Help me in understanding estimating financial goals. Am I understanding it correctly?

[Emily B.]

I’m trying to set some financial goals for myself and I keep hearing how I should be specific so that I know exactly what I’m working towards. With that, I want to make sure I’m understanding some of the calculations when trying to figure out how many properties I may need to get to said goal, so I was hoping someone could check my understanding here. I want to get into long-term buy and holds, single family to start but possibly MF as I get more comfortable with what I'm doing.

Here’s my practice example:

Say I have a property that I’ve bought and worked on with my after-tax dollars from my job so that, essentially, I own it without a mortgage payment. And then I rent it for $1,000/mo. Using that, am I correct in planning that I should take 50% of that and put it into a reserve for expenses ($500), pay taxes and insurance ($250), which then leaves me with $250 in positive cash-flow? Which then, essentially, means $3,000 cash-flow for the year before taxation ($250x12).

Again, I’m trying to learn more about the financial planning aspect, and I know this is a fairly simple example. I just want to make sure I’m at least on the right track.

If I am, let’s take it another step. What percentage is that yearly cash-flow taxed at? In other words, how can I estimate what I will actually net from that? I hear all the time that passive income is subject to a lower taxation than what I make at my job (earned income), but how does one estimate what percentage that is?

[Chris Simmons]

The 50% rule is a general guide and is both market and property specific.  It is generally a good starting point but once you get into the business, your historical costs will likely differ.  

My recommendation is to use your historical expense ratio or 50%, whichever is higher.  If you buy an old turd of a property that has not been recently overhauled and updated....plumbing, electric, roof etc...not just paint and carpet....then you could easily exceed 50%.  On the other hand, buy into relatively new construction or properly overhauled homes and the expenses can be less.  If your numbers come out to 60% expense ration, then stick with that for future properties you buy in similar condition.  If your expense ration comes out to 35%, until you have a long history with multiple properties to show this isn't a lucky streak, i would stick with 50% and just hope you don't use it all.

Now, for your question....property taxes and insurance is part of the 50%.  So with your scenario of a house that rents for $1,000/month, you should expect to AVERAGE 50% or $500/month for operating expenses and general upkeep.  This includes property management, insurance, taxes, general upkeep and repairs...occasional plumber visit etc.  This is an average so at the end of the year when you have set aside $6000 for expenses and only paid $1200 in taxes and $900 in insurance and somehow managed to avoid any maintenance calls or property management fees because you self manage, don't just go spend that left over expense fund just yet.  Your $3,000 sewer line replacement, $5,000 roof or $8,000 eviction & home repair bill might be right around the corner so keep that money set aside and hope the big expenses like that are far far away.  

The other 50% that is left should be available to service debt...not needed in your scenario or to spend if you want.  Personal opinion again....i would sock everything away into a large expense fund and once I had $10,000 or so...plenty for most major scenarios...then you can start spending money for whatever you want....perhaps another house.

Regarding passive income tax....at this point in the game, this is all pass through income to you and just adds on to whatever you make elsewhere.  This does not count as capital gains or dividend payouts like big investors get.  You will need to talk to a tax person about this to understand your specifics, but learn about the tax breaks.  The biggest one is depreciation.  You basically get to write off the purchase of your property over 27.5 years.  So if your house cost $100,000....Cost...not worth...and the land is worth $10,000, you get to depreciate $90,000 over 27.5 years for a paper expense that you really don't pay of $3272.72/year.  So basically, your $12,000 in income minus expenses paid...not budgeted...gets you your taxable income that just gets added to all of your other earned income.  $12,000 income minus $1200 in taxes, minus $900 insurance, minus $3273 depreciation, minus property management if you paid for that and then minus your general business expense like your marketing expenses if any, your mileage and whatever other expenses you have in operation the business and you get your taxable income.  

Hope this helps.