It seems like there is almost a sense of obligation to purchase rental real estate once a person hits one of two financial milestones:
1. They maximize their airline retirement savings plan
2. Their income tax bill becomes so onerous that it compels them to take evasive action!
If you’re not there now, you will be soon!
Are either of these milestones reason enough to pull the trigger and purchase physical real estate for rental? My short answer is, no! However, there may be some other good reasons to do so, and we’ll explore them in this article.
In my financial planning practice, I am fascinated by the number of people that almost feel a sense of obligation to purchase rental real estate. It’s as if there’s a message out there somewhere that says:
• Step one: max 401k
• Step two: purchase rental real estate
Otherwise, you’re not really a sophisticated or properly diversified investor.
Unfortunately, real estate is not always the tax savings or investment panacea it’s made out to be.
In this article, I will explain some common myths and misconceptions about the tax and investment benefits of owning rental real estate. If you’re in a hurry, look to the end of each point for the lessons learned. These lessons may prevent you from going down a path that may not be right for you or, at least, prevent you from making the same mistakes I did!
1. Rental Real Estate is Not a Hands-off Activity
There is no easy money. Grant Cardone makes it look like you purchase a real estate property and then board your private jet for the Caribbean. Easy breezy!
The phrases “side hustle” and “passive income” sound sexy and easy, but they are extremely misleading. In my experience, if you’re investing in real estate the right way, you’re probably self-managing and maybe even doing some of the work yourself. Sweat equity! If you’re outsourcing all these tasks to a management and maintenance company, be sure to check your profit margins and compare them to an alternative investment.
We’ve seen people spend all their investment profits on HOA fees, management, maintenance, taxes, insurance, etc. There are plenty of other great investments that do not require any of those expenses.
Lesson Learned:
Always think about the opportunity cost of investing in real estate. For example, you can get close to 5% guaranteed right now (August 2024) in treasury bills without worrying about renters, maintenance, and eviction notices. Make sure you’re rewarded appropriately for the time, money, and risk of real estate investing.
2. Are You Running a Real Business or Just Being Nice?
Many rental real estate investors that I know do not treat their rental real estate like a real business. I’ll use my father-in-law as an example. He’s the nicest guy in the world, so he rarely raises his rent. There is some value in keeping your renters happy if they treat your property well. However, no matter how nice your renters are, you don’t need to take money out of your business and give it to people. That’s called charity.
• Capitalization Rate (Cap Rate):
Evaluates the profitability of an investment property. A higher cap rate indicates a higher potential return on investment. This is also a great number to evaluate whether the time and effort are worth investing in rental real estate.
Cap rate = Net operating income ÷ Property value:
Example:
$24,000 (net operating) ÷ $500,000 (property value) = 4.8% Cap Rate
In this scenario, your success as a real estate investor hinges on the hope that your property will significantly appreciate. This is because (At the time of this writing- August 2024), you could get approximately 4.5% – 5% in a treasury bill guaranteed, with zero effort or worry about renters.
If you believe you have a high chance of property appreciation, you may be willing to accept a lower cap rate and vice versa. However, be careful that solely relying on property appreciation does not become your main real estate strategy.
One maxim of real estate investing that stuck with me was, make money when you purchase, make money when you rent, and make money when you sell. I learned from experience that any one of those is relatively easy to achieve. All three of those components are challenging and take great effort and due diligence.
• Net Operating Income (NOI):
Shows how much money a property is making. It can help evaluate your return on investment (ROI), assess cash flow, and make decisions about pricing, expenses, and business strategy.
NOI is used to measure the profitability of your property. To calculate the net operating income (NOI) of a rental property, use this formula:
Real estate revenue – Operating expenses = NOI
The NOI is used mainly to determine if a property should be considered for investment. Calculating NOI shows your potential profitability. If a property has a very low NOI compared to similar rentals in the area or investment alternatives, you may want to look elsewhere to invest your money.
• Non-measurable Measurables:
What is your time worth? You may be able to put a precise number on this since you are paid by the hour. Don’t forget to factor in the cost of your time when calculating the cap rate and the NOI.
Lesson Learned:
Do you enjoy being a real estate landlord? Or do you worry or stress about the next call from the renters or management company? I did, and it sucks! I became tired of the kids flushing their toys down the toilets. I also did not like the boyfriend threatening to burn the place down because my renter broke up with him. True stories! And there are many more good stories where those came from. Those events helped me to remember that I had the ability to earn as much as one month’s rental income by picking up a two-day airline trip!
