Methods for Optimum Income from Rental Property

[Huston55]

Situation: I have a rental property (2BR/2BA condo) which I've owned for ~10yrs. It generates 4.5% ROC, I use that income as part of annual income (retired in 2014) and I view it as part of my Bond-ish allocation. I've been analyzing what to do with the property long term to maximize value/income (next 20+yrs, essentially until demise of me & DW), and would like other's opinions on the best option.

Analysis: I did a simple NPV comparison for four options, which I've summarized below. Key numbers used are: Property Value=$200k (same as purchase price); 3% discount rate; 2% annual property appreciation; 6% realtor fee @ sale; 7% state sales tax @ sale; 20% "blended" cap gains tax on sale; 25% cap gains tax on Depreciation Recapture; CRT requires 'donation' of 10% of value & avoids Cap Gains & Depreciation Recapture on 100% of value; I value the CRT income by pricing a 2-life SPIA on immediateannuities.com.

1. Option#1: Retain condo as a rental for next 20yrs (to end of depreciation)
NPV = (net monthly income)+(net sales proceeds in 20yrs)
= ($750x12x20)Disc@3% + [$200k(1.02)*20x(1.00-.06-.07)x0.80}Disc@3%
= $135k + [$297k(0.87)(0.80)]Disc@3%
= $220k

2. Option#2: Put condo into a Charitable Remainder Trust (CRT) Now
NPV = [(Prop Value)X0.90]>>Converted to 2-Life SPIA + [(Prop Value)x0.10(20% cap gains savings]
= [$200k(0.90)>>Converted to 2-Life SPI} + [$20k(0.20)]
= $731/mo(Disc@3% for 30yrs) + $4k
= $177k

3. Option#3: Put condo into a CRT in 20yrs (when depreciation ends)
NPV = [net monthly income, 20yrs] + [90% to CRT in 20yrs(Disc@3%)]
= [$135k] + [$297k(0.87)(0.90)Disc@3% + Cap Gains Savings]
= $135k + $129k + $4k
= $268k

4. Option#4: Sell condo now
NPV = [Prop Value] - [Depreciation Recapture]
= [$200k(1.00-0.06-0.07)] - [$80k(0.25)]
= $154k

Preliminary Conclusion: Option#3 is the clear winner based on my analysis, and is currently our tentative plan.

I'd like feedback on my analysis (Complete? Mistakes?) and whether there are other options I should consider. Thanks in advance for taking the time to evaluate this.

 

[Sunset]

You didn't state the goal that you want.

Seems like you are comparing apples to oranges.

If your goal is maximize the $$$ from the rental then
Number 2) The CRT does not get you 177K , perhaps it gives you a deduction of 177K, (no idea exactly what a CRT is, but the name is suggestive). So assuming a deduction value of 25% then number 2) is worth $44,250

 

[Sunset]

You are unfairly comparing number 4) to 1) .
To make it fair, you would need to compare for number 4) after putting the $154K into VTI (or 60/40 blend) for 20 years.

 

[jimnjana]

Option 5 - 1031 exchange to a property with a higher net ROC and/or a property that you could use as a vacation rental and enjoy during the year.

 

[Huston55]

You didn't state the goal that you want.

Seems like you are comparing apples to oranges.

If your goal is maximize the $$$ from the rental then
Number 2) The CRT does not get you 177K , perhaps it gives you a deduction of 177K, (no idea exactly what a CRT is, but the name is suggestive). So assuming a deduction value of 25% then number 2) is worth $44,250

You are unfairly comparing number 4) to 1) .
To make it fair, you would need to compare for number 4) after putting the $154K into VTI (or 60/40 blend) for 20 years.

Sunset-Thx for the input. Clarifications below.

My goal is stated in the thread title & "Situation" paragraph - it is to produce the most ("optimum") income, which I chose to value using a Net Present Value (NPV) analysis.

CRT=Charitable Remainder Trust, which I explained a bit in my post. Essentially, you 'donate' your asset (condo in my case) and receive an income stream for life. You must 'donate' a minimum of 10% of the asset's value, meaning that 90% of it is used to generate said income. More details are available with a quick search.

Since I'm using NPV to compare options, I don't think assuming "investment" returns is appropriate; especially a 60/40 mix.

