I've been looking at lots of syndicated real estate deals over the last year or so. I have noticed a common theme among them and it finally dawned on me the reasoning behind it. These deals are generally structured to have a down payment of around 1/3, and generally last 5-7 years. The reason for this is to maximize the cash flow that can be protected from taxes by the depreciation, while still being able to take advantage of a decent amount of leverage, and having a number of years over which to spread the transaction costs.
How to Maximize Your Real Estate Investments for Tax-Efficiency and Cash Flow
Cash Flow
The best way to maximize your cash flow is simply to pay cash for the property. Using the 55% rule, about 45% of the gross rents will go toward non-mortgage expenses. So a $100,000 property with a capitalization rate of 6% (cap rate = net operating income/value of the property) would have gross rents of $10,909 and a net operating income of $6000. The best way to maximize your cash flow ($6000) is to have no mortgage expenses, i.e. to pay cash for the property.
Tax Efficiency
Likewise, the most tax-efficient property is one in which you put zero down. Not only will the expenses eat up all the gross rent and then some, but you can (and will probably have to) add money to the property, increasing the value of your investment in a very tax-efficient manner. In fact, if you really want a tax-efficient investment, you could overpay for the property too and use the losses each year and when you sell it to offset your regular income (or if you make too much, at least your other passive income.)
Getting Positive Cash Flow
However, most real estate investors don't want to feed money into their properties. At a minimum, they want it to at least pay for itself. What is the minimum amount of money you need to put down to get that? Well, it depends on the cap rate of the property and the terms of the loan. Let's assume that same $100K, cap rate 6 property. Let's assume a 5%, 30 year loan. If you put down 10%, you have a loan on $90K. Your total mortgage payments would be $5,575, so you'd be slightly cash flow positive. Your gross rents would be $10,909, your non-mortgage expenses would be $4909, and your mortgage expenses would be $5,575. You'd be left with $425, or $35 a month in positive cash flow, for a cash on cash return of 4.25%. If you only put down 3%, you would have zero cash flow and your cash on cash return would be 0%.
Maximizing Cash on Cash Return
If you put down 100%, you would have a cash on cash return of 6%. If you put down 3%, you'd have a cash on cash return of 0%. If you put down less than 3%, you'd be feeding the beast (technically a negative infinity cash on cash return). As seen below, the more you put down, the higher your cash on cash return. This simplistic example, of course, ignores the fact that if you put 20-50% down you're going to get better mortgage terms than if you put 0-20% down.
| $100,000 Cap Rate 6 Property with 5% Mortgage | |||
| Down Payment | Mortgage Payment | Cash Flow | Cash on Cash Return |
| $0 | $6,195.37 | ($195.37) | N/A |
| $10,000 | $5,575.84 | $424.16 | 4.2% |
| $20,000 | $4,956.30 | $1,043.70 | 5.2% |
| $30,000 | $4,336.76 | $1,663.24 | 5.5% |
| $40,000 | $3,717.22 | $2,282.78 | 5.7% |
| $50,000 | $3,097.69 | $2,902.31 | 5.8% |
| $60,000 | $2,478.15 | $3,521.85 | 5.9% |
| $70,000 | $1,858.61 | $4,141.39 | 5.9% |
| $80,000 | $1,239.07 | $4,760.93 | 6.0% |
| $90,000 | $619.54 | $5,380.46 | 6.0% |
| $100,000 | $0.00 | $6,000.00 | 6.0% |
Random Pondering
So, if the best way to maximize cash flow is to put 100% down, and the best way to maximize tax efficiency is to put 0% down, and the best way to get the maximum cash on cash return is to put 100% down, why are all these deals structured with about 1/3 down? Perhaps its the benefit of depreciation.
