Real Estate Investment: Return On Investment and Cash Flow Calculation

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Tax Advantages on Rental Property

There are many tax advantages in real estate investment in rental properties. Be it to rent out a room, your second home, your vacation house or properties solely for rental, you are rewarded with numerous deductions and tax benefits that allows you to lower your tax burden.

For your principal residence, you only deduct your property taxes and home mortgage interest. For a rental property, almost all the costs related to rental activities are tax deductible. Your rental income is very simple, the monthly rent you collect. The deposit is not your money or income. You are supposed to return the deposit at the end of the lease. You pay tax on the rental income offset by rental expense. What iterms are counted as rental expense?

Rental Expense

  • Property tax
  • Land owner's insurance
  • Mortgage Interest Expense
    You can deduct mortgage interest you pay on your rental property but not principal.
  • Depreciation
    You may begin to depreciate your rental property when it's ready and available to rent. If your property is ready to rent in April and you put ads out, but your tenant move in July, you still may depreciate your property starting from April. You can only depreciate the structure value. The land value doesn't depreciate.
  • Repairs
    You may deduct the cost of repairs to your rental property but you can't deduct the cost of improvement.  However, you can recover improvement cost by taking depreciation
  • Realtor Expense and Advertise
    If you pay realtor for rent it out or you spend money to advertise on newspaper, you may deduct the expense.
  • Travel expense to look after the properties
    If you have to ravel away from home to inspect or repair rental property, you may deduct the expense but you need to show that it is the primary purpose of your trip rather than vacationing or other personal purpose.
  • Home Association Fee
  • Management fee
    If you hire a management company to manage your property, you can deduct the management expense.
  • Personal Services
    You may not deduct the cost of your own labor as an expense. If you fix the rental property by yourself, it's not an expense. But if you hire your children to do it, then you can deduct the expense then.
  • Tax Return Preparation
    You may deduct the part of a tax preparation fee you paid to prepare part1 of Schedule E(form 1040). You may also deduct as a rental expense, any expense you paid to resolve a tax underpayment related to your rental activities.
  • Other Expenses
    You may be able to deduct a phone, a car, business cards, and other expenses you incur managing the property

Passive Activity

Renting property is considered a passive activity which means that you may not deduct a rental loss against nonpassive income such as your salary from your job or investment income such as stocks and bonds. If the amount of rental loss that exceeds rental income is not deductible for the current year, you can carry it to the next tax year though. The IRS passive activity laws were intended to discourage tax-shelter investments. There are two exceptions though to this passive activity loss limitation.

  • Real Estate Professionals
    To meet the IRS Real Estate Professional exception you must meet the following activity tests for the tax year.

    1. You perform more than half of your business working hours in the real estate business.
    2. You perform more than 750 hours of this type of work during the year.

  • Material Participation

    If you actively manage your real estate investments, then they will not be considered "passive activities" by the IRS. You materially participate in an activity if you are involved in the operation of the activity on a regular, continuous, and substantial basis.

    You actively participate in a rental real estate activity if you and your spouse owned at least 10% of the rental property and you made management decisions in a significant and bona fide sense. These management decisions would include approving new tenants, deciding on rental terms, approving expenditures, reviewing expenses and similar decision.

Rental Loss Limit

If you meet the "real estate professional" exception, there is no limit to the amount of losses you can deduct. The real estate losses are deductible against any other form of income.

If you meet the "material participation" requirements you may deduct up to $25,000 of loss from your non-passive income. This amount is phased out, however, if your modified adjusted gross income is between $100,000 and $150,000.

Consult with your CPA for any tax related issues before you make investment decision.