Want to Make Money in Real Estate? Understand Returns

Most people purchase real estate in hopes of earning wealth from their purchase, just as they would with any other investment asset.

However, real estate is unique in that it has four distinct components of investment return.

Essentially, here are the four ways you can make money as a result of real estate ownership:

  • appreciation in value
  • cash flows
  • income tax benefits
  • mortgage principal pay down

make-money-in-real-estateIt’s important to note that just because there are several components of returns, that does not mean you will earn money on real estate investments.

Many people lose money due to insufficient research and analysis, as well as through unmitigated risk issues. Do your homework before investing in real estate.

Appreciation in value

Most people buy investment properties with the thought that “it will appreciate in value and I’ll get rich.”

If the past six years have taught us anything, it is that real estate doesn’t always go up on value.

However, over long periods of time, say 15 to 25 years, real estate seems to perform well and has earned much wealth for many long-term holders.

Be aware, though, that appreciation does not pay the bills. It is better to invest based on cash flows, the next noted component of returns.

Cash flow positive

Most real estate investors do not understand how to pencil out their real estate deal. What this means is putting conservative estimates of rents and expenses down on paper and making sure that the rents, less all the expenses, leave the owner some cash in the bank. We call these “cash flow positive” properties.

Buying properties with true positive cash flow is the best way to ensure that your investment will add to your wealth. Far too many buyers purchase negative cash flow real estate and take additional monies out of their bank accounts each month, for years, to cover the deficit. That is no way to invest your hard-earned capital.

Income tax benefits

There are potential income tax benefits from owning rental properties. “Benefits” means that as a result of your ownership, you pay less in taxes than you would have if you did not own the property. Unfortunately, few investors really understand how this works.

If you are self-employed and pay little in taxes or you have income greater than $150,000, you probably have little tax benefit from your real estate ownership. Before you start banking on the tax benefits you’re going to get from a real estate investment, consult with a tax pro who can tell you whether or not you will actually save a dime.

Mortgage principal pay down

If you have an amortizing mortgage – which most are these days — you may realize some return. Each monthly mortgage payment pays the accrued interest, plus a little bit of the outstanding principal of the mortgage. That principal is pure investment return and it can really super-size your returns.

However, principal pay down does not provide cash flow, so it can’t help pay the bills if you need money for a plumber, electrician or handyman.

While all the investment returns may help your long-term wealth, the cash flow component is the most important. Cash feels nice in your hands, it pays the bills and, most importantly, it accumulates in your bank account and earns interest.

If your investment doesn’t generate cash, you won’t be able to pay the mortgage, you’ll likely lose the property and you’ll never realize the returns you’d hoped for.

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Do You Understand Income Tax Considerations of Rental Properties?

A rental property can generate “taxable losses” that can be used to reduce your normal salary income, hence the federal income taxes you pay.

Do-You-Understand-Income-Tax-Considerations-of-Rental-PropertiesIt’s difficult for most people to understand how taxes work, and even more confusing once we get into the realm of rental properties and taxes. Note that understanding how taxes impact personal residences are a completely different topic, as those are governed by totally separate tax codes and go elsewhere on your 1040 form.

Below are some of the basics to understanding rental properties and federal income taxes.

Often I hear people saying that they want to buy some real estate to save money on income taxes. However, depending on your tax situation, owning real estate might not save you a dime on taxes. It wholly depends on your specific tax picture and the IRS rules about Passive Activity Loss Limitations.

First and foremost you should never make real estate investment decisions based solely on tax considerations. The first order of business is do your due diligence and determine if an investment makes sense based on cash flows, cash on cash returns, renovation costs, rental income, financing, and the risk of any particular property. Once you believe it makes sense in every other sense, then you can contemplate the tax effects.

Important note: Always have a CPA, attorney or licensed tax professional guide you through your individual tax picture — this article is an illustration of one scenario but your scenario can be very different based on your financial picture.

To better understand, let’s first quickly discuss the IRS 1040 form.