Depreciation
Although there are several different methods of depreciation, the simplest is to simply depreciate the value of the building (not the land) over 27.5 years. So if the land on our Cap Rate 6 property is worth $30K, and the building is worth $70K, then you get to depreciate $70,000/27.5 = $2,545 per year. That means that $2,545 of your positive cash flow PLUS the amortization on the loan (remember only the interest portion of the mortgage payment is deductible) comes to you as tax-free income. (Yes, depreciation has to be recaptured when you sell, that's why you exchange properties until you die and pass it to your heirs with a step-up in basis.) So let's remake the chart a bit.
| $100,000 Cap Rate 6 Property with 5% Mortgage | ||||||||
| Down Paym. | Mort Paym. | Cash Flow | ConC Ret | Interest | Principle | Prin _+ CF | Deprec. | Taxable Inc |
| $0 | $6,195.37 | ($195.37) | N/A | 4690.23 | $1,505.14 | $1,309.77 | 2545 | ($1,235.23) |
| $10,000 | $5,575.84 | $424.16 | 4.2% | 4221.21 | $1,354.63 | $1,778.79 | 2545 | ($766.21) |
| $20,000 | $4,956.30 | $1,043.70 | 5.2% | 3752.19 | $1,204.11 | $2,247.81 | 2545 | ($297.19) |
| $30,000 | $4,336.76 | $1,663.24 | 5.5% | 3283.16 | $1,053.60 | $2,716.84 | 2545 | $171.84 |
| $33,333 | $4,130.27 | $1,869.73 | 5.6% | 3126.84 | $1,003.43 | $2,873.16 | 2545 | $328.16 |
| $40,000 | $3,717.22 | $2,282.78 | 5.7% | 2814.14 | $903.09 | $3,185.86 | 2545 | $640.86 |
| $50,000 | $3,097.69 | $2,902.31 | 5.8% | 2345.12 | $752.57 | $3,654.88 | 2545 | $1,109.88 |
| $60,000 | $2,478.15 | $3,521.85 | 5.9% | 1876.09 | $602.06 | $4,123.91 | 2545 | $1,578.91 |
| $70,000 | $1,858.61 | $4,141.39 | 5.9% | 1407.07 | $451.54 | $4,592.93 | 2545 | $2,047.93 |
| $80,000 | $1,239.07 | $4,760.93 | 6.0% | 938.046 | $301.03 | $5,061.95 | 2545 | $2,516.95 |
| $90,000 | $619.54 | $5,380.46 | 6.0% | 469.023 | $150.51 | $5,530.98 | 2545 | $2,985.98 |
| $100,000 | $0.00 | $6,000.00 | 6.0% | 0 | $0.00 | $6,000.00 | 2545 | $3,455.00 |
So what do you see? At around 1/3 down your entire annual return is tax-free. The appreciation (if any) is tax-free until you sell (and if you exchange, eternally tax-free). The cash flow and amortization are completely off-set by the depreciation. So what do you get? At 1/3 down, your property might be worth 2% more due to appreciation (a 6% gain on your original investment), you paid down about $1,003 on the mortgage, and you got $1,870 almost tax-free ($328 was taxable) to spend on whatever you like. Not a bad return on a $33,000 investment-14.6% pre-tax and with a 35% marginal tax rate, 14.3% after tax. Now you see why these real estate guys get all excited about this stuff.
Years Two Through Seven
So what happens in year two? Well, the mortgage is paid down a little bit more. You raised rent 2%, and depreciation stays the same. Let's look at another chart demonstrating perhaps why these deals are often structured over 5-7 years.
| Year | Cash Flow | ConC | Int. | Prin. | Prin. + CF | Taxable Inc | Tax-free Inc | After tax Ret | Leverage |
| 1 | 1870 | 5.6% | 3127 | 1003 | 2873 | 328 | 1542 | 14.3% | 3.00 |
| 2 | 1990 | 5.6% | 3077 | 1054 | 3043 | 498 | 1491 | 13.7% | 2.81 |
| 3 | 2112 | 5.7% | 3024 | 1106 | 3218 | 673 | 1439 | 13.3% | 2.64 |
| 4 | 2237 | 5.7% | 2969 | 1162 | 3399 | 854 | 1383 | 12.8% | 2.49 |
| 5 | 2364 | 5.7% | 2911 | 1220 | 3584 | 1039 | 1325 | 12.5% | 2.36 |
| 6 | 2494 | 5.7% | 2850 | 1281 | 3775 | 1230 | 1264 | 12.1% | 2.24 |
| 7 | 2627 | 5.7% | 2786 | 1345 | 3971 | 1426 | 1200 | 11.8% | 2.13 |
Several things to notice that happen after 5-7 years. First, the percentage of your cash flow that is taxable increases each year and at year 7, the majority is taxable. Second, your after-tax return decreases each year. This is primarily because you are becoming less and less leveraged each year. In fact, after about 8 years, your leverage has gone from the original 3:1 to a factor of 2:1. Finally, I've been completely ignoring transaction costs both in doing the cash on cash returns as well as in the total returns. The more years you spread these costs over, the less of a bite into your return they take each year.
