Headlines scream “America is becoming a nation of renters!” Renting instead of buying a home is a growing trend for a number of reasons. The Millennial generation is living with their parents and carrying high student loan debt, jobs are difficult to find, and mortgage requirements are tougher these days. It is a tough economy, but there is one group enjoying this trend, single family rental home investors.
There are solid financial reasons for the dominance of small investors in this space; many owning only one to three rental properties.
- ROI, Return on Investment: The average savings account interest rate is very tiny these days, and the stock market is always risky. The average rental homeowner is banking double-digit returns through cash flow and tax advantages of rental property ownership. This isn’t hype:
a) $125,000 home purchase with $25,000 down payment.
b) $200 positive monthly cash flow after mortgage payment & expenses.
c) That’s 9.6% cash-on-cash invested for an annual return.
d) Then the tax advantages can be rolled in as well.
The return number comes from $200 x 12 months for $2,400 annual cash flow from rents over mortgage and expenses (a conservative number). Since only $25,000 cash is invested, we get the 9.6% number.
- Tax Advantages: Consult an accountant, but generally the owner of rental property can deduct all expenses for management, taxes, insurance, and maintenance, but there’s something even better. Depreciation of a rental home over 27.5 years is currently allowed by the IRS. You must break out the structure value, as you can’t depreciate the land. However, in our example above, if $25,000 is land value, the remaining $100,000 would be structure value. $100,000 / 27.5 = $3,636/year in depreciation deduction against income. Whoa! What we just did was completely wipe out our $2,400 in income for taxes!
- Inflationary Hedge: While savings accounts and bond interest suffer from inflation, and these days actually can yield a negative return at current rates, real estate normally fares much better. When the cost of materials and labor rises through inflation, the cost to build a home rises as well. A rising tide floats all boats, so values of homes generally hold well or rise with inflation. Your bank account may be losing, but your home value is hedging that loss.
- Grow Your Net Worth: As you pay down your mortgage balance and the property appreciates in value, your equity increases, which increases your net worth. You have another resource from which to borrow if you want to leverage your investing.
- You Can Take It With You!: If you choose to grow your real estate investment portfolio over time, you can take advantage of the IRS 1031 Tax Deferred Exchange rule to defer payment of capital gains taxes. Let’s say that you own a small rental home for a number of years and decide to sell it with a nice profit over your cost basis. If you follow the rules for this exchange (carefully), you can buy another investment property, larger and more expensive, and not have to pay any taxes on your gains. You simply defer them until later if you liquidate your full investment. If you do not, you can leave your properties to your heirs, and their inheritance is valued at the “stepped-up” current appreciated value of the properties. In other words, all of that gain disappears! Yes, you can take it with you in a sense!
If you’ve considered real estate but haven’t taken the plunge, perhaps this little list of goodies will help you to investigate further.