Rental Income—Calculating Your Paycheck From Real EstateBy
Greetings from the Inn Of The Mountain Gods in Ruidoso, NM. Enjoying the weather before heading to El Paso, TX to hang out with family and friends. I will also visit some of our retail shopping centers and discuss some vacancy issues with our property management company, Jaxon Texas Property Management as well as our asset management company, True North Asset Management.
Before landing in Ruidoso, NM, I just returned from Sucre, Bolivia and trying to get my head around what I experienced. Seeing Food for the Hungry in action was an incredible experience and looking forward to going back.
Today’s blog post is a topic that is a difficult one to learn becuase it is not a lot of fun. Although most of the post is “definition” on thing I would like to point out is that “falling in love with the numbers” is a priority. Many investors, especially inexperienced investors get emotionally involved before they study the numbers and their emotion will help them “fudge” the numbers. This is a terrible mistake….but I digress…..
So…..evaluating cash flow….
In the evaluation process of determining whether the property can and will generate enough income, you must analyze the numbers. According to Kiplinger.com, you need to look at several different variables to make the best decision. An interactive worksheet is available at: http://www.kiplinger.com/tools/renthouse/
These variables include the following items, which have been defined based on input from investorwords.com and Kiplinger.com:
• Mortgage Balance: The mortgage balance is the amount remaining due on the mortgage. A mortgage balance is a debt against the asset of the property. There are many creative financing tools available that can help you assess the options with the lowest balance.
• Interest Rate: An interest rate is the rate you pay to use money. IT is often expressed as an annual percentage of the principal (amount of someone else’s money you are using). Interest rates are calculated by dividing the amount of interest by the amount of principal. Interest rates are subject to change based on the rate of inflation and policies of the Federal Reserve.
• Loan Term: A loan term is the period during which a loan agreement is in force and during which the loan is repaid or renegotiated for other terms.
• Building Value At Purchase (including capital improvements): Building value at purchase means the numbers used to calculate your tax basis and annual depreciation. For tax purposes, residential real estate depreciates over 27.5 years, which allows for an annual 3.6% write off of the property tax’s basis. Building improvements are included, but lot value is not. This is different than net present value. Net present value is the difference between the present value of the future cash flows from an investment ant e amount of investment. Present value of expected cash flow is computed by discounting them at the required rate of return.
• Modified Adjusted Gross Income: MAGI is the income from taxable sources less adjustments. According to the IRS, you can deduct up to $25,000 of rental losses annually to reduce your tax bill on other income if your MAGI is less than $100,000. If your MAGI is too high, passive loss rules put your losses into suspended animation, which means that they have no value at the time but will resurface to offset taxable profit when the property is sold. MAGI is calculated for passive activities by subtracting the following from your grow income (not including rental income):
o Job related moving expense
o Penalties for early savings withdrawals
o HSA Deductions (health savings accounts)
o Deductions for qualified plans and self-employed insurance
o Alimony Payments
o Penalties for early withdrawals from tax savings or deferred plans.
• Annual Property Tax: This is the local tax assessed on owned property.
• Active Management Expenses: These include expenses from actively managing a property.
• Private Mortgage Insurance: PMI is mortgage insurance provided by a non-government insurer that protects a lender against the loss if the borrower defaults.
• Inflation (used as a yearly percentage increase in rent, property tax and insurance): Inflation is the upward price movement of goods and services in an economy usually measured by the Consumer Price Index and the Producer Price Index. Over time as costs rise, the value of the dollar decreases because you can’t buy as much with the dollar that you could before. The Federal Reserve actively tries to maintain a 2-3% rate of inflation but the annual rate has greatly fluctuated.
• Income From Rents: This is the amount that tenants or lessees pay you to use the property.
• Utilities: This is the amount spent on heating, cooling, providing water or gas to a property.
• Parking Costs
• Homeowners Insurance
• Maintenance and Repairs: Maintenance can be deducted from the cost of the property. Improvements are not deducted but recovered through depreciation.
• Other expenses: Other expenses include points, commissions, tax return preparation, travel expenses, rental equipment and other expenses related to maintaining your property.
Until next time……rob