Income producing real estate - enlighten me!!!

On rental property, the interest rate is usually a bit higher than owner occupied, so 6% or a bit higher is the current rate, $1000 is the interest only expense. Interest - $12K Property tax - $3k (?) Insurance - $1500 or so. Snow/Lawn/yr - $2000 Repairs - $4000

Tot - $22.5K Rent - $18K-$21.6K

There's no tax because there's no profit. In theory, the above works for some if you consider. My costs may be a bit high. The property depreciation provides a tax write-off and helps the cash flow. If the above numbers are interest only, and zero down payment, the owner gets all the appreciation, and potential for increased rents. Even claiming low appreciation, say 3%, jump ahead 5 years. The property is up $30K, and the rent has jumped nearly $3,000/yr.

The numbers you present are not a clear good or bad deal. What is the property tax on the house? Is there a cost for snow/grass? I guess at $4K repairs given how college kids can beat a place up, dishwasher/fridge, etc. have lower life than in your home. Carpet replaced every 3-5 years compared to mine, 10 years old and looks new. JOE

I've never been able to translate the textbooks' examples of income-producing properties to actual real life examples. Seems like most of the time it's break-even to negative cash flow, and you need to rely on capital appreciation for gains.

I agree with Bucky. It is very hard to have income-producing properties in real life examples. I own 3 hourses - 2 apartments and 1 landed properties. Out of these 3 properties that I invested only 1 apartment confirmed is making money. This is due to the fact that the place around that area is the *hot* area for foreign visitors. As for the other apartment that I have, the value has been constant for 6 years (no capital gains at all) and I'm paying my loan interest every year. What a sad story. I just bought another landed properties last year, hopefully it can make some profits.

I play a very conservative game in real estate so the chances I lost is lower. This is what I do. I will only buy a house if I have enough cash to buy the house. Assuming the house $300K, I will have $100K down payment and take the $100K loan from bank and finally invest the difference (which is $100K) in other investment (e.g. stock, mutual funds and etc.) to make sure the investment that I invest are higher than the bank's interest. Does this make sense?

Here is my personal blog to track my real estate investment. :) You guys may want to have a look if you guys are interested.

http://f> kastnna wrote:

Thanks all. That's kind of the impression I got when looking at the math. I am guessing the biggest benefit is that you are slowly developing an asset that will one day be owned outright (and hopefully very valuable) that was largely paid for by others.

Another question: Does having an existing martgage on rental property affect your ability to get a mortgage for a new home (the mortgage is a large liability afterall)?

One could argue that the rental property poses no additional financial burden on the owner because it is paid for with revenue generated from the property, and therefore would not effect the owners ability to pay the residential note.

When you invest in stocks and mutual funds, the money you have saved to get started has a good chance of growing over the years. When you invest in real estate, the money you have saved PLUS the money you borrow from the bank to get started has a good chance of growing. You have to pay back the mortgage money you have borrowed, but not the amount it has grown.

Now some people will say that leverage works both ways, and that it magnifies losses as well as gains. I don't think it is quite the same. Generally real estate does not go through frequent swings of gains and losses like stocks. In most areas of the country there are usually short periods of fast growth mixed with longer periods of no growth. Abrupt decline in value does not happen as often. Of course there are exceptions, but by and large the chances of big losses are greater in stocks than in real estate.

In my opinion, you are tracking well on the metrics of the deal. The cash flow tax shelter isn't what it used to be bit is still part of the equation. Appreciation will be a big part of your total return. With that said, you will make your money on the deal on your purchase and finance decisions. Buying value with positive leverage - that is, your return on equity should be greater than your weighted cost of capital [debt + equity (think opportunity cost)].

Just my thoughts,

Chris

D>

Financing certainly is important, and paying close attention to mortgage interest rates, for one thing, can make a big difference. I am surprised that this item doesn't enter into peoples' calculations more than it does. Compare, say, a fixed rate of 6.25 with 6.00. That small difference in mortgage rates can mount up to a huge difference in cost over a period of 20 or 30 years. It is well known that a relatively small difference in the expense ratio of mutual funds has a huge effect on gains over a long period. It is the same with mortgage interest rates.

So while buyers put much effort into negotiating the purchase price, whether the washer and dryer or the drapes will be included, and other small matters, they will often take the first mortgage their bank offers without question and feel lucky to get it. Shopping around for the best financing can make a big difference in overall gain.

Well really you might never own it outright. And you need to assess the tax side of it to evaluate any property, it makes things much better. Not that those duplexes aren't jacked too high, but after-tax they might be doing fine. I'll try to summarize...

