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In last week’s episode, Devin and John talked about whether you should own rental real estate in your retirement portfolio. So, today, we’re going to talk about some mechanisms for evaluating a rental property, and John will entertain you with taxes.
First, you have to figure out what kind of property do you want to buy. There are so many options – big, small, house, townhouse, condo, anything! And do you want a long-term rental property, or a short-term rental property? Each option has various pros and cons, and it can be really hard to pick.
Then, what is the right price to pay? There are a couple of tools that you can use to determine whether a property is a good price.
First is the standard 1% rule. Under this rule, if your total monthly rental needs to be at least 1% of the total acquisition costs (purchase, closing costs, renovations, etc.)
The second method is the capitilizatio rate (“cap rate”) method. That tells you what percentage you’re getting when you take your net operating income divided by your total acquisition costs. Most professionals are looking for a cap rate of at least 5%, but probably 6% or 7%.
A third method, that Devin hates, is the cash-on-cash method. This takes your monthly cash flow and divides it by your total out of pocket cost. This method emphasizes putting as little money down as possible, which might be okay for a house or two, but if you start amassing a lot of houses, then you are very highly leveraged.
Regardless of which method you’re using, you need to run the numbers to see if the property is going to be profitable.
Now let’s move on to taxes!
Last week, Devin and John talked about the value of property depreciation. It lowers your profit each year, which lowers your tax bill. But what happens when you sell? When you sell the property, you’re going to pay tax on the sales price, minus the cost basis. With depreciated real estate, your cost basis goes down with each depreciation, so those taxes can add up.
Now, if you pass this property on to your heirs, they get a stepped-up cost basis, and this will eliminate or reduce those taxes.
Another way to postpone depreciation recapture is the like-kind exchange. In the traditional like-kind exchange, you just swap rental properties with another owner. But it’s hard to find the other property with an owner that wants to buy your property. So, you can use a deferred exchange. You have 45 days to identify up to 3 properties that you might want to buy (with some exceptions.) You then need to complete the purchase within 120 days. If you do that, then your cost basis is transferred to the new property. These exchanges can get a little complicated, and don’t do this without professional help, but they can be a good way to postpone the taxes that you owe.
Retirement income can come from rental properties, and it helps to make a diverse stream of income coming in during retirement. Be sure you understand the risks, responsibilities and rewards before you jump into the real estate market.
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