Rental properties are considered by many to be the IDEAL investment, using an acronym describing the five primary benefits of owning rental real estate. While any particular property must be carefully evaluated on it's own merits before making an investment decision, rental properties, in general, have historically proven to be one of the best investments in America.
Rental properties provide a monthly income via the collection of rent from tenants. The properties obviously come with expenses, too, such as the mortgage payment, maintenance, insurance, and property taxes. The net operating income of a property would be any amount left over after subtracting operating expenses from rental income. In order to avoid buying rental properties a negative cash flow, many investors evaluate the NOI of the property and use this number to determine the mortgage payment the property can support. This, combined with any down payment, determines the maximum price an investor would pay for a property while still getting the desired cash flow income.
While depreciation is not an actual cash expense, it allows for significant tax savings. IRS depreciation rules allows you to write off the cost of the property, minus the value of the land, over a period of 27.5 years. This creates a substantial tax deduction without having spent any actual cash and can heavily reduce or even eliminate the tax you would otherwise pay on the rental income from the property. Depreciation costs might even create a loss that will decrease other taxable income.
As you pay the mortgage on the property each month, you are building equity in the property. The best part of this process is that you are actually doing it with somebody else's money when you have a tenant paying you every month. Equity accelerates with time as more of each monthly payment goes toward paying your mortgage principle rather than interest. Equity building is the primary benefit of using a long-term "buy and hold" approach to real estate investing.
Real estate values historically climb over the long term. Property values in the United States increased an average of about 5 percent per year during the period from the 1970s until the late 2000s. While not guaranteed to appreciate, real estate traditionally has done so, and generally does not suffer from the volatile price swings of the stock market.
The idea behind financial leverage is that you can use a relatively small of money, or sometimes none at all, to obtain control over an investment asset. In the case of real estate, you obtain control of a rental property with little money out of your own pocket in relation to the value of the investment. The remainder is provided by a lender in the form of a mortgage. By controlling an appreciating, income producing asset that also provides tax benefits for a small investment, your actual rate of return is magnified.
Jassen Bowman is an IRS-licensed enrolled agent who specializes in IRS collections representation, small business tax law and international tax treaties. He has also served as a licensed real estate broker and investor. Bowman holds a Bachelor of Science in nuclear engineering technology.