Renters

If you're paying rent, the probability is that you are covering all or part of the costs of ownership for someone just like you who happened at some time in the past to have bought the property you are living in.  That owner is accruing appreciation, mortgage pay-down and tax advantages while you are paying rent. To give you an opportunity at a comparison between renting and owning, following is an example. Assume that you purchase a home for $260,000 and make a $54,000 down payment (20% of the purchase price) so that you will then have a mortgage of $206,000. Assume a 5.5% interest rate, fixed for 30 years, the monthly payment is $1,170, or $14,040 annually. Property taxes can be calculated at 1.25% of the purchase price or $3,250.00, and insurance will be about $600.00 for the year. 

Your total housing expense will be as follows:

Annual Mortgage Payment            $14,040

Property Taxes                               $3,250

Insurance                                           $600

Annual Housing Expense           $17,890

                             (or $1,490 per month.)

But here’s the payoff: the income tax consequences!

Mortgage Interest (first year)         $11,260

Property Taxes                               $3,250

Deductible Expenses                     $14,510

Tax Savings                                  $3,627
(assume you are in a 25% combined federal and state taxes)
 

So your true cost of home ownership is shown to be:

Your Annual Housing Expense      $17,890

Minus Tax Savings                        ($3,627)

Annual Net Housing Expense    $14,263
                                (or $1,189 per month)

In other words, if you are paying more than $1,189 per month in rent, you will save merely by purchasing a home. Of course, you need a down payment and good credit.

INVESTORS

Using the same assumptions as above, the housing expense is $17,890.
Owning rental property has two annual benefits... Cash Flow and Tax Benefits.

Cash Flow
Rental levels are high and expected to go higher. Interest rates are quite low. (The biggest expense for investment real estate is the interest expense; it absorbs at least 50% rental income, often more.) The happy combination of higher rents and low interest rates makes it likely that an investment can generate positive cash flow, exclusive of operating expenses and debt service. If we assume rental rates for a three bedroom, 2½ bath house is $1,650 per month...

The cash flow is as follows:

Annual income                           $19,800

Annual expense                       ($17,890)

Cash flow (positive)                  $1,910

Tax Benefits
Tax laws favor real estate investment to encourage development of residential housing. An investor buying and renting out the house will get a benefit unique to real estate: a non-cash deduction called depreciation. The investor can reduce income by depreciating the improvements (not the land) over a 39-year period; if the house is 80% of the total cost of $260,000 or $208,000, the depreciation deduction each year is $5,333. Assuming the monthly rental is $1,650...

The taxable income or loss for an investor is as follows:

Annual Rental Income                     $19,800

Annual Expenses

   Interest (first year)             $11,260

   Property taxes                     $3,250

   Insurance                               $600

   Depreciation                        $5,333

   Total Annual Expenses       $20,443        

Taxable Loss                                 ($633)

The property has a cash flow of $1,910 under the assumptions described above AND $633 in taxable loss so 33% of the cash flow is sheltered from income taxes in the first year. No other investment has the advantages of sheltering cash flow from taxes. When the property is sold, this sheltered income is taxable but the tax has been delayed and it has been converted to a capital gain which is taxed at a lower rate at least for now.

Capital Gain
Another unique feature of real estate (for homeowner or investor) is the concept of equity build up. In these newly more sensible times, a fixed interest rate, 30-year loan is steadily reduced each month.  Using our example, the note balance is reduced in the first year by $2,780 and each year’s reduction is larger so even if the property’s value does not increase, the investor’s equity in the house is growing; unlike stocks or bonds, real estate equity increases even if the house does not appreciate. So, why buy real estate? Because it is an excellent investment with many benefits. It is, however a long term investment and not to be “bought and flipped”; ideally, it should be purchased as either a home or income property, then cared for and improved. Over a period of years real estate will prove to be an excellent investment. Perhaps over that long period of time, it will prove to be the most important and profitable investment for the family.