As the saying goes, you have know when to hold them, and know when to flip them (or something like that). Buying a property for rehab works means deciding if you are going to flip it back on the market as soon as possible, or possibly keeping it and renting it out for a while. There are a bunch of questions you have to ask yourself before making that decision, though. Do you want to be a landlord? Do you think the market is at its peak, or is it going to go up in the future? Will selling now really allow you to recoup the highest return? If you are leaning toward a fix-and-hold, there may be one consideration that you haven’t thought of: tax benefits.
The tax benefits associated with owning real estate are far better than any benefits you’d receive by owning your own business. Cash flow from rental property in particular has its own set of IRS rewards. A Socotra Capital hard money loan can help you secure rental property, so you not only reap the investment but also its related tax deductions. Having rental property in your possession can be a great way to expand your business while still enjoying tax benefits.
Rental Income Fares Better With the IRS
Investing in real estate is much like being self-employed, with one big difference, as Brandon Turner points out in Entrepreneur magazine. In his article, Turner asks, “If you earn $100,000 at your own business and I earn $100,000 through rental properties, who gets to keep more?” You might be surprised, but the answer is the real estate investor. Rental income is taxed differently than self-employment income, and, in some cases, extraneous taxes, such as Medicare tax, are not due on real estate property income.
For example, assume you own one rental property with two units. You charge a monthly rent of $1,000 for each unit. Because both units are leased, your total rental income for the year is $24,000. You will not owe Medicare taxes on your rental income because you did not meet the income threshold, which ranged from $125,000 to $250,000 depending on your filing status for tax year 2014. However, you would owe Medicare tax on your business income regardless of your overall earnings.
Another advantage of rental income over self-employment income is that you get to deduct the expenses of maintaining your rental property, and these expenses tend to total a greater amount than general business operating expenses. The list of allowable deductions is extensive, and includes:
- Casualty losses
- Local property taxes
- Management fees
- Mortgage interest
- Pest control
- Real estate taxes
- Trash removal
- Yard upkeep
Let’s continue with our scenario above. Assume one of your tenants has just moved out and you need to advertise to rent the unit. You work full-time, so you’ve hired a property management company to sort through the applications and find the perfect tenant. They do so and bill you. Your advertising fees and commissions paid to the property management company will be deductible expenses for that tax year. When you add those to all of the expenses you incur maintaining your duplex, you have a nice chunk of change to reduce your taxable rental income.
Your Property Depreciates
Depreciation is a fancy word for aging, and as your rental property ages, you can recover what the IRS calls the property’s “cost basis” via depreciation. Unlike with a car, a rental property allows you to deduct the normal wear and tear of doing business. Remember, this isn’t just something you own, it is your means of income, so it is treated differently by the IRA.
Once you’ve rented out your property, your allowable time for depreciation begins. You are in this depreciation period until you stop renting or until you sell the property, after you have recovered the cost basis of the property via the deduction. This deduction provides an even greater reduction of your taxable rental income throughout the depreciation period.
You Can Use Your Savings for Additional Investment
What does all of this mean? Your tax savings can be put back into your rental property, increasing its overall value and your ability to assess higher rents. You can also use your tax savings to purchase additional property to rent out as long-term housing – or you can:
- Upgrade your properties
- Purchase other types of rentals, such as vacation rentals
- Pay off your mortgages more quickly, and once paid…
- Sell the original rental property for a profit
It’s never a good idea to try to time a market perfectly. However, having a rental property as part of your portfolio allows you flexibility, income, and tax benefits, so that you can see a market evolve over the long term. You earn additional income from your tenants, you are taxed at lower rates, and you are afforded deductions to reduce your overall taxable gain. You just have to get started. Socotra Capital can get you into the rental property game with cash-out refi or buy-and-hold loans, among other lending options. We work with investors to get them into rental properties perfect for turning a profit.