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How do you know if a rental property is potentially a good investment?

One important metric is its annualized rate-of-return (ROR), sometimes called return-on-investment (ROI).

How do you know its ROR?

You create a rental property cash flow schedule.

Creating a cash flow summary, however, can involve a lot of tedious work, particularly if you are going to consider the impact of taxes so you can calculate an after-tax ROR.

This Rental Property Calculator (aka Rental Income Calculator) removes the tedium from the task. More below...»

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Calculate any investment unknown including income. Considers taxes, inflation and fees.
Property
Expenses
Income
Initial Up-front Investment
Purchase price + initial improvements - mortgages or loans + points.
Mortgages & Loans
Enter a "0" (zero) for one unknown value above.

Enter a "0" (zero) for one unknown value above.
Mortgages or loans are optional.
If you provide 3 values, the calculator will calculate the 4th.
If you enter all four values for a loan the calculator will use them.
Tax Considerations
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Tip: Before you start changing inputs, I suggest you click on the "Cash Flow Schedule" first. This way, you get to see what you are working towards before you worry about understanding the requirements for each input and drop-down. (If you have changed an input and the cash flow schedule doesn't display, just refresh the page.)

What follows, is an explanation for each input. At this point, we are going to have to get into the weeds of US Tax code. The calculator adheres to the Internal Revenue Code (IRC) as closely as possible. Where appropriate, I will note exceptions. However, the investor should not get bogged down with details that may not be thoroughly understood. For example, depreciation recapture could have a tax impact depending on circumstances and past tax filings. But it is not an issue until you sell the property. And if you are creating an analysis that spans 20 years, who's to say what the tax code will stipulate at the time of the sale?

Options, settings, and inputs explained

Property

Purchase Price - The closing price or contract price of the rental property. In tax terms, the closing price is the "basis."

Value of Land - Estimate the value of the land. The value of the land gets deducted from the "Adjusted Basis." Per IRS Publication 527 Residential Rental Property 2016, p.6, "Certain property cannot be depreciated. This includes land and certain excepted property. You cannot depreciate the cost of land because land generally does not wear out, become obsolete, or get used up."

Additions to Purchase Price - When buying a rental property, taxpayers cannot expense (deduct from income) all the costs associated buying and preparing a building for use. When buying a rental property, some costs associated with closing and preparing a building for use must be depreciated (they cannot be expensed). Here is where you include all one-time costs that you cannot expense per the IRC.

The calculator adds these costs to the purchase price to calculate the "Adjusted Basis."

Per IRS Publication 551 2016, Basis of Assets, p2, "the following items are some of the settlement fees or closing costs you can include in the basis of your property":

  • Abstract fees (abstract of title fees).
  • Charges for installing utility services.
  • Legal fees (including title search and preparation of the sales contract and deed).
  • Recording fees.
  • Surveys
  • Transfer taxes.
  • Owner's title insurance.
  • Any amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.

And from Publication 527, p5, "Improvements. You must capitalize any expense you pay to improve your rental property. An expense is for an improvement if it results in a betterment to your property, restores your property, or adapts your property to a new or different use.":

  • Additions such as bedroom, bathroom, deck
  • Lawn & Grounds including landscaping, driveway, walkway, fence
  • Miscellaneous items such as storm windows, doors, new roof, central vacuum, wiring upgrades
  • Interior Improvements, for example, built-in appliances, kitchen modernization, flooring, wall-to-wall carpeting

Business Use - Set this to 100% unless you use part of the structure for personal use. For example, if the rental building has three equally sized rental units and you live in one and rent two, then set business use to 66.6% (two-thirds). Business use impacts the depreciation calculation.

Estimated Selling Price (FV) - The rental income calculator creates a cash flow statement from the time you purchase the property until you sell it. The selling price determines the capital gain or loss. Set this to "0" and the calculator will calculate it using the "Annual Appreciation" rate.