3. Use Leverage Wisely!
Leverage: When I helped a friend run all the rental real estate numbers like a real business, I realized that using leverage (borrowing-mortgage) played a major role in the profitability of his rental real estate.
Does this mean you should borrow 100% of the property’s value? Absolutely not. Think Great Financial – Housing Crisis 2008. Brought on largely by the over-levered housing consumer. On the other hand, is completely paying off every rental property the highest priority? Probably not.
You, as the investor, must be comfortable with a responsible balance of debt. One thought to guide your decision is to consider if you could make the mortgage, property tax and insurance payments if there were no renters? How long could you sustain these payments with no renters? These are questions you must consider as a real estate investor.
4. Tax Implications of Owning Rental Real Estate: The good, the bad and the many disclaimers and exceptions.
First, never let the tax tail wag the dog!
Focus on increasing your net worth and purchasing quality investments. The tax benefits are a nice secondary benefit.
Paying taxes often evokes a visceral response and drives us to take actions that may reduce our net worth solely to reduce our tax burden. I’ll admit, it is a nice feeling when I get that two-thousand-dollar refund at tax time. (Even though it may be better to zero out my tax refund as to avoid loaning the Government my money.)
The point is we are overly focused on the net tax result at tax time. We quickly forget about the benefit of rental income during the year. For example, many people are willing to reduce their monthly rental income to zero, usually by spending more on the rental property, simply to avoid a large tax bill in April. We find ourselves advising clients not to lose money on purpose just to save on taxes!
Lesson Learned:
Purchase quality real estate that may provide a good return on your investment. Focus on the investment and the tax benefits will follow.
Depreciation Tax Deduction: The phantom rental expense.
Rental property owners can use depreciation to deduct the property’s purchase price and improvement costs from their tax returns.
Here are two quick examples to explain the benefits of depreciation. But before I wade into these dangerous tax waters, understand that there are exceptions to every tax rule and something that initially sounds like tax magic will probably be taken away by the IRS as your income increases. This is the case with depreciation of rental property as well. Click here to learn more about the details of MACRS depreciation system.
Overly simplistic example for illustrative purposes: Deducting the depreciation expenses from your current rental income (probably not deducting from your airline income – see below and seek advice from a tax professional):
The IRS assigns a “useful life” to residential rental property of 27.5 years. Therefore, if you purchased your property (cost basis) for $300,000 then you simply divide the cost basis by 27.5. Your potential depreciation tax deduction may be $10,909 per year.
For every full year a property is in service, you would depreciate an equal amount:
3.636% (100% divided by 27.5) each year as long as you continue to depreciate the property.
More disclosure:
Do not use this example to calculate your tax deductions. If your income exceeds certain limits, you may have to defer the deduction. You would also need to calculate the true adjusted cost basis which is not equal to the purchase price of the home.
Lesson Learned:
Take the time to understand these tax nuances. It’s not good enough to delegate this knowledge to your tax preparer. They can help you accomplish your tax return correctly but if you want to be a great CFO of your real estate business, you need to have a working knowledge of the IRS tax regulations pertaining to rental real estate.
Do not expect to offset your airline income with rental real estate losses.
In most real estate investing scenarios, you will not be able to deduct rental real estate losses against your airline income.
Real estate investors have been known to spend lavishly on anything having to do with their rental properties, thinking that the tax-deductible expenses would reduce their airline income and therefore their income taxes. Why not spend $80,000 on a used Kubota skid steer for your rental property if you could use that expense to potentially save $19,200 in income taxes. Wow! Less taxes and an awesome toy.
Unfortunately, there are very strict tax rules about deducting passive real estate expenses against your active airline income. To better understand this concept, we first must know that the IRS’s definition of active and passive income is very different from that on Instagram.
First the easy definition – active income is income received from a job or business that you actively participate in, such as your airline job.
From TaxSlayerPro.com: “Passive income” is often used colloquially to define anything from stock investments to blogging. But the IRS has specific parameters for passive income activity. For tax purposes, true passive income activities are either 1) “trade or business activities in which you don’t materially participate during the year” or 2) “rental activities, even if you do materially participate in them, unless you’re a real estate professional.”
