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Little Boxes on the Hillside
In a previous post, I highlighted some of the non-technical, non-financial reasons I love real estate for financial independence. Those were some of the “common sense” reasons which make real estate an attractive option for investment income.
But there’s many more reasons to pick up some rental properties. In this post, I’m going to get a little technical and discuss some of the other reasons why I love real estate as an investment.
Multiple Ways to Make Money
Real estate has more ways to build wealth than any other asset class (that I know of).
Many assets have one or more of the following money-making characteristics but real estate has all of them:
Cashflow. This is what real estate is known for! The monthly “mailbox money” is what earns real estate the label as a passive investment. Land lording is not passive but there are other ways to invest in real estate which are. In short, real estate is one of the best ways to get monthly cashflow.
Equity Capture. Buying a property for far below market value means that you can get a pretty big chunk of equity the moment you sign the papers. It’s not uncommon in my area to capture equity equal to 50-100% of your out of pocket cost with all the foreclosures on the market now.
Appreciation. If you are lucky, your property will go up in value every year. Some areas appreciate faster than others but generally you can expect appreciation to keep pace with inflation. When evaluating a potential investment, I would never include appreciation in my analysis since it’s entirely out of your control. Appreciation, if you get any, is the icing on the cake. The cashflow and equity capture is the cake. Never forget that!
Principle Pay-down. If you have a mortgage on the property, part of your payment goes towards the principle. As your renters pay you – and you pay the bank – your loan balance gets smaller and smaller over time. When you sell the property, you can put this extra money in your pocket.
Ridiculous Tax Benefits
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Hi, I'm your landlord... And your senator.
As an investment, real estate has some crazy tax benefits. I don’t know if its because so many of our congressmen are real estate investors, but no other asset class gets the same kind of tax treatment as real estate.
Note: I’m not an accountant – I just play one on TV (Note: no, I don’t.) I’m not a tax professional but I know enough to be dangerous. Tax laws are constantly changing so always check with a professional before making tax decisions.
Depreciation
Normally when a business incurs an expense, it goes directly against their income for calculating taxes.
$4000 income
$3000 expenses
= $1000 net income
Well, because your rental property is used, but not consumed, as a part of doing business, you can deduct a portion of its cost over each year of its useful life. According to the IRS, your rental property has an expected lifespan of 27.5 years which means that you can claim as an expense 1/27.5 of the cost of the building and improvements. You can’t depreciate the land, however. Apparently dirt never wears out.
As an example, let’s say you purchased a house for $100,000. This makes your cost basis $100k (plus some closing costs).
According to the tax appraiser, the building is worth 75k and the land is worth 25k so that leaves us with 75k as the depreciable basis.
To calculate your depreciation,
$75,000 divided by
27.5 years
= $2,727.27 depreciation expense per year.
If your cashflow is $200/mo ($2400/year), this means you won’t pay any taxes on that income for the next 27.5 years. You can even use the extra $327 and change to reduce taxes you pay from your day job (within limits).
Depreciation is actually tax-deferral, not tax-avoidance. When you claim depreciation, you have to adjust the cost basis of the property to reflect it’s loss of value over time. Since the cost basis is what determines how much tax you pay on the sale, you will pay more taxes when you sell if you held the property for several years.
It’s still beneficial to take depreciation since the tax rate on the sale will likely be the capital gains tax rate whereas the income from your property would have been taxed at your ordinary income rate.
Exchanges
Speaking of tax-deferral, with real estate you have access to this crazy mechanism called a 1031 “like-kind ” exchange. The name comes from the section of the tax code it’s defined in, but essentially it allows you to defer taxes on the sale of a property if you use the money to buy another property.
For example, let’s take our $100,000 house. If you held the property for 5 years and sold it for $120,000, that would result in a capital gain of $20,000. It would actually be higher because of depreciation but we will ignore that for now. After paying taxes on that 20 grand you could go throw a big party (as long as you invite me Image may be NSFW.
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) but instead, you could roll it into another property and defer paying taxes. You hand the $20k to a “qualified custodian” and you have 45 days to identify a new property and 180 days to purchase it.
If you successfully identify and purchase a property, then hooray! You’ve deferred paying those taxes until you sell this new property, where you will pay taxes on the old sale and the new one.
What if, after a few years, you 1031 exchange this new property into another one? You guessed it: you won’t pay taxes on that sale either. You can do this for as long as you like, kicking the tax can down the road. And when you die and leave the property to your heirs, the basis gets stepped up to the market value and those taxes get erased. I’d congratulate you, but alas… you’re dead.
That’s Probably Enough
I’ve got to save some for part 3 but if you’ve gotten this far, you can probably see why owning real estate can be a fantastic way to build wealth and investment income for financial freedom. There’s still plenty of great reasons so stay tuned!