Buyers

Ryan K. Bohl, CPA Bohl and House, LLC

Ryan K. Bohl, CPA
Bohl and House, LLC

Contributed by Ryan K. Bohl, CPA; Partner, Bohl and House Certified Public Accountants

1.     Greater control over your investment

 

When investing in real estate, you are in control of the investment.  You are able to choose who you want to rent to and can control your expenses through well written rental agreements.  You determine what improvements to make to the property and how much you want to rent it for (as long as market conditions allow).  Also, inflation is usually less of an issue with real estate because as inflation goes up, your rental income will also likely rise.   

Contrast this to investing in stocks or bonds, where the managers of the company make the decisions and outside economic factors, such as general market conditions and inflation, have more of an effect on the value of your investment.   

 

2.     Tax-free growth of your investment through appreciation in property values

 

As with stocks, real estate can appreciate or go down in value from year to year.  The good news with both types of investments is that you are not taxed on the appreciation in value until the investment is sold. 

One advantage of real estate over alternative investments, though, is that you may be able to create additional property value through property improvements, upgrades, etc.  For example: say you pay a contractor $10,000 to update an old kitchen in a rental property.  That update could cause the market value of the property to increase by even more than the $10,000 you paid the contractor, giving you additional equity in the property.  It could also allow you to increase the rent you are charging, creating additional value through greater monthly income.     

 

3.     Diversification from your other investments

Real estate investments can give your investment portfolio added diversification, which you can use to hedge against losses in years when the stock market does poorly.

 

4.     The ability to use other people’s money to create a greater return on investment

With real estate, you have the ability to borrow money from a lender to increase the potential return on your money invested.  For example, if you have $20,000 to invest, you can only buy $20,000 worth of stock (maybe a little more if you have a margin account).  However, that same $20,000 could allow you to buy $100,000 or more worth of real estate through leveraging other people’s money.  This can drastically increase your return on investment.

Example:  You purchase a $100,000 house with 20% down, or $20,000.  The house will rent for $12,000 per year and has expenses, not including debt payments, of $3,000 per year.  The debt service on your $80,000 note over 25 years at 5.5% is $491.27/month, or $5,895 per year.  After making your monthly loan payments, you are left with $3,105 positive cash flow in year 1.  This represents a 15.5% return on your $20,000 invested.

In addition, the income from your monthly rent was making your full loan payment.  This resulted in your tenant paying down your loan by $1,534 in the first year on top of your positive cash flow.  Add that additional equity to your cash flow income and you made 23.2% on your $20,000 investment in year 1, which does not even account for any appreciation in property values.  

 

5.     Real Estate has tax advantages not available with other investments

There are several tax advantages available with real estate that are not available with other investments.  Just some of these advantages include:

1.       The ability to use a 1031 tax-free exchange to rollover profits to defer paying taxes on gains

2.       The potential ability to use paper losses from rental real estate to offset other income (this is a complex issue, so consult your tax adviser to see how this applies to you).

3.       The ability to pull cash out of your property tax-free through a cash-out refinance

4.       The ability to deduct all expenses associated with your rental activity, including mileage, interest expense, repairs and maintenance, taxes, insurance, etc. 

5.       The ability to deduct depreciation expense on your rental property investment.  The following example will illustrate how depreciation will lower your taxes compared to investment alternatives:

You have $100,000 to invest and are comparing two investment options:

Investment Option 1:  Invest $100,000 in a corporate bond, which will provide you with a 6% pre-tax annual return on your investment. 

Your 6% annual return yields you $6,000 of income that is 100% taxable.  If you are in the 35% combined Federal and state tax bracket, this will cost you $2,100 in taxes, leaving you with only $3,900 of after-tax income.

Investment Option 2:  Invest $100,000 in a residential rental property, from which you will receive annual rents of $10,000.  You will have expenses, however, such as taxes, insurance, management fees, maintenance costs, etc, that will total $4,000 per year. 

Since your rental income less your expenses leaves you with $6,000, your total pre-tax income from this investment is the same as Investment Option 1, above.  However, unlike Investment Option 1, the $6,000 of income from your rental property is not 100% taxable.  The reason for this is that you are allowed to depreciate the purchase price of your rental house over 27.5 years (possibly even faster for some components).  For this example, we will say the $100,000 purchase price was allocated $10,000 to the land (not depreciable) and $90,000 to the house.  This will allow you an annual depreciation deduction of $3,273 ($90,000/27.5).  You are allowed to deduct this depreciation from your net income for tax purposes, leaving you with only $2,727 of taxable income ($6,000 – $3,273).  Assuming again you are in the 35% combined federal and state tax bracket, you would only pay $954 in taxes ($2,727 times 35%), leaving you with $5,046 of after tax income. 

As a result of depreciation expense, Investment Option 2 will actually leave you with $1,146 more dollars after-taxes each year, even though each investment had the same pre-tax rate of return.

Contributed By:

 

Ryan K. Bohl, CPA

Partner, Bohl and House, LLC

www.bohlandhouse.com

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