There are four primary benefits to investing in real estate:
1.The first of these is cash flow. What is cash flow exactly? Well, to put it in simplest terms, cash flow is what money you have left over after the mortgages, the taxes, and the insurance have been paid. Again, the tenant pays you rent, and that money pays off these items. Whatever is left over goes into your pocket……that is cash flow.
2. Though many people buy rental property for cash flow, the real benefits that can build your net worth lie elsewhere. The second main benefit from buying rental property is the tax shelter that it creates for you. What does this mean exactly? Well, each time you buy a residential rental property, the IRS allows you to depreciate that property over 27.5 years. In other words, you can take this depreciation expense against your active income from your job. Let’s use a quick example:
Say you buy a $200,000 rental property. Again, the IRS lets you depreciate the building, not the land. Normally, 85% of the purchase price is used to determine the building, the physical house’s value. In this example, the IRS lets you depreciate $170,000 (the property) over 27.5 years. This is equal to $6,181 per year you can take a depreciation expense against your active income. In other words, say you make $80,000 in income from your job. Now, take $80,000 minus $6,181, which gives you $73,819. Now this is the income that you pay income tax on, $73,819, not $80,000 (which you actually made.)
You can see how by buying this one property, you have reduced your taxable income significantly. As you can guess, if you buy two houses, this number doubles, three, triples, etc. A real estate investor can usually take up to a max of $25,000 in depreciation expense each year. For those who qualify as a “real estate professional” through the IRS definition, this can be an unlimited number. Please be sure to talk with your CPA to find out how the numbers will play out in your personal situation.
It is important to remember however that the above examples are tax deferrals. If you sell the property, you do have to recapture this tax. However, many real estate investors use a 1031 exchange to continue to defer this tax.
3. The third main benefit from owning rental property is appreciation. As we know, not all debt is bad debt. In fact, many say that real estate debt is the best type of debt to have, for it is potentially appreciating debt. Again, your home may not appreciate at 10%, or even 5% every year, but at the very least, it should go up over time. This is the area that most real estate investors build their long-term wealth. Buy the properties, and then hold them.
Time for another quick example: say you buy two rental homes totaling $400,000. Now let’s say those two homes appreciate 2% a year over 10 years. You now have homes that are worth $488,561. You now have $88,561 in equity by simply buying the houses and holding onto them. Remember however, equity is not cash in your pocket. It is a number on your balance sheet. If you wanted to sell the above properties, you would have selling expenses of course which would reduce the above numbers.
For comparison sake: Minnesota real estate, from 1940 to 2000, has appreciated 2.26% on average per year. (See this link below)
We also encourage you to go out and read the book Equity Happens (www.EquityHappens.com.) The basic premise of this book is yes, over time equity does happen, often times very, very slowly. But if you hold onto the real estate long enough, most owners see an increase in prices over time.
4. The last benefit from owning rental property is achieved through the paying down of the principal balance on your mortgages. Again, the rent you receive from your tenants will go towards paying those mortgages. Most of that money goes towards interest the bank charges you, however, some will go towards paying down the debt you owe. Over time you will build equity through paying down the loans as well.