So far, we’ve talked about the most obvious stream of rental income (cash flow) and the less obvious concept of viewing depreciation as income through tax reduction. Today, I want to talk about equity growth.
As you continue to make monthly mortgage payments, your equity in the property grows. But remember, you are not making the payments. Your renter is. So that equity growth represents a very real increase in your wealth, and you don’t have to do anything to get it except keep your rental property in rentable condition and rented.
Before we get started today, I want to be clear that I am making some unreasonable assumptions in this discussion. I make these assumptions because I want to talk about making money on borrowed money, and clouding that concept with other issues makes that concept much more difficult to understand. We’ve all been taught for years that debt is bad, but Robert Kiyosaki points out that there is good debt and bad debt. I’m talking about good debt. So here are my assumptions:
- You are only breaking even every year for the duration of a thirty year mortgage.
- Chances are you’ll make more than enough money to cover all of the expenses of owning a rental property and put money in your pocket besides. So for the purposes of this discussion of good debt, we’ll assume you neither make nor lose money but that your cash flow remains completely neutral with regard to your mortgage payment.
- Your rental stays occupied 100% of the time.
- This is the only assumption I believe is totally bogus. You will have downtime in your rental income stream. But over time, your cash flow from the property should be more than sufficient to cover all the payments.
- There is no such thing as inflation.
- As you’ll see in the next post in this series, inflation will ensure you make more money the longer you hold the house, even if you start out with negative cash flow. But for this discussion, your rental will neither depreciate nor appreciate. Taxes and insurance will remain as fixed as your interest rate, and along with maintenance, they will be irrelevant. Another way to visualize this assumption is to think of all your maintenance costs being wrapped into your mortgage payment.
So here’s the deal:
Even if you only break even on your monthly payments, your rental property will increase your wealth from day one.
The chart says it all. The golden bars are the balance you owe on the rental. It goes down over time. The blue bars represent your equity in the house, and it goes up as your tenants make your payments. The green line is your return on the $25,000 cash you invested to buy the rental.
While the first year’s return is almost insignificant, the annual return on your initial investment only gets bigger each year until you sell or refinance. By the end of the 30-year mortgage, you have achieved more than a 300% return on your $25,000 investment simply by borrowing enough money to buy a rental property. You borrowed $75,000, and someone else paid of that loan, leaving you with a $100,000 property you essentially bought for $25,000. And they paid for all the taxes, insurance, and upkeep on the property along the way.
Now here’s the kicker!
If you hold or refinance cash out of the property for another purchase, there is no tax on that increase in your wealth because you haven’t “realized” it yet.
That increase in wealth only becomes taxable when you sell. If you die, your heirs’ basis is the value of the property at the time of your death, so the increase essentially is invisible from a tax perspective—assuming your estate is worth less than about $5.4-million today, or whatever the threshold for the estate tax is at that distant point in the future. Even then, the value of the estate is taxed, not the value of the individual properties that comprise it.
That’s right. If you later refinance the rental to get your $25,000 investment out of it, your tenants continue to make your payments and you have an infinite return on investment. If you refinance enough out of this property to pocket your $25,000 (but why would you) and buy another rental, you’ve essentially doubled your infinite return. You’ve done what Buzz Lightyear only talked about; you gone to “Infinity and Beyond!”
Posts in this series:
- Streams of Income from Rental Properties
- The Two Examples and Cash Flow
- Tax Reduction Through Depreciation
- Equity Growth