Offsetting Cash Cows With Rising Stars

Mrs. C. and I are planning to rapidly grow real estate investments in large 4 to 5 bedroom homes that cost under $40,000 each that we can rent out for around $950 a month.  These are certainly cash cow properties that produce a large profit per year.  We are targeting a 20% to 25% CAP rate. I’ve been plugging in future planned income into my tax spreadsheets to project future income and realized that there is an opportunity to increase cash flow and cut our future tax bills further by diversifying our holdings in the future.

An average house for us would look like this:

  • Total invested: $35,000
  • Gross Rent $950
  • Mortgage Interest :$0
  • Taxes: $75
  • Insurance $40
  • Net Rent 835
  • Depreciation -105
  • Net Taxable Rent: $730

So each house gives us cash flow of $10,020 and income of $8,760.  After the QBI deduction the taxable income per property is $7,000.

Let’s fast forward 7 years and say we own 8 paid for properties that each cash flow $10,000 a year, netting us $80,000 in income, $70,000 in AGI, $56,000 after QBI and roughly $32,000 after our standard deduction.  Since real estate income is not considered self employment income or W2 income we do not have to pay Social Security tax.  On $80,000 of total income our Social Security and Medicare tax would be $6,120 if this was earned income.  With current tax brackets our total federal and state tax would be $6,094.  This is if the 20% QBI deduction stays in place, certainly not bad.

On the opposite end of the cash cow spectrum of investing is the rising star side.  Real estate investors buy properties they expect to appreciate greatly over time that they can take a large deduction on due to the depreciation deduction.  In our area the best opportunity for this would be property on Lake Michigan that we could rent as vacation homes via weekly rentals.

Take a look at this house right here for $650,000.

I think $800,000 is closer to a normal price on the lake and this particular house is an amazing deal.  If we put down $160,000 and got a loan for $640,000 on an $800,000 house with a 30 year mortgage at 5.5% our loan amount would be about $3,600 a month. Looking at comps on VRBO.com we can rent it out for around $700 a night.  If we are booked for a total of 14 weeks at this rate the gross rent would be $68,600.

  • Gross Rent: $68,600
  • Mortgage Interest: – $35,000
  • Taxes: – $19,300
  • Insurance: – $2,000
  • Repairs / Maintenance – $6,000
  • Net Income: $6,300
  • Depreciation: -$29,000
  • Net Income After Depreciation: -$22,700

This phantom expense of depreciation allows us to count against our other rentals, which would lower our gross income from $70,000 to $47,300. This would also drop our total taxes to $3,054 saving about $3,000 in taxes.  Overall this property puts us ahead by $9,300 and keeps us out of the 22% tax bracket.

You may be wondering why in the world would we take on $640,000 of debt for a house that costs 20X our normal to only get ahead by a little more than what an extra rental property would get us?  The reason is appreciation.  The primary properties we are investing in will most likely never keep up with inflation.  These houses are not increasing in value over time any substantial amount.  A house on Lake Michigan on the other hand could easily double in 10 years. Add $60,000 a year to the appreciation and you have the reason why we would do it.  The house will certainly cash flow based on rental income, and the appreciation provides a huge boost to total net worth.

Another plus is that we can also use the house for personal use for 14 days out of the year (or 10% of total rental days whichever is greater.) I only used 14 weeks because that is the length of the summer season, however vacation rentals here are often also rented in April, May, ,September, and October at lower rates, so it is possible this property could cash flow a lot more, yet have minimal effect on our tax bill.

Example 2:

Vacation Rental Rented for 14 weeks at $700 a night and 12 weeks at $350 a night

  • Gross Rent: $98,000
  • Mortgage Interest: – $35,000
  • Taxes: – $19,300
  • Insurance: – $2,000
  • Repairs / Maintenance – $6,000
  • Net Income: $35,700
  • Depreciation: -$29,000
  • Net Income After Depreciation: $6,700

In this scenario we end up ahead by $35,700 in cash, less the taxes we would have to pay on $6,700 of additional income.  after the 20% QBI deduction this is $5,360, total tax is $902 a rate of only 2.5% on the new income.  So we end up ahead in cash $34,798 a year. And of course we never pay the depreciation recapture because we never sell the house.  We either 1099 exchange it or we give it to our kids when we die.

Then REPEAT.

For each property we increase our total cash by $35,000 and pay only $900 in taxes.  Although I don’t like being leveraged at 80%, the rest of our portfolio in this scenario would be paid off, including our personal residence, so the leverage isn’t as bad as it seems.  When buying a rental house the appraisal will show how much rental income the property can generate and this is set against the mortgage of the house.  Even if it comes in low, your income from other sources only has to cover the difference.  So to get a $640,000 mortgage I don’t have to have existing income to cover a $3,600 mortgage payment, I just need to be able to cover the difference if the appraisal says the rent will be less.  If the appraisal for example said it will only bring in $3,000 a month in rent, then I would need other income to cover the $600 a month delta.

With 2 properties like this in addition to 8 of our standard properties we would have the following:

  • Total portfolio value: $1,880,000
  • Total debt: $1,280,000
  • Total Cash Income: $151,400
  • Total Depreciation: -$68,000
  • Total QBI: -$16,680
  • Taxable Income:  $66,720
  • Standard Deduction $24,000
  • Taxable Income: $42,720
  • Federal Income Tax:$4,745
  • State Income Tax: $3,205
  • Total Income Tax:$7,950
  • true tax rate 5.25%

Here is a way to pay only $8,000 in taxes on $150,000 of total income.  Hard to beat that.  It is really interesting to see what happens when you play around with different tax code scenarios.  I’m not sure if we actually will invest in a vacation home on Lake Michigan at any point in time,b y nature I am very debt/risk adverse, but it is interesting to know that this is a route we COULD take if we wanted to minimize taxes.  Do you have any rentals that run at a yearly loss on paper that allow you to pocket tax free cash?  What do you think of the idea of mixing cash cows and rising stars? I don’t think I would be comfortable taking on that much debt, although the rapid appreciation of lakefront property is highly attractive.

John C. started Action Economics in 2013 as a way to gain more knowledge on personal financial planning and to share that knowledge with others. Action Economics focuses on paying off the house, reducing taxes, and building wealth. John uses the free tool Personal Capital to track his net worth and posts quarterly updates on his finances. Check out the Action Economics archives section for all past posts.

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