How do you make your money on rental properties?

[Sharad M.]

From what I understand there are four ways to make money from a rental property:

1) Cash flow - Pretty straightforward. Total money you receive as income is more than total expenses.
2) Appreciation - Increase in the value of your property over the rate of inflation.
3) Equity buildup - This comes from paying off your mortgage principal balance each month. The lower the rate of interest on your loan, the more money you have going towards your principal, the better your equity build up will be.
4) Tax write off - You get to write off expenses for tax purposes like operating expenses, depreciation, etc. Tax write off is something that every rental property investor benefits from.

In my market, I am not relying much on appreciation. Though properties are a lot cheaper than they were a few years ago, but I am not being too optimistic for some decent appreciation. I plan to make my money from cash flow, equity buildup and tax write offs.

Each investor has individual goals and there is no right or wrong way to make money as long as we make money. So how do you expect to make money from your rental properties? Any other ways besides the four listed above that you are utilizing to make money from your rental properties?

[Jon Holdman]

I would argue that #3 isn't "making" money at all. Rather its a savings account.

I would (and have, numerous times) argued the tax benefits are very often overhyped. The AGI limits on using passive losses to offset ordinary income limit this strategy. Further, properties that actually produce cash flow generally do not generate passive losses. They - horrors! - actually make money. Where the tax benefits do come into play is that they can allow you to shelter a good portion of the rental income.

Unfortunately, the tax benefits unwind when you sell and pay depreciation recapture tax. Something rarely mentioned with an ugly deal gets plastered with some "tax benefit" lipstick.

Personally, I like a strategy Rich outlined long ago. Buy a house a year. Pay them off in 15 (or whatever) years. After 15 years, you own it free and clear. Take out a new mortgage and use that for a year's worth of living expenses. As long as you keep the loan amount to an amount supported by the rent (i.e., your new tenant is paying down the new mortgage), even if its just break even, you have the loan proceeds to live off. Now, perhaps its just as well to spend the net cash flow, but that may be taxable where the loan is not.

Then, die. Let your heirs inherit the properties at a stepped-up basis. Now they can sell, pay off the loans and there are no capital gains or depreciation recapture (I think) taxes. Since you will have houses in various states of paydown, they should get a nice chunk of tax-free change.