There are a couple of other factors, of course, that explain why these exchanges often happen after 5-7 years. First, investors don't like to tie their money up forever. We're not immortal. Second, those who are putting these deals together often get additional flat or asset-based fees for structuring the deal, buying the property, and selling the property. The more complete round trips they do, the more they get paid.
Transaction Costs
Just for fun, let's look at the effect of transaction costs. Let's assume transaction costs of 4% to buy (exactly the fees on a recent syndicated deal I looked at), and 5% to sell. In my experience, on a private residence 5% to buy and 10% to sell is a pretty good estimate, but with an investment property, especially a syndicated one, it would hopefully be less. Obviously, if you can achieve lower costs, then your returns will be better. Keep in mind these percentages are based on the entire value of the property, not just your equity. So if you sold after just one year, your cash on cash return would be just 5.0%, instead of 5.7%, and your overall return would be -13%, instead of +14.3%. It would be slightly better than that after tax because you could deduct your losses!
So even though your property was cash flow positive, and appreciated while you held it, you still lost money due to your hold period being too short to make up for the transaction costs. In my $100K property example, the total round-trip transaction costs are in the $9-10K range. Spread over 7 years, it's $1,392 per year, lowering the return by something around 4% a year.
Boosting Returns
So in the end, this Cap Rate 6 property, leveraged 3-1, ends up with an annualized return of around 10%, about the same as historical returns on stocks. If it appreciated faster, or if it had a higher Cap Rate, then your return would be a little higher. So if you're buying real estate expecting outsized returns, you need to do a few things to make sure it happens. First, you need to buy property with a higher cap rate than 6. Second, you need to buy property that will appreciate faster than 2% a year. Third, you could leverage it up a bit more or get better terms on the mortgage. For example, if you had a cap rate 9 property and a 3.5% mortgage, the first chart in this post would look like this:
| $100,000 Cap Rate 9 Property with 3.5% Mortgage | |||
| Down Paym. | Mort Paym. | Cash Flow | ConC Ret |
| $0 | $5,253.27 | $3,746.73 | N/A |
| $10,000 | $4,727.94 | $4,272.06 | 42.7% |
| $20,000 | $4,202.62 | $4,797.38 | 24.0% |
| $30,000 | $3,677.29 | $5,322.71 | 17.7% |
| $33,333 | $3,502.20 | $5,497.80 | 16.5% |
| $40,000 | $3,151.96 | $5,848.04 | 14.6% |
| $50,000 | $2,626.63 | $6,373.37 | 12.7% |
| $60,000 | $2,101.31 | $6,898.69 | 11.5% |
| $70,000 | $1,575.98 | $7,424.02 | 10.6% |
| $80,000 | $1,050.65 | $7,949.35 | 9.9% |
| $90,000 | $525.33 | $8,474.67 | 9.4% |
| $100,000 | $0.00 | $9,000.00 | 9.0% |
Pretty hard not to get excited about figures like that! Add in some appreciation, a little leverage, and the tax benefits from depreciation and you could make out like a bandit on a deal like that if held long enough.
Conclusion
Overall, I think about a third down is a pretty good balance of having positive cash flow but being able to shield most of it with depreciation. You get the benefits of leverage, while still being able to avoid being underwater even in a nasty real estate downturn. A 5-7 year holding period allows you time to spread the transaction costs over multiple years while allowing you to get out as the investment becomes less tax-efficient. However, be aware that a longer hold period may be more appropriate for your goals with the investment.
