Buy land, they’re not making it anymore.
Mark Twain
Investing in real estate is a tried and true method to creating wealth. There is a lot of information and misinformation about real estate online. The misinformation may be unintentional because it usually comes from someone who does not know how real estate works, like a stockbroker trying to compare stocks to real estate. Here are some of the common reasons people invest in real estate.
Appreciation
According to Zillow the average appreciation of real estate in the US is between 3 and 5 percent a year. This is often the metric used when compared to the stock market and why you will find a lot of articles online saying it is not worth the hassle. Be careful what they are trying to sell you. If you continue reading you will see that there are a lot more factors in play for rate of return.
Appreciation is a nice benefit of real estate though. If you own your own home, you will see your home value go up over time. Look at home prices 30 years ago and you will be able to get some sense of what home prices will look like in 30 years from now.
Equity Build-Up
When your property is worth more than what you owe on it, the difference is equity. With the appreciation of a property and the reduction of the loan through payments, the equity in a property starts to build over time. Having equity in a property is adding to your net worth on paper.
There is some cool stuff you can do with the equity in a property. On a personal residence you can take out a Home Equity Line of Credit (HELOC), which is borrowing against the equity. You can also do a cash-out refinance of the property to take equity out. This is one of the best exit strategies of real estate in my opinion. Refinancing a property and getting cash back is a non-taxable event.
Depreciation
Real estate can be written-off. Like Kramer said in Seinfeld, it’s a write-off!
Depreciation as a write-off means an income tax deduction. You claim losses on wear and tear of the property to reduce your tax liability.
(Note that I am not a tax professional.)
The asset appreciates in value, but you pay less income tax because of losses claimed from depreciation. This is well known among real estate enthusiasts. The depreciation will have to get recaptured if you sell the property. The IRS will want to be paid back for all the losses you claimed over the years and also any capital gains, but there is a way to defer these taxes through a 1031 exchange.
There are many articles written on 1031 exchange so I won’t go in to too much detail, but the idea is that you exchange a property for a similar property that is equal or greater in value to defer all taxes. The idea is to swap till you drop so that you will defer the taxes indefinitely.
A major change in the 2018 tax law is bonus depreciation. Bonus depreciation is a tax incentive that allows you to immediately deduct a large percentage of the purchase price of eligible assets in the first year of purchase. This is a powerful tool for real estate investors to not pay as much in taxes.
Taxes
In addition to the depreciation tax benefits, the taxes you pay on real estate are also an income tax deduction. Starting in 2018, the deduction for state and local taxes, including property taxes, was capped at $10,000 ($5,000 if married filing separately).
If you pay $10,000 a year in property tax, you can take an income tax deduction or $10,000. If you are in a 25% tax bracket you just saved yourself $2,500.
Cash Flow
Investing in real estate is all about the cash flow. Properties should be analyzed with cash flow in mind. Real estate investors look at the mortgage (principal and interest), taxes, insurance, maintenance, capital expenditures, management fees, and any other expenses to know what they will be paying monthly and yearly.
Looking at comparable rents in the area determines if the rental income can cover all the expenses. Cash flow is when the rents or income from tenants exceeds the costs of owning the property.
Leverage
Another key advantage for real estate investors is leverage. Leverage is when you borrow other people’s money to buy real estate.
The most common form of borrowing is from a bank. On a conventional mortgage the bank will loan 80% of the purchase of residential real estate. This means you only need to pay $20,000 for a property worth $100,000. The loan of $80,000 is the leverage. If the property appreciates to $120,000 in a few years, then you made $20,000 on a $20,000 investment. That is a 100% return or doubling your money. Note that the return is larger because of the previous mentioned topics.
There are special programs like the FHA loan and VA loan that allow for even more leverage.
Bottom Line
This article just scratches the surface in the world of real estate investing, but the topics covered are applicable to most real estate investing. It is the reason why a lot of investors really love real estate. It offers a lot of tax advantages and is a powerful wealth building tool.
A lot of people start out with a single-family residence and move up from there, but it is not necessary. There are so many tools and free education online that you can become an expert in any real estate investing niche.
