Learn how you can invest in real estate in a winning style….
It is important that those who plan to invest in real estate know what to expect on the front end–not after purchase when they could have possibly made costly mistakes.
And with rising interest rates and rising property values at this time, it is more important than ever that you purchase your property in the best way possible.
In this discussion TheWealthIncreaser.com will discuss the importance of investing in real estate in a manner that is more beneficial and rewarding for you and your loved ones.
If you are one who have invested in real estate in the past and are curious if you invested in the best way possible–or you desire to invest in real estate at some time in your future–you can now do so in a more confident and assured manner as you move through the various stages of your life.
By learning what you need to know prior to investing–you can achieve results that will show, and you can move at a pace that is not slow. Although conciseness is the goal–this post may be somewhat longer than most that are created by TheWealthIncreaser.com
Even so, this post will be created with your lasting wealth building success as the guidepost.
Determine if you are in position to invest
Although you can choose to invest in real estate or any other investment on a whim, that is generally not the best approach to take. It is important that you have your finances in order at a “designated level” so that you can enhance the odds of success in your real estate investing.
By fully grasping your need to have an understanding and effective application of cash flow management, credit management and the overall management of your finances, you put yourself in a much better position for lasting wealth building success.
Determine that your cash flow before taxes, expected appreciation, principal reduction and income tax position are at an acceptable level on the property you plan to invest in
Prior to purchasing real estate as an investment, it is important to as best you can to know your cash flow before taxes, your anticipated appreciation, your principal reduction and income taxes that you will pay or save on an annual basis, and for at least a 5-year period, if you plan on holding the property for 5 years or longer. Estimates over 5 years are more likely to be inaccurate as forecasting over 5 years with real estate can be highly unreliable.
Just where would I get the above information and how do I calculate that information for my greater benefit–you ask?
If you are purchasing a single-family home that has not been rented by the seller you will have to research and make more assumptions than if the property was already a rental property. If the property is currently rented or leased, you have more options.
If it is a rental or leased property that you are purchasing, you can get the Gross Operating Income (annual rent minus vacancy rate of 10%–i.e., $100,000 minus $10,000 equals $90,000) from the seller (possibly on IRS form schedule E) along with the operating expenses and come up with the net operating income.
GOI = $90,000
Operating Expenses $40,000 (you would get from the seller’s schedule E–you may have to make adjustments)
Net Operating Income is Gross Operating Expenses minus Operating Expenses
$90,000 – $40,000 = $50,000 NOI
You would then calculate your annual debt service based on your anticipated offer or purchase price unless you were paying all cash.
$600,000 Purchase Cost
$100,000 Cash Invested
Financing Amount $500,000 Interest Rate 7% Term 30 years
Monthly Principal and Interest $3,326.51–Assume January closing
If you have an HP 12C financial calculator the keystrokes would be as follows:
$500,000 pv, 7gi, 30gn, PMT = $3,326.51 multiplied by 12 months = $39,918 which is your Annual Debt Service.
Assume that the depreciation that follows was allocated at closing by the seller, you will often see depreciation broke down by only the building and land and that may not be the most beneficial to you from a monetary perspective over the length of your real estate holding period.
Depreciation: Land $100,000 (you cannot depreciate)
1) Building 27.5 years–$400,000 * 3.48% = 13,920 2) Land Improvements 15 years–$40,000 * 5% = 2,000 3) Personal Property 5 years–$60,000 * 20% = 12,000
Total Depreciation (depreciation percentages are from IRS Depreciation Chart) $27,920
NOTE: Land cannot be depreciated, also note the breakdown for depreciation consists of the potentially more advantageous breakdown into 3 categories–not 1 (building only) –as you normally would see on many tax returns that have rental property.
Inform your accountant, tax professional or other professional (or preferably have the seller break down for you prior to closing the amount allocated for the building, land improvements and personal property–must be reasonable to withstand IRS scrutiny) of the above breakdown if you purchase rental real estate as it could mean more money in your pocket.
Now that you know your gross operating income is $90,000, you then subtract out both the operating expenses (seller’s schedule E–you may have to make adjustments) and the annual debt service (you calculated based on your offer price) from your Gross Operating Income to come up with your Cash flow before taxes.
