Is this a good deal on a rental property?

[Ivan Poon]

Hey guys,

I'm looking to buy a single family home in fairfield county in connecticut. It's about 50 minutes drive (assuming no traffic) to NYC so property values are pretty high around here.

There's a deal on a foreclosed home for 360K. The FMV is probably around 420K. Property is in pretty good shape, though i'll just have to replace a hole in the wall (in a closet) and replace a wooden door. Taxes are 5500 a year. I'm looking to put 20% down. I could probably get 2K monthly in rental income.

What do you guys think? Thanks!

edit: almost forgot, it's almost 1700 square feet and has a pool in the backyard, if that makes any difference.

[Jon Holdman]

The 2% rule is really only accurate with rents of about $500 a month. Higher rents can use a smaller percentage and still clear $100 a month. But the percentage is never as low as the "1% rule often bandied around. At rents lower than $500, you have to use an even larger percentage.

The tax advantages are WAAAY overrated. The real rule is that you cannot use passive losses (i.e., the losses produced by deprecaition on rental property) to offset ordinary income. However, there's a "special allowance" that allows some taxpayers to use up to $25K of passive losses to offset ordinary income. But that allowance phase out if your AGI (married or not) goes over $100K and is gone if your AGI is over $150K. If you're in the 25% bracket and married filing jointly, your AGI could be as high $137K, so this limitation would affect you.

Further, its only $25K. That sounds like a lot, and it works if you're just buying a few rentals. If you want to build a portfolio, its not.

Good deals don't actually produce much, if any, passive loss. A good deal, even after adding in depreciation, will tend to produce some taxable income.

And here's the real kicker. You have to pay back the depreciation deduction! That is, when you sell a property, the gain is the net selling price (price less selling cost) minus your BASIS. Basis starts at the net purchase price (price plus purchase costs). It gets increased by some of the improvements you make. But it also gets decreased by the amount of depreciation you take or are allowed to take, whichever is larger. So, if you take $50K in deprecation on a property and then sell it, your basis is lowered by that $50K, and your gain is $50K bigger. Then, to figure the tax on the sale, you take the amount of gain up to the amount of depreciation taken or that could have been taken and you pay depreciation recapture tax on that amount. That's paid at your ordinary rate, though its currently limited to 25%. Any remaining gain is taxed at capital gains rates.

So, you can really only consider the benefits (i.e., the avoided tax) of depreciation a loan. You get to "borrow" the money while you hold the property, then pay it back when you sell.

Want to avoid this tax? Die. Seriously, if you sell, you pay. If you 1031 into another property, you defer the tax, but the liability is still there. If you die, your heirs inherit the property with a basis of the value on the day of your death. So, they avoid the tax.