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One of the greatest tax deductions offered to landlords is depreciation expense. The IRS allows landlords to depreciate the improvement of a rental property (single family residence) over 27.5 years. So, if you purchase a rental property for $125,000 and the land is worth $25,000, you can deduct the $100,000 improvement ($125,000 – $25,000 = $100,000) over 27.5 years, or $3,636.36 per year.

Depreciation is an invisible expense. The depreciation expense is added to yearly property taxes, mortgage interest, insurance, property management fees, and repairs. Below is a year 1 sample mortgage analysis with purchase price of $125,000 and financing $100,000 at 7% with a 30 year note:

Principle payment            $84
Interest payment              $581
Property Taxes                $250
Insurance                        $50
Management fee              $50
Total Payment                 $1,015

Assuming a monthly rent of $1,000, you can deduct all above expenses except the $84 principle payment. Your total monthly deductions are $931 ($1,015 – $84 = $931). This calculates to a monthly gain of $69, or yearly gain of $828. Now apply yearly depreciation of $3,636, and your property shows a yearly loss of $2,808. Depreciation can be a very powerful tool once you start acquiring more properties. If you owned eight properties with this scenario, you could deduct $22,464 against ordinary income. The IRS allows landlords to write off up to $25,000 in rental property losses against ordinary income.

High paid wage earners are not able to fully take advantage of rental property losses.  The IRS limits the amount of losses you can deduct against ordinary income once your adjusted gross income (AGI) exceeds $100,000. AGI includes W2 wages, self employment income, interest, dividends, capital gains, and rental income before any Schedule A deductions or exemptions are considered. Once your AGI exceeds $100,000, the IRS multiplies the overage amount by 50% and reduces your loss by that amount. So, if your AGI is $110,000 and you have a passive loss of $5,000, you are not able to write off any losses against ordinary income ($10,000 x  50% = $5,000). Instead, you can only carry over the loss. With an AGI of $150,000, all deductions are phased out.

If you are a licensed real estate agent, charge a management fee, and use the rental property you own to generate business income, you can apply the yearly depreciation expense against your Schedule C business return instead of Schedule E. Once you deduct the depreciation as a business expense, the property usually shows a profit on Schedule E as shown in the example above. Because the property shows a gain on schedule E, you are able to bypass the IRS AGI calculation. Please check with your CPA for details. 

Taking advantage of depreciation and acquiring more rental property can drastically reduce your tax liability. The longer you own the property, the more profitable it becomes. Rents usually increase yearly in a good market. In a standard amortization schedule, the principle payment increases and the interest expenses decreases slightly each year. The longer you keep the property, the more it will cash flow over time.

Once the property cash flows a couple hundred dollars per month, the depreciation expense makes the cash flow profit tax free. Take the tax free cash flow dollars and apply those funds to your Schedule A deductions for interest and property taxes on the home you live in. This is double dipping. You are taking tax free dollars and then using those funds to reduce ordinary income. 

One final tip. Buy a property for each child when they are young. Rent the property out for 18 years. Once your child is ready for college, pull cash out with a line of credit or cash out refinance, and send your child to college for free. The interest is deductible; you pay no income taxes for the loan; and your tenant pays for the note and for your child’s college education. After you die, give the property to your children. The cost basis is the same as fair market value when they inherit the property. If they sell immediately, they pay no capital gains (assuming properties meet estate limits).

Rental Property and Expanded Services Can Generate Huge Profits

In my last article, I discussed how 2008 will be a great opportunity to purchase rental property from motivated landlords with negative cash flow properties.  As property managers, we can leverage our personal rental properties and expand our services to generate huge profits for our business.

Property managers have a huge advantage in being able to purchase a property below market and realize instant equity. We have access to a pool of motivated sellers, MLS, and can earn a commission at closing. The return on your investment can be further increased with monthly cash flow, principle reduction, yearly appreciation, and tax savings in depreciating your rental property.  However, only licensed real estate professionals can use rental property to generate business income.

I leverage my personal rental properties to generate business revenue for my companies. We provide maintenance and repair services, sales, leasing, property management, and mortgage services.  Our goal is to generate as much revenue per client as possible.  We offer a one stop shop for our customers and market to buyers, builders, Realtors, sellers, investors, and tenants. What better client to leverage our services to than tenants renting homes that I own.

We assist tenants in repairing their credit, obtaining a mortgage, representing them as a buyer’s agent, and utilizing our in house maintenance company to help them fix up the property or make any necessary repairs. We offer incremental savings with each additional service they choose. For example, if the tenant uses our buyer’s agent and mortgage services, we will waive the loan origination fee. We will also discount our repair and maintenance services. Bundling our services at an aggressive price point provides a win-win scenario for both the tenants and our companies. We earn incremental business and potentially save tenants thousands of dollars. Not only are tenants happy to utilize our services, but they refer business to us as well. Our state requires that we disclose a multiple role form when providing real estate and mortgage services.

