Owning rental properties can be a great way to fund one's retirement. Not only are they assets that can increase substantially, but they are at least partially funded by the tenants who stay there.
Along with this, they can offer a deduction every year, or upon sale, despite having positive cash flow. This all depends on whether the property owner is an active or passive landlord.
The Difference in Types of Landlords
An active landlord is one who has at least some involvement in the management of the property.
For example, if a person owns a two-family home and rents out the other half to someone while collecting the rent and taking care of any problems that arise, he would be an active landlord. If that same person buys a second home to upgrade his growing family's lifestyle and square footage, and allows a property manager to handle collecting the rent, but he performs maintenance or sets up the appointments for maintenance people to do work, he is also an active landlord.
A passive landlord, on the other hand, has no involvement other than receiving a check from a property manager. Property management is a service offered by many real estate agencies for an average fee of 10% of the rental income.
The Tax Advantages for Active and Passive Property Owners
Active property owners can use losses in rental properties as tax deductions every year. Passive owners cannot claim yearly deductions, but get to use total losses as a means of not paying capital gains taxes upon the property's sale.
Where some may think that a property operating at a loss is a bad thing, it is important to note that the income is not only matched to expenses, such as the mortgage and regular maintenance. It is also compared to depreciation.
Depreciation and Tax Write Offs in Real Estate
The way depreciation works is by taking the total cost of the home (purchase price plus any improvements) and amortizing it over 31 years. So, a home that costs $113,000 that had $11,000 in renovations done would have a total value of $124,000. When this total is divided by 31 years, it depreciates by $4,000 annually.
If the property owner took in $12,000 in rent for the year while paying $11,000 towards his mortgage, it is common to think that his net profit would be $1,000, but the bottom line would actually be a net loss of $3,000 after depreciation, bringing him a deduction on this capital loss for the year.
A passive owner would not receive a deduction at the end of the year. Rather, the losses will accumulate with gains to be considered against any profit made on the final sale. If the owner of the above $124,000 property incurred average losses of $1,000 over 30 years and then sold the home for $160,000, he would not pay taxes on the entire $36,000 gain since $30,000 would be written off as past losses. Instead, capital gains would only be paid on the remaining $6,000, leaving the investor with about $35,000 on top of all the equity he held in the home.
Between the potential for rising values and tax advantages, real estate investments can be a very competitive asset for people to consider when thinking of how to improve their retirement portfolios.
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