Rental properties are a great way to build wealth and passive income if you buy them right. Figuring out what a good rental property investment is, is not always easy. When you factor in expenses like property taxes, maintenance and vacancies it gets even harder. Some people ignore these expenses and buy for appreciation, which can lead to big problems down the road. I invest for cash flow, but what may be great rental numbers to me in Colorado, may not be a good rental in other states due to property taxes. Taxes can vary greatly from state to state and even within states and they must be accounted for.
Why do people buy rentals for the wrong reasons and ignore property taxes?
I recently saw an article in Forbes magazine about the best rental property markets for investors. The article listed the top markets to buy rentals in, with Denver being one of the best. I live in Colorado and I can tell you that Denver is not an easy place to buy cash flowing rentals. The reasoning behind rental properties being a good investment in Denver involved a great economy, people are moving in and prices are increasing and predicted to increase more.
The article did not mention cash flow and barely mentioned price to rent ratios. It is no wonder why so many people don’t understand investing in real estate, when main stream investing articles are guiding people to buy in markets with almost no cash flow available. The article did not mention property taxes either. If you are reading articles like this and basing your investment strategy on how hot a market is, you may be making a huge mistake. Many articles I see about the best places to invest in rental properties completely ignore the property taxes.
Why do investors miscalculate returns on rentals?
Another problem I see over and over is miscalculation of income on rentals. The income is not the rent minus the mortgage payment, taxes, insurance and other fixed costs. The profit is those numbers minus the vacancy and maintenance costs as well. The vacancy and maintenance costs can vary greatly on what type of houses you buy and what condition they are in. My cash flow calculator is a great help to figure those numbers. Property taxes can have a huge effect on the returns of rental properties in different states as we will see soon.
I think some people don’t believe the returns I get on my rentals. One reason I can make so much money on my rental properties is Colorado has very low property taxes. On my rentals that I bought in the last four years for $80,000 to $140,000 I pay from $400 to $800 in property taxes a year! Some states have property taxes ten times that amount. If you are looking for the best places to invest in, make sure you account for the property taxes in that state or area.
How much do property taxes change from state to state?
I mention my property taxes on homes that I bought from $80,000 to $140,000 are around $400 to $800 a month. The great part is those houses are worth much more than I bought them for! In this article you can see how your state ranks as far as property taxes. Colorado is listed as number 10 with an average property tax of $1,089. However, taxes in my area in Northern Colorado are even lower than most parts of the state. Here is a list of the ten lowest property taxes in the country.
It is important to know that some states have different property tax rates for investors and owner occupants. South Carolina has a much higher rate than what is listed for investors.
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As you can see there are many states with even lower taxes than Colorado, but that is not all you can consider when looking for a place to invest. Hawaii has the lowest property taxes, but the cost of living is one of the highest in the country and housing prices are astronomical. On the other hand people see the price to rent ratios in places like Chicago and New Jersey and think buying rentals there would be a great investment. But Illinois and New Jersey have two of the highest property tax rates in the country. The states with the highest property taxes are listed below.
You may wonder why property taxes vary so much from state to state, but there is a simple explanation. Some states have no income tax, some have a high income tax, some states have no vehicle taxes and some states have no sales tax. When you are living in these states the taxes are paid one way or another to the state. But when you are investing in rental properties from another state you don’t care what the income taxes are or the vehicle tax.
How much can property taxes affect cash flow on rentals?
If you look at my rental I pay about $50 a month in property taxes and I make around $500 a month in cash flow. If you lived in New Jersey you would pay over $300 a month in property taxes, instead of $50 a month. It is much tougher to cash flow on rental properties when your taxes are so high, but new Jersey has no vehicle taxes. The same goes for Illinois and Texas, which are also popular places for out-of-state buyers to purchase rentals.
How do you find a great location to buy rental properties?
I think the local economy is something that should be looked at when deciding where to buy rental properties. If you buy in an area with a decreasing population and very little economic upside you might be asking for trouble. The first thing I would consider when buying out-of-state is:
- What are the rent to value ratios? If I can’t cash flow on properties because prices are too high, then I don’t want to buy a rental property there.
- What are the property taxes? If property taxes are too high it will make it very tough to cash flow and I will not want to buy there, unless the other numbers are good enough to make up for those taxes.
- What is the economic outlook? Is the economy growing or shrinking and is the area dependent on one industry or multiple?
- Do I know anyone in the area? It is very hard to get to know a strange town or area. If I know someone who can help guide me it will save me a ton of time and give me assurance that I am buying properties in areas that I am comfortable with.
If all this seems like a lot of work, it is! You can go the turn-key route to buy an out-of-state investment property which I did over the summer. With those properties you get great rent to value ratios, but you still must make sure the turn-key companies are calculating the cash flow correctly and watch out for property taxes.
Buying rental properties that have great cash flow are a great investment. But you must do your homework when finding areas to invest in and calculating the numbers. Make sure you know the property taxes in areas you are not familiar with and do not assume they are similar to where you live. I did write an article a while back on the best places to invest for out-of-state investors you can check out here.