$90,000 – $40,000 – $39,918 = $10,082 Cash flow before taxes
As far as the Appreciation calculation, it is best to do your initial analysis with the assumption of zero percent appreciation. In addition, you can further analyze the purchase by using the average of appreciation over the past three years in the area you are considering purchase of your property (or some other reasonable benchmark) to gain added insight on the wisdom of investing in the given property.
As calculated above, your first-year debt service would be calculated based on your loan amount, loan term and interest rate and you would then know your interest for the first year and Principal reduction (again you may need a financial calculator or loan chart).
If you have an HP 12C financial calculator handy, the keystrokes would be as follows:
HP 12C $500,000 pv, 30gn, 7gi, PMT = $$3,326.51
1n, 12f amort = interest of $34,839.10 for year 1
xy button = principal of $5,079.05 for year 1
Total P & I: $39,918
Based on the calculations above you know that your Cash Flow before Tax is your gross operating income of $90,000 minus your operating expenses of $40,000 minus annual debt service of 39,918.
$90,000 – $40,000 – $39,918 = $10,082 Cash flow before taxes
Total Principal and Interest: $39,918 is your Annual Debt Service.
Appreciation: Assume 8% after 1 year of ownership–$600,000 * 8% = $648,000 or $48,000
Principal Reduction would be $5,079 after 1 year
Your Income Tax paid or saved would be calculated by taking your Net Operating Income (gross income minus operating expenses–$90,000 – $40,000 = $50,000) minus the first-year interest minus the total depreciation to come up with your taxable income. You would then multiply the taxable income by your marginal combined federal and state (if applicable) tax rate to come up with your income tax paid or saved.
NOI $50,000 – Interest $34,839 – Total Depreciation $27,920 (calculated above) = Taxable Income of $12,759 multiplied by tax bracket of 35% equals Income Tax SAVED of $4,466.
$1,082 + $5,079 + $4,466/$100,000 = 10.63% ROI
Note: If your NOI exceeds your interest and depreciation, you will pay taxes and not save on taxes, however depreciation and expenses would still have the effect of lowering your overall taxes. In addition, if you purchase real estate and quick turn for a profit you will pay taxes on the gain at your ordinary income tax rate. If you sell after one year you would pay tax at your capital gains rate. Your rental paper losses can be used to offset other income on your personal tax return up to a limit, unless you qualify as an “active investor” during the year.
i.e NOI $50,000 minus Interest of $34,839 minus Total Depreciation of $2,161 (hypothetically) = Taxable Income of $13,000 multiplied by tax bracket of 35% equals $4,550 Income Tax PAID on the rental property. Your other income, deductions and credits would determine whether you owed taxes on your personal return.
$1,082 + $5,079 + ($4,550) / $100,000 = 1.61% Hypothetical ROI when interest and depreciation does not exceed NOI in this particular example
Determine if the return on investment (ROI), capitalization rate and cash on cash ratios are acceptable to you
You then take the Cash flow before taxes, your first year Principal reduction (unless you were paying all cash) and your Income taxes paid or saved and add together and divide by your cash invested to come up with your Return On Investment or ROI. If return is acceptable based on your market and what was acceptable to you–you would possibly consider proceeding with your offer. You can also add your expected appreciation to the equation to gain added insight on whether you want to proceed.
$1,082 + $5,079 + $4,466/$100,000 = 10.63% ROI
$1,082 + $48,000 + $5,079 + $4,466/$100,000 = 58.6% ROI with 8% appreciation after 1 year
You also want to calculate your Capitalization Rate (Cap Rate) to gain even more insight as you may be looking for a certain cap rate to determine if investment is worthwhile. If you are financing some of the purchase price, you want to make sure your interest rate is at least lower than the Cap rate–generally speaking.
The Cap rate is calculated by dividing the Net operating income ($50,000) by the Purchase price.
Gross Operating Income minus Operating Income: $90,000 – $40,000 = $50,000 NOI
Net Operating Income of $50,000 divided by Purchase Price of $600,000 = 8.33% Cap Rate
The Cap Rate does not take into account financing and is a favorite tool of Individual and Group Investors who pay ALL CASH, Insurance Companies, REIT’s, Institutional Investors and large investors as they are looking for a specific rate of return and they too will often pay ALL CASH–if the Cap rate is satisfactory and the property otherwise meet their criteria!
