You purchase a duplex on April 15, 2000. You plan to live in one side and rent t

Question

You purchase a duplex on April 15, 2000. You plan to live in one side and rent the other side. The rental side is placed in service the day you buy it. Depreciation only applies to the rental half so the remaining numbers correspond to that portion. The purchase price for the rental protion was $60,000. In your research, you determine the land is worth $12,000 of that amount and the appliances and carpeting are worth $3000 of the purchase price. When doing your taxes, you may use IRS Publication 527 to determine the appropiate depreciation amount each year. Assume your marginal income tax rate is 25% every year (capital gains rate is then15%). Assume taxes are refunded or paid on April 15th each year, so that the savings from April through Dec of 2000 is realized on April 15, 2001 (EOY 1). You continue to rent until you sell on April 15, 2007 for $75,000. Use an MARR of 6%.

A. For each Year, EOY 1-EOY 8 calculate the following: the depreciation amount of each asset class, the total depreciation each year, the book value for the property at the end of each year, and the amount of tax saved using the deprecication expense to reduce income each year.

B. When the property is sold, you realize a capital gain from two protions: First, the book value was lowered by the total depreciation taken to date. Calculate the capital gain due to the total depreciation amount and the capital gain tax owed due to this amount. Second, the rest of the gain comes because the sale price was higher than the purchase price. Calculate the capital gain and the tax owed on this portion of the gain.

C. Draw a cash flow diagram for just the tax amount due to the depreciaiton, including the gain from this portion at EOY 8. Calculate the present worth of this cash flow. This is the amount gained by depreciating the property.

D. Draw the cash flow diagram for all the amounts, including the purchase (EOY 0), the tax saved each year, the sale (EOY 7), the capital gain tax (EOY8). Calculate the present worth of this cash flow. Calculate the annual worth of this cash flow. This is the amount of net rental income (rent-expense) needed each year to make the property a good investment.

Explanation / Answer

To make money renting real estate, you need to know what real estae is renting for and what the costs are. In our area, the costs of real estate are way too high for the rental market, and I won't invest, here anyway. A good real estate agent who has experience in commercial transactions can help you there.

In a good market, you need to make more money on rents than what your mortgage will cost, plus any repair costs. You also need to factor in vacancy rates. If your type of property has a 20% vacancy rate (or in some markets, it's the reverse and is called the occupancy rate which, in this case, would be 80%), that needs to be factored in to your costs, as that will mean that 20% of the time, you won't have rents coming in.

If you're really flush with cash, it doesn't matter much what kind of property you invest in. ALL real estate is an investment. The home you buy to live in, the apartment building you buy to rent out, or the commercial building you buy to have your business in or to rent out. It's all an investment, because once your property is depreciated out, you'll want to sell it. Depreciation is usually only a factor in commercial and/or rental properties because you're getting an income off of it.

If you're not so flush with cash, a really good way to get started in renting property is to purchase a duplex and live in one side and rent out the other. I started out this way and it's nice to get almost enough rent to cover your mortgage. That way, you can live there almost for free!

There are headaches involved with renting. Some people will tear the place up, inside and out. (Ask for hefty, or at least adequate, deposits for cleaning and damages.) The duplex situation is good, in that you're living right next door. People will be less likely to abuse your property if you are on the premises.

It can be difficult to find good renters. If you have property on the poor side of town, it will be more difficult to keep good renters, if and when you do find them. Don't purchase property in a neighborhood where there is garffiti. The graffiti is an indicator for crime levels. Just bad all the way around. Don't go there. Get the best place you can afford in a better neighborhood.

There's money to be made in just purchasing a fixer upper. Buy a run down property in a nice neighborhood, fix it up and resell it for a fat profit.

I've done all of the above, and I've always made money. I've never had to take a loss, because real estate is almost a no lose investment.

Right now, some of the markets are over valued, and it may not be a good time to purchase a very high end property. But you can't go wrong with a starter home, the kind that will be a first home for a young couple. They are always in demand.

Those are some high points. There can be a lot of complexity to buying commercial real estate. Find a good realtor who has experience in commercial sales. They can help you find something that will give you a profit after all expenses are paid. Most investors look for a minimum of 12% profit per annum. (Of course, more is better, but that's a minimum to shoot for).

There are also some REITs out there that can be a way to go. (Real Estate Investment Trusts).

Other than that there are some investment gurus that can give you an education on how to invest, what to look for, what to avoid, etc. Ron LeGrand and his group are very knowledgeable and pretty accurate.

Best wishes in your endeavors.

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