Strategy, ROI, Buy-n-hold, exit, etc.

[Roman Rytov]

I'm hearing that nothing is more advantageous from the tax standpoint than real-estate also one never wants to part with good properties but use it as a cash cow. Help me connect the dots.

Let's use a portfolio of 10 SFH purchased on average at $200,000 and rented at 2000/month. Let's say each house is leveraged with a 20% downpayment for 5% for 30 years and a property management company charges 8%. Roughly the gross income is about 15% which is extremely good. Without getting in small details and trying to factor in vacancy rates, new tenant acquisition cost, and capex let me get to the questions:

1. Gross income from the house is abtou 18% cash on cash (principal payment is not an expense so only interest, taxes and PM fees are). With the current tax code you can write off via depreciation (if I'm not mistaken in this case) 150% of your downpayment in the first year. So assuming that you didn't buy the entire porftolio at once each new house drives your P&L down 50% of what you've factually invested. That's a lot of money and I realize that in the year when you purchased the house you're negative. First year.

2. The second year assuming the numbers stay the same you can depreciate only a portion of the house original value. 1/30th if I'm not mistaken which is 3.3% of the total cost or  about 15% of your gross income. What do you do with the rest of the income? Bring receipts from Home Depot? What do you do if you have 10 houses?

3. After 30 years the house is fully depreciated. What is the "tax advantage of the real estate" at that point with the same house? Or you're switching on the way by deferring taxes?

4. With 1031 exchange assuming that you need to buy a more expensive house will you have to change your portfolio from SFH to commercial one day? Nobody will rent a $5000 house.

I'm reading a lot of sources claiming that the real estate is unique specifically in tax implications and can't figure out a complete play. What am I missing?

Any references will be appreciated.

[Jaysen Medhurst]

@Roman Rytov, first thing I recommend you read is Frank Gallinelli's What Every Real Estate Investor Should Know about Cash flow... It goes into all the different metrics of REI and how profits are generated.

Next, you're missing a few key tax advantages and making some skewed assumptions. *Please note, I'm not a CPA, nor do I pretend to play one on TV. Talk to your accountant.*

There are 4 other key tax advantages that you're missing:

1. Medicare (1.45%) and Social Security (6.2%) taxes are not levied on rental income. So that's a 7.65% reduction right off the bat, vs. earned income.
2. Qualified Business Income (QBI): per the 2017 tax law, the 1st 20% of profit is not taxed as long as it is determined to be QBI. While this does phase out at a certain income level, it's still a pretty terrific tax break.
3. Being a Real Estate Professional: if you are a RE pro (there are guidelines), not only can you claim business expenses (like mileage, office supplies, etc.), but depreciation can offset income beyond that generated by RE. I think it can offset your spouse's income as well? Maybe a CPA can fact check me here.
4. Cost Segregation: This only really makes sense when you get into properties worth $750k+, but basically you're able to pull a bunch of the depreciation forward by segregating the property into its various components and depreciating those components on their own schedules. E.g. carpet might depreciate over 7 years, not the entire 27.5 or 39 years.

A few of your assumptions I would challenge:

1. Your portfolio example is not a great investment. You're just hitting the 1% rule, would likely need 25% down with a slightly higher rate, and the small details REALLY matter. My back-of-the-envelope math shows $130/month cash flow from your portfolio. That's not per house, that's the whole portfolio.
2. A far better investment would be a MFR with lower expense ratios, lower per-unit cost, and the ability to force appreciation, but I digress...
3. "150% of down payment as depreciation the 1st year." I've never heard this before. I assume what you're referencing is "bonus depreciation," but I don't think it's as easy as that formula.
4. Depreciation schedule for residential properties is 27.5 years, commercial is 39 years.
5. Yes, you bring the receipts from Home Depot and any other eligible expenses. If you have 10 houses, you probably have 10X the receipts. Tracking expenses is part of any business, not just REI. One more reason to go MFR, BTW.
6. If you get a full 27.5-year ride with a great investment property, you toast your spouse with a glass of outstanding champagne and count your blessings. Then...
7. 1031 into a passive NNN or DST property and bounce your grandchildren on your knee, knowing their financial future is secure.
8. Nobody will rent a $5k/month house? Wanna bet? What do you think a $1500/month house will rent for in 30 years?

Hope this helps start to explain why so many people are convinced that REI is the best path to financial independence and long-term wealth building. Don't hesitate to reach out with any questions.