Is Rental Real Estate a Good Investment in the First Place?
Last year a client called to ask my view on a piece of rental real estate he wanted to purchase; a four-plex. In theory, I think the right type of rental real estate can be a good investment, particularly when you account for the ability to use rental real estate tax deductions. And of course the key advantage is you get to use someone else’s money to accumulate an asset. Sounds pretty good to me.
Reality doesn’t always mirror theory. (Read What Would I Do, Buy Investment Property or Invest in the Stock and Bond Markets for a thoughtful analysis on the pros and cons of investment property.)
In his case, I asked him to send me all the numbers; things like purchase price, down payment, financing terms, repair money he would have to put into it upfront, real estate taxes, estimated annual maintenance costs, expected rents, etc.
We added in an expected vacancy rate and additional expenses because we know there are always costs people forget about. (Read 3 Things to Consider Before You Buy Investment Property to see what you need to consider.)
Rental Real Estate Tax Deduction Basics
We ran the numbers through a spreadsheet we created so that we could see the affect of any rental real estate tax deductions that he might be able to use; basically the spreadsheet factors in his tax bracket and his ability to use any net rental losses to offset other income. (To make good financial planning and investment decisions you must do tax planning.)
When you own rental real estate you get to depreciate the asset, and even if your rental income covers all expenses, more often than not, from a tax perspective a loss is created. This loss is often referred to as a rental real estate tax deduction. Whether you can use this rental property tax deduction or not depends on how much, or how little, other income you have.
If you have too little taxable income, this loss doesn’t benefit you much. And if you have too much taxable income ($150,000 or more) you are not allowed to use the loss. But for those in-between, the tax deduction created from owning a piece of rental property can be advantageous. (See See Rental Income and Expenses – Tips for Schedule E for specific on rental real estate tax deductions.
Our analysis showed that it would likely be a good long term investment, and that he would be able to use the rental property tax deduction. He bought the property.
How Rental Property Tax Deductions Affect Other Planning Decisions
Now, a year later, we were re-evaluating. It took longer than expected to get the property into rental-ready shape (it always takes longer). The rents he could actually charge were less than what his agent had told him (they always are, but we had accounted for some of this with the vacancy rate we had used). He was feeling like maybe it had not been a smart move.
The factor he forgot about in his own analysis was that the tax deduction created saved him $4-$5,000 a year in taxes. That’s real money that would have been paid to the IRS in the current year.
As an aside, as we were talking, he also wanted to know if he should increase his 401k contributions. Because of the rental loss, and his other deductions, his effective tax rate was running at about 15%. We decided it did not make sense to put deductible money into his 401k plan at 15%, and possible pay a higher tax rate ten years down the road when he withdraws it. A ROTH IRA contribution made more sense for him.
It will be many years before we know if the return on the investment property was in the range we projected. Only hindsight will tell us whether it was a good move. We do know we did the planning right.
These kinds of decisions are complex. What you decide to do financially in one part of your life (buy investment property) affects what you do in other parts of your life (401k or ROTH IRA).
When making these decisions make sure you take the time to learn the rules yourself and/or hire a qualified financial advisor and a good accountant.