A key tax deduction—namely, the allowance for depreciation works somewhat differently. Depreciation is used to deduct the costs of buying and improving a rental property. Rather than taking one significant deduction in the year you buy (or improve) the property, depreciation distributes the deduction across the useful life of the property.
The Internal Revenue Service (IRS) has particular rules regarding depreciation, and if you own rental property, it’s essential to understand how the process works.
According to the IRS, you can depreciate a rental property if it meets all of these requirements:
You own the property (you have considered the owner even if the property is subject to a debt).
You use the property in your business or as an income-producing activity.
The property has a determinable useful life, meaning it's something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.
The property is expected to last for more than one year.
Even if the property meets all of the above requirements, it cannot be depreciated if you placed it in service and disposed of it (or no longer use it for business use) in the same year.
Note that land isn't considered depreciable since it never gets "used up." And in general, you cannot depreciate the costs of clearing, planting, and landscaping, as those activities are considered part of the cost of the land and not the buildings.
You can begin taking depreciation deductions when you place the property in service or when it's ready and available for use as a rental.
Here's an example: You buy a rental property on May 15. After working on the house for several months, you have it ready to rent on July 15, so you begin to advertise online and in the local papers. You find a tenant, and the lease starts on Sept. 1. As the property was placed in service—that is, ready to be leased and occupied—on July 15, you would begin to depreciate the house in July, not in September when you start collecting rent.
You can continue to depreciate the property until one of the following conditions is met:
You have deducted your entire cost or another basis in the property.
You retire the property from service, even if you have not fully recovered its cost or another basis. A property is retired from service when you no longer use it as an income-producing property—or if you sell or exchange it, convert it to personal use, abandon it, or if it's destroyed.
You can continue to claim a depreciation deduction for property that's temporarily "idle" or not in use. If you make repairs after one tenant moves out, you can continue to depreciate the property while you get it ready for the next.
Three factors determine the amount of depreciation you can deduct each year: your basis in the property, the recovery period, and the depreciation method used.
Any residential rental property placed in service after 1986 is depreciated using the Modified Accelerated Cost Recovery System (MACRS), an accounting technique that spreads costs (and depreciation deductions) over 27.5 years. This is when the IRS considers a rental property’s “useful life.”
While it’s always recommended that you work with a qualified tax accountant when calculating depreciation, here are the basic steps:
Determine the basis of the property. The cause of the property is its cost or the amount you paid (in cash, with a mortgage, or some other manner) to acquire the property. Some settlement fees and closing costs, including legal fees, recording fees, surveys, transfer taxes, title insurance, and any amount the seller owes that you agree to pay (such as back taxes), are included in the basis. Some settlement fees and closing costs can’t be included in your cause. These include fire insurance premiums, rent for tenancy of the property before closing, and charges connected to getting or refinancing a loan, including points, mortgage insurance premiums, credit report costs, and appraisal fees.
Separate the cost of land and buildings. As you can only depreciate the cost of the building and not the ground, you must determine the value of each to decline the correct amount. To determine the deal, you can use the fair market value of each at the time you bought the property, or you can base the number on the assessed real estate tax values. Say you bought a house for $110,000. The most recent real estate tax assessment values the property at $90,000, of which $81,000 is for the home, and $9,000 is for the land. Therefore, you can allocate 90% ($81,000 ÷ $90,000) of the purchase price to the house and 10% ($9,000 ÷ $90,000) of the purchase price to the land.
Determine your basis in the house. Now that you know the basics of the property (house plus land) and the house’s value, you can determine your cause in the place. Using the above example, your base in the house—the amount that can be depreciated—would be $99,000 (90% of $110,000). Your basis on the land would be $11,000 (10% of $110,000).