Annual Appreciation - If you do not want to estimate a selling price but rather instead assume a set rate of appreciation, set the property's appreciation rate here. Note, if you set neither the "Estimated Selling Price" or "Annual Appreciation" price to zero, then to keep both in sync, the calculator will recalculate "Annual Appreciation."

Closing Date (purchase date) - The day the buyer takes ownership of the property and the closing date for the mortgages. The day the expenses start.

In Service Date - The day rental income and depreciation start. "In Service Date" and "Closing Date" may be the same day. If they are not the same date, then the "In Service Date" must be the first of any month after "Closing Date."

Other rental income calculators don't offer this flexibility. That's sub par. What happens if an investor needs time to renovate the property? It is feasible that a property is not ready to rent for months after closing, and the delay impacts cash flow.

Date Property Sold - In almost all cases, you'll be entering an estimated date. The date you enter determines the length of the cash flow statement that the calculator prepares.

Estimated Selling Costs - Usually, this is the commission paid to the real estate broker and well as fees to the attorney. There may be other costs as well.

Expenses

Initial One-Time Expenses - are payments made that can be expensed (not depreciated) in the first tax year. "Initial One-Time Expenses" have no impact on basis.

Per Publication 551 (2016) Basis of Assets, p2,

The following items are some settlement fees and closing costs you cannot include in the basis of the property.
  • Casualty insurance premiums.
  • Rent for occupancy of the property before closing.
  • Charges for utilities or other services related to occupancy of the property before closing.
  • Charges connected with getting a loan. The following are examples of these charges.
    • Points (discount points, loan origination fees).
    • Mortgage insurance premiums.
    • Loan assumption fees.
    • Cost of a credit report.
    • Fees for an appraisal required by a lender.
  • Fees for refinancing a mortgage.

Monthly Expenses - are ongoing charges that occur during the term of the cash flow. "Monthly Expenses" must, for accurate analysis, include expenses that do not happen monthly but none-the-less impact cash flow. If an expense occurs quarterly, for example, prorate it to a monthly value. A $600 quarterly property and casualty insurance premium is $200 a month.

Expenses get deducted from income.

Per IRS Publication 527, Residential Rental Property (2016), p3, Listed below are the most common rental expenses:

  • Advertising.
  • Auto and travel expenses.
  • Cleaning and maintenance.
  • Commissions.
  • Depreciation.
  • Insurance.
  • Interest (other).
  • Legal and other professional fees.
  • Local transportation expenses.
  • Management fees.
  • Mortgage interest paid to banks, etc.
  • Points.
  • Rental payments.
  • Repairs.
  • Taxes.
  • Utilities.

Annual Expense Increase - Estimate by how much your monthly expenses will increase each year. Set the value to between 0% and 99%.

Annual Property Taxes - Enter the annual amount even if paid quarterly or monthly. Property taxes impact cash flow and are deductible from US Federal taxes as an expense. Even if you pay property taxes quarterly, enter the annual total.

Annual Property Tax Increase - Enter an estimate for how much you expect property taxes to increase each year. If you expect them to fall over time, you can enter a negative value. (Yeah, right.)

Income

Monthly Rent Total - Enter your maximum monthly rent totals. This input, plus the "Monthly Service Income," account for your entire income stream. Enter an amount that assumes you have all units rented 100% of the time.

Monthly Service Income - If you offer additional services to tenants that you charge for, enter the prorated monthly total. Income is increased by the amount you enter here.

Annual Rent Increase - Landlords like to be able to increase rents to improve cash flow, cover rising costs and improve their rate-of-return. Enter the annual percentage you expect to

Occupancy Rate - For a more accurate analysis, you probably should not assume that you'll be able to rent all units 100% of the time. The percentage you enter here adjusts the income to allow for vacancies. Expenses are not adjusted.

Why is the default "Occupancy Rate" 95.8%?