What do you think? Do you invest in real estate either directly or through a syndicated deal? How much leverage do you typically use and why? How long do you hold your investments and why? Comment below!
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I see why you did the analysis in this way, but I’d be interested to see the numbers run on two different methods over 20-30 years. Say, cycling through transactions every 5-7 years with 1/3 down vs a very low amount down held over the full 20-30 years. That would highlight the effect of the transaction costs more, wouldn’t it? Of course I haven’t done any real estate investing outside of my primary residence, but the difference seems to me a bit like that between a buy and hold approach vs more active trading.
Although most would argue that holding an investment for 5-7 years IS buy and holding compared to flipping properties. 20-30 years is only relevant because that’s the time the bank says you should hold a mortgage over. Otherwise, why not 10, or 50 years.
To each his own, but cannot understand why a physician would want to complicate his/her life with rental real estate. If you want diversification into property, purchase shares in a mutual fund REIT.
I have watched my partners who own apartments, business office building, condo’s etc over my 27 year career. Near as I can tell, they are a total pain in the rear, associated with a lot of hassle and heartache.
I do truly believe in the KISS principle of investing and it has given me a nest egg beyond my wildest dreams as an anesthesiologist. My off time I do not want to deal with “rental issues.”
There’s a good post coming up next week showing why one doc decided to complicate his life.
Although I mostly agree with Sam Adams (and incidentally like his beer), the return can often be better than just a KISS principle with a diversified portfolio (including REITS)…Especially in situations where physicians have maxed out tax sheltered investing. Having another avenue to grow a portfolio while “essentially” not paying taxes on that growth is huge. Is it worth the hassle? Maybe, and especially if it is something you enjoy. WCI had a post a couple months back about turning your investing into a well paying hobby. If Real Estate is your hobby it can have a very nice return. Is the next post on 1033ing real estate sales? Hopefully you can discuss this somewhere. Thanks!
I tell you, nothing comes to you without work. Buy property for investment if you want to work some more (maybe 2-10% more), buy REITS if you dont want to work some more. To each one his own.
Quite a few options between those two.
If diversification is your goal with real estate, then you do not get that with REITs. If your portfolio is paper heavy, buying REITs adds to that. REITs are stock. Real estate flavored stock that do not give you the tax benefits of direct ownership.
You’ve got a weird definition of diversification Dennis. Yes, REITs have relatively high correlation to the stock market, but not diversified? Hard to argue that. Buying Vanguard REIT Index Fund gets you over a hundred REITS, each of which owns hundreds of properties. I think 10,000 properties is pretty diversified.
Sorry, but I don’t believe that good diversification is having a 100% paper asset portfolio that is all market based or highly correlated with the market. REITs certainly have their place, but they are highly volatile just like other stocks and do nothing to reduce sequence risk.
I know, we’ve had this discussion before. You feel 4 or 5 properties in Texas provides more diversification than 10,000 properties across 50 states just because said properties can be traded on a daily basis. 🙂 Everything is a “paper asset” and everything is a “non-paper asset.” I see that as a false dichotomy.
I absolutely think that buying more stock when all you own is stock is poor diversification. You and I both know that you cannot trade 10,000 properties on a daily basis. It’s not possible. You can trade REITs on a daily basis because they are stock and not real estate.
Perhaps Joe Davis, Vanguard’s chief economist says it better:
“REITs tend to correlate with the broader equity market”
“if you substitute REITs for bonds in order to generate greater income, the final result is a more aggressive and more stock-heavy strategic asset allocation……it’s because stocks are riskier and more volatile than bonds.”
“…dividend stocks, including REITs….”
“…inflation-hedging potential of REITs, like U.S. stocks in general..,”
http://vanguardblog.com/2013/01/10/reits-a-word-of-caution/
All through his piece, he correctly equates REITs with stocks. He does this, because REITs are stock. As such they behave like stock and not like real estate.
At the end of the day, it may or may not be worth owning, but don’t fool yourself into thinking you own doors. You don’t.
