Real estate investing is a divisive subject. You either love it or you hate it.
We’ve all seen the social media posts from people saying they don’t want to own rental properties because they don’t want to have to get a call in the middle of the night about the furnace breaking or some other annoying task. And while that does not sound enjoyable, we cannot dismiss the opportunity that also exists from investing in properties.
In this blog post I am going to talk about some of the benefits that come from investing in real estate that attracts so many.
In the US real estate market, the average return on investment is 8.6%. This results from the property’s appreciation as well as the rental income. This return rate is quite attractive as so many people love the cash flow coming in. You can either choose to leverage short term or long term rentals (or both) depending on what you want and the time you have to put in.
With a rental, you take out a mortgage which gives you leverage and then someone else is paying all the expenses. The goal is to take advantage of all that while also generating getting cash flows on top of that. All of this sounds great, but remember, this is a still a job you are taking on. You have to find and deal with renters. You have unexpected expenses occur. And all of those can be stressful if you do not plan well.
When receiving income from a rental, you also get to write-off certain expenses against that income. Some of these include: mortgage interest, property taxes, operating expenses, depreciation, and repairs. This means your taxable income on it is not just the cash flow you bring in. It is the cash flow minus the expenses you get to write off. Things get even better down the line if you can become a real estate professional, but it is not easy to qualify. I will write another post later on to talk just about that.
Depreciation is the part of real estate everyone loves to talk about. It allows you to deduct the costs from your taxes of buying and improving property over its useful life which reduces your taxable income. All this basically means is you get to deduct the value of the home over 27.5 years at a rate around 3.636% a year (this only includes the home not the land). This depreciation helps lower your taxes since you can deduct this from the cash flows you bring in. But what many don’t talk about is the fact that this gets recaptured down the line when you sell. Let’s say you have a $500,000 home (this is your basis), after you depreciate it for a number of years, the basis drops. So when you sell later on, the tax is not determined with $500,000 being the basis. It’s based on how much the property has depreciated as well which lowers the cost basis and leads to a higher tax bill. Not that this is necessarily bad, but it’s just not talked about enough.
Almost everyone I talk to has the goal of building equity in something. There is no denying the fact that starting a business is hard, hard work. There is also no denying the fact that rental properties are not truly passive unless you hire a property manager. However, they are way more passive than owning 99% of businesses out there. This makes rentals attractive to many people. You get to be a business owner, build equity, and have another income stream aside from your primary income.
Everyone in real estate loves to talk about 1031 exchanges. All 1031 exchange really means is that you can defer taxes upon the sale of an investment property by swapping one property for another. This is not simple and has a ton of moving parts, but it is definitely something you want to be aware of. There are time frames that need to be understood to make this work so I highly recommend you work with a great team if you are going to try and make a 1031 exchange happen.
1031 exchanges are a huge part of the tax benefit narrative that exists with investment properties.
As you own a rental, the cash flows you bring in help pay off the mortgage (unless you do interest only loans). This helps build equity, along with the price appreciation of the house which you can ultimately borrow against. Many choose to leverage this equity and use it as down payments on other properties. This can help fuel your investing, but you have to understand you are taking on more debt via home equity line of credit or cash out refinance which does need to get paid off. It also adds more risk for you if the home loses value. You definitely have to be wise with you use debt.
Everyone knows how hard it is to hold onto stocks when the markets are dropping. Fear of recessions, price changes, etc. are all thrown in your face day after day which leads many to sell out of fear. This is way harder to do in real estate as it is relatively illiquid plus the price drops are not thrown in your face in the same way. The illiquidity of the asset can be a bad thing but also can be a good thing as it pushes people to hold for longer periods of time.
There is no denying that real estate is an attractive asset class to invest in. But… it is hard work. You have to make the decision based on whether you want to manage it or not!
Disclaimer: None of this should be seen as advice. This is all for informational purposes. Consult your legal, tax , and financial team before making any changes to your financial plan.
Financial Advisor