This article is part of the End of Year Tax Tips Series from tax and legal expert Mark J. Kohler.
As entrepreneurs find success with their primary business ventures, many search for the proper investments for their profits. With that said, after reviewing thousands of clients' situations and tax returns each year, I am convinced that more entrepreneurs should consider rental real estate as an important part of their portfolio.
Now, you may shrug off the concept of owning a rental property and having tenants, due to the time and skills it may take to manage a rental portfolio. But let me list a few reasons that may change your mind:
1. The use of leverage.
Real estate is one of the few investment vehicles where using the bank's money couldn't be easier. The ability to make a down payment, leverage your capital and thus increase your overall return on investment is incredible.
2. Tax deferred growth.
Buying rental property based on speculation of its value is a dangerous tactic since cash flow is the key. However, appreciation over the long run is certainly realistic and at the least, you should be considering a tax-deferred strategy. In the future, you may even consider a 1031 exchange, charitable trust or installment sale to lessen your tax liability further.
3. Tax-free cash flow.
It's no secret that because of depreciation and mortgage interest deductions (if you leverage your capital), your cash flow should be tax-free. That's right! The far majority of the time, an investor will never pay taxes on their cash flow and can wait for capital gains on the sale of the property in the future.
4. The tax write-offs against your other income.
Having a rental property affords investors with another incredible opportunity to convert personal expenses to potentially valid business deductions. Also, depending on your classification as an Active Investor or Real Estate Professional and your income level, there is a good chance that your rental property will give you an overage of tax deductions that you can use against your other income. With that said, this is something you will want to discuss with your tax professional before investing so that your expectations are realistic.
5. Rental real estate is a forced retirement plan.
Americans are terrible savers. We lack the self-discipline to put a monthly deposit into our IRA, SEP or 401k as small-business owners. However, buying a rental property is a significant commitment that you are required to commit to and maintain. You will always be grateful in the long run when you don't give up on it and build future cash flow and wealth.
Based on this fact and the list above, I have consistently urged my clients to buy one rental property a year and already have clients with rental properties earning them money they never imagined they'd have.
YEAR END TIP: Start shopping now for a rental property, track your expenses and, even if you purchase the property in 2017, make the goal to buy one rental property a year.
Now, finding the right rental property for you in your situation can be a challenge. Over the years, I have purchased rentals myself and also work with clients each week, if not daily, to structure their rental real estate with tax and asset protection benefits. Here are six strategies I have learned and applied over the years that can help you find the best rental property for you in your situation.
1. Buy local if you can.
Let me repeat the words “if you can.” That’s the key. Don’t get hyper-focused on buying local so you can “check on the property.” It’s okay if you don’t buy local. It’s far more important to buy quality rental properties, rather than local. But, if you are lucky, and you truly live in an area where there are good returns and rental markets, where the return on investment is legitimate without having to own it outright or put down a fortune …then consider yourself lucky. Gain some experience, put in some sweat equity and shop 'til you drop!
2. Learn to manage your property manager.
Unless you are a full-time real estate investor and one tough cookie, get a property manager! If you don’t have the temperament to be tough and start eviction proceedings three days after a tenant is late, have a personal intervention with yourself. You may not have the time, skills or system to be your own property manager, even if the property is local. Be a realist. Your time could be better spent looking for other rentals, doing the books and earning income with your day job or operational business. So with that said, always, and I mean always, put a budget in your rental property analysis for a property manager (approximately 10 percent of gross rents). Even if you have visions of grandeur and start managing, you will want the budget to add a property manager if that need arises.
3. Don’t use a shotgun approach.
I recently met with a client that had five properties in four states. They were great properties, but seriously? Look at the inefficiency of registering an LLC in four states, four state tax returns, four different property managers, four different trips to at least occasionally check on your rentals and four different markets to understand and follow. Now when you have 25-plus rentals and you can afford to make your full-time job managing your rentals and property managers, then tackle four or five markets. But if not, consider the alternative: Bundle your properties in one or two markets, maybe three. Get to know your property managers, get to know the areas and try to be efficient with your tax and legal planning. Save time and money with “bundling.”
4. Have a master rental property analysis spreadsheet.
Create an Excel spreadsheet to analyze any and all possible deals. That's right -- you’re not going to buy the first rental you see this year! Run every property through the gauntlet of your spreadsheet. Own your spreadsheet. Know every column. Start with fair market value, money down, improvements and mortgage/carrying cost, then move it through rental income and expenses, and wrap it up with a cash-on-cash return-on-investment figure. Base your decision on this key factor generated by your spreadsheet. This is why you took fifth-grade math -- embrace it!
5. Remember, you are buying numbers.
Too many investors get emotional about their purchase and can even envision themselves living in the rental property they are analyzing. This is a terrible mistake. In these situations, the investor often over improves the property, investing far too much time or capital and blows their return on investment out of the water. You aren’t buying a property -- you are buying “numbers.” Consider: What do your dollars get you in dollars and cents? Not, what cute neighborhood or yard do they get you?
6. Do your research.
Let me say that again: Do your research and then do it again. Don’t look at a property as to Why shouldn’t I get this? Look at it as, Why should I get this property? Make the numbers prove it to you. Don’t assume you’re going to buy it unless you find something wrong with it. I love a positive attitude and glass-half-full approach, and thus, this has been one of my greatest learning experiences. I have trained myself over the years to be a lot more skeptical -- at least when it comes to analyzing rentals.
The far majority of us will never get rich overnight. It takes long-term investing and a diverse portfolio to build true wealth. Bottom line, these are the key themes, strategies and approaches to real estate that my successful clients use. Don’t underestimate the power of real estate on your tax return in your portfolio of wealth.
Mark J. Kohler is a CPA, attorney, radio show host and author of The Tax and Legal Playbook: Game Changing Solutions For Your Small Business Questions and What Your CPA Isn’t Telling You: Life Changing Tax Strategies from Entrepreneur Press. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP. Check out Mark's YouTube channel or Buy Mark’s Educations Products Today!