Simple we are assuming each rental unit is vacant one month out of every two years (1/24). The result is, the income portion of the cash flow statement will reflect 95.8% of the total maximum amount you entered for "Monthly Rent Total" and "Monthly Service Income."

Initial Upfront Investment

Cash Required - Calculated. The "purchase price" + "initial improvements" - "mortgages or loans" + "points." If you want to finance the initial improvements, but their cost is not included in the mortgage, use the second loan option to cover their cost.

Mortgages, Debt and Loan Calculators

This Rental Property Calculator includes two, fully functioning loan calculators, and the cash flow analysis will incorporate two debt streams, if needed, in the statement.

You may enter "0" or "Unknown" for any ONE of the following.

  • Mortgage amount
  • Annual interest rate
  • Number of monthly payments
  • Monthly payment amount

When you click "Calc" or "Schedule Preview," the unknown input will be calculated.

IMPORTANT: You may also enter all four values, and the calculator will use them. Recalculation will not occur. This feature is particularly useful in the event you've arranged for financing with special terms.

You need to be aware, however, that after you've calculated an unknown value, say payment amount, and if you change one of the other loan parameters, say loan amount, the calculator will continue to use the payment amount from the first calculation if you don't reset payment amount to unknown.

Amortization Method - If you finance the property with a traditional mortgage, leave this set to "Normal." Otherwise, as you can see, this you may select interest only loans, Canadian loans or no interest loans. (Perhaps a relative is financing part of your investment?)

Loan Origination Points - Points are an upfront payment made in exchange for a lower interest rate. Points are a percentage of the amount borrowed. One point is one percent. If the mortgage is $500,000 and the lender wants 2 points for a lower interest rate, then you'll pay $10,000 as "points" at closing.

Warning: points, while handled correctly in the cash flow, are NOT incorporated into the tax calculation correctly. When handled correctly, points get neither expensed as a lump sum nor do they get depreciated.

IRS Publication 527 (2016), p 4, states:

"The method used to figure the amount of points you can deduct each year follows the original issue discount (OID) rules. In this case, points are equivalent to OID, which is the difference between: the amount borrowed (redemption price at maturity, or principal), and the proceeds (issue price)."

Since I have never studied this calculation, I've included the points in the depreciation. This treatment will probably have the effect of understating the tax impact. When calculated using OID rules, any refund will most likely be, on a relative basis, somewhat larger, or any tax payment due will be slightly smaller.

Deductible Closing Costs - You can expense some (very few!) fees associated with obtaining a mortgage in the tax year you took out the mortgage. This input is where you enter the total deductible charges.

Here are some examples of fees and charges you can immediately deduct.

IRS Publication 527 (2016), p 7, states:

"The following are settlement fees and closing costs you cannot include in your basis in the property." (Which means you expense them.)

  • Fire insurance premiums.
  • Rent or other charges relating to occupancy of the property before closing.
  • Charges connected with getting or refinancing a loan, such as:
    • Points (discount points, loan origination fees),
    • Mortgage insurance premiums,
    • Loan assumption fees,
    • Cost of a credit report, and
    • Fees for an appraisal required by a lender.

"Also, do not include amounts placed in escrow for the future payment of items such as taxes and insurance."

Tax Considerations

Marginal Tax Rate - The marginal tax rate is the percentage of tax a taxpayer pays on the next dollar earned. The marginal rate for each tax payer depends on their income and filing status. You may check the details in IRS Publication 17 - Additional Material.

For 2016, the marginal rates are:

  • 15%
  • 25%
  • 28%
  • 33%
  • 35%
  • 39.6%

Capital Gain Tax Rate - If the investor sells the property for more than the "Adjusted Basis" there is a capital gain, and the investor will usually have to pay a capital gain tax. Enter the tax rate used to calculate the tax due on the gain.

The cash flow statement shows your projected capital gain or loss in the "Sold" row in the "Profit and Loss" column.