The 1040 form you fill out each year does two things:

  1. Calculates the amount of federal income taxes you owe for the year based on how much you earned in salary, income, wages, profits and distributions — LESS all the deductions (tax “shields”/subtractions) to those totals in the form of losses, deductions and exemptions to get to your Taxable income on Line 43. Then, look at the IRS Tax Tables and determine how much you owe in taxes based on your tax filing status (Single, Married Filing Jointly, etc.) and your Taxable Income.
  2. Second, it reconciles the amount you owe from #1 above against the amount you have already paid during the year. This is commonly called “withholdings” from your salary, or if you are self-employed, you probably paid quarterly estimated income tax amounts to the IRS during the year.
  • If you paid more in #2 than you owe in #1, you get a tax refund!
  • If you paid less in #2 than you owe in #1, you write the IRS an additional check!

Tax Considerations of Rental Properties

Rental properties generally show taxable losses for the first many years. That taxable loss is essentially another “deduction” that lowers your taxable income — noted in #1 above — and hence lowers your income taxes.

This chart below shows an example of how a loss would be calculated. For example, this property might show a ($7,500) loss. That loss would filter through your IRS 1040 form, reducing your taxable income, and hence reducing your taxes.

This is how you might save money on taxes by owning rental properties — using losses on your rental real estate to reduce your taxable income, which allows you to pay less in federal income taxes.

How much it reduces your taxes depends on your income and filing status. It is a little complicated and can get very complicated depending on your situation.

There are also limits on how much of a loss on rental property any particular taxpayer can use to “shield” their income. These limits are called Passive Activity Loss Limitations. If your losses are over $25,000 and/or your Adjusted Gross Income is over $100,000, you may not be able to use all of the losses. You may have losses, but you are not allowed to reduce your income with them based on the IRS rules. Consult a professional.

Have questions? Just leave me a comment below and I’m happy to help you!

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Is Now a Good Time to Buy Real Estate?

People always ask, “Is it a good time to buy real estate?” The answer is always, “Yes, but it depends.” In order to make that determination for you, we first must understand the three most important words in real estate:

Long-Term Ownership

is-now-a-good-time-to-buy-real-estateWe buy property, whether a personal residence or for investment, in hopes that we are financially better off down the road than we are today. The chance of that occurring is very low if one does not own real estate for at least five or more years. The reason is that transaction costs, repairs, monthly ownership costs higher than comparable rent, and ownership hassles dictate that it is better to invest your money elsewhere and stay as a renter if you are not sure you will own long term.

Therefore, since you are going to be a long-term holder (the longer the better) you really should not be that concerned with short-term current market price fluctuations because ten years from now the home’s value will be more than it is today.

What you should be concerned about is finding a house that you “love”— one that fits all the right reasons you want to own that particular property for a long time!

That could almost be the end of this article…but there are a few more issues to consider to make sure it is a good time for you to buy property. If you fail any of the below tests, you should think through the issue(s) and whether or not it really is a good time for you personally to buy.

1. You are planning to be a long term holder, 5+ years of course

2. For owner occupants – payments are affordable and you have a steady job

3. It isn’t significantly more expensive to own over renting – this very important.

4. For investors – It makes cash flow sense, 4-5 percent-plus cash on cash. The higher the better but watch out for returns that appear too good to be true.

5. It is the RIGHT property for you for all the right reasons; you “love” it!

6. It is fairly priced relative to the recent comparable market sales in the immediate area for similar properties

7. You plan to own it for a long long long time!

8. Vacancy isn’t too high in the area. This is very important whether an owner occupant or investor. Empty unstable neighborhoods or communities have a higher risk of vandalism and risk downward price spirals.

9. It is in decent shape and doesn’t need much fixing-up. Skip the junkers, the ones with foundation issues, or anything labeled as “needs a little TLC” in the listing, as that means it is a wreck. Leave the fixers for the contractors. And doing it yourself doesn’t usually save you much money.

