 above equates to just under $30 per day for just one small property owned. ($29.15 to be exact). So, if you’re on the fence about investing in real estate and need a bit more time to mull it over, be sure to add up the 30 bucks you’re missing out on each night that you go to sleep without action! On the other hand, if you’re an action-taker and want to start earning your $30 “sleeping money” every night, get the ball rolling today, and buy rental property!

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