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Real Estate Investing 101: Benefits of Investing in Real Estate

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Real Estate Investing 101: Benefits of Investing in Real EstateI’m a big fan of investing in real estate.  Although I set money aside in tax advantaged retirement accounts and have other investments, I hope to be able to fully fund my future retirement with income from real estate.  Real estate investing has the potential to create wealth like few other investments can.

Real estate is tangible, it’s real, you can touch it, and you can move into it yourself if times get rough.  Real estate investing definitely has its risks and may not be appropriate for everyone, but the benefits of investing in real estate can be great.

This article discusses both the pros and cons of investing in residential rental real estate.

Advantages of Rental Real Estate Investing

There are many advantages to investing in real estate.  Here are some of them:

1.  Tax Benefits

How many investments are you familiar with that allow you to do the following?

  • Deduct most or all of your expenses of ownership
  • Depreciate your investment
  • Receive a full step up in tax basis at death.
  • Deduct losses when selling
  • Exchange your investment property for a different investment property without having to recognize any gain

Although not all of these tax benefits are unique to rental real estate (and some apply to many different investments), I can’t think of many other investments that offer you all of these tax benefits.

Be aware that US tax laws are quite complicated and it is impossible to discuss every tax nuance of real estate investing in an article such as this.  If appropriate, seek out the assistance of an appropriate financial advisor or attorney who can help you with these issues.  Learning a few tax planning basics on your own can also go a long way.

Tax Deductions

If you invest in a residential rental property, you may be able to deduct expenses such as the following:

  • Interest
  • Property Taxes
  • Repairs
  • Maintenance
  • HOA Fees
  • Property Management Fees
  • Insurance

Depreciation

Depreciation generally assumes that an asset decreases in value over its useful life, which the US government has decided is 27.5 years for residential real estate.  The truth is, however, real estate generally lasts much longer than 27.5 years, and your property may very well be increasing in value while you receive a tax benefit because of depreciation.

Although many real estate investors have properties that cash flow (i.e. cash inflows exceed cash outflows), they may not pay any taxes on the rental income for nearly 30 years due to depreciation.  They may be making money each month but on paper they are losing money each month due to depreciation, so they receive a tax loss on their tax return that may decrease their tax liability.

Step up in Basis at Death

Be aware though that as you depreciate your rental property, your tax basis will decrease.  This will likely increase any future gains (difference between the sales price and your tax basis) you recognize if you sell your property.

Fortunately, there is a way around this—hold the property until you die.  If you hold a property until you die, your estate or heirs will receive a full step up in tax basis equal to the property’s fair market value.  If you sold a fully depreciated property the week before you died, you could be looking at paying tax on a fairly hefty gain.  However, if you hold it until you die and your heirs sell the property a week after your death, they may not have to pay any tax at all.

Holding a rental real estate property until death may allow you to enjoy the tax benefits of depreciation without ever having to pay any of it back.  Since real estate is quite illiquid and there are high transaction costs associated with frequently buying and selling properties, it may be in your best interest to hold your real estate for a long time anyway.

Like Kind Exchange

Let’s say you decide to hold your rental property for a long time; however, you wish that you could exchange it for a different property.  Perhaps you want to upgrade or maybe you want one closer to home.

A 1031 exchange, also known as a like kind exchange, may allow you to exchange one investment property for another investment property and pay no taxes at the time of the transaction, assuming certain conditions are met.

2.  Inflation Hedge & Appreciation

Real estate may go up or down in value in any given year.  However, real estate is seen as a good hedge against inflation; that is, its value and also rent potential tends to increase over time with inflation.

Although corrections in the real estate market are needed from time to time, I can’t image the price of most real estate in the US going down in value over a long period of time for the following reasons:

  • The population of the US continues to go up, requiring additional housing
  • The cost of building homes tends to increase as the cost of raw materials increases.
  • The amount of land/real estate in the US is fixed.  Unless we try and take over Canada, the amount of land available to people in the U.S. will not change.

Similarly, in any given year rents may increase or decrease, but over time, rents tend to increase.  This generally works in your favour if you own a rental property.  Fixed income investments such as bonds or CDs generally don’t have such a benefit.

3.  Leverage

Leverage is basically a fancy word for purchasing property using someone else’s money.  Leverage has the ability to significantly magnify your overall returns (or losses), since you are investing using borrowed money.

Even though you are using someone else’s money, you get to keep all of the cash flow and appreciation–you don’t have to share it with your lender.

For example, let’s say you have $10,000 to invest.  You are debating whether to invest it in the stock market or use it as a down payment to purchase a $100,000 rental property.  If you invest in the stock market and your first year receive a 10% return on your investment, you earned $1,000.  If you invest in real estate and the property increases in value 10%, your property is now worth $10,000 more.

Keep in mind though that leverage can work for you or against you.  It can increase your overall returns; however, it can also increase your overall losses if your investment were to tank.  It is something that should not be taken lightly.

4.  Cash Flow Potential

If you find a property that brings in more money than it costs to own (rental income exceeds your expenses), then that is extra cash in your pocket each month.  This is in addition to any appreciation in value the property may experience.

