Unlike some other famous maxims in real estate investing (like the seventy percent rule, for example), the two percent rule is widely discredited in most U.S. metropolitan areas. The rule holds that the rental amount should equal two percent of the property's purchase price. By that calculation, if you purchase a house for $100,000, the monthly rent should be $2,000. That seems unrealistic at first glance and becomes even less likely the deeper you dig in.
For example, in low-cost areas with moderate housing purchase prices, rents are (not surprisingly) also lower. According to recent statistics from Zillow, the average rental cost in Philadelphia is under $1,700, and the purchase price is over $200,000. While those amounts sound great compared to many parts of the country, the rent would need to more than double to satisfy the two percent test. In Los Angeles, the median sale price for a house is just over one million dollars, with single-family homes hitting the median at $1.2 million. The median rent for a single-family home is over $6,000 while including multi-family properties cuts the average in half to $3,000. In either case, the rent is far below the twenty to twenty-two thousand dollar price that would equate to a two percent return.
Rent Is not the Only Important Factor
However, cash flow from rent payments is not the only way a real estate investor can seek to generate income. Investing in real estate offers opportunities to manage taxes in ways that may not be available with other endeavors. For example, real estate owners may be entitled to recover the cost of the asset used as a source of rental income through depreciation. Depreciation typically starts when the investment is "placed into service" and ends when the owner disposes of the asset (or when the depreciation schedule has run its complete course).
The depreciation amount depends on the tax basis (sometimes referred to as the cost basis). That figure is the purchase price of the property plus any out-of-pocket costs like closing costs and repairs, minus the land's value. Since land does not lose utility, it is said to retain its value. Therefore, only the improvements such as dwellings, garages, storage, and amenities are depreciable. Residential real estate is depreciable over the course of 27.5 years, while commercial real estate has a depreciation schedule of 39 years. Other items that are used to support the property have shorter depreciation schedules.
Passive Versus Active Income
Depreciation is classified as a passive loss, like rental income is passive income. Because of that, depreciation (and other passive expenses) must be deducted from passive income, not from other income. Also, it’s important to note that depending on when you dispose of a depreciated asset (and whether you enjoy profit from the appreciation attributable to depreciation), the IRS will need to recapture some of the deductions you have previously taken. In these cases, it’s wise to consult your tax advisor for professional support.