The Cash-on-Cash ratio can also be used, and it is calculated by simply taking the Cash flow before taxes and dividing by the cash invested.
Cash Flow Before Taxes $1,082 divided by $100,000 = 1.08% Cash-on-Cash ratio
NOTE: The above calculated results will vary by market and investors risk tolerance level and other factors, therefore additional research will be required by you. Be sure to do your own independent research as this discussion is not intended to be tax or accounting advice.
Analyze whether other real estate and non-real estate investment options are better for you based on your risk profile
You have the option of refinancing (cash-out or make improvements to property) or borrowing against your equity and pulling out cash at a later date after purchase, sell your property for a profit immediately or at a later date (taxes would be due unless an exception applied) or if done wisely–utilize a 1031 exchange to avoid or delay taxation and get a better return on your investment while doing so–if done properly.
You also have the option of investing in real estate by investing in Real Estate Investment Trusts, Exchange Traded Funds and/or Mutual Funds that hold real estate investments. You could also decide after reading this post and doing additional research that you would not like to invest in real estate at all but would like to invest outside of real estate or invest in your retirement accounts in some other manner.
In the same manner that some people have no desire to be a homeowner–you may have no desire to invest in real estate–however if you do, you at least have a reference point of what it may entail.
In the operating expenses on schedule E, you will normally find property taxes, insurance, management fees, maintenance fees, repairs (improvements or additions may not qualify as expenses) and other expenses related to the property.
Investing in real estate provides you the opportunity to attain a ROI and gain from the appreciation (equity) at a future date–if done wisely. If you can get a 15% return for 5 years and later sell after 5 years and get $100,000 in sales proceeds after the payoff of the loan and the payment of closing costs–that is cherry on the cake!
However, more work by you will be involved in real estate investing as compared to other investments.
Are you up to it, or would you rather not have that additional investment responsibility as you must be an active investor to maximize your investment in real estate–generally speaking–as there may be depreciation limits (you can only use rental losses up to a limit against your other active and portfolio income) if you are not an active investor?
Whether you desire to invest in single family homes, multi-family homes, apartments, shopping centers, office buildings or anything else real estate related, there are certain fundamentals that you must be aware of on the front end.
You must ask yourself if you are truly ready to invest and furthermore determine proactively if you are in position to handle the responsibilities that lie ahead.
As the current law now stands in the United States, you can purchase your home and cash in on the appreciation and principal reduction by selling your home and excluding the gain from taxation on up to $250,000 if you are single and up to $500,000 if you are married and you meet certain requirements. Therefore, it is important to purchase your home with these and other tax advantages in mind when you decide to purchase–and eventually sell.
If you can’t meet the 2 out of 5-year rule for your home and qualify for the tax exclusion, you may still qualify for a 1031 exchange where you can defer your taxes by exchanging your rental property for another like-kind property (be sure you are aware of the timelines) that provided a better return and/or appreciation potential.
IRAs can also be used to hold your real estate assets and may be worth looking into further by you. If you were to purchase a property and decided to do repairs and quick turn for a profit you would do a similar analysis as mentioned above–with some changes including proactively determining the costs and adjustments (particularly repairs and upgrades) that would be needed to get the best price when you re-sell.
Be sure to do all of the necessary analysis prior to purchase–not after!
For those who have invested in real estate in the past and still hold rental property who did not take advantage of the more advantageous (pun intended) depreciation options–it is still not too late as you can use form (actually your tax professional or accountant) 3115 to adjust your depreciation categories and amend your prior year returns if it makes good financial sense to do so.
You can send me the check in the mail later, just kidding!
It is normally not worth the hassle of doing so unless it makes real financial sense to do so as dividing your rental property by building, land improvements and personal property can normally increase your depreciation amount and reduce your taxes or increase your refund amount. Many tax professionals (including the creator of TheWealthIncreaser.com) find changing the depreciation in the manner mentioned above to be cumbersome, and should preferably be done on the front end (when you first purchase your rental property).
Even those tax and accounting firms who do the “depreciation separation” generally only do so for their high net worth clients.
In all seriousness–all the best to your real estate and wealth building success as you are now in a better position to put your real estate investing fears to rest…
Learn how you can achieve more–by getting more income, cutting your expenses or doing a combination of the two–if you sincerely desire to make your dreams come true!
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