Rental property can be an excellent investment. In exchange for potentially being more trouble than other types of property, it offers three different opportunities for return. You can make money through its cash flow while growing your equity through appreciation and principal pay down. At the same time, you will enjoy extremely favorable tax treatment.
Tax Sheltered Cash Flow
When you own rental real estate, the Internal Revenue Service lets you subtract all of your property expenses from your rental income so that your are only taxed on your profit. The ability to write off expenses, though, provides additional tax shelter in two different ways. The first is that you can write off the business use percentage of personal items. For example, if you go to Hawaii to visit your rental property there and do work on it, your trip is deductible to the extent that it is related to the expense of running your rental property. The IRS also lets you write off a depreciation allowance on your rental property. To calculate your depreciation allowance, you divide your cost basis in the building, but not the land, by either 27.5 or 39, depending on whether your rental is residential or commercial. You can then write that amount off against your income every year until the property is written down to zero. The depreciation write off shelters a portion of your profit from taxes without you having to spend any money.
Your rental property can also go up in value in two or three different ways. The first occurs when you pay down your mortgage. As you reduce your loan balance, you gain additional equity. The second is that real estate typically appreciates at or slightly above the rate of inflation. When you compare this to a bond which offers no appreciation, this is a healthy rate of return. Finally, if you do work on your property to improve it, you can also create additional appreciation.
Tax Free Gains
When you sell your rental property, you will be subject to the same kind of capital gains tax that affects you when you sell appreciated stock. You will also have to pay depreciation recapture tax on the depreciation that you claimed. However, if you use the proceeds of the sale of your rental property to buy more rental property, even if it is located in a different state or is a different type of real estate, you can defer all of your taxes. Taking advantage of the ability to do a 1031 Exchange lets you keep all of your money invested in real estate, instead of having to siphon some off for the government.
Real estate also offers healthy returns. Between 1978 and 2010, privately held real estate had an annual return of 9.1 percent while large institutional-grade buildings generated 14.1 percent returns. The Barclays Capital Aggregate Bond index returned 8.8 percent over the same time while the Standard & Poors 500 stock index achieved 12.6 percent with higher risk. These indices do not take into account the additional benefit of the favorable tax treatment that rental property receives.
- The Tax Adviser: Depreciation and Changes in Use of Real Property
- IRS: Schedule E (Form 1040)
- US News and World Report: The Future of Home-Price Appreciation
- HouseLogic: Tax Deductions for Rental Homes
- RentalSoftware: Real Estate Investors Beware: The Capital Gains Unrecaptured Section 1250 Gain Tax Trap
- Commercial Partners Exchange Company: 1031 Exchange - Defer the Tax - Retain the Gain
- Clarion Partners: Why Real Estate, Why Now?
- Goodshoot/Goodshoot/Getty Images