The last statement is what really limits an airline pilot’s ability to deduct real estate expenses from your airline income. So, what is a real estate professional you ask:
From IRS.gov; Instruction for Form 8582:
Any rental real estate activity in which you materially participated if you were a “real estate professional” for the tax year. You were a real estate professional only if:
More than half of the personal services you performed in trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated, and
You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
It is not impossible to be considered a real estate professional but the “…more than half of the personal services you performed…” statement is the one that usually prevents pilots from also being considered a real estate professional. Clearly if you are married, filing jointly and your spouse is a legitimate real estate professional, you may be able to take advantage of the tax benefits of a real estate professional.
Lesson Learned:
Use caution and seek professional legal and tax advice to keep out of trouble if you decide to pursue this path.
What can you deduct and why may quality real estate still be a tax-smart investment?
Even though you may not be able to offset your airline income with rental expenses, you can offset your rental income with expenses incurred in the activity of renting. For example, if I earn one thousand dollars per month in rent, that could potentially be taxed at my marginal income tax rate. For an airline pilot that can easily be 24%, 32% or even higher, considering the latest contract bonuses and pay increases.
That could increase my tax bill by $3,840 (32% x $12,000). That feels really painful when the tax bill comes due in addition to your airline tax bill. (You’ll quickly forget about the $12,000 in rental income you made throughout the year!)
So, in this example you could use your advertising costs, auto expenses, cleaning costs, and our favorite, depreciation just to name a few. Clearly you would not want to spend more on advertising simply to reduce your taxable income, but the expense can help reduce your tax bill if you need to advertise.
Lesson Learned:
Keep great records of all your potential deductible expenses. It will be required if you get audited by the IRS and it will help you determine if you’re spending too much on your investment.
5. The psychology of money can make rental real estate a good investment.
That sounds weird so let me explain. Many of us stress out about the stock market fluctuations. The fact that the stock market seemingly tanks at the release of any negative news headline is frustrating to many people.
Furthermore, we can view the value of our investments minute-by-minute on our phones. It seems like when the price of an investment goes down because of something completely unrelated to the quality of the company, my life savings disappear.
When I own rental real estate in my local town, or any location really, I usually do not see or hear about any price fluctuations. In fact, before the housing crisis of 2008, we began to believe that the price of real estate could not go down!
We learned the valuable lesson that real estate values can and will go down but at least I can’t see the price fluctuations minute-by-minute like I do in my 401k. This can be a tremendous benefit that helps me stay the course with my rental properties.
Investing in real estate, especially locally, gives investors a sense of control. And, sometimes, there really is more control. For example, you may have valuable information about your local real estate market that another investor might not have access to. In the world of stock investing, this is called insider trading and it’s illegal. Furthermore, in the stock market, any valuable information is processed and integrated into a stock’s price in milliseconds. This is called an efficient market. Your local real estate market is most likely not an efficient market.
Lesson Learned:
Find mentors that know your local area. Get involved in local organizations like the chamber of commerce. Learn about what new businesses are coming to your area. Network with local real estate agents since they may be the first ones to know when a property may become available.
Hopefully, you found this article helpful in deciding whether investing in rental real estate is right for you. There are many people that are really good at investing in real estate and being landlords. Those people are really good because they enjoy it, and they believe it’s worth their time. I am not one of those people! I’ve been down that road most of my adult life and I learned it’s not for me.
In my humble opinion, I can get exposure to many different types of real estate investments through the public stock markets. More importantly, I’m the type of person who is okay with the temperament of the stock market. Many people want relief from that roller coaster ride, and I understand that.
Final Lesson Learned
The final lesson for helping to decide whether investing in real estate is right for you is to know thyself!
• What do you want?
• What do you enjoy doing with your time?
Life is short, don’t do anything solely for the benefit of taxes or even to make a bit more money if that’s not what you really need.
See Pilot Money Guys podcast to learn more about investing in rental real estate: Flight #52: Gina Roth on How to Be a Real Estate Professional and Save on Taxes.
Charles Mattingly, MBA, CFP®
CEO, Leading Edge Financial Planning
If you have any questions, contact us at:
• Phone: 865-328-4969
• Email: charlie@leadingedgeplanning.com.
Also, please tell us if we can help you on your journey to financial peace and prosperity! Click here to sign up for our newsletter or click here to schedule some time to chat about your circumstances in more detail. Also, check out our Pilot Money Guys podcast where we regularly discuss these types of financial topics along with some fun airline news updates and interesting guest interviews.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this video will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any information or any corresponding discussions serves as the receipt of, or as a substitute for, personalized investment advice from Leading Edge Financial Planning personnel. The opinions expressed are those of Leading Edge Financial Planning and are subject to change at any time due to the changes in market or economic conditions.