Determine the adjusted basis, if necessary. You may have to make increases or decreases to your base for certain events between when you buy the property and when you have it ready for rental. Examples of increases to basis include the cost of any additions or improvements that have a useful life of at least one year before you place the property in service, money spent to restore damaged property, bringing utility services to the property, and specific legal fees. Decreases to the basis can be from insurance payments you receive due to damage or theft, casualty loss not covered by insurance for which you took a deduction, and money you receive to grant an easement.
If you rent real estate, you typically report your rental income and expenses for each rental property on the appropriate line of Schedule E when you file your annual tax return. The net gain or loss then goes on your 1040 form. Depreciation is one of the expenses you’ll include on Schedule E, so the depreciation amount effectively reduces your tax liability for the year.
If you depreciate $3,599.64 and are in the 22% tax bracket, you’ll save $791.92 ($3,599.64 x 0.22) in taxes.
Depreciation can be a valuable tool if you invest in rental properties. It allows you to spread out the cost of buying the property over decades, reducing each year’s tax bill. Of course, if you depreciate property and then sell it for more than its depreciated value, you'll owe tax on that gain through the depreciation recapture tax.
Because rental property tax laws are complicated and change periodically, it’s always recommended that you work with a qualified tax accountant when establishing, operating, and selling your rental property business. That way, you can be sure to receive the most favorable tax treatment and avoid any surprises at tax time.
Two of the most beneficial financial metrics real estate investors use to forecast the potential return from rental property are cap rate and ROI. One calculation measure what the return could be, while the other calculates what the return is or should be
Capitalization rate – or cap rate, is a financial metric used by investors to calculate the rate of return from an investment based on the net operating income the property currently or should produce and the property value or price.
The cap rate calculation should only compare similar properties in the same market or submarket for two main reasons.
First, income and property prices vary between asset classes – such as residential rental property versus office buildings. Cap rates are also different from city to city for the same property type due to supply and demand, people working from home instead of commuting into the office, and real estate prices in general.
For example, the cap rate from a residential rental property in the San Francisco Bay Area might be much lower than the cap rate from a house in Nashville because housing prices are extremely high in California versus a lower cost of living area like Tennessee.
The cap rate formula divides the net operating income (NOI) that a property generates before debt service (P&I) by the property value or asking price:
Cap Rate = NOI / Property Value
Debt such as a mortgage payment is excluded from the cap rate calculation to make an apples-to-apples comparison because some investors will use more leverage than others, and vice versa.
Assume you’re looking at a rental property with a gross annual rental income of $18,000 per year. Based on the 50% Rule, you anticipate that your regular operating expenses (excluding the mortgage payment) will be half of your gross annual income. That means your NOI will be $9,000 per year.
If the property has an asking price of $120,000 your projected cap rate will be 7.5%:
NOI / Property Price = Cap Rate
$9,000 NOI / $120,000 Property Price = 0.075 or 7.5%
When comparing two more similar properties in the same market to invest in, the property with the highest cap rate will be the better investment because your potential return is more elevated, everything else being equal.
If you see a property with a cap rate much higher than the going market cap-rated flag, there could be a red flag.
For example, if a home is rented at an above-market rent, the cap rate will be higher because the NOI is higher. But if the current tenant doesn’t renew the lease because the rent is too high and you have to lower the rent for a new tenant, your cap rate and return will be lower.
You originally purchased a property with an NOI of $12,000 for the asking price of $150,000. Twelve months later, assume you have to lower the rent for a new tenant. If your NOI decreases due to lower rent, your cap rate and return from the investment will also be lower:
Current tenant: $12,000 NOI / $150,000 Property Price = 0.08 or 8%
New tenant: $10,000 NOI / $150,000 Property Price = 0.067 or 6.7%
The value of the property you recently purchased will decrease because your NOI has reduced. Let’s use the cap rate formula to calculate what the property value should be and what the NOI should be.
The cap rate formula can also be used to calculate what the NOI of a property should be and the property value, as long as you know two of the three variables in the cap rate formula.