I don’t disagree the correlation is high with stocks, the evidence is quite clear. But diversification is not correlation. Diversification means multiple investments, the more the better. Ideally, you have diversification both within asset classes and between them. There is plenty to criticize with REITs, but diversification is a strength, not a weakness of REITs.
noun
1.
the act or process of diversifying; state of being diversified.
2.
the act or practice of manufacturing a variety of products, investing in a variety of securities, selling a variety of merchandise, etc., so that a failure in or an economic slump affecting one of them will not be disastrous.
It’s silly to say you don’t own doors. You sure do. And the price of a single property varies just as much as the price of a REIT, it just isn’t marked to market each day. If it were, that volatility wouldn’t be invisible.
I don’t disagree that Vanguard REIT index fund is a diversified mutual fund holding. However, if your only holding is mutual funds, then you may have diversification within mutual funds, but you don’t have diversification across asset classes. Do you recommend people hold 100% mutual funds?
If you honestly believe that you own physical real estate when you own a REIT, then you should try doing a 1031 exchange when you sell so you can defer the gain. 🙂
I don’t disagree with you that one huge advantage of investing directly in real estate is the tax benefits. Another advantage is the ability to concentrate a bet on something you have control over. I also agree that the correlation of a reasonably sized portfolio of direct or syndicated real estate investments with the overall stock market is lower than the correlation between REITs and the stock market.
However, there is nothing inherently wrong with a mutual fund. A mutual isn’t an asset class. It is merely a vehicle, a way to invest in an asset class. There are mutual funds of REITs, large stocks, small stocks, international microcap, china, TIPS, muni bonds, commodities, precious metals etc etc etc.
I think a 100% mutual fund portfolio is entirely reasonable and coupled with a reasonable savings rate can enable an investor to reach his financial goals. I became a millionaire less than 7 years out of residency with nothing but a 100% mutual fund portfolio despite investing through the largest bear market since the Great Depression. It certainly works. Can a portfolio be strengthened by adding some direct or syndicated real estate? Sure. But to argue that a “mutual fund portfolio isn’t diversified” is silly. I own literally thousands of securities in dozens of countries on every populated continent in the universe in a dozen asset classes. It’s diversified. To argue it isn’t is silly.
To each his own. I haven’t seen many people advise others to own 100% stock mutual funds. Certainly if one did, they would have diversification among stock, but not across other asset classes. Most advise for bonds, real estate, etc. to provide for diversification across asset classes.
Personally, I don’t think it is silly to advise people to diversify across asset classes and not just own 100% stock based mutual funds. A portfolio of 100% stock based mutual funds has significant sequence risk…..and while 2008 may not have hurt you at your age, a 100% stock mutual fund portfolio owned by a 70 year old was significant.
I guess we will just have to agree to disagree.
You know I don’t generally recommend a 100% stock portfolio, right? When I talk about a 100% mutual fund portfolio it’s not all stock.
You guys are both “last word freaks” see Jack Nicholson…
However, appreciate both of your view points and opinions.
Thanks!
What’s funny is we’ve had this same discussion about 5 times before.
I hadn’t thought that was your recommendation, but I must admit that I was starting to wonder.
I think it has only been 4 times that we’ve had this conversation but I’m alright with that as long as I get the last word 🙂
Always good chatting with you.
My real states investment are in TRIPLE NET NNN, NO HASSLE ARE ALL.
There are a number of ways to minimize hassle for sure. Easiest is REITs. Then probably syndicated deals. Then probably something like your triple net where the tenant is responsible for just about everything.
Would you mind sharing your contact information for NNN?
You mean “net net net” meaning triple-net? That’s not an investing firm, it’s a description of the fact that the tenant pays everything.
