Rental Real Estate

Rental Real Estate
Investing in rental real estate has long been considered a smart way to build equity in an appreciating asset while enjoying significant tax benefits. However, with every new piece of tax legislation, Congress seems to whittle away at the tax breaks for real estate investors.

Today, tax breaks alone no longer justify an investment in real estate. However, if the investment is economically sound, tax benefits can enhance your return.

The Basic Rules
To make investments in rental property pay off, you should analyze taxes and cash flow. Here is a simple example to illustrate the basic rules.

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 cash down payment of $30,000 and a mortgage loan of $95,000 for 25 years at 8%. The first year's payments would be $8,799 including 
   about $7,555 of tax-deductible interest. 
Suppose the property is rented for $12,000 a year, 
and operating expenses, 
    such as property tax, insurance, and repairs, total $2,500.
To calculate the taxable income (or loss) from the property:  

You will subtract from the
 rental income of                    $12,000
the three types of expense
 depreciation                           - 3,636
 interest expense                    - 7,555
 operating expenses               - 2,500
 the result, for tax purposes                 .

is a rental loss                       $(1,691)
============================== 
The tax rules on rental losses are different, if you are a real estate professional. But if you are not a professional, here is 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.
In this example, multiply the rental loss of $(1,691) by the federal income tax rate of 31% bracket, the federal tax avoided as a result of this deductible rental loss is $524.
Cash flow can now be calculated:
Rental income                         $12,000
Plus: Tax savings                        + 524  [Rental loss $(1,691) x 31% tax rate] 
Less: Operating expenses        - 2,500
Less: Mortgage payment          - 8,799
.                                                            .
Positive Cash Flow                   $1,225
=============================== 
The investment produces a cash flow of $1,225 in the first year. Your equity in the property would increase each year as the mortgage loan is paid down. Any increase in the value of the property during your years of ownership will increase you ultimate return.

Calculating the cash flow on a rental property investment you are 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 will have to come up with additional money to cover operating costs and debt payments.