How I was able to cover my mortgage and generate cash flow: Increasing your financial IQ with Real Estate Hacks
I am sure you remember how 2012 was smack in the middle of the “Great Recession”.
During this time I was able to purchase a 3 bedroom/3 bathroom + den with a 2-car garage for $135,000. I put 20% down and had a $600 monthly mortgage payment.
Generating Cash Flow to Cover the Mortgage and Live for Free:
Since I was relatively young (23 and was used to having roommates), I decided to rent 2 of the rooms out. Each room rented for $400 per room + their share of the utilities.
I was able to live in my own home for free, while other people paid for the mortgage. I was paying off the amount I owed to the bank, and earning extra money on the side!!
This means that I was grossing $800 from rent, and only paying $600 for the mortgage. I was cash-flowing $200 per month.
Cash flow is my favorite kind of income because it is passive (money comes in even when you are sleeping), and is taxed at capital gains rate.
Increasing the Cashflow:
In 2016 I started dating someone, who I eventually moved in with. Since I now had an empty master bedroom, I rented it out as well for $500.
The gross income increased to $1,300 per month, and the cash flow went from $200 to $700.
By the middle of 2016, the guy who rented out the master bedroom found himself a girlfriend. She decided to move in and wanted to use the den area because she sometimes worked from home.
She was over at the property so often that the other roommates agreed and she paid $400 per month plus her share of the utilities.
By 2017 there were 4 people living in this 1800 sqft house, and the total gross income was $1700. The mortgage was still $600, which means that the cash flow was $1,100 per month.
Achieving Above Market Rent:
The monthly market rent in the area for a comparable home with one lessor was $1,200-$1,300. I was able to generate higher cash flow by renting each room out individually.
The downside is that I would have to worry about re-renting each room at the end of the tenant’s 1-year lease. That is if they decided to move out. Most of the tenants stayed for longer than 1 year. Keep in mind, it is a hassle for a tenant to move each year. I found that most tenants stayed longer than a year.
Leasing out each room was beneficial because there was never a time when the entire house was vacant. Only two of the four tenants had to occupy the property to cover the mortgage.
Usually, when you rent out an entire property, you need to assume some percentage of vacancy. Typically, we would assume a 90% occupancy rate.
- Rule of Thumb: Good property managers should be able to get the house in rent-ready condition for a new tenant and market the home within one month. There are 12 months in a year, so if the house is rented for 11 of 12 months that equals 91% occupancy rate.
- A side note: The company that I had built sold at the end of 2015. I decided to move to the Reno Tahoe area in January 2016. By the summer of 2017, I was in graduate school obtaining a Master’s degree in Business Administration with an emphasis in Renewable Technology.
This means that I was a long-distance landlord, and managing the home from so many miles away became a hassle.
Typically, a primary residence should not be considered an investment.
I was able to make my primary residence an investment because I generated cash flow by renting out several rooms.
The market had appreciated over the time that I had owned the property, and I had just hit the 5-year mark.
- Tax Hack (the 2-of-5-year rule): There is a tax law that states that an owner who has lived in a property for 2 of 5 years can sell the property and keep up to $250,000/$500,000 (if you file as a single vs married) capital gains tax-free.
This is a huge tax saving!!!
Going with a Conventional 20% Down Payment Loan:
When I purchased the home, I used a conventional loan and put 20% down. You may ask why I would decide to put so much money down when I could have gone with an FHA 3.5% down payment loan.
The reason is because the higher the LTV (loan to value), the more you will owe on the property. This means that your monthly payments will also be higher.
By putting more money down, you open up the ability to generate passive income (cash flow). One huge bonus is that passive income is taxed at a lower rate (capital gains rate).
- Avoiding Extra Costs: when you purchase a home with 20% down, you avoid a PMI payment (Primary Mortgage Insurance). PMI is an additional fee that banks charge to cover themselves in case you default on your loan (end up in foreclosure).
With a conventional 20% down payment loan, you can live in the house as a primary residence or purchase the property as an investment.
The reason for using the 20% conventional loan is to be able to live in the property for a minimum of 2 years and take advantage of the 2-of-5-year rule (explained above).
During these two years, you can fix up the property while you are living in it. You can decide to rent the property out after the 3rd year and purchase another home to live in.
- Tax Hack: Once the first home reaches 5 years of ownership, you could 1031 exchange (like-kind exchange) the property out for a larger investment home or purchase 2 investment properties. The IRS allows you to tax defer any money owed on the property!!!
Tax Defer Indefinitely:
You can continue to tax defer indefinitely until you decide to sell the property. Most likely you will want to keep the properties indefinitely and set some aside for rental income while selling others.
Did you find today’s topic interesting? If so, what did you like (or didn’t like) and is there anything you want to know more about. Looking forward to reading your comments.