I think that this post is more referring to syndicated RE deals, which actually would not be a whole lot of “pain in the rear,” because the person putting together the syndication would handle the property management aspects of the deal and you are just a financing partner. Of course, these deals can be structured in all kinds of ways. The main risk I see in this for a high income individual investing in a RE syndication is making sure that the person asking you to invest knows what the hell he/she is doing so that you can be sure that the cap rate is as expected, there are not any additional costs, etc. 10% real plus with the inherent tax advantages I think is going to give you a huge advantage over a paper assets investor investing outside of tax protect accounts. It is true that a high income earner with a high savings rate does not necessarily need that kind of return to retire comfortable but if you want to really become a super high net worth individual on a physician salary, real estate is probably the most tried and true way to get there. Just my opinion though.
Having a ” real estate professional ” tax status would increase tax efficiency.
Combine this with buying properties at discount with cash, the returns increase further.
You mention double digit returns AFTER fees as well as tax free yield…which I absolutely agree with….but don’t forget that you can also get tax free equity growth by harvesting equity and refinancing.
Other than farming and gas / oil, real estate has the best tax advantages!
I invested in a real estate syndication last year. If the syndication ends with the sale at the end of 7 years is there an opportunity to do a 1031 exchange or do I have to pay the tax? I probably should have known this prior to investing.
They will typically specify at the time of investment whether it is eligible for 1031 exchange on the back end. In my experience, the vast majority of them are not due to their LLC structure with multiple owners.
One of the biggest downsides of this investing method in my opinion.
If others are not allowing you to 1031 exchange, then they are doing you a disservice.
I guess harvesting equity/refinancing out your equity is tax-free. Kind of like life insurance though, you can get your money tax-free and you can get your money interest-free but you can’t get your money interest-free and tax-free!
Very timely post! I am in the process of leaving my employed group and going out on my own and starting my own pain practice. I am looking to rent for a few years and then hopefully buy my own building and rent to myself. If you could ever include being an owner operator/ landlord in a post I would love it! But I love all the posts anyways
What are your thoughts on investing in a real estate syndicate? Any good companies that you would recommend in this space?
I’m cautiously optimistic. There are lots of firms out there doing this sort of thing, but it’s definitely a buyer beware situation since it’s all accredited investors.
Another common reason most of the deals are 30% down: that is what most banks require for commercial property loans. Our physician group started buying up our 5 office buildings that we previously rented (or moved to new offices if they wouldn’t sell) about 3 years ago. I estimate a conservative 14-18% total annual IRR (6-11% cash-on-cahs) on each of the buildings (I assume no value appreciation over time). One of the best reasons to own your own building is that you control vacancy. When discussing cap rates, a true cap rate should take into account vacancy. Realtors often try to convince you that you only need to figure 3-5% vacancy rate when you buy an occupied building, but it is often closer to 10% for office buildings (obvious many factors play into this). If you run your own established practice that has no reason to move in the foreseeable future, you control your vacancy and boost your overall returns (compared to renting to someone that may bolt anytime their contract is up–or sooner). I have also participated in several syndicated deals over the past year–too early to say whether they will pan out as advertised.
Jon, I have recently invested with a syndication in San Antonio, TX for a 150+ apartment complex and I am waiting to see if it works out as well. Is there any chance you can share with me what your experiences have been like so far and the companies information?
Part of the difficulty of these situation is it literally takes 5-7 years to know if it works out well. And at that point, you may not be able to invest with those same people in a new deal!
I agree with WCI, I have nothing meaningful to say on these deals as the longest one I have is less than 1 year old. For all I know, there is some Nigerian on a cruise somewhere on my dime.
Does your analysis include the COW – cost of ownership? I.E. property insurance, property taxes, utilities, repair, maintenance.
For my primary residence, the COW is 0.05/value of home. For my vacation house, the COW is 2.5%/value of home.
That’s all included in the cap rate. Cap rate is net income (total revenue minus total expenses) divided by value.
A true cap rate should also reflect reserves and vacancy as well.
Absolutely.
I read this twice. Then a third time. I have no idea what those tables are representing. Cap rate? Just totally lost on this one. Even the conclusion was confusing to me.
Can I get a simplified translation of this post?
