Are You Taking Advantage Of These 5 Benefits?
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DISCOVER 5 REASONS WHY REAL ESTATE IS AN IDEAL INVESTMENT
Are You Taking Advantage Of These 5 Benefits?
A few years ago my wife and I were driving on our way home from a vacation. We checked her company stock and it had dropped from $60 per share to $35. That was probably the worst re-entry we ever had following a vacation. The stock in the company my wife worked for lost almost half of its value in one week. And her 401(k) was heavily invested in it.
Have you ever had a stock investment that kept going up, and then one week it dropped like a roller coaster? Were you concerned that losses would erase all of your gains and some of your principal? Does this make you question the amount of risk you are actually taking?
Are you concerned about the loss of purchasing power due to inflation over the last few years?
Do you wish there was a way to shelter more of your income from taxes?
If you answered “yes” to at least one of the questions above then read on and learn why real estate has been the vehicle of choice by many for building wealth and creating additional income.
But what features make it a great investment? And how do you take advantage of those features to maximize your returns?
Here’s a quick look at what those five features are.
The first letters spell the word I.D.E.A.L. Learn about each of these and see why real estate is an “IDEAL” investment.
Income is the first feature typically sought from a property held for investment. The property should produce regular, reliable income. This is the net income, after expenses such as taxes, insurance, management, utilities and repairs. It should also be enough to cover the mortgage. Note that income is taxed at ordinary income tax rates.
Net income can be increased by making improvements that make the property more attractive. This might be turning a C-class apartment into a B-class apartment by sprucing up the grounds and interiors. Or it might be renovating a house that was in foreclosure.
Expenses can be reduced with effective property management and preventive maintenance. Property taxes can be appealed and insurance can be shopped for more competitive rates.
Net Income also increases over time with inflation. As market rents go up the net income will follow. Although taxes and maintenance costs increase with inflation, the principal and interest paid on the mortgage typically remain constant. So the increases in net income can outpace inflation.
Some stocks are income-producing and distribute dividends, but they do not enjoy the next benefit, depreciation.
Depreciation is a tax reduction strategy. The IRS requires owners of investment properties to account for the deterioration or wear and tear on the buildings each year. This is called depreciation.
Although real estate increases in value, the IRS permits us to write off the cost of improvements over time, reducing our taxable income. Since taxes are the second greatest threat to your wealth it pays to know how to use the tax code to your advantage.
Depreciation can be used to offset income from the property and, in some cases, other income as well. It is not uncommon for depreciation to offset the taxable income. Residential properties can be depreciated over 27 ½ years, while commercial properties can be depreciated over 39 years. It is only allowed on the improvements, not on the land.
The allowance can be higher if you choose to break out components with a shorter useful life. This is very common on commercial properties through the use of a cost segregation study.
Again, traditional stock and bond and mutual fund investing cannot take advantage of this tax benefit.
Equity is the market value of the property less any mortgages and liens. It may be obtained by buying at a discount or created over time as inflation increases the value of the property. Equity can also be created by taking a “junker” house and improving it to a “jewel” for rental or sale.
The market value for single family homes is driven by comparable sales in the neighborhood, which may be obtained from a Realtor. However, for commercial properties, it is driven by the net income the property produces and market CAP rate, or capitalization rate. So a significant amount of equity can be created in a commercial property by improving its appearance, appeal, occupancy and rent in addition to reducing expenses. The increase in value resulting from improvements is called forced appreciation.
How much control do we have over creating “equity” in our traditional investments such as stocks or bonds? With real estate we do have a level of control over the growth of our equity.
If a property is sold the gain in equity is taxed at capital gains tax rates. If the property is held for at least 12 months the rates currently range from 0 to 20 percent, depending on your tax bracket. Unlike stocks, the gain from real estate can be rolled into another property and the tax liability deferred by using a 1031 Exchange. This is like trading houses for a hotel in Monopoly.
Amortization is the reduction of a mortgage balance over time as it is paid for by the tenants. In the early years most of the payment is interest. The interest paid is deductible as a business expense. Over the life of the loan an increasing portion of the payment is allocated to paying down the principal and becomes additional equity.
This is yet another benefit that is not available with most traditional investments.
Leverage is the feature that makes real estate a very powerful investment.
You don’t need $100,000 cash to buy a $100,000 investment. A good house can typically be purchased with a conventional loan for 20-30 percent down. Using creative financing techniques this can be done for less, but we’ll stick with the conventional down payment as an example. This enables you to enjoy the gains of a $100,000 asset with only $25,000 cash.
Now this house you purchased for $100,000 increases in value to $125,000 over the next several years. That’s an increase of 25-percent. But you only put $25,000 down, so your equity has doubled and created a 100-percent gain over time. We can do the same thing with commercial properties.
These five attributes make real estate an IDEAL investment. They include income, depreciation, equity buildup, amortization, and leverage. These can be combined to make a particular investment better. And while you may be able to maximize some attributes, it is not usually possible to maximize all attributes in a given investment. It is the sum of these attributes that creates our total return.
Since that vacation a few years ago we have chosen to diversify our portfolio further, selling some stock and purchasing additional real estate.
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Mike is a retired aerospace engineer with a passion for real estate investing and teaching financial literacy. He lives with his wife in Daytona Beach, Florida.