Much of the media coverage on real estate investing focuses on making a quick buck: buying cheap properties, slapping some lipstick on them, and then flipping. Hopefully, you make more reselling than you spent fixing the place up.
At any moment, you can find one of five or six TV shows based on this practice on TV. But for long-term-focused real estate investors, that approach can be akin to day trading.
When you flip houses, you're betting on a quick turn in the market for that house. Of course, you spend time and money helping that happen, but for most people, there just isn't the same level of consistent gains that you can get in long-term rental property investing.
Image source: Getty Images.
With long-term rentals, there are four sources of income: rents, capital gains, tax write-offs, and debt paydown. Let's go over each of the four using the below example, based on a purchase price of $500,000.
- Percent down: $20%
- Mortgage term: 20 years
- Interest rate: 3.5%
- Monthly payment: $2,320
- Rent per month: $2,750
1. Rents
The first source of passive income on rental properties is the rent you charge tenants. In this example, you earn $33,000 per year from rent and have to make $27,840 in debt payments. On the surface, that's $5,160 of passive income per year.
Of course, there are more expenses than that. Depending on the property and the lease, you could also have expenses for property taxes, utilities, maintenance, repairs, management, income tax, HOA fees, and even lawn gnome replacement.
It's possible that a property won't be profitable at first. The key is to stick with it for the long term. If you choose a property in a good location, your rent rates will slowly grow over time while debt payments stay the same.
2. Capital gains
You have capital gains when you sell the property for more than you paid. If you purchased the example property for $500,000 and sold it five years later for $550,000, you'd have a capital gain of $50,000.
That's a 10% gain over five years, which is not great. In long-term rental investing, capital gains usually aren't the source of returns. And if you're making good income through rents and the other two sources of income we discuss later, you won't want the capital gains anyway -- because that would be giving away the golden goose.
If you do buy a property that has a rapid increase in market value, there is a way to access that gain. Let's say the property is in a great location and the price doubles over five years (not much different than what has happened where I live in Utah). You could refinance the debt on the property with a new appraisal and take cash out to use on another investment. Otherwise, you'll only access capital gains when you sell a real estate investment.
3. Tax write-offs
The problem with having a profitable rental property is the taxes. If you don't plan ahead and make estimated tax payments throughout the year, you could be hit a with a surprising five-figure tax bill come April 15.
The good news is there are tax write-offs you can take advantage of. The key write-off is depreciation. Depreciation is a noncash expense that you can claim on your tax return to reflect natural deterioration of property value over time. Residential rental properties are depreciated over 27.5 years, so that means we can write off $18,182 per year from the example property. This is a legitimate tax expense that you don't have to pay for.
It's possible to own and rent a property that declares a tax loss each year while being cash flow positive. That means you don't pay taxes on it but receive cash from it.
Another write-off is interest expense. When you finance a property, you pay interest each year on the debt. In the example, total interest in the first year of the loan is $17,219.80. This amount is deducted from rental revenue when you report the income on your taxes, even though, as we'll discuss in a minute, it's effectively paid by your tenants.
4. Debt paydown
The final way that you make money on rental real estate is debt paydown. Let's look back at the capital gains example. The property was sold for $550,000, which I said was a 10% return. That isn't technically correct.
It's better to look at the cash-on-cash return. The property was purchased with 20% down, or $100,000. Over five years, the debt was paid down to a balance of $403,916 . You receive $146,084 in the sale, which is good for a five-year return of 46%. That's not life-changing but definitely amplified by the power of leverage.
The best part is that the tenant is making those debt payments. If you can rent the property for more than the monthly debt payments, you've created a situation where the tenant makes the principal and interest payments and you can write off the interest and get the full benefit of the reduced debt.
Long-term investing is the way to go
As with stocks, long-term investing in real estate based on the fundamentals is the best way for most people to generate consistent income. If your rents fall short or you end up having a larger-than-expected tax bill, you still have other sources of income from each rental property.