It’s like the first time you learned about Roth IRAs or index funds or ERs or whatever. Until you speak the language you can’t follow the conversation. Cap rate and other important real estate concepts are discussed in this book: https://www.whitecoatinvestor.com/great-real-estate-investing-book/
WCI- do you recommend investing via syndicated real estate deals? I get the sense from your previous posts on this subject that you don’t think they are worth the hassle
I’m not sure I’ve ever said they’re not worth the hassle. They’re certainly optional but I’m cautiously optimistic about them. I’m involved in a couple of them (one associated with my work, one that isn’t.) Jury’s still out for me. The hassle factor is quite minimal, it’s the fees and the difficulty in exchanging that I find onerous.
Beware of syndicated deals only involving Physicians.
Can’t help to quote from today’s Washington Post article “As Forbes magazine with rare accuracy suggested a dozen years ago, tax shelter economics were so bad that nineteen out of twenty investments could only be sold to groups of doctors. The twentieth scheme was awful beyond belief and could be sold only to dentists”
That’s an awesome quote. Do you have a link?
Never mind, found it.
Hey wait a minute!!! I resemble that.
how would one go about 1031-exchanging a property owned in syndicate?
It’s certainly possible. The syndicator just has to allow you to do it (and there has to be another opportunity you’re interested in that you can get into within the time limit.) It’s just that some syndicators don’t allow it due to the hassle factor.
I apologize for my inexperience but I just want to make sure I understand this correctly:
If a physician has, let’s say, $250k AGI (no passive income) is going to purchase his only investment property for 100k with the ability to pay anywhere from 0-100% down.
If he puts (hypothetically) 0% down, will he be unable to deduct the depreciation and the mortgage interest due to the phase out based on his AGI?
He can deduct both depreciation and mortgage interest against his passive income, but not his earned income. Details here: http://www.nolo.com/legal-encyclopedia/can-you-deduct-your-rental-losses.html
WCI: Thanks for helpful info! My question is similar to EMresident.
I have a new rental property bought last year. After all the tax cacluations, due to my income bracket being >$150k, am unable to take any losses on rental, ie. no tax savings whatsoever due to the rental property. That part I understand, not happy about it, but ok whatever. The question is with respect to the depreciation.
As I still have to put in depreciation (which is not helping to deduct taxes), down the road, when property is eventually sold, the cost basis is minus the depreciation each year that I supposedly “took”. Will this end up screwing me as that is not the true cost basis?
I also understand due to recent changes in depreciation, basically I will eventually lose the portion of tax free depreciation over the years it generated rental income.
Second issue. Do I have to change from being a passive to active investor? Is that “easy” or “wise” to do? (I actually do not have management company, so I do all phone calls/emails). Will I be able to claim depreciation as an active “real estate professional”?
Per Nolo:
“Property owners with modified adjusted gross incomes of $100,000 or less may deduct up to $25,000 in rental real estate losses per year if they “actively participate” in the rental activity. You actively participate if you are involved in meaningful management decisions regarding the rental property and have more than a 10% ownership interest in the property. This allowance is phased out for taxpayers whose MAGI exceeds $100,000 and eliminated entirely when it exceeds $150,000. Thus, it is useless for high-income landlords.”
Thanks!!!
You still get depreciation. You can use it offset all your rental income. What you can’t do is use it to offset your earned income. If you do run losses on your rental property year after year, those can be carried forward until they are used. Hopefully, that doesn’t last too long! The goal of real estate investing IS NOT to generate tons of losses, it’s to make gains.
And the definition for an active real estate professional is pretty easy to find, but it’s unlikely if you’re practicing medicine full time that you qualify.
1. More than one-half of the personal services you perform in all trades or businesses for the tax year must be performed in real property trades or businesses in which you materially participate (you must spend more hours on real estate activities than non-real estate activities, to prove that you earn your living in the real estate world), and
2. You must perform more than 750 hours of services during the tax year in real property trades or businesses in which you materially participate. (This minimum-hour requirement prevents a retiree who spends 400 hours a year managing a rental property from qualifying).
http://www.forbes.com/sites/anthonynitti/2014/07/09/tax-geek-tuesday-the-irs-finally-figures-out-the-real-estate-professional-rules/
WCI,
One way to legally use the “professional real estate investor” designation is to have your spouse work “full-time” in the real estate profession of your business and file your returns jointly.