In the previous section, we said that if the NOI on the property you purchased for $150,000 decreases, the property value will decrease. Here’s how you would calculate the change in property value, assuming the going cap rate in the market for similar properties is 7.2%:
Cap Rate = NOI / Property Value
Property Value = NOI / Cap rate
$10,000 NOI / 7.2% Cap Rate = $138,889 Property Value
In other words, your property value just declined by over $11,000 because you purchased the property rented to a tenant paying above-market rent, and they did not renew the lease.
You can also use the cap rate formula to determine what the NOI should be based on the property value and the market cap rate. Let’s assume you’re looking at the same property with an asking price of $150,000. You know that the going cap rate for similar properties in the same market is 7.2%. Based on that information, you also know that the realistic NOI generated by the property should be $10,800:
Cap Rate = NOI / Property Value
NOI = Property Value x Cap Rate
$150,000 Property Price x 7.2% Cap Rate = $10,800 NOI
Now that you know that the realistic NOI for the property is $10,800 and not $12,000, your next step is to ask the seller why. Maybe the seller’s answer will make sense. If not, you might better look at another potential real estate investment.
ROI – or return on investment – tells you what the percentage return on investment could be over a certain period. Unlike the cap rate calculation, the ROI formula includes debt service and the amount of money you used to purchase the property instead of the entire property value.
The ROI formula divides the annual cash your rental property is generating after operating expenses and the mortgage payment by the total amount of money you invested:
ROI = Annual Return / Total Investment
Once you’ve narrowed down alternative investment options using the cap rate formula, you can use the ROI formula to calculate what your return could be for each property.
Assume you’re thinking about buying a property with an asking price of $120,000 that generates an NOI (before debt service) of $9,000.
If you use a conservative down payment of 25%, your total investment would be $30,000, and your annual return would be $4,420 after factoring in the mortgage payment (P&I). Based on this information, your ROI would be 14.73%:
ROI = Annual Return / Total Investment
$4,420 Annual Return / $30,000 Total Investment = 0.1473 or 14.73%
If you’ve allocated $30,000 to invest in a rental property, the ROI will generally be the best investment. Of course, you’ll still need to make sure the current rent is at the market and that the property operating expenses won’t increase after you purchase the property due to items such as deferred maintenance.
You can also increase your ROI by using different amounts of leverage. Here’s what the ROI on the same $120,000 property would look like based on a down payment of 25%, 15%, and 10%:
Down Payment Total Investment Annual Return ROI
25% $30,000 $4,420 14.73%
15% $18,000 $3,804 21.13%
10% $12,000 $3,504 29.2%
For an investor focused on maximizing ROI, the lower the down payment is, the better, even though the annual return on the cash invested is lower. However, it’s good not to use too much leverage when investing in a rental property.
If your loan-to-value (LTV) on an investment property is too high, you’ll have trouble getting a loan at a reasonable interest rate. Also, you could have negative cash flow if there are unexpected repairs or it takes longer than expected to find a new tenant to rent the home.
No rule says you must choose between cap rate and ROI. That’s why the most successful real estate investors use financial metrics to select the best property to invest in.
Both calculations are easy to do. Cap rate tells you what the return from an income property currently is or should be, while ROI means you what the return on investment could be.
If you’re considering two potential investments, the one with the higher cap rate could be the better choice. On the other hand, if you’ve allocated a certain amount of money for an investment, you can use the ROI calculation to see which property will produce more income based on your initial investment.
For beginning real estate investors, the different concepts and financial metrics used to value rental property can be confusing at first. Two of the most accessible calculations to make are cap rate and ROI.
Begin by using the cap rate calculation to narrow down similar properties in the same market, then calculate the potential ROI based on the total amount of money you have to invest.
When it comes to individual retirement accounts (IRA), financial assets—stocks, bonds, mutual funds, or exchange-traded funds (ETFs)—are the usual investment suspects. Still, it’s possible to hold real estate in your IRA under certain conditions. You can buy single-family or multiplex homes; apartment buildings; commercial properties such as retail stores, hotels, or office complexes, raw land and lots; and even boat slips.
