Andrew Carnegie is famous in many circles, but one of his quotes stands out: “Ninety percent of all millionaires become so through owning real estate.”

Although there are several real estate investment strategies, most novice investors start with a rental home, often their own or the other half of their duplex. Barriers to entry are not high, and the ultimate rewards can be amazing.

Attractive profit margins is what attracts most investors. Over the decades, Congress and the IRS have instituted tax advantages that leverage those profits.

Maximizing Profit

There are two profit components in a rental home investment:

  • You generate cash flow from rents over expenses.
  • The property appreciates in value over time, so you make a profit when you sell.

You must understand the local real estate market to know the market value of a property, the rent you can charge, and your costs of doing business. Expenses are almost all deductible for tax purposes.

Your goal in choosing a rental property is to buy it at a below-market price. That way you start out with a built-in profit. Before the purchase, you must have determined you can rent the home for more each month than the mortgage payment and the monthly expenses to own and maintain it. This is your positive monthly cash flow. The higher you can set this, the better. Remember, you will have short periods of vacancy between tenants and possible nonpayment of rent.

You hold the property and rent it out until you want to change the investment or liquidate it completely. You profit on the sale from the appreciation in value over time.

Minimizing Taxes

Against your profits, you can write off just about every dollar you spend out of pocket for allowed expenses. If you have other investments, you may be able to write off excess expenses against them. Expenses you can normally deduct include:

  • Repairs, maintenance, landscaping
  • Mortgage interest
  • Advertising for tenants
  • Property taxes
  • Professional fees, attorneys, accountants
  • Utilities, owner provided
  • Trash collection
  • Property management fees, if you use a property manager
  • Homeowners insurance
  • HOA fees

Before you purchase a rental home, carefully estimate these costs so you can set your rents and cash flow appropriately.

Depreciation, the Bonus Tax Deduction

A rental property structure, not land, can be depreciated over 27.5 years. The value or purchase price of the property is divided by 27.5 to arrive at an annual depreciation deduction amount. This is money that you are not spending out of pocket, so it’s like a bonus. For an easy example, a $275,000 property would be depreciated at $10,000/year (275000/27.5). That $10,000 is deductible against income from the property.

Growing a Rental Portfolio Free of Capital Gains Taxes

There is one major tax-saving measure remaining. When you sell an investment property at a profit, you will owe capital gains taxes on the profit. However, another special deal for real estate investors is the 1031 Like-Kind Exchange. The IRS will allow you to roll the profits of an investment property sale into another investment property and defer capital gains taxes. There are strict rules, but learning and following them are worth the effort.

Investors use the 1031 Exchange to grow their portfolio of properties. One way is to sell a current investment property that has gained a lot in value over time. Rolling the profit into one or more rental properties you purchase according to the rules allows you to defer the capital gains. The taxes are still there, but you don’t have to pay them until you finally liquidate the investments.

This is a “you can take it with you” thing. Suppose you have used sharp investment skills and 1031 Exchanges over the years to build up a nice portfolio of rental homes. You are retired with a lavish income from the homes’ rental cash flows. As long as you don’t liquidate the properties, upon your death, you take those deferred capital gains taxes with you. Your heirs inherit the property at its “stepped-up value.” This is its value in the current market. It is as if all those sales and taxes over the years just didn’t happen.

Real estate investment has been the path to wealth for many—and it can be your path as well. Be conservative in your research and practice due diligence. Know your market values and prevailing rents. Keep excellent records. And, if you want to spend some time and build wealth, retire and have some fun.

Abhi Golhar is a real estate investor, entrepreneur, a three-time nationally syndicated radio show host on the Wall Street Business Radio Network, and media figure, whose experience encompasses print, podcasting, radio, and television appearances.

Tags | Rentals | Taxes
  • Abhi Golhar

    Abhi Golhar is a real estate investor, entrepreneur, 3x nationally syndicated radio show host on the Wall Street Business Radio Network, and media figure, whose experience encompasses print, podcasting, radio, and television appearances.

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