How a Rental Property Can Provide Financial Returns
Several financial considerations come into play
Numerous financial facets can contribute to successful ownership a rental property and your financial returns, and they can seem intimidating at first glance. Cash flow, depreciation, and tax implications are just a few, and they interlock to some extent. Your profits can depend on working each to your advantage. Here are a few examples.
This is a breakout of the rental cash flow on an example property. It's not a tax liability calculation but rather a straight out-of-pocket cash flow problem that this company is experiencing. We take out the mortgage payments, even though all that won't be tax-deductible. We want to see the difference in actual cash flow in and out of pocket.
Your goal, of course, is to create a positive flow of cash that you can deposit into the bank every month for the life of your ownership of the property. Every cash outflow and inflow is calculated and the amount left over should be a reasonable return on your investment. Yes, you expect to eventually sell at a profit as well, realizing appreciation in value over the course of your ownership period.
Next, we'll calculate depreciation, as well as how it reduces our income tax liability on the cash flow determined in the previous step. We'll put the mortgage payment back into this calculation to begin looking at this from a tax perspective.
The depreciation deduction is a valuable component in our property analysis. For people in high tax brackets with other investments, it might even reduce the profits from other investments. Of course, you'll want to contact an accountant or other tax professional to explore this, but when your costs of ownership plus depreciation add up to more than your profit, you might have a leftover loss that you can use against other income for tax purposes.
It's not actually a cash loss because depreciation isn't cash out of pocket. It's a calculated number treated as an expense for tax purposes. You didn't actually spend it so you can still have a positive monthly cash flow while still showing an operational loss for tax purposes.
Now let's consider the tax deduction for the mortgage interest you pay on your rental property. Although current tax law passed in 2017 has restricted the deduction for mortgage interest on real estate used for personal purposes, you can still deduct interest from your rental income if you don't live in the property as your personal residence.
Without any other deductions that a particular owner might bring into play, the result predicts your approximate tax liability. We've reduced your taxable rental income considerably by claiming this deduction and you've realized a net positive cash flow after taxes in this example.
The overwhelming evidence is that most real estate investors are in the game for profit, and those profits are in large part due to advantageous IRS rules for certain real estate such as this one.