It’s not as easy as purchasing a few hundred shares of stock, though. If you want to plunge into property purchases through your self-directed IRA, you need to know the rules—and there are a lot of them.
You can hold real estate in your IRA, but you'll need a self-directed IRA.
Any real estate property you buy must be strictly for investment purposes; you and your family can't use it.
Purchasing real estate within an IRA usually requires paying in cash, and the IRA must pay all ownership expenses.
Holding real estate in your IRA can be tricky, with tax issues and red tape. But, on the other hand, the property can provide you with a good (or great) rate of return and diversify your portfolio.
First of all, your IRA has to be self-directed. The term “self-directed” means that alternative investments are accepted or offered by the IRA custodian, the financial institution, or the company responsible for record-keeping and IRS reporting requirements. A self-directed IRA is independent of any brokerage, bank, or investment company that would make decisions for you (most brokerage accounts don’t allow real estate holdings, anyway).
To buy and own property via your IRA, you will need a custodian, an entity specializing in self-directed accounts that will manage the transaction, associated paperwork, and financial reporting. Everything goes through the custodian to keep you from violating the strict rules regarding these types of real estate transactions.
As you would expect, the custodian will charge a fee for the service. However, it won’t advise you on the best structure of your holdings. This custodian’s job is to handle the back-office work.
Before we look at the rest of the rules, understand this basic fact: You and your IRA are two separate entities. Your IRA owns the property—you don’t. The title to the property will read “XYZ Trust Company Custodian [for the benefit of] (FBO) [Your Name] IRA.”
If you buy real estate with your IRA improperly, you can disqualify the IRA. If that happens, all the funds in it immediately become taxable.
Your real estate property must be purely an investment. You can’t use it as a vacation home, a place for your kids to live, a second home, or an office for your business. These rules apply to you and people the IRS deems “disqualified”So, who is considered a disqualified person?
Your spouse
Your parents, grandparents, and great-grandparents
Your children and their spouses, grandchildren, and great-grandchildren
Service providers of your IRA
Any entity that owns more than 50% of the property
You also can’t purchase the property from one of these disqualified people—this is called a self-dealing transaction—nor can the IRA purchase property you already own. You can learn more about prohibited transactions in section 4.72.11.2.1 of the Internal Revenue Manual.
Your IRA balance will have to be pretty high because getting a mortgage to purchase property inside an IRA isn’t easy. You’ll likely have to pay in cash, which takes a big bite out of the account and affects your rate of return down the road.
Real estate investors often put down a small amount and take advantage of relatively low-interest rates to leverage the purchase, figuring they can make more money on the property than they’ll pay in interest. If you can’t finance your real estate purchase, you lose that potential for a significant return on investment (ROI).
Some banks will consider loans for this transaction, but it presents another problem: Any revenue from the property may then be regarded as unrelated business taxable income (UBTI). You can learn more about UBTI from Section 511 of the IRS Internal Revenue Code (IRC).
As your IRA doesn’t pay taxes, you can’t take advantage of the deductions for owning real estate. Because you’ve paid cash, there are no mortgage interest payments to deduct. Nor do you get the benefits of property tax deductions or depreciation. If your property generates rental income, every bit of it goes right back into your IRA. As you don’t own the property, you can’t pocket any of the payment. (Of course, you will get the money eventually when you withdraw from the account at retirement.
On the bright side, none of the maintenance or other associated costs of owning real estate comes out of your pocket. The IRA pays for everything. However, this is not without drawbacks. Every dollar that comes out of your IRA is a dollar that no longer gets a couple of decades to appreciate tax-free.
One colossal risk: maintenance expenses that drain your IRA's cash and lead to expensive penalties if you "over contribute" to the account to cover them.
And what happens if the property incurs a series of significant expenses that push your IRA balance so low that the account doesn’t have enough money to pay for it? Remember, you can’t pay for anything relating to this property out of your pocket, and IRA contributions are limited: The annual contribution limit for 2021 and 2022 is $6,000, $7,000 if you’re 50 or older.