5.  Diversification

Investing in real estate can be a great way to diversify your investments.  I like the thought that although the stock market may tank, there is a good chance that I will still receive the same monthly rent checks from tenants.

6.  Tenants Pay Off the Mortgage

When I purchase a rental real estate property, I generally have a mortgage attached to it.  However, my tenants basically pay off the mortgage for me—part of my monthly rent income is used to pay my monthly mortgage payment.  With each mortgage payment, principal is paid off and I increase my equity in the property.

7.  Home Equity Loans

Once you have built up some equity in the property, you may be able to take out a home equity loan to invest in other properties, to use in case of an emergency (rainy day fund), etc.

Disadvantages of Real Estate Investing

I’ve already pointed out that I am a big fan of real estate investing and have discussed some of its amazing benefits.  However, it’s important to also understand the disadvantages and cons of investing in real estate, because they do exist.  Some real estate agents and mortgage lenders are quick to point out real estate’s virtues but are a little slower in pointing out the downsides of investing in real estate.  It’s important to understand both.  Below are some of the main disadvantages of investing in real estate:

1.  Illiquidity

You generally cannot quickly and cheaply convert real estate to cash like you can a publicly traded stock or a mutual fund.  Real estate can take a long time to sell if you want to get a good price for it.

2.  High Transaction Costs

There are a lot of fees involved with buying and selling real estate.  For this reason it may not make sense to purchase a property unless you plan on holding it for a while.

Additionally, there aren’t many opportunities to dollar cost average with rental real estate.  If you buy when the market is high or sell when the market is low, you could take a big financial hit.

3.  Work & Stress

It takes a lot of work to properly research which property to buy, take out a mortgage, and purchase the property.  If you actively manage the property yourself, you also have to deal with finding tenants, making repairs, dealing with complaints, etc.  It can be stressful.

4.  Bad Tenants

Bad tenants can be a nightmare.  They can destroy your property, not pay their rent, have ridiculous requests demands, and even try and sue you.

5.  Taxes

Wait, I thought you said there were a lot of tax benefits associated with real estate?  There are, but there are also some tax disadvantages that you should be aware of:

  • In certain cases, you may not receive all of the tax benefits discussed above.  For example, the passive activity loss rules, alternative minimum tax, mortgage interest limitation, and other tax rules may defer or eliminate certain tax benefits of real estate ownership.  Additionally, tax benefits may vary depending on whether a property is your personal residence or some type of investment property or vacation home.
  • Depreciation may lower your tax liability but it also reduces your basis in your property.  If you sell your property at a gain, the value of any deductions you were able to take in the past may be offset by gains you may have to recognize when you sell.

6.  Real Estate May Decrease in Value

A lot of real estate goes up in value over time.  In any given year, real estate may increase or decrease in value, but over long periods of time, a lot of real estate increases in value.  However, there are always exceptions.

7.  Leverage

Leverage has the potential to magnify not just gains but losses as well.

8.  Private Mortgage Insurance

Private Mortgage Insurance, or PMI, may be charged if you don’t put down at least a 20% down payment.  You can later have PMI removed once you have paid down enough of your mortgage.

9.  Concentrated Portfolio

Real estate can be quite expensive.  As a result, many real estate investors are not as diversified as they may like to be.  Let’s say you have $400,000 to invest.  If you purchase two properties worth $200,000 each and an earthquake destroys one of them, you may take an enormous hit to your portfolio (assuming you don’t have any sort of earthquake insurance, which can be prohibitively expensive).

Now let’s assume that you instead took that $400,000 and invested it in 10 different mutual funds.  You are likely indirectly investing in hundreds if not thousands of different companies.  If an earthquake destroys the factory of one of the companies held by a mutual fund, your financial hit will likely be minimal.

10.  Personal Liability

We live in a very litigious society.  If someone were to injure themselves on your property, you could potentially be sued.

Obtaining homeowners insurance and personal liability insurance and setting up an appropriate legal entity, such as an LLC, may help reduce your risk.

11.  Costly

Real estate can be expensive to own.  Take repairs and maintenance for example.  Some repairs and maintenance are cheap and fairly routine.  Others may be unexpected and very costly.

One of the biggest costs of rental real estate can be vacancies.  Whenever you don’t have a paying tenant, you are personally paying the mortgage and any other expenses of ownership (on top of any expenses of your personal residence).

Options for Investing in Real Estate

As you can see, there are many, many benefits to investing in real estate.  Real estate investing can create wealth like few other assets can.  However, there are also many downsides and pitfalls to investing in real estate as well.  Before diving in, make sure you know how to be a successful landlord.

If you aren’t interested in direct ownership of real estate, you can also consider indirect ownership, such as through a REIT (real estate investment trust).  You can generally purchase REITs in a brokerage account or IRA.

Additional Real Estate Investing Tips

For additional information about investing in real estate, check out one or both of the below books:

What are your thoughts about real estate investing?  Is investing in real estate right for you?  Leave a comment below!

Image: SirArmstrong/Bigstock

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