How Do You Make Money in Real Estate?
In this article, I will explain how you make money with investment real estate. Note that while this is a high-level view, the real world is more complex. Later I will provide a more real-world view of the key topics.
50,000 Foot View
The goal of investing in real estate is to buy a property such that the income (rent) is sufficient to pay all the recurring expenses (debt service, taxes, management fee, maintenance, etc.) and have money left over (which is referred to as cash flow or profit). See the image below.
Taxes are a major consideration in any investment decision because it's not how much you make, it's how much you get to keep. One of the many advantages of investment real estate is the ability to deduct almost all recurring costs plus a portion of home office expenses, professional services, maintenance and travel expenses (within reason) related to management PLUS depreciation.
Depreciation is confusing to most people so I will overview how it works. One definition of depreciation is the reduction in the value of an asset with the passage of time, due to wear and tear. Despite the fact that real estate typically increases in value over time, the IRS views investment real estate much as it does factory machinery (drill, grinder, fork-lift, office furniture, etc.). The concept is that as you use a drill it starts to wear down and will eventually have to be replaced. The "useful life" of items such as drills are specified by the IRS. For example, the IRS guidelines state that the useful life of office furniture is 7 years so you are allowed to deduct 1/7th of what you paid for the furniture each year for 7 years from your income.
With investment real estate, the useful life (for most investment real estate) is 27.5 years (why 27.5 years????). The only significant difference between depreciating office furniture and real estate is that you can only depreciate "improvements" (structures and such), not the land. The concept is that land never wears out so it is not depreciable. How does this work in practice?
For example, if you assume that 80% of the total purchase price is depreciable improvements (20% of the purchase price is the cost of the land) and we paid $180,000 for the property, you would deduct ($180,000 x 80% / 27.5) about $5,236/Yr. year from the net income generated by the property.
As an example, suppose you owned the following property:
- Purchase Price: $140,000
- Rent: $1,200/Mo. or $14,400/Yr
- Management Fee (8% of Collected Rent): $1,152/Yr
- Property Taxes: $750/Yr
- Landlord Insurance: $550/Yr
- Debt Service (30Yr, 20% Down, 4.5%): $567/Mo or $6,810/Yr
- Interest Portion of Debt Service: $5,448/Yr
- Depreciable Percentage of Purchase Price: 80%
- IRS useful Life: 27.5 Yrs
- Annual Depreciation = ($140,000 * 80%)/27.5 = $4,072/Yr
|Item||Tax View||Cash Flow View|
|Debt Service Int.||-5448||-6810|
Notice that your taxable income is $2,428/Yr but your actual cash flow is $5,138/Yr. Frequently, you will have a tax loss while having positive cash flow. The image below illustrates the difference between cash flow and taxable income.
With a mortgage, each month the principal is reduced by a portion of the debt service payment and, over time, the mortgage is paid off. When the mortgage is paid off, the cash flow significantly increases as illustrated below.
You make money in investment real estate by purchasing properties that generate more income than expenses. The difference between income and expenses is called cash flow.