If you are looking to grow your portfolio and generate wealth, investing in rental homes may be a perfect solution for you. Real estate is a great way to diversify, as it often is counter-cyclical to the stock market. When you take the time to do careful, detailed research you’ll be able to identify and select homes that provide an excellent cash flow and strong ROI.
The steady stream of income coupled with increases in valuation makes this a worthwhile venture. In addition, during times of high inflation rents have historically increased at a faster rate, adding even greater returns to your portfolio. There are also important tax benefits and considerations that should be part of your decision-making process as you build your collection of properties.
1. Investing in Rental Homes
One of the tax-related considerations you should evaluate when investing in rental homes is how these holdings might fit into your retirement plans. With a self-directed IRA it’s possible to use the funds in your retirement account to buy shares or properties. Your rental income can accumulate tax-free within your account, and the appreciation in the properties will increase the value of your IRA. If you further diversify by adding Real Estate Investment Trusts (REITs) to your IRA you’ll also benefit from the REIT tax advantages. REITs operate as passthrough entities, and if they follow very detailed rules, they don’t have to pay corporate income tax. This allows an investor to keep even more of their property earnings.
2. Track Deductible Rental Home Expenses
One of the worst business mistakes you can make is not properly tracking expenses. When you invest in rental homes, you’ll need to make sure that you carefully track all of your deductible expenses. In general, you’ll be looking to deduct a variety of expenses that are associated with the management, operation, and ongoing maintenance of the property. Examples of these expenses include interest on any mortgages or loans, taxes, insurance, and property management fees. You’ll also want to deduct any costs related to repairing or maintaining the assets. Payments for utilities you paid, such as water and sewer, or pest control can also be taken off on the return. Accurate records and receipts must be kept for any claimed expenses.
3. Be Sure to Deduct Expenses
An active real estate investor puts a lot of time and effort into managing and growing their portfolio. As you prepare your return, be sure to take all the deductions related to running your investment business. These expenses might include office space, advertising and accounting, and legal fees. Money spent on purchasing business equipment and supplies, such as stationery and business cards, is also deductible. Travel expenses related to this venture can also be written off, as can mileage. Be sure to keep accurate, timely records showing the purpose associated with any auto mileage.
4. Deduct Depreciation on Your Properties
As an owner of a rental home, you are allowed to take depreciation on the property. Residential holdings have a recovery period of 27.5 years, so you can prorate the purchase prices over that time and then take 12 months of depreciation each year you own the dwelling. This expense will serve to reduce your income and may lower your overall tax liability. You might also choose to take depreciation on major improvements you make to the home, such as when you install a replacement roof. When you sell the property, you’ll have to pay careful attention to options related to the sale since the depreciation you’ve taken would be taxed at a standard rate. You can avoid this depreciation recapture if you use a 1031 exchange strategy.
5. Carefully Consider the Impact of Capital Gains
Capital gains may come into play when you make a profit selling one of your properties. The two types of capital gains, short-term and long-term, each have a different effect on your taxes. Short-term capital gains apply when you sell one of your assets within a year of purchasing it. Typically, rental homeowners look to hold an asset for much longer, but at times you may face the need to sell more quickly.
When you do sell within a year, the profit on the sale is treated as regular income and is added to any amounts you made on your job. This effectively moves you up to an even higher bracket. If you have held the home for over a year, any profit will be taxed at the lower long-term capital gains rate. The long-term rate is calculated on a sliding scale based on your income bracket, so there may even be times when there is no tax due on the profit from the sale.