As promised … numbers!
Let’s say you bought a property for $325,000 with the land valued at $50,000 and the building valued at $275,000. You rent the property for $2,000 a month. How much rental income does your property produce each year?
$24,000? Nope—that’s just rent. Rental income is rent minus all the expenses related to managing your property. Some expenses are fixed and straightforward—your mortgage payment, for example. This payment usually contains four separate components: principal, interest, taxes, and insurance. Except for the principal, all are costs you can subtract from rent collected to determine rental income.
For ease of calculation, let’s say your monthly mortgage payment is also $2,000 and of that, approximately $400 is principal. I say approximately as the amount of your payment applied to interest and to principal will change each month. Then you’ve got things like repairs, maintenance, and any utilities that you provide. Estimate $150 a month for these costs.
How’re ya doing? From a cash flow perspective—literally, cash coming in and cash going out—not great. You’ve collected $24,000 in rent but you’ve paid out $24,000 to the mortgage company and another $1,800 to various service providers (note to self: encourage children to go into a building trade).
From an income perspective, you’re doing even worse. While only $19,200 of the payments to the mortgage company are costs per se (don’t count the principal!), you also have the ongoing maintenance and … a $10,000 depreciation expense. The friendly folks over at the IRS say your $275,000 building has a useful life of 27.5 years. So every year, you “use up” $10,000 of its value as you rent the property out for … raves or pop-up parties or whatnot. Assuming these figures, your property’s annual income is a whopping -$7,000 ($24,000 – $19,200 – $1,800 – $10,000).
Hmm. Makes you wish you’d bought ten of these, doesn’t it? Imagine your losses then!
Except here’s the thing. That depreciation is a non-cash expense. You didn’t actually hand over $10,000 to anyone. Not to mention you can potentially offset the -$7,000 rental loss against other income, saving around $1,500 in taxes. All of a sudden, cash flow moves tantalizingly close to positive territory. Nifty trick, that depreciation. Not confusing at all that the person who sold the property to you also used up all 27.5 years of the building’s useful life 🤔.
Wait, wait. So you might be getting close to not losing money? Is this really cause for celebration? Yes, because the number we care about here at LBYM is Net Worth. And your Net Worth is moving in the right direction … to the tune of $400 a month. That’s how much your tenant is paying down your mortgage balance each month. Almost $5,000 a year. And that’s the impact on Net Worth before taking into account any kind of appreciation in the value of the property.
You read that correctly. The building value is likely appreciating while you are simultaneously depreciating the building itself. I would like to meet the lobbyist / Houdini who slipped this into the tax code.
So useful – thanks! So…a question for you: say you’ve completely paid off your mortgage, so your net worth is looking pretty strong. Is it better to keep the house and rent it out, or sell the house and invest the money in an age-appropriate mix of stocks, bonds, etc? Or sell it and roll it into your next house? Considering that you kept your house and then bought another, maybe that answers the question….
I’d keep it and rent it out. Alternatively, you could take out another mortgage on the property and use the cash to invest elsewhere, say in another property or in other investments. Before you do either of these things, though, you need to figure out what you are trying to do … goals! You mention “age-appropriate” investments, but are these assets ones that YOU’D like to use (spend) in your lifetime? Or to potentially pass on to heirs?
Goals help you make decisions. Thanks for the question!