In our market, there is a huge demand for home buyers who just sold their home and need a place to park while they build a new home. Few property managers offer lease terms less than six month, because short term leases are not profitable for the owner. I fill this market demand with properties I personally own and network with Realtors and builders and offer short term leases for their clients and customers. In return, I ask them to refer my company future property management business. We will refer the owner back to the Realtor if they decide to sell the property in the future. This makes the sales transaction go very smoothly, and Realtors are thankful for us providing this service.

Our maintenance company specializes in getting properties ready for sale and lease. We do small and large projects. We market our maintenance and repair services to homeowners and Realtors. Most Realtors don’t have relationships with maintenance vendors. We provide reliable services at affordable rates. Our handymen are full time employees, and we provide company transportation. Our maintenance company can take care of most inspection repair items, and we can assist Realtors in getting their client’s home ready for sale. 

The more properties you own, the more you can leverage your services to generate business income. I encourage property managers to take advantage of near record low interest rates and purchase as many rental properties as possible. Consider expanding your service offerings. Mortgage services are extremely profitable and require little capital to get licensed. Many states require only a few classes to obtain your loan officer license, and you may be able to get real estate MC E credits with the completed classes. Consider subleasing some of your office space with a mortgage broker who will pay you rent and sponsor you as a loan officer. Offering maintenance and repair services can generate future real estate clients. A homeowner needing painting services may be in the market to lease or sell their property.  Expanding your service offerings and levering your personal rental properties and can offer a limitless return on your investment.

In my next article, I will discuss how property managers can take advantage of tax loopholes only available to licensed real estate agents.

While Austin has continued to have one of the best real estate markets in the country, we will finish the year with lower sales activity, higher unemployment and real estate inventory levels, lower rents, and a deteriorating economy. Real estate sales are trending down, even with near 50 year low mortgage rates. Rents are following the same pattern.

Consumer confidence is very low. Consumers are holding cash and focusing on their immediate needs. This has impacted every industry. Though credit is harder to obtain, it is not the driving factor for the reduction in consumer spending. It is consumer confidence. Even if car dealerships are offering huge discounts and zero percent interest, consumers are keeping their existing cars and not going into debt for a car they don’t absolutely need.

We are seeing the same trends in the real estate market. Tenants are staying put and renewing their leases; homeowners are delaying home purchases on fear of job loss or price erosion in the real estate market; and it is getting harder to qualify for a mortgage as Fannie Mae changes its guidelines. For example, a borrower now must have a 740 fico score to obtain the best mortgage interest rate, assuming they have the down payment and reserves for a conventional loan.

For the past two years, we have consistently raised rents. This trend continued until the financial crisis hit us this fall. Many homeowners are not able to sell their homes at a desired price point and are forced to lease their homes and become landlords. Inventory of rental homes is at an all time high in Cedar Park/Leander and Round Rock areas.

We are dropping rents on all existing inventory. Properties priced below $1,100 month have weathered the storm better than higher priced rental properties. The most resilient rental homes are those priced below $1,000/month. Homes leasing at or above $1,200/month earlier in the early part of the year are now leasing for 10% less. As rents increase, the pool of qualified tenants decreases. We are also seeing tenants downsize and move to more affordable homes.

We have transitioned from a landlord market to a tenant market. Next year, we will renew most of our leases at the same price point and may drop rents to keep current tenants. I expect to see more rental applicants affected by job losses, financial troubles, and foreclosures as homeowners lose their homes and are forced to rent. I anticipate the days on market will increase as long as our inventory remains at high levels. Owners will need to look harder at applications to avoid long term vacancies.

Though Austin continues to have one of the best economies and real estate markets it the country, our unemployment rate has increased, and our real estate sales market is deteriorating. According to the Austin American Statesman, our unemployment rate was below 4% in early 2008 and 3.5% a year ago. It has now reached 5.0%. This is still below the Texas and national average. However, Austin is not immune from the national economic, mortgage, and financial crisis. November home sales were down 40% in Austin, a level not seen since 1997. Some areas were down almost 60%.

Long term, Austin will continue to have one of the best economies and real estate markets in the country. 2009 will be a year of recovery. Rents and home prices most likely will trend downward, and inventory levels will remain high. If the job market recovers more quickly, we will see the market stabilize. Now is a great time to purchase a home or take advantage of the down market.

If you have a current mortgage on a primary residence with a rate above 5.75%, it may be a great time to refinance your mortgage. Mortgage rates for primary residence are in the 4.75% range. Our office provides sales, leasing, property management, handyman, and mortgage services.

Article written by our Broker, Chris Warren, Smart Source Realty