 

[Huston55]

Option 5 - 1031 exchange to a property with a higher net ROC and/or a property that you could use as a vacation rental and enjoy during the year.

I thought about that but, did not include it as an option because DW & I have no children and no goal to bequeath anything.

Given that, would you still do a 1031 exchange? If so, can you provide a NPV to demonstrate it's a better option?

 

[nwsteve]

Keep in mind, that if total property is valued at 200k, your depreciation recapture will be less since land is not subject to depreciation. Some portion of your original purchase price should have been allocated to the "dirt" element. Check your property tax assessment for an approximate ratio.
Nwsteve

 

[Huston55]

Keep in mind, that if total property is valued at 200k, your depreciation recapture will be less since land is not subject to depreciation. Some portion of your original purchase price should have been allocated to the "dirt" element. Check your property tax assessment for an approximate ratio.
Nwsteve

Excellent point. I think I've addressed that using the approximate numbers in my analysis (purchase price & annual depreciation on past tax returns); and, since it's a condo, my piece of 'dirt' is very small.

Do you have any other input on the options and/or analysis?

 

[MooreBonds]

Situation: I have a rental property (2BR/2BA condo) which I've owned for ~10yrs. It generates 4.5% ROC, I use that income as part of annual income (retired in 2014) and I view it as part of my Bond-ish allocation.

I'm confused with how you determine your "ROC". Is that 4.5% figure AFTER you take out an allowance for fixing up the place, condo assessments over 20 years (over 20 years, I'd expect at least one substantial big assessment), and true 'depreciation' (I.e. replacing the carpets after X years, repainting after Y years, etc.), other losses, etc.? Or is that 4.5% assuming a perfect attendance record, and perfect tenants and perfect lifespans on everything?

If you have to lower that 4.5% figure for the average allowances that many landlords experience and allow, I'd sell now and dump it in a diversified fund.

 

[brucethebroker]

We have owned condos as investments before and it is tough making the numbers work due to increasing fees and assessments. (We prefer single family homes, with more control of how the money is spent.)

Have you considered 1031 exchange into something you can rent out temporarily and later move into as principal residence? Articles I have read say you only have to keep as an investment a year or two. That would allow you to sell current personal residence and take tax free cap. gain. At the sale of the rental, it gets complicated as far as how much gain was pre- and how much post- of conversion to principal residence. But that keeps the CPA busy! Just an idea I have noodled with......

 

[Huston55]

I'm confused with how you determine your "ROC". Is that 4.5% figure AFTER you take out an allowance for fixing up the place, condo assessments over 20 years (over 20 years, I'd expect at least one substantial big assessment), and true 'depreciation' (I.e. replacing the carpets after X years, repainting after Y years, etc.), other losses, etc.? Or is that 4.5% assuming a perfect attendance record, and perfect tenants and perfect lifespans on everything?

If you have to lower that 4.5% figure for the average allowances that many landlords experience and allow, I'd sell now and dump it in a diversified fund.

MB-4.5% is Net after all expenses. It varies a bit year to year but, it's close enough to what I've experienced for the past few years to use in this analysis. Given that I use the property to generate income, a diversified fund would be riskier. To generate similar predictable (dividend style) income, I don't know where else I could get 4.5%. Open to suggestions though.

 

[Huston55]

We have owned condos as investments before and it is tough making the numbers work due to increasing fees and assessments. (We prefer single family homes, with more control of how the money is spent.)

Have you considered 1031 exchange into something you can rent out temporarily and later move into as principal residence? Articles I have read say you only have to keep as an investment a year or two. That would allow you to sell current personal residence and take tax free cap. gain. At the sale of the rental, it gets complicated as far as how much gain was pre- and how much post- of conversion to principal residence. But that keeps the CPA busy! Just an idea I have noodled with......

I've looked at the 1031 exchange option but, our rental is in the East in a moderately inexpensive location while we are now retired in the SF Bay Area. So, doing an exchange/conversion to primary residence would mean investing a LOT more $$$ in the new property.

Edit: When I evaluate it from a NPV perspective, it doesn't fair well versus other options; likely because I don't really have any Cap Gain on the property, just depreciation. But..

