4 Ways to Earn Passive Income on Rental Properties
Much of the media coverage of real estate investing focuses on quick payback: buying cheap properties, slathering lipstick on them, then flipping them. I hope you make more resale than you spent to fix the place.
At any time, you can find one of five or six TV shows based on this practice on television. But for real estate investors focused on the long term, this approach can be like day trading.
When you flip houses, you are betting on a quick market turnaround for that house. Sure, you’re spending time and money on this, but for most people, there just isn’t the same level of consistent gains you can get from investing in long-term rental property. .
With long-term rentals, there are four sources of income: rent, capital gains, tax deductions, and debt repayment. Let’s go through each of the four using the example below, based on a purchase price of $500,000.
- Percentage down: $20%
- Term of the mortgage: 20 years
- Interest rate: 3.5%
- Monthly payment: $2,320
- Rent per month: $2,750
The first source of passive income on rental properties is the rent you charge tenants. In this example, you earn $33,000 a year from rent and have to pay off $27,840 in debt. On the surface, that’s $5,160 in passive income per year.
Of course, there are more expenses than that. Depending on the property and lease, you may also have expenses for property taxes, utilities, maintenance, repairs, management, income tax, HOA fees, and even replacement lawn gnomes. .
A property may not be profitable at first. The key is to stick with it for the long haul. If you choose a property in a good location, your rent rates will slowly increase over time while debt payments will stay the same.
2. Capital gains
You have capital gains when you sell the property for more than you paid. If you bought the example property for $500,000 and sold it five years later for $550,000, you would have a capital gain of $50,000.
That’s a 10% gain over five years, which isn’t huge. In long-term rental investment, capital gains usually are not the source of returns. And if you’re earning good income from rent and the other two sources of income we’ll talk about later, you won’t want capital gains anyway – because that would be a goose chicken.
If you are buying a property that is rapidly increasing in market value, there is a way to access that gain. Let’s say the property is in a great location and the price doubles in five years (not much different than where I live in Utah). You can refinance the debt on the property with a new appraisal and withdraw the money for another investment. Otherwise, you will only have access to capital gains when you sell a real estate investment.
3. Tax write-offs
The problem with a profitable rental property is taxes. If you don’t plan ahead and make estimated tax payments throughout the year, you could be hit with a surprising five-figure tax bill on April 15th.
The good news is that there are tax deductions you can take advantage of. The key damping is damping. Depreciation is a non-cash expense that you can claim on your tax return to reflect the natural deterioration in property value over time. Residential rental properties are depreciated over 27.5 years, which means we can deduct $18,182 per year from the example property. This is a legitimate tax charge that you don’t have to pay.
It is possible to own and lease property that declares a tax loss each year while being cash positive. This means that you do not pay taxes on it, but receive money from it.
Another write-off concerns interest charges. When you finance real estate, you pay interest on the debt every year. In the example, the total interest for the first year of the loan is $17,219.80. This amount is deducted from rental income when you declare the income on your taxes, although, as we will see in a moment, it is actually paid by your tenants.
4. Debt repayment
The last way to make money on rental real estate is paying down debt. Let’s go back to the example of capital gains. The property sold for $550,000, which I said was a 10% return. It’s not technically correct.
It is better to look at the cash-on-cash return. The property was purchased with a 20% down payment, or $100,000. In five years, the debt was repaid to a balance of $403,916. You receive $146,084 on the sale, which is good for a 46% return over five years. It is not life changing but is certainly amplified by the power of leverage.
The best part is that the tenant makes those debt payments. If you can rent the property for more than the monthly debt payments, you have created a situation where the tenant pays the principal and interest and you can write off the interest and take full advantage of the reduced debt.
Long-term investing is the way to go
As with stocks, investing in real estate for the long term based on fundamentals is the best way for most people to generate consistent income. If your rents are insufficient or you end up with a larger tax bill than expected, you still have other sources of income for each rental property.