If that doesn’t cover the repair and you have to deposit more, you’re on the hook for penalties associated with contributing too much. This is a significant risk, as property can often require pricey upkeep, and the income you get from rentals may not cover what you need to spend in a high-maintenance year.
Work out a sales price just as you would with any other real estate holding to sell your property. Once both parties agree on a price and terms, request that your custodian sell the property on behalf of your IRA. All money will go back into your IRA, either tax-deferred or tax-free, depending on the makeup of your IRA.
One final consideration: liquidity. Just how easy is it for you to get out of the investment? With stocks, it’s relatively easy. Sometimes you can have your money back in seconds. In contrast, real estate is a notoriously illiquid investment. It may take a long time to divest, and you could lose money. As nearly eleven million people learned in the great recession of 2008, you could find yourself with an asset worth less than the amount of money you owe on it.
We've mentioned so many hassles and drawbacks that you might be wondering at this point if there is any point to putting property in an IRA. Historically, real estate has been an excellent long-term investment as property values rise over time, and long-term appreciation goes hand-in-hand with the long-term investment horizon of a retirement account. Any income the property generates is tax-sheltered within the IRA in the short term. Finally, as a hard asset, real estate helps diversify a portfolio otherwise invested in equities and other securities—not the worst idea globally.
Real estate helps diversify a portfolio, often moving counter to financial markets.
Real estate has historically appreciated over time, ideal for an IRA's long-term investment horizon.
Real estate can provide a steady income stream from rents, and any rental income you collect grows tax-free within the IRA.
You can buy, sell, flip, and accumulate properties.
You need to set up a self-directed IRA with a custodian.
You can’t claim deductions for property taxes, mortgage interest, depreciation, and other property-related expenses.
All expenses, repairs, and maintenance costs must be paid with IRA funds, and you must pay others to do them and manage the property.
You and your relatives can’t live in or run a business out of the property.
Using an IRA to buy an investment property is not for the faint of heart, nor is it for anyone unfamiliar with the differing types of individual retirement accounts. Real estate investing is quite risky or, at best, high maintenance; for an IRA, real estate is a particularly high-risk choice. Property values may drop rather than rise, but a year of significant maintenance costs could also result in penalties if your income and IRA contribution limit doesn’t cover repairs you can't afford to ignore.
Unless you have both the time and expertise to manage real property, you are probably best off with more mainstream strategies for your IRA. Or consider securitized real estate options, like real estate investment trusts (REITs) or mutual funds and ETFs that invest in property. These are an indirect form of property ownership, but they're a more straightforward, liquid proposition—and they can be held in regular IRAs, too.
The main difference between single-family and multi-family is the number of residences they contain. Single-family homes have just one dwelling unit, whereas multi-family properties have between two and four. You may hear multi-family homes called duplexes, triplexes, or quadplexes, which refers to the number of units they contain.
Each unit within a multi-family home has its kitchen, bathroom, utility meter, address, and entrance. This enables the families to live separately, even though they share common walls and a roof.
Although multi-family homes have several units, one person usually owns the entire property. This distinguishes multi-family homes from condo complexes and apartment buildings where different people own each unit.
Because owners of multi-family homes can rent the units out, they’re popular among real estate investors. They’re also a good choice for multigenerational families who want to live under the same roof while still having their own space.
Although multi-family homes are standard, there tends to be more demand for single-family homes. Most families often prefer single-family homes because they have square footage and large, private backyards, which gives them extra space to spread out.
If you’re on the fence and can’t decide which type of house is right for you, here are some pros and cons of single-family and multi-family homes to help guide your home search.
When considering single-family vs. multi-family homes, to help you decide if a single-family home is right for you, here are some significant benefits and drawbacks of this style of housing.