10. It is not near a big vacant parcel, non-residential zoned parcel, empty or retail/industrial/religious site where you are not 100 percent sure what is going to be built or in use there. A new use of that land could impact your “quiet enjoyment” of your residential unit.

11. You complete the proper due diligence steps to reduce your risk as much as possible. Mind your contract terms and contingencies, pencil out your deal, get a couple of bids on financing and dissect your GFE, review the HOA condition, review the property condition, make sure you have the right type and amount of property insurance in place, make sure you adequately review the title abstract and title policy and everything else you need to do to lower your risk.

12. And you plan to own it a long long time!

Those Three Important Words? I laughed when someone once said “location, location, location” were the three most important words in real estate. Not only is that actually only one word but we pay a handsome premium for “location” and is that premium worth it? It may or may not be, but “long-term ownership” are by far and away the three most important words in real estate.

To summarize: Subject to the above issues, it is always a great time to buy real estate but:

  • Not for everyone,
  • Not at any price, and
  • Not just any property.

Find a house you love or rental property that makes sense, that you will own for a long time, is in decent shape, lock in a long-term mortgage and sleep well.

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Investing? 6 Types of Properties to Pursue

If you’re interested in improving your lot in life — no pun intended — by becoming a property mogul and investing your hard-earned capital into income-producing properties, there are some general guiding principles that should increase your chances of earning wealth.

One of the better ways to improve your wealth is to reduce your risk on the properties you purchase. This will allow you to buy lower-risk real estate, which hopefully will earn a fair amount of wealth for you over time. Go for these:

Properties in very good shape

Too many people buy fixer-uppers thinking they’ll add value by doing a renovation. Then they get mired in a much more expensive and time consuming property than they ever expected. More money into the property means lower investment returns for you and less wealth-building than you expected. Skip fixers and instead buy properties that are in as good shape as possible, which should get those rental checks coming into your bank account in as short a period as possible.

Properties in moderately priced areas with good cash flows

Real estate is all about location, location, location! The properties in the best locations (think beach areas, downtown, wealthy enclaves) generally have very negative cash flows, so those are the location, location, locations you want to avoid. The moderately priced properties in working-class areas are the real gems; they generally have the boring locations, but much better cash flows. Of course pencil out any deal with conservative rents and expenses, and go for beginning year cash on cash return of at least 4 to 6 percent, based on your conservative estimates.

Communities with HOAs in good financial, legal, operational shape

There are many, many landmines in buying properties in common interest developments. And you aren’t just buying your property; you’re buying into a larger entity called the homeowners association (HOA). And if it is in financial, legal or operational trouble, you pay the bills. Make sure to do your due diligence on this — and it’s a lot of hard work to do it properly. Learn what you need to look at way before you go into escrow.

Properties that come with decent credit quality tenants in place

There is nothing better than buying a property with a decent tenant already in place. You get the security deposit and pro-rated rent, and you don’t have to go in and clean, paint, update or fix too many things in the unit. If you buy properties in areas that have decent credit quality tenants, that’s hopefully the type of tenant you will inherit. Also take a look at the current tenant’s lease, credit application andcredit report, if you can, before you make the decision to purchase the property.

Properties in low vacancy areas

Vacant units get robbed, incur vandalism and don’t have any rent coming in to cover the bills. If you buy in places with really high vacancy, it might be months or years before you get the property rented out at a fair rental rate. So really think through buying properties in areas with many unoccupied units. Drive around at dinner time: No lights in a lot of neighborhood houses means no one is residing there, and you shouldn’t, either.

Properties you will own a long time

The most important factor in real estate investment property is to own it for a long time — in fact, forever is the optimal ownership horizon. So do your due diligence and buy quality properties that you really like for all the right reasons, and plan to own them for good. That’s your best bet to earn wealth on real estate.

If you buy properties with ALL the above characteristics, that will greatly increase the chances you will add wealth to your nest egg from your real estate ownership. So try to acquire properties that have as many of the above good qualities as possible, and skip the ones that don’t make the cut!

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