Rental property is depreciated over 27.5 years, creating a "non-cash" expense that offsets rent. Your $200k unit, assuming 20% of that cost for the land (which you don't depreciate), leaves 160/27.5 ~$5,800 in depreciation expense annually. With this expense included, a property may be cash-flow positive without having any taxable income -- it may even be a loss on paper. So that's a big tax benefit, you're acting as if the property is becoming useless while it really may be going up in value (even factoring in required maintenance & upkeep).

Those earning below $100k get a tax benefit from "loss" rentals, because they can use up to $25k of these losses to offset other income - dividends, interest, salary, etc. Those earning between $100k & $150k get a partial benefit (there's a phase-out in this income range). Keeping in mind that depreciation is a non-cash cost, meaning the "loss" may be a fiction from a cash-flow perspective, this can reduce the true ownership cost for the rental.

Those earning over $150k can't do this, but the losses are carried forward to offset passive income in future years. There are some benefits to owning multiple rentals if you are in that situation.

The other tax benefit (and a biggie) is Code Sec. 1031 which addresses "like-kind exchanges". Sec 1031 lets you avoid recognizing taxable gain when you exchange property for other property, instead of selling it outright. It can't be used for stocks or mutual funds, but it can be used for rental properties. The application of this is to "lever up" your investment periodically. Take your $200k property on which you put $60k down (70% financed). Imagine it goes up in value to $250k. Instead of selling and paying tax on those gains, you could do a 1031 exchange into another property. If it is also 70% financed, now you have $110k in equity, so it's a 110/.3 = $367k property and the rents (hopefully) are that much higher. And you now take depreciation on $367k so your taxable income might not budge much despite the higher cash flow.

Repeat, repeat, etc...and you gradually spool up ever-larger rentals and higher rental income, while depreciation and 1031 protect you from much of the tax. Then, you die, and it all gets step-up of cost basis, so those gains are never taxed. Add all these tax gifts together and you can describe how some very large multi-generational wealth was created in the US! This could explain why the numbers don't work for a new buyer of those duplexes...perhaps some of the collegetown slumlords are 40 years into their 1031 exchanges, and they own a bunch of them.

That said, I think a lot of recent rental-property activity has been among people that don't know 1031 from the I-10. Even with these tax aspects figured in the numbers on your local duplexes might not make sense. And of course, plenty of people buy rental properties with more modest goals, such as having a paid-off rental that provides income during retirement.

-Tad

Does there have to be another party for such an exchange? Or is this simply a financial characterization of selling one property and investing the proceeds into another?

A 1031 exchange must involve the exchange of one property for another. I own a property in NY and want instead to own one in Boston. I may very well find someone with the opposite goal, but if not, I can get a third party involved, or have the buyer of my NY place instead be directed to purchase the Boston one and swap. The multiple transactions much occur within 45 days or the 1031 can be disallowed. JOE

So the bottom line still is you have to have someone else who wants to do the same thing, and finds your property suitable for that purpose?

The other buyer doesn't have to have the same motivation. For my example, wanting to sell in NY and buy in Boston, I simply need to find a NY buyer who is willing to go through the extra paperwork, by buying the Boston property with the intent of swapping. That person can be a first time buyer who just needs to be educated on why he's being asked to do this. Best to read on irs.gov for the exact laws. I understand the general rules/reason, but don't have all the fine print as noted in the correction above. JOE

Are there 3rd party brokers that coordinate this kind of deal?

Chris, while the original uses of 1031 were supposedly true swaps (horse-for-horse, e.g.) that's extremely uncommon now. Instead it's usually done through a third party that, in effect, creates a fictional swap between the property you're disposing of and the property you're acquiring. If you google "1031 intermediaries" you'll find out info. The entire transaction is typically done using an intermediary, and an attorney with expertise in this area. Lots of potential pitfalls, it's not a DIY kind of thing.

-Tad

makes this all sound rather scary. My interest in this is academic. I have no property to swap. As this thread is straying from financial planning, we probably should drop it. With your recommendations on how to find relevant info, I can get all the information I want elsewhere.

Thanks.

Chris,

That article is a little bit of a spin story that probably has alterior motives behind it. Every industry has crooks, but that doesn't make fraud the norm.

A simplified exlanation is that 1031s allow people to sell a peice of RE and buy another property without having to pay taxes on the gain in the old propery's value. Key idea is "like-kind exchange." 1035s work in a similar fashion when dealing with life insurance and annuities.

No doubt. They're trying to feel scared of everyone else and safe with them. But if you ignore the obvious bias, some facts are still there.

Thanks.