NPV = [$174k (from Option#4 above w/o Depreciation Recapture] - [$2,000 (1031 exchange fees)] = $172k. This is assuming I could get neutral (Net $0) cash flow from the rental of the new property for 2 yrs. I'd also lose two years of positive net rental income from the current property (~$18k) so, more accurately NPV = $154k.

 

[MooreBonds]

MB-4.5% is Net after all expenses. It varies a bit year to year but, it's close enough to what I've experienced for the past few years to use in this analysis. Given that I use the property to generate income, a diversified fund would be riskier. To generate similar predictable (dividend style) income, I don't know where else I could get 4.5%. Open to suggestions though.

So you have no 'reserve fund' that you are putting rent revenue into that is building up to 'pay for' when your tenants leave and it sits vacant, or condo assessments, etc.? If that's the case, then you do NOT have a 4.5% return - you are getting 4.5% return now....but will have a much smaller (or negative) return when the inevitable happens. Given that, I'd take a diversified fund now that I know will likely have returns greater than 4.5%, without any hassle factor or unknown factors.

For instance, what is the state of the condo association's balance sheet? What do they have in reserve? Are there any elevators? How big are the parking lots? What shape are the roofs in? A single elevator to be reworked can easily be $75k, possibly more. Roofs cost big bucks. So can parking lots. Just that alone makes it a large unknown, much less the other future possible factors with tenant rentals.

 

[CaliKid]

CRTs are costly to set up and require additional accounting. Generally for big dollar donations in my experience. At least $500k if not a mil or more.

 

[Huston55]

MB-4.5% is Net after all expenses. It varies a bit year to year but, it's close enough to what I've experienced for the past few years to use in this analysis. Given that I use the property to generate income, a diversified fund would be riskier. To generate similar predictable (dividend style) income, I don't know where else I could get 4.5%. Open to suggestions though.

So you have no 'reserve fund' that you are putting rent revenue into that is building up to 'pay for' when your tenants leave and it sits vacant, or condo assessments, etc.? If that's the case, then you do NOT have a 4.5% return - you are getting 4.5% return now....but will have a much smaller (or negative) return when the inevitable happens. Given that, I'd take a diversified fund now that I know will likely have returns greater than 4.5%, without any hassle factor or unknown factors.

For instance, what is the state of the condo association's balance sheet? What do they have in reserve? Are there any elevators? How big are the parking lots? What shape are the roofs in? A single elevator to be reworked can easily be $75k, possibly more. Roofs cost big bucks. So can parking lots. Just that alone makes it a large unknown, much less the other future possible factors with tenant rentals.

MB-

My Net after ALL expenses (mgt fees, HOA dues, special assessments, vacancies, taxes, maintenance & repairs, etc.) is $9,200/yr on $200k, which is 4.6% ROC.

Regarding where to "invest" that capital, my $9,200 is largely sheltered by depreciation. Comparatively, selling the property and investing the resulting $154k (sales price - fees - sales tax - depreciation recapture) in a diversified fund (say VWINX) would return $8,532/yr after taxes (based on VWINX 10yr returns). On a risk-adjusted basis, the rental property is doing OK.

BTW, I appreciate all the questions; it makes me evaluate whether I'm making good choices or not. I would like to know your views on the options listed in my OP.

 

[Meadbh]

My Net after ALL expenses (mgt fees, HOA dues, special assessments, vacancies, taxes, maintenance & repairs, etc.) is $9,200/yr on $200k, which is 4.6% ROC.

You said that the property value (at the time of purchase, and now) is $200K. If you own 100% of the property, your capital (or equity) is $200K, and net ROC (or ROE) is 4.6%.

But......when you purchased the condo 10 years ago, did you pay for it in cash? Or did you leverage your investment? Because that makes a big difference to your return on investment, or ROI.

For example, let's assume that when you bought the condo, you put a deposit of $50K and took out a mortgage for $150K. Let's also assume that the mortgage payments were covered by the rent, and that the mortgage has now been paid off without any further injections of cash from you.

If all these conditions were to apply, your initial investment would have been $50K. Your current return on your initial investment (ROI) would be $9200/$50,000 = 0.184 = 18.4%.

This is why I am in no hurry to pay down principal on investment property mortgages. ROI is maximized by allowing the tenants to do that for you.

