Tag: real estate

Tax Deductions in Real Estate Rentals

deductions in rental real estateRich people love to rave about how they were able to reduce their tax burden. How about paying 15% in effective taxes on a $1,000,000 income? In the United States, laws favor those who are small business owners. In the previous post, I discussed fundamental ways that one makes money from rental real estate. Here I will go over some of the more common ways to reduce your tax burden as a landlord in the real estate business.

Why are tax deductions important?

Running a real estate business is not easy. You are basically taking out a loan to purchase an expense property to generate cash flow while hoping that the property appreciates over time. This is by no means passive—things break, renters can be deadbeat, your property can go unrented—in essence, in real estate you are hoping to generate a stream of growth on the money that you locked down. Can you get 4% growth? How about 7%, 9%, or more? Whatever you do in real estate, make sure you end up with more money that you started, beat inflation, and get a tolerable return for the effort you put in.

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Fortunately the U.S. tax system allows you to offset your paper gains with many of the expenses of running a business. If you do venture into the real estate business, make sure you are taking advantage of what is available to you.

Common deductions that you can tax in your rental real estate business.

  1. Mortgage interest is deductible. Most landlords will obtain bank loans to finance the purchase of a rental property. The interest on the mortgage paid every year can be deducted from the business earnings to reduce your tax burden. Uncle Sam is effectively reducing your marginal income tax if you spent that amount of money on interest payment on a loan!
  2. Depreciation of real property — Depreciation is a complex subject that is beyond the scope of this generalized overview. However, depreciation should be construed as MONEY IN YOUR POCKET. Commercial real estate is treated differently than residential property. In the broadest sense, real estate for tax purposes loses value over time. The amount lost can be used to reduce your tax burden. For instance, residential real estate can be depreciated over 27.5 years. This amount only includes the building structure, and not the land. So if you purchase a home for $500,000, with the land accounting for $150,000 of the purchase price, you can divide up the remaining $350,000 cost of the home to depreciate over the next 27.5 years. Yes, this seems like a long time, but the amount becomes quite substantial over time, especially if you can keep generating rental income in your property.
  3. Repairs — Things break. Fortunately if a critical component of your rental property needs to be repaired, you can use that to offset income. There is a fine line in this perk. If the roof needs to be replaced, the fan on the AC air handler breaks, or the garage door needs to be patched, these costs can be deducted from your income. The rules are quirky too. If you pay the HVAC person to clean your AC fan for $50 because it wasn’t working well, you can deduct the cost of your repair. If you do it yourself, you cannot.
  4. Personal property — Items such as carpets, furniture, and appliances used in a rental property can also be depreciated as personal property. This means that the cost of this type of item can be depreciated over 5-7 years instead of the 27.5 years for the building itself.
  5. Insurance — You can essentially deduct any insurance you pay for your rental property from your income. This includes fire, theft, landlord liability insurance…etc. Not bad!

There are plenty of other nuances in the U.S. tax system that allows real estate investors to maximize their options for reducing income tax. You can’t do this with other types of investments.

The caveat of tax deductions for high income earners.

Remember, you are a highly paid professional. Maybe even a neurosurgeon. Maybe you are a horrible businessman (or woman) with no ideal how to operate a real estate business. You still forge ahead and buy real estate to rent out to your unsuspecting neurosurgery residents (they are locked into your rental for at least six years!) You lose money in the process. Can you deduct your losses from your professional income as a surgeon?

Unfortunately not.

The tax system does forgive lower income folks with rental property. (lower income is obviously a relative term) If you earn less than $100,000 a year from your current job, you are allowed to offset up to $25,000 in rental business losses from your earned income! This deduction benefit phases out until an earned income of $150,000, where you don’t qualify at all. The neurosurgeon earning $600,000 of annual income will not receive any remorse from Uncle Sam.

What deduction benefits of real estate ownership do you like the most? Which other ones do you use?

 

Note: I am not a licensed tax expert, accountant, or financial or business advisor. All information contained in this post and this website are solely opinions of the author. We are not responsible for any damages incurred from information contained on this website.

 

(Photo courtesy of Flickr)

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How to make money in real estate

how to make money in real estateThere is money to be made in real estate. My mother in law constantly informs us of great opportunities in real estate that we could sink our hard earned dollars into. The problem with real estate investing is that most of us normal people don’t spend every waking moment of our days trying to find ways to get rich. We really aren’t informed about most of our investments. Most doctors I know want to take care of patients, get compensated fairly during the process, and spend their free time with family, friends, or with their hobbies.

For those of us who have any potential interest in real estate as a means to supplement our income, this primer is my overview to those who want to learn some fundamentals. If you want a get-rich-quick strategy or real estate investing guide, look elsewhere. If I establish any clear tips from my own experience, I will post them in later entries.

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What are the ways in which I can make money from real estate? 