This obviously needs to be documented and legit, but it is one thing I’ve been working with my own spouse on that once she’s tired of her corporate career, that our assets are substantial enough to cover all of my W2 income as well as that of our real estate investments (We have a current portfolio of a couple dozen SFH’s and a partial interest in a couple MF’s).
Just some food for thought.
ADK
I’ve been trying to talk my wife into a real estate career for years. No dice.
Great post. You are spot on. Better explained than most RE books.
Potentially stupid but here goes:
I have this deal in place. Bought single family home for 134000. 20 year amor 5 year balloon at 4%. Rents for 1200/month. Insurance is 600/year, property tax is 1300/year. Lease stipulates that renter pays utilities and yard care. Cap rate is thus (if I’m doing it correctly) is a bit over 9. Mortgage payments will be 9744.12 a year. Cash flow is therefore 2255.88 ((14400-1300-600)-9744.12). Of the 9744.12, 5173.46 is interest and 4570.66 is principal. Building/land is assessed at 110000/30000. So I depreciate 110000/27.5 for 4000 a year. So Princ+CF is 4570.66+2255.88=6826.54. Subtracting deprec is 6826.54-4000.00=2826.54 as taxable income.
Does all that seem correct?
I estimate your cap rate at under 6%. I find it highly unlikely that you’ll get a cap rate of 9 out of this property. That would imply very few management, maintenance, and vacancy costs.
Its a new construction home, will be finished at the end of May, has a leaser ready to go in June 1st. We close on it May 30th. That’s why I estimated all the things you mentioned at close to 0. I live in the area so I will “manage” it myself. All appliances and equipment have a 1 year warranty being new construction. Vacancy I didn’t properly calculate, but I have a leaser for at least the first year under contract before the house is even finished, so I estimated 0 for that for the first year.
Does the rest of the math seem correct? Would it be more appropriate down, even thought the cash flow is positive with zero down?
Thanks for the reply!
Remember that just because you do it yourself, doesn’t change the cap rate. You’re just doing a second job as a manager/handyman etc. When figuring the cap rate, assume you’re hiring somebody to do all that. I find the 55% rule is a pretty good estimate, but could be lower for quite a while on a new construction.
One more (sorry for excessive questions),
What is the math behind finding the after Tax return % and leverage? I can’t make the numbers work…
I’ll try to find that spreadsheet when I get a chance and look at it again. Keep in mind this was published weeks ago and written months before that.
I can’t figure this one either. any help is appreciated.
What is the math behind finding the after Tax return % and leverage? I can’t make the numbers work…
What numbers do you get?
Is the reason you are targeting 5-7 year hold to accelerate the depreciation schedule? Otherwise, I don’t see the logic in turning over the property (increased transaction cost, etc).
Everything else makes a lot of sense to me. Thanks, as always, for the great topic.
Most of these deals seem to have 5-7 year holds presumably for liquidity. Obviously if you’re buying a property yourself and not going through a crowdfunded site, you can do whatever you want. But your leverage decreases significantly over those 5-7 years due to amortization.
I was curious to whether or not if you have actually done a 1031 Exchange before? I am aware of the several rules required to execute this strategy, but have not read much in regards to how much this actually costs. I see it often referenced to larger valued properties (Commercial, multi-family, etc.), but wanted to know if the fees are pretty heft and if it is even economical on smaller single-family residential income properties? The economy of scale doesn’t help on these smaller valued properties. Sounds great, but is it?
I don’t think the fees are terrible, but obviously don’t do it if the costs are greater than the benefits. It’s just a little extra paperwork, not another realtor commission.
The goal of every business should be to increase your money. To put it in easier words, money is a double game. The goal is to multiply your money again and again and again. As a real estate investor, investing is where most of our money comes from and as we all know, the real estate business is a slow but steadier business. The real estate business is a business that usually takes years to make a profit which is why our real estate training course wants to teach you how to be more time efficient to make sure that the you reap your profits without any delay.