 

[BeachOrCity]

I have a not too dissimilar situation with a rental property where the gain and depreciation are huge and the income relative to equity is pretty good.
In general i like your math, and what i would suggest is you hold onto it and revisit the math annually. When the math no longer makes it look so good you can sell and or crt.

 

[Huston55]

CRTs are costly to set up and require additional accounting. Generally for big dollar donations in my experience. At least $500k if not a mil or more.

CaliKid-

Can you explain in more detail?

 

[Huston55]

I have a not too dissimilar situation with a rental property where the gain and depreciation are huge and the income relative to equity is pretty good.
In general i like your math, and what i would suggest is you hold onto it and revisit the math annually. When the math no longer makes it look so good you can sell and or crt.

Thx "Beaver"

Does this mean, given current math & assuming it holds, you would choose Option#3 (Rent ~20yrs, then convert to CRT)?

 

[MooreBonds]

MB-

My Net after ALL expenses (mgt fees, HOA dues, special assessments, vacancies, taxes, maintenance & repairs, etc.) is $9,200/yr on $200k, which is 4.6% ROC.

Ah, sorry for the misunderstanding. It's good that your return does take that into account...but if you are taking into account special assessments/vacancies, etc., I'm assuming that if you are getting a 4.5% return, then you are not actually incurring those non-recurring expenses every year, and are building up the expenses in a separate savings account, since you won't have that every year? If so, just out of curiosity, what is your gross return after your set annual expenses (mgt fees, annual assessments, taxes)? It can be good to see what your theoretical 'maximum' return is in a good year with no vacancies/special assessments/no repairs for comparison purposes.

Also, is it an option to move into the rental for 1-2 years to establish your residency, and then sell it as your personal residence to avoid depreciation recapture? I'm not well versed in real estate, but I thought I remembered reading that if you have a rental property, then you could move into it to make it your personal residence for a certain number of years, then sell it as your own personal residence without the depreciation recapture coming up? IF you did that, you could save on your unrealized gains (after depreciation), then simply put the sales proceeds into a Donor-Advised Fund with several good companies (I have one with Vanguard) instead of the hassle of messing with your own stand-alone charitable account.

 

[BeachOrCity]

Thx "Beaver"

Does this mean, given current math & assuming it holds, you would choose Option#3 (Rent ~20yrs, then convert to CRT)?

Basically yes, but given things change over 20 years i would reevaluate annually

 

[BeachOrCity]

The below statement is not correct:
Also, is it an option to move into the rental for 1-2 years to establish your residency, and then sell it as your personal residence to avoid depreciation recapture? I'm not well versed in real estate, but I thought I remembered reading that if you have a rental property, then you could move into it to make it your personal residence for a certain number of years, then sell it as your own personal residence without the depreciation recapture

You have to pay depreciation recapture if the property sells for more than the adjusted basis. As far as the 500k exemption it is prorated based on total time rented vs lived in.

 

[Huston55]

You said that the property value (at the time of purchase, and now) is $200K. If you own 100% of the property, your capital (or equity) is $200K, and net ROC (or ROE) is 4.6%.

But......when you purchased the condo 10 years ago, did you pay for it in cash? Or did you leverage your investment? Because that makes a big difference to your return on investment, or ROI.

For example, let's assume that when you bought the condo, you put a deposit of $50K and took out a mortgage for $150K. Let's also assume that the mortgage payments were covered by the rent, and that the mortgage has now been paid off without any further injections of cash from you.

If all these conditions were to apply, your initial investment would have been $50K. Your current return on your initial investment (ROI) would be $9200/$50,000 = 0.184 = 18.4%.

This is why I am in no hurry to pay down principal on investment property mortgages. ROI is maximized by allowing the tenants to do that for you.

Meadbh-

The mortgage has now been paid off. While I wish that I had net income of $9,200/yr with only $50k invested & still carrying a mortgage, that is not the case. So, it's $9,200/$200k = 4.6% ROC/year.

If you are getting anywhere near 18.4% return on your property, more power to you!

 

[Meadbh]

If you are getting anywhere near 18.4% return on your property, more power to you!

I wish! Currently I am in a cash flow neutral situation, with equity increasing by approximately 10% of my original investment per year. The remaining mortgages will disappear in ~4 years, 7 years and 14 years, leading to an increasing monthly cash flow.

 

[Huston55]

Thread bump to see if I can get any more input on the OP.