Real estate usually does not involve quick flips like what you see on TV. If you ever get to that point, you’re likely to already have your own real estate business and probably aren’t going to be practicing medicine anymore. I have seen doctors and other professionals who love real estate so much that they do flip homes and make a pretty dime during the process. If that is you, then read no further. You’ve nothing new to learn here. Here is my take on residential properties:

  1. Appreciation. One purpose that real estate serves is to provide you, the investor, a place to park your money. Think of it as a means to beat inflation. When you decide to sell your property after a decade or two, you hope that the land value has increased, the neighborhood has improved, and you will not lose anything to time. This is also one of the risks of real estate investing. Sure, if you’re investing in a metropolitan area where there is no more land to develop, your chances of having property appreciation will be higher. If you are in Lubbock, TX, you have to be more discriminating in what you buy. Remember, purchasing real estate to live in yourself is one thing, purchasing real estate for investment is another. Selling a house you purchased for $600,000 ten years ago for $625,000 probably means that you got lucky, and only lost out slightly to inflation. Looking at a ten-year period between 2005 and 2015, $600,000 in 2005 would need to grow to upwards beyond $720,000 in 2015 to have the equivalent buying power.  If you lived in it the entire time, at least you had a roof over your head. If you used this property as a rental, you’d between have profited through other means.
  2. Cash flow. If you have a property that is rented out, you are generating income. That is your cash flow. Subtract out your mortgage costs, maintenance, and expenses and you will get your net operating income (NOI). A more detailed analysis about how cash flow incorporates into profitability will be discussed in future entries. Essentially, you would hope that your rental income will cover at least your mortgage income so that you’re looking to make a profit.
  3. Leverage. This principle works when you have multiple real estate properties that you manage. Typically one would take out a mortgage to purchase a rental property. The cash flow generated by the first property can also be used to purchase additional properties. In effect, you are leveraging your purchasing power to generate multiple streams of cash flow.
  4. Tax benefits. Yes, you can have tax breaks on real estate properties. There are depreciation benefits with properties that you can use to offset your rental costs. It’s not the sole reason why you should own real estate, but it is one benefit from the U.S. tax system. Might as well use it.

That’s it: appreciation and cash flow. There is no magic involved. If you hold onto property for twenty years or flip it in 6 weeks, these are the only ways you’re only going to make money. This applies mostly to residential properties, but in some ways to commercial as well.

Stay tuned for further articles on real estate.

(Photo courtesy of Flickr)

What other basic principles of real estate should beginner investors be aware of? 

 

Mortgage Interest Deduction Phases Out with High Income

mortgage interest phaseout for high income earnersOne of the benefits of home ownership is that mortgage interest as well as property tax can be itemized on your tax returns for deduction. This is one the top reasons my mother-in-law insists why I should buy a home. It sounds plausible although you still have to spend money to save money. I’ve mentioned before that I feel that mortgage interest deduction is more of a perk than a reason for owning a home.

How Mortgage Interest Deduction Works.

Let’s say you bought a McMansion and pay about $40,000 a year on your mortgage interest alone (think 30-year loan). Your adjusted gross income before any deductions is $700,000 as a neurosurgeon. For simplicity’s sake, you could potentially reduce your tax burden by $40,000 by deducting your mortgage interest. This means that the government will tax you as if you made $660,000 that year instead. At a marginal tax of 39.6%, you “saved” $15,840 of federal taxes! That’s right, by spending $40,000 of your money, you’ve saved yourself from paying $15,840 in taxes (Yes, you are also building equity in real estate in the process)

High Income Earners Get Hit with the Pease Limitation.

If you are a high income earner, you don’t get off the hook that easily. The Pease limitation starts phasing out how much you can deduct as your gross income increases. For 2015, this phaseout range begins at $258,050 for a single filer (not married).

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The deduction amount is decreased by 3% of the difference between your gross income at the phaseout limit. For the neurosurgeon example, this amount is: ($700,000-$258,050) x 3% = $13,258.50. This means that instead of deduction $40,000 in mortgage interest, the neurosurgeon can only deduct $40,000 – $13,258.50 = $26,741.50. At a marginal tax bracket of 39.6% your deduction is not pocket change, but it is certainly still reduced.

Buy A Home For the Right Reasons

Don’t just buy a home for the mortgage deduction with the expectation that you can sell it in a heartbeat if you need to move. Understand that home ownership comes with both perks and headaches. There are plenty of people who opt to rent for life. As a high income earner, you will be hit with phase-outs. Remember that the Pease limitation is annoying but not a reason why you shouldn’t own property. If it stings you, the way out is to make more money. Hustle.

(Photo courtesy of 401k 2012)

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Why You Should Rent Instead of Buying a Home

Should I buy a house in medical school? What about residency? What if I stay in the same area for both medical school and residency?

