Investment property is a proven way to build wealth over the long term. The key is selecting the right property, structuring the deal correctly, and knowing how to take advantage of opportunites the IRS gives you. While I was somewhat dreading it, I went to a tax seminar on investment properties this week and came away surprised with how interesting and useful the information turned out to be.
When approaching real estate investments, many people simply pick a property they hope will go up in value and then try to negotiate the best price possible. Over the long term, real estate will appreciate, but the property had better 'cash flow' in the meantime. Cash flow is the net operating income being greater than the mortgage. Obviously, this it critical for being able to hold on to a property year in and out, but it's only the first step in evaluating a property.
An important question to ask is what is the return on the investment. To answer that, you need to take pre-tax cash flow, add in the principal reduction and the taxes saved (through writing off interest payments and depreciation) and then divide that number by the actual cash invested in the deal. This can give you a fairly comprehensive number to compare and contrast with other properties.
Capitalization or "cap" rate is always a popular percentage to toss around when evaluating commerical and/or investment properties. The formula to determine the cap rate is the net operating income divided by the purchase price. There are a lot of questions about what the cap rate should be: 7%, 8%, 9%, or more if you can get it. Since this number doesn't take into consideratin the interest rate on the loan, ultimately the real question is whether the cap rate is high enough to pay for your financing - with a little left over to pay yourself.
"Cash on Cash" is another formula that simply looks at the pre-tax cash flow and divides it by the cash invested. That number will give you a quick analysis of how well you are putting your money to work. Once you find an investment property that meets the criteria you are looking for, the next step is buying it in the right way.
Most people know to depreciate, but they simply divide the property into land and the rental building at 20% and 80% respectively - or whatever the tax records tell them. The building depreciates at around 3.5% a year, while land doesn't depreciate all. More sophisted investors will 'bifercate' by including two often overlooked catagories into their offers: 'personal property' and 'land improvements.'
Appliances qualify as 'personal property' and depreciate at 20% the first year; 32% the second year. Land improvements include anything that doesn't service or need the main building (pool, shed, fence, landscaping, etc.) and depreciates at 5% the first year; 9.5% the second year. These numbers add up quickly and can help to offset any gains, making the property more valuable on an after tax basis.
What IRS giveth, it also taketh away - and it taketh away (or 'recaptures') at a tax rate of 25% for any deprecriation that was taken on the property. The way to avoid this is to use a 1031 tax deferred exchange and buy another property equaled to or greater than the original property.
There are more rules regarding 1031 exchanges, bifercation, and the rest, so make sure you consult a real estate expert and/or an accountant before acting. Feel free to respond if you have other tips regarding real estate investing, or contact me if you have any questions about investment properties.
Whether you're looking for a duplex or home in Franklin to invest in, or a condominium in Nashville TN, I will be glad to help you find the right property for you and your budget, as well as help you buy it the right way.
You can always reach me at jeff@jefffulmer.com, 615-545-8611 or through Facebook or my Greater Nashville Real Estate web-site.
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