Having a discussion about investing in real estate can go so many ways. You could be talking about investing in a primary residence, a partnership or trust, or rental properties. Depending on that, then we need to determine if it’s about commercial or residential. Active or passive? What about the tax treatment? Will this concentrate your wealth too much? etc.
In this post, I’m going to focus on investing in residential rental properties. Many physicians are in a position where they can afford to invest in larger assets like these. But should a physician do it? Rental properties can be a great way to build wealth and provide income. As I take you through how they can do that, use this rental property analysis to use your own numbers and assumptions.
In any investment, you want to receive either growth (capital appreciation) or income. Real estate is much better at producing income than it is at growth. How can this be? Haven’t we all heard about how staggeringly low the price grandpa and grandma bought their home forty years ago? The Case-Shiller Home Price Index is currently 175.3 (national). In 1976 it was 26.6. That means a home worth $200,000 today would have cost $30,315 in 1976. That’s a 560% gain, or 4.8% per year! But that was the “nominal” measurement, meaning it hasn’t been adjusted for inflation. After making the adjustment, $30,315 becomes $126,643 and our 560% gain becomes 51.7%. That’s 1.0% annually. Compared to the S&P 500’s 4.3% inflation-adjusted annual return since 1976, it’s not a great growth asset.
It should be mentioned that certain locations have experienced exceptional growth rates depending on the desirability of the area. Whether we’re talking about Manhattan island or the Silicon Valley, we’re getting into speculative territory when we try to anticipate the growth rate of real estate in certain areas. I’m not going to pretend that I know anything about real estate speculation, so I’m sticking with national averages.
While growth isn’t a strong point for investing in rental properties, it is a good producer of income. As with growth, income will vary depending on the location. Just check out the price to rent ratio statistics from the latest US census¹. Instead of fretting over the vast differences in varying markets, let’s use a common rule of thumb that investors of rental properties use to determine how much they will pay for a property, the 1-2% rule (this rule varies from person to person, so I’ll use 1.5%). The rule says that the monthly rent should be at least 1.5% of the cost to acquire the property. Annualized, that’s 18% of gross income. Using this rule, a property purchased for $200,000 should produce $36,000 annually. But, of course, we have to considered the ongoing costs listed below.
|Expense||Description²||Cost in this example|
|Property tax||Between 0.5-1.9%³||$2,000|
|Maintenance||10-20% of rent||$5,400|
|Homeowner’s Association Dues||$0 to potentially hundreds per month||$1,500|
|Property management||8-12% of rent||$3,600|
|Utilities||$0-$1,000 Depending on which utilities you provide||$500|
So in our example here, the net income amounts to $22,000. That’s 11% annual net income. Not bad at all. You could even improve that by doing the property management on your own, maintenance too if you don’t mind some manual labor.
Perhaps the most effective tool the investor of rental properties can use to boost income is leverage. By financing the above example with a 15 year fixed mortgage at 3.5% and a 20% down payment ($40,000), you can more than double your annual income yield to 23%! You’d be reducing the income you actually receive because of the added mortgage payment of $13,726, but the principal portion of the mortgage counts as income to you. Using leverage, you pay $46,000 out of pocket (down payment plus closing costs) and $45,886 in interest, paid from rental income. After 15 years, you get a $200,000 property paid off, plus positive cash flow for as long as you continue to own the property.
Sounds tempting, right? The catch, however, is even though you can outsource a lot of the work, this isn’t passive income. Finding properties that “cash flow” isn’t a walk in the park. You have to manage the property manager. You have to make sure the bills get paid. It’s a side business. So you have to ask yourself if you are willing to put in the extra time and effort to earn a higher income than the S&P 500’s 2.8% average annual dividend yield since 1976.
If you do continuous work to run your rental properties, the IRS will recognize that you are running a business, not merely making an investment. Because of this, you will be able to take advantage of various benefits. To try and cover all these is it’s own article, so I’ll keep it basic.
Deduction on interest for loans to acquire and repair properties
Interest is a business expense, thus deductible. This one isn’t too special since the IRS allows you to deduct interest on your personal residence too.
When you have an asset that breaks down over time, that loss in value is an expense that is deducted over a span of multiple years. Real estate is tricky because it usually appreciates in value over time. So you’re getting the benefit of depreciation, but the property is actually appreciating. This is known as “phantom appreciation”. It’s a great benefit while you own the property, but once you sell it, you will have to experience depreciation recapture. This is where the amount you were able to deduct is counted as a gain, limited to the actual gain, and is taxed.
You have to travel to conduct business, whether it’s across town or across the country. Auto, Airfare, accommodations, and food can all count as legitimate business expenses. And hey, if you happen to get some personal things done along the way, then it has a positive impact on your personal life too. Just don’t get greedy and try to deduct a family trip to Disneyworld under the guise that you were looking to purchase Orlando real estate.
Home office deduction
You have to conduct business from somewhere. If you have some space in your home to use as an office, you can deduct that portion of your home. The rules are pretty strict on this one, so be sure to talk to a tax preparer about how much you can take.
Various other deductions
There are a lot of legitimate business deductions you can use. I’ve chosen to only feature a few key ones here. Expenses that are deductible are meant to be solely attributable to business activities. However, some of these business expenses can have a personal benefit to you. Be careful not to blur the line between business and pleasure, otherwise, the IRS could disallow these deductions.
Rental income not subject to FICA tax
Unless you are operating as a separate legal entity, rental income is reported on schedule E of your individual tax return. You will pay income taxes on this income, but you won’t pay FICA taxes! This is a great benefit because income attributed to self-employment is taxed at 15.3%.
When you sell an asset for a gain, you have to pay capital gains taxes on it, right? Not always. Not when the asset is held in a tax-sheltered account like a 401(k) or an IRA. Well, rental properties aren’t usually held in these types of accounts, but similarly, the IRS allows you to defer taxes on investment properties upon sale through a 1031 exchange. As long as you purchase a “like property” within 45 days of the sale, you can defer the recognition of gain. Just like an IRA, you will eventually have to pay taxes, but at least it will be at the long-term capital gain rates.
Can access equity tax-free
The last tax benefit I want to point out is that once you’ve built up equity in your properties, you have a place to access cash, tax-free, by refinancing your debt. Sure, you’ll pay interest on what you pull out, but this could be a better alternative than pulling money out of IRA where it will be taxed at the ordinary income tax rates, or even have a 10% penalty if done before turning 59 ½. If you have an emergency and need to access extra cash while you’re still working and are already in a high tax bracket, this provides you with a tax efficient way of getting that cash.
There are many attractive reasons to invest in rental properties, the risks, however, have higher stakes. Rental properties are a highly concentrated place to put your wealth, even for high income earning physicians with significant assets diversified elsewhere. Earthquakes and floods aren’t covered under a standard homeowners insurance policy and thus need to be covered separately. But not all risks can be insured away. There’s the risk that your property goes vacant for months at a time, or worse, you have bad tenants. Bad tenants can cost you thousands of dollars in lost rents if they don’t pay and eviction can take months, not to mention the headache.
So if you’re willing to put in some extra work and take on some extra risk, investing in rental properties could be a great move for you. I wouldn’t discourage doing it, but I would discourage letting it represent the majority of your assets. You should always exhaust your pre-tax contribution options first, then consider regular taxable investment accounts in stocks and bonds. Income from rental properties can represent a great way of providing income for your retirement and using leverage is a powerful tool to accumulate equity in a property with a relatively small investment out of pocket.
So what do you think? Does investing in rental properties appeal to you?