Real Estate Investing is a good option for your hard-earned money to grow. Especially when you're nearing your retirement. You'd want to keep growing your wealth to live a lifestyle you want or maybe entrust your family with wealth that will ensure their future. To help you set off your real estate investment here are:
10 Things You Should Know About Real Estate Investing
To start off, we'll compare Real Estate to other wealth-creation options you have. These wealth-creation options vary differently but all offer the same goal of creating wealth for you. Exploring your options before going into real estate is a wise decision because real estate may not be your field of expertise or there are more options that are suitable for you.
1) "Potential" Tax Advantage
If you're still considering investing in real estate then you should know that it has many tax benefits compared to others. Here are the tax benefits you get for investing in real estate:
- Capital Gains - Depending in your tax bracket, your long-term capital gains may range from 0% - 20%. This is relatively lower compared to common income tax rates.
- Rental Income - Rental income is not subjected to social security and Medicare taxes. In a salaried income job, you have to pay Medicare taxes. This could range from 7.5% to 15.5%. But when the money is earned through a rental income, you don't have to pay any Medicare taxes at all!
- Appreciation - There is no tax on real estate appreciation. Which means you can buy and hold a real estate property without incurring any tax by the IRS. So it might be a good strategy to buy and hold on real estate properties and wait for their value to go up.
- Depreciation - Depreciation is when an asset wears down or is declining of value. Depreciation expense can help cut your taxes and help you save money. However, when you try and sell the property, the IRS will likely have you compensate for the depreciation and pay taxes on it which is usually at 25%.
- Live-in Flips - If you want to avoid capital gains tax then just move into the house you bought as your principal residence. As long as you live in the house for at least 2 years in the next 5 years, you'll be exempted from tax. You can have a potential tax-free profit of up to $250,000 to $500,000 if you're living as a couple.
- Installment Sales - installment sales are only available to property investors. It allows them to defer capital gains. However, the total amount of depreciation needs to be recaptured at the time of sale. It helps sellers escape high tax brackets by dividing the income in years. Instead of paying taxes off a huge profit in one year, the seller only pays taxes depending on the profit received each year.
- Tax-Free Borrowing - you can use your real estate to pull capital out tax-free through refinancing. Because refinancing funds are technically borrowed money, you won't be paying any taxes. However, it also comes with risk since you're getting yourself in debt. Make sure you choose to refinance with viable options like fixed interest, low rates, or long amortization.
- Tax-Free Exchange - You can use 1031 tax-free exchange to avoid capital tax gains. This option is only available for investors and not for house flippers. 1031 exchange allows you to exchange your property for another property and it's all tax-free! However, there are specific rules that you need to follow during the procedure.
- Self-Directed IRAs - You can actually use your IRA and 401k accounts to invest in real estates like traditional investments such as stocks, bonds, and mutual funds. Although there are risks and the rules are very strict which could result in large penalties or disqualify your account from tax-free status.
- Death - If you want to leave your heirs free of capital gains tax or recaptured depreciation, then you could keep your real estate until you die. This helps your heirs sell the property without paying capital gains tax.
2) Investing for Retirement
Real estate is a really great investment option for your retirement. There are different options you can engage in real estate even without that much funds in your name. You can engage in tapping the equity in your home, REITs, crowdfunding, rental properties, or owning real estate property for vacation which you can advertise on a website like airbnb.com.
Real estate gives you very versatile and flexible options in how you would invest for your retirement. Like all other investment retirement options, you also need to be knowledgeable of it. So before considering real estate, you should also widen your knowledge of it.
3) Real Estate vs Stocks
Before we start comparing these two options for investment, let's clarify that there is no better option for investment. It all comes down to the effort you put into your investment and a little bit of luck.
First off, we need to define these two investing options.
Real Estate - The buying of land or property. It's up to the owner what to do with it. You can renovate it or wait for prices to go up and then sell it. You can also generate income from it through renting it for commercial or domestic use.
Stocks - The buying of shares of stocks. Stocks are a part of a company. The company could be involved in different fields like medical, agriculture, mining, mobile technology, and etc… and you're entitled a share of the profit. Among the stockholders, there are select people who are elected as Board of Directors. They oversee the management group and decides how much of the yearly profit gets allocated for expansