Is it more profitable to pay cash for an investment property or get a mortgage? In other words, should I leverage my new investment property or pay cash? As we all know, the main advantages of owning rental real estate are: Appreciation, Cash Flow, Tax Savings and Mortgage Principal Reduction (Leverage).
Appreciation: Even in our down market, Arizona homes have maintained an average appreciation of 4.9% over the past 30 years. The true power of appreciation is that market value will grow at a compounded rate over time. A big reason real estate is one of the best tax shelters in America is because appreciation in not taxable until you sell the property.
Cash Flow: This represents the most direct type of return since it’s money you can “put in your pocket” right away. Investing in real estate is a way to increase your cash flow. That in turn, can provide the working capital you need to further expand your investment opportunities and obtain greater financial security.
Tax Savings: Tax benefits are a major advantage to owning investment property. Unique to real estate is the fact that you can sell a property and purchase another one while deferring the capital gains tax. This is known as a 1031 tax-deferred exchange. Another advantage involves being a “real estate professional”. A person with this title meets certain time requirements and “materially participates” in managing their investment property. If you are this person, you are allowed almost unlimited income tax deductions from your investment property.
Mortgage Principal Reduction (Leverage): This is using other people’s money to increase your own returns. The less an investor puts down on a property, the more leverage. Provided your mortgage is structured properly, the greater amount of leverage you obtain, the more profitable your investment will be.
Let’s assume you purchase a $200,000 property with 25% down and obtain a mortgage at 6% interest. Let’s also assume annual rents are $15,000 ($1,250 per month), the property appreciates 5% annually and you file in the 30% tax bracket (25% Fed / 5% State).
Which scenario offers a higher first year Return on Investment (ROI)? Here is a quick “back of the napkin” calculation to find out.
The numbers speak for themselves. Furthermore, these numbers are only for the first year. As time goes on, your Return on Investment for the leveraged property should outpace the all cash Return on Investment.
Understanding and using leverage is one of the keys to maximizing the return of your investment property. When you are ready to invest, feel free to call me!
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