Single-family homes usually offer much more space than units in multi-family homes. Most detached homes are around 2500 sq feet, whereas multi-family housing units are only 1076 sq feet. So if you plan on buying a multi-family home and living in one of the units, you won’t have a lot of room to stretch out.
Single-family homes also offer more privacy. Since detached houses don’t have any shared walls, they’re quieter than units in multi-family dwellings. You won’t have to worry about disrupting your neighbors by playing music or having friends over, which may help you feel more relaxed in your space. You’ll also have your private backyard that you won’t have to share with anyone else.
Single-family homes usually cost less than multi-family properties, so they’re better for buyers with a limited budget. They’re also easier to finance and have lower down payment requirements. You’ll also spend less on maintenance and insurance. Purchasing a single-family makes it the cheaper option all around.
If you’re an investor, vacancies will hit you much harder with a single-family home than with a multi-family. Since you can only have one tenant at a time, your rental income will go down to nothing when they leave. Depending on your financial situation, this could cause you to have trouble making your monthly mortgage payments.
With a multi-family property, the income from the other units can help cover the mortgage and maintenance costs while you find a tenant for the vacant apartment.
When considering single-family vs. multi-family dwellings, investors should consider that single-family homes don’t generate as much cash flow as multi-family properties. You’ll only be able to collect one payment every month instead of several, so your rental income will probably be lower.
Multi-family homes are a good option for investors and prominent families. Read on to learn more about their pros and cons.
If you plan on having multiple generations live under one roof, a property with two to four units may work well for your family. Everyone will be able to have their own space while still enjoying the benefits of being right next door to loved ones.
When considering single-family vs. multi-family homes, one of the significant benefits of multi-family properties is the potential for mortgage-free living. If you occupy one of the units and lease out the others, you may be able to bring in enough rental income to cover your monthly mortgage payments in part or whole. This will give you more money to spend, save, or invest as you wish, which is a big plus.
Although multi-family homes can be a profitable investment because of their rental potential, they aren’t suitable for everyone. Maintaining a large, multi-unit property takes time, interfering with your lifestyle.
If you plan on renting the units out, you’ll be responsible for screening tenants, executing leases, handling repairs, and more. Being a landlord can be difficult and time-consuming, so consider whether you’re ready for that commitment before buying a multi-family home.
When considering single-family vs. multi-family homes, single-family homes seem to appreciate faster than multi-family properties. This may be because there’s more demand for single-family homes, which drives up prices.
Since more buyers are interested in detached houses, they’re also easier to sell. If you ever need to get rid of your multi-family property, it may sit on the market for longer, which is something to keep in mind.
Before looking at single-family or multi-family homes, you need to know whether you can afford to own either one. Mortgage payments are typically higher than rent in most states. And even when the prices are close, there are other costs associated with owning your home instead of renting.
Your property taxes will be added to your monthly mortgage payment. And if you put down less than 20% for a down payment, your lender will probably require you to pay for (PMI) private mortgage insurance.
You’ll also have to pay some costs that you might not have had to pay while renting utilities, cable, garbage pickup, and any necessary repairs.
Make sure you can comfortably afford your mortgage and any additional expenses before buying your first home.
If you’ve run the numbers and decided that you can afford homeownership, your next step is to meet with a mortgage lender. You can discuss the different types of mortgages and decide which would be best for you. You’ll also want to be pre-approved before you begin house-hunting.
To get pre-approved for a mortgage, you’ll have to share your financial and employment information with the lender. They’ll require documentation such as tax forms, pay stubs, and more. Once they review and verify your information, they’ll determine whether to approve you for a mortgage. They’ll let you know your mortgage options and terms if they do.
The lender will also issue a pre-approval letter. You can show this to sellers when you’re looking at homes to let them know that you’re able to secure financing.
We provide trusted expertise in property management, real estate, and development throughout the Treasure Valley to include Boise, Meridian, Eagle, Garden City, Star, Middleton, Nampa, Caldwell, Hidden Springs and Kuna.
