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Key Expenses

If you've owned any property before, you'll be pretty familiar with the first few expenses here. However, rental properties have a few more expenses you wouldn't often think of if you've only considered your own home's costs.

This is not an exhaustive list, but should cover most of the typical expenses.

Down Payment

As with any property with a loan, you will generally need some amount of down payment. In general, it is best to keep this as small as possible while still getting a positive return on your investment. By minimizing your down payment, you will generally maximize the return on your investment. See more in our

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section.

Banks generally require a higher down payment on rental properties than on owner-occupied properties.

Mortgage Principal and Interest

As with almost any property, you'll have an ongoing mortgage expense.

Many people who rent properties opt for a fixed payment mortgage that amortizes over some time period - usually 30 years.

One big reason to go for a fixed payment, amortizing mortgage is so that you can avoid unexpected mortgage rate fluctuations that could hurt your cash flow. Life is fairly unpredictable, and a fixed payment here helps a lot.

Banks generally charge a higher interest rate on mortgages for rental properties than for owner-occupied properties.

Property Tax

Most cities, counties, and/or states charge property tax on property owned in those localities. The rates vary quite a lot from locality to locality. It's important to understand the rate you'll pay (plus any local levies added on top, though those are usually minimal).

The amount of property tax you'll pay each month/year is likely to grow over time, since property tax grows with property value, so you need to account for this as you calculate your investment returns.

Insurance

Banks generally require insurance on properties where you have a loan. Also, most people aren't willing to take all the risk of some disaster destroying their property.

Maintenance Costs

As things deteriorate, every property needs maintenance. Rental properties are often not maintained by the residents as well as owner-occupied homes, so they will often need more maintenance than you might expect. Industry experts often suggest to expect spending 1-2% of the property's value annually on maintenance. So, if you have a $500,000 rental property, you should plan to spend $5,000 to $10,000 annually on maintenance of that property. This will include things from leaks, to roof replacements, to repaving parking, to repainting, and more.

Utilities

Depending on the type of property and your contract with your renters, you may need to pay for utilities for the property, or you may pass some/all of those through to the renters.

Usually, when buying a rental property from someone else, they'll be required to disclose how much the utility expenses were. This will be helpful in estimating the initial expenses, and may also give you some insight into how much the expenses will grow over time. If you're buying an owner-occupied property with plans to rent it out, you may have to do more research to get good estimates of these expenses.

Vacancy Rate

When your property is empty, that is effectively an operating cost to you. Tenants will always leave at some point, and depending on how hot the market is, you may need time to find new tenants. Even if you have a new tenant ready to go, you'll need some time between tenants to do some minor repairs and cosmetic improvement for the next tenant.

It's often helpful to think of vacancy as a percentage of time your property is vacant.

Concrete example:

You rent a property for $1,000 a month, and you expect your property to be vacant 5% of the time.

In this case, your expected gross rent will be only $950, since you assume you'll lose $50/month (on average) due to vacancies.

Delinquency Rate

Like vacancy rate, you can assume that some percentage of your tenants may be late on payments, or may never pay you. In cases where you may end up evicting, you may only get some or none of that money back, especially if you turn things over to collections.

For many scenarios, you could probably assume a near 0% delinquency rate, but for many, you might need to take this into account.

Property Management

If you plan to be the on-call landlord for your property, this will cost you $0, and will significantly improve the return on your investment.

However, many people prefer to have someone manage properties for them. Property management companies will do almost all the management work for your property, from coordinating and paying for repairs, finding tenants, collecting rent, evicting tenants, periodically checking on the property, and more. For this service, they will often charge 6% to 10% of your gross rental income.

Keep in mind that the gross income to net income margin is often fairly thin, so losing 6% to 10% of your gross means that you have to have more than 6% to 10% margin, or you'll be in the red.

Concrete example:

You rent a property for $1,000 a month.

Your monthly expenses are $950 a month without a property manager. Your profit is $50/month

Your monthly expenses are $1050 a month with a property manager. Your loss is $50/month

Now that the bad news is out of the way, let's read about

Income Tax

In addition to the property tax, you'll also have to pay taxes on your rental income. However, this tax is greatly reduced by depreciation. You can assume that the rental income will be on top of whatever you are making in your day job (if you have one), so keep in mind what your marginal rate is, and if this pushes you into even higher marginal rates.

Depreciation

Depreciation allows you to spread out an expense over an extended period of time.

For example, say you have a construction company and you need to buy a bulldozer. Instead of claiming the entire cost of that bulldozer as a corporate expense on your taxes that first year when you buy it, you can claim a little bit of that expense each year for some number of years, as defined by the IRS. This helps avoid having a massive expenditure one year that exceeds the losses you can claim, and thus lose the ability to recoup the tax benefit of those losses/expenses.

The same applies for property used in rental. When you buy a property, you can depreciate it on your taxes for 27.5 years. This means that, if you buy a $275,000 property, you can claim a loss/expense due to depreciation of the property of $275,000 / 27.5, or $10,000 per year.

Let's say your net income after all expenses (utilities, repairs, etc.) on your rental property was $12,000, and that your marginal tax bracket was 30%. Normally, you'd be paying 30% * $12,000 = $3,600 in taxes on that income. However, the $10,000 of depreciation lets you offset that $12,000 net income to be only $2,000 of net income, so you'll end up paying only $600 in taxes.

This $10,000 a year offsets any gains you may have had that year. So, let's say your net income, after all other expenses (property management, utilities, etc.) was $15,000. Depreciation allows you to reduce that income to only $15,000 - $10,000 = $5,000.

If you assume your marginal tax rate is 30%, then this means you'd normally

Capital Gains Taxes

On the surface, this is fairly simple. If you bought a property for $50,000 and you sell it for $150,000, you'll have to pay capital gains on the $100,000 profit you made. This will generally be a long-term capital gain, and you'll be charged as such. If you are in the 15% capital gains bracket, you'll pay $15,000 in capital gains tax.

Implications of Depreciation

When you sell your property, you will have to pay an extra tax on the depreciation. This is roughly equivalent to lowering your cost basis on your initial purpose, except that the depreciated amount is charged at a higher rate than long term capital gains.

For example, if you depreciated your property over 10 years, each year you'd be claiming a deduction of about $1,818. After 10 years, you'd have claimed $18,182 in depreciation. When you sell the property, you'll pay the capital gains as described earlier, but, additionally, you'll pay a higher rate (25%) on the $18,182 of depreciated value. This is an additional 25% * $18,182 = $4,545, for a total of $19,545.

Real Estate Agent Fees

If you ever want to retire and get out of the rental business, you'll need to take into account the sale of the property. At the current time, selling a property typically will cost you roughly 5% to 6% of the sales price. This will eat hugely into your overall profits.

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