Are you wondering how to start investing in real estate? Maybe you own a rental property already? So many choose residential rental properties for investment income for several reasons. These include potential appreciation in value, income tax write offs, funding retirement, and providing income along the way. In order to achieve real estate investing success there are two main keys: Knowledge and a great Realtor. In this article, the goal is to share knowledge in these key areas:
- Rental Property Write Offs
- How Lenders Calculate Rental Income
- Rental Property Cash Flow
- Buying a New Rental Property
- Avoid a Tax Ticking Time Bomb!
Real Estate Investing Write Offs
Owning rental properties has a lot of potential advantages with buying a desirable rental home including obtaining good financing, cash flow, plus building equity. So, building equity means increasing wealth. In another of our articles entitled “How to get into real estate investing and build wealth“, we explain how even first time buyers can eventually get into real estate investing. Check out the article below after finishing this one!
In addition to these benefits, there are potential income tax write offs. Rental property write offs can lower taxable income. Therefore, lower taxable income means less income taxes to pay. Expenses that are commonly used as deductions include…
- Mortgage interest
- Improvements and repairs
- Insurance & taxes
- HOA dues
- Auto & travel
- Cleaning & maintenance
- Legal & professional fees
- Miscellaneous items
It is a good idea to look at the IRS form called Schedule E – Supplemental Income and Loss. Then, it is easier to understand how expenses play a role in taxable income. Additionally, don’t just plug in the figures. Discuss details and develop a plan with a good CPA who is experienced in clients with rental properties. Many real estate investors use rental income and expense strategies like these as a part of wealth and income building portfolio. Furthermore, it may provide a potential reduction in tax bills. Just keep in mind that certain write offs lower income as far as lenders look at it.
How Lenders Calculate Rental Income
With real estate investing, it is important to realize how mortgage lenders calculate rental income. If the rental property was rented during the prior tax year and the income needs to be used for qualification, the rental income calculation worksheet must be used.
Now, if the rental income is not needed to qualify, this calculation may not be necessary. But when it is used to prove a net profit or at least to offset some of the mortgage payment, lenders will usually be required to figure rental income this way. Keep in mind, not to just use the lease agreement or the bottom line on the IRS schedule E.
Furthermore, it is always best to provide the information to a qualified mortgage professional to figure the income accurately. A typical rental income worksheet used by lenders is below. Notice how the expenses are added back to the net income/loss and then the total mortgage payment is subtracted out to calculate the rental income or loss used for mortgage qualification.
So, as you can tell there are expenses in the rental section of that effect the bottom line of taxable income. But not all of the expenses reduce the income that lenders use which can be a good thing. For an experienced mortgage loan officer to calculate your rental income accurately, it is always best to provide the following up-front:
- Most recent federal tax return
- Proof of mortgage payment with escrows
- Taxes & insurance proof (if not escrowed)
- Proof of HOA dues (if applicable)
Rental Property Cash Flow
Cash flow or net income is what most investors want. Now, this is not always true! Some investors are looking to use rentals as a way to lower their income taxes liability while building equity. But, many buyers that get into real estate investing are looking for cash flow. Cash flow is the monthly net profit a landlord receives on a rental property. Otherwise, it means you’re making money.
More cash flow could then be used to buy another rental property. Not only does cash flow make the owner more income, it is also easier to qualify for a mortgage. The new mortgage could be a refinance as well as to buy another primary residence or investment property.
Avoid This Huge Ticking Tax Bomb!
There is one area that can be very profitable to an investor but if missed, could cost a ton of money! That deals with the capital gains tax on the sale of real estate. The rule deals with how much the owner has occupied the home over the last 5 years. So, there is actually a way that an owner can make a nontaxable profit on a rental property. The key is that the home must have been a primary residence for 2 of the last 5 years. We have a great article that any real estate investor should read. It is called “Property owners, avoid this huge income tax ticking time bomb“.
Overall, real estate investors who are knowledgeable in these areas will have a leg up on how to qualify, plan, and hopefully enjoy owning rental properties. So, if you’re looking to buy a first or subsequent rental property, build your rental team now! This team should at least include a knowledgeable Realtor, mortgage lender, CPA, and handyman.