One of the many benefits of owning cash flow properties is that real estate rent, collected as income, are considered passive income by the IRS and are exempt from FICA taxes –no matter how large they grow! Most earned income is not exempt, and if you happen to look at your standard paychecks you will see a FICA deduction.
In addition, all expenses for the real estate investment are deductible against the passive rent income. Examples of deductions are: interest expense, taxes, insurance, utilities, repairs, homeowner’s association dues, management fees, legal fees, accounting fees, and any other expenses paid due to owning and/or renting a property. The depreciation of the property can also be used as a deduction. After deductions are taken –if your income is zero or a net loss you will pay no ordinary income tax and under limited circumstances may be able to apply some or all of the loss to offset taxes on your salary. Of course, I am not a tax advisor and you would be wise to consult a tax professional on your own individual taxes.
For most property owners, interest expenses are the number one deduction during the initial phases of ownership. Many investors finance as much as possible, up front, to leverage their initial capital investment. The interest expense declines over the life of the loan, unless of course the loan is refinanced to take out equity. While the interest deductions decrease, the cash flow of the property typically increases as rental rates increase or keep up with inflation.
When the property is sold, the capital gains can be deferred if a 1031 exchange is utilized in the transaction to purchase another “like kind” property. All the closing costs including real estate commissions reduce the taxable gain amount or the cost basis being rolled forward in a 1031 exchange. Furthermore, its important to note that the sale of a personal residence is exempt from $250,000 (or $500,000 if married and filing jointly) of capital gain if the owner has resided in the home for greater than 2 years.
What to be aware of when you invest in real estate
Real Estate can be a very lucrative way to make money. One of the main indicators is the CAP Rate. This tells you your annual rate of return and how many years it will take to recoup your investment. This does not include the tax benefits, rather the actual return. If you buy a building for $1,000,000, but you only put down $250,000 (25%) then your personal CAP Rate is based on $250K.
You add up the rent and all other income and subtract the following (each case may different, but this is just a guideline what to look out for):
* Mortgage Payments
* Vacancy Rate (this can depend on the building and area)
* Management (even if you do it yourself you should calculate what it costs you)
* Utilities (If the tenants don't pay it)
* Maintenance (every day stuff like cleaning the common area)
* Minor Repairs (you should assume a certain amount of repairs will need to be done throughout the year)
* Major Repair Work (depending on the age of the building, and when certain items were replaced)
* Legal Fees (some tenants might not want to leave on their own, this is not a constant, just something you should be aware of)
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