I heard all of these questions during my training. I even went to lectures on this matter sponsored by “financial advisors for physicians”. Those lectures were educational too. No money for a down payment? No problem! You can even take out a Doctor Loan! Buying a home while you have a temporary job like residency always seems enticing, but there aren’t too many good reasons why you should do so. Buying a home for your first job may not necessarily be a great idea either. Here’s why:

You Need More Money Up Front to Own a Home Than To Rent

Traditional loans require a deposit around 20% to obtain the best interest rate. Yes, there are Doctor Loans that require no mortgage insurance or deposit depending on how much you have in your bank account. You will still pay for it. If you don’t pay for it up front, you will pay for it in monthly increments in your mortgage payments. Unless you had a job prior to medical school or have family help (or are independently wealthy), it’s unlikely that you actually have enough to put down for a decent house that you’d want to live in. I certainly didn’t. I also had no stable income during medical school either and a three to four figure bank account balance.

As a resident, you make approximately $50,000 pretax. While many families with children live off of $50,000, there is obviously a limit to the amount of house you can purchase and have enough for living expenses. Obviously if you have a working spouse, the circumstances change…

Mortgage Interest Deduction is Less Than You Think

Mortgage deduction sounds great in theory, but remember that any deduction requires you to pay money up front. You have to SPEND money to SAVE money. Tax deductions treat a certain percentage of monies you’ve paid as untaxed income. Tax laws allow you to deduction mortgage interest from your income. So if you pay $10,000 in mortgage interest in one year and are in the 25% marginal federal tax bracket, you “save” $2,500. In other words, you still pay $10,000 in mortgage interest but at the end of the tax season, the government taxes your income as though you earned $10,000 less on your income.

Additionally, you must itemize your deductions if you wish to be eligible for a mortgage interest tax deduction! I certainly did not itemize my tax returns during my entire residency or fellowship due to limited expenses and income! By not itemizing, I actually saved even more money through TurboTax/TaxACT since it was free.

As a full-time physician, mortgage interest deductions make a little more sense simply because you are in a higher tax bracket. I still consider this more of a perk rather than a reason to own a home.

Home Ownership Has Upkeep Costs

If you rented a home, your landlord is responsible for most of the maintenance costs (unless your landlord is an asshole and puts conditionals on certain home appliances). Stuff breaks. Appliances need maintenance. Air filters need to be changed.

If you owned your home, you or your spouse is responsible for it. If you don’t know how to fix your toilet, tough luck. You hire your friendly neighborhood plumber* who hits you with a $100 house call fee and $130/hour rate on a job that takes him 32 minutes but he still bills you for the full hour. Don’t forget the 3x markup price on parts and a miscellaneous charge for shop items. Oh, and if you really knew how to fix it yourself, it’d only take you a trip to the local hardware store and 10 minutes of your time.

There are fees for lawn care, cleaning, maintenance, property taxes, and home association fees. Even if you can outsource all of the basic tasks, you will still have to deal with the hassle of calling for help. As a renter, you don’t have to worry about this. If you are a busy medical student, resident, or have any busy career, you want to minimize tasks outside of your work life.

Your Money Is Tied Down in Your House

Equity in your house is illiquid unless you have a buyer. Even with a buyer, it may still take weeks to months to even close unless you have a cash offer. The problem with equity in real estate for medical trainees and young doctors is that their jobs may be transient. Medical school and residency only spans a set period of time. Most doctors do not stay at their first jobs forever either. Professionals who are early in their careers cannot afford to have equity tied down in real estate if they have to move.

Real estate value cycles. If the housing market is down when you need to move, you either have to sell at a loss or hold onto the home until the next housing peak. If you rent, the money that isn’t tied down can be used to invest elsewhere.

Example

The benefits of renting vary depending upon locale. For example, homes in one neighborhood in my town are selling for approximately $350,000. Rent for a similar unit goes for around $1800 a month. The Price-to-Rent ratio is roughly 15.4, which means that the cost of renting is equal to that of owning.

Assuming a 30-year mortgage at 3.5% interest with 20% down and closing costs rolled into the mortgage, this is what I estimate:

Rent

Own

$1900 monthly rent $1304 monthly mortgage
$4830 annual property tax
$10,500 closing costs on first year
$3500 annual maintenance
$1853 monthly payments with taxes, insurance, and mortgage insurance

So based on this projection, owning this home can possibly save you around $47 a month at the expense of tying down a portion of your money and dealing with home ownership. Obviously if you can cut down your annual maintenance costs, you will save even more. The breakeven point for a house in this price range will be at least 3-4 years. Remember, most markets have at least a 6% seller fee.

Conclusion

While I know many intelligent medical students and residents who own homes, most of them have no business owning one. Many of them have spouses who stay at home to take care of the kids, so they often have limited income. After 3 years of residency, some end up moving to a different city and either rent or put up their home for sale. Those that stay in the area even move simply to live in a larger home. It does not seem worthwhile to go through the hassle of home ownership with such a busy day job.

Did you own a home during medical school? What benefits did you find in home ownership? Sound out below!

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