Per IRS Topic 409 "Capital Gains and Losses":

"The tax rate on most net capital gain is no higher than 15% for most taxpayers. Some or all net capital gain may be taxed at 0% if you're in the 10% or 15% ordinary income tax brackets. However, a 20% tax rate on net capital gain applies to the extent that a taxpayer's taxable income exceeds the thresholds set for the 39.6% ordinary tax rate."

"There are a few other exceptions where capital gains may be taxed at rates greater than 15%:"

"3. The portion of any unrecaptured section 1250 gain from selling section 1250 real property is taxed at a maximum 25% rate."

Recapture Tax Rate - This tax rate has to deal with depreciation recapture. Personally, I find this to be a very (unnecessarily) complicated topic. You can read about it in IRS Publication 544, p29. There you'll find a section devoted to "Depreciation Recapture."

Adjusted Basis - Calculated. "Purchase Price" plus "Additions to Purchase Price " equals the "Adjusted Basis." The "Estimated Selling Price" minus the "Adjusted Basis" plus "Estimated Selling Costs" equals the capital gain or loss.

Depreciation Basis - Calculated. "Adjusted Basis" minus "Value of Land" equals the "Depreciation Basis."

Depreciation Method - The Rental Income Calculator carefully follows all the requirements in IRS Publication 946, How to Depreciate Property regardless of the depreciation method selected. You should check with your accountant about the exact depreciation method to use. However, a reasonable one to choose is "GDS Straight Line." If you pick this one, you'll get a slightly greater tax benefit than if you select ADS straight line and it is not as an aggressive method as the two declining balance (DB) methods.

Also, if you pick a straight line method, per p.30, IRS Publication 544, you'll avoid taxes for depreciation recapture at the time you sell the property (assuming you held the property for more than one year):

You will not have additional depreciation if any of the following conditions apply to the property disposed of. You figured depreciation for the property using the straight line method or any other method that does not result in depreciation that is more than the amount figured by the straight line method;

Accordingly, residential rental property is depreciated for 27.5 years under General Depreciation System (GDS) and for 40 years under Alternative Depreciation System (ADS).

Want to learn more details about depreciation? See this MACRS Depreciation Calculator.

Suggestions for tax rate settings

Do NOT take anything you read here (or anywhere on this site) as tax advice. I am explicitly NOT qualified to give such advice. I'm offering suggestions and examples, so you'll understand the options. If you are going to make an investment, you should still consult an attorney or tax accountant.

Marginal tax is straight forward. For accurate results, you'll need to enter your marginal tax rate. This rate is used to calculate "Taxes Due" in every row of the schedule except in the row labeled "Sold."

Calculating taxes on capital gains ("Taxes Due" in the "Sold" row) is more complicated than calculating the tax on ordinary income. There are two parts to the calculation. There is the depreciation recapture portion of the gain which is taxed at one rate, leaving the balance of the gain which is taxed at a different rate.

If this is too much detail for you to be concerned about, no problem. Set both "Capital Gain Tax Rate" and "Recapture Tax Rate" to the same percentage. Setting both to the same rate will tax the entire gain at one rate.

If you want to account for depreciation recapture, then set the "Recapture Tax Rate" as needed. The tax gets calculated on the portion of the gain, up to the total "Accumulated Depreciation," using that rate. The tax on the balance of the capital gain, if there is any, is calculated using the "Capital Gain Tax Rate."

Tax Effects - This setting affects income tax calculations. If you select "All Advantages," the default, then depreciation and loan interest reduce the profit (or increases the loss) and lowers the taxes due (or increases the refund). When "No Depreciation" is selected, depreciation does not get calculated and the profit increases (or the loss narrows). When "Not considered" is selected, neither depreciation or loan interest gets deducted.

Are you a financial professional? CPA? Attorney? Investor?
If you found this calculator useful, then you should also know about the Ultimate Investment Calculator and the Ultimate Financial Calculator.

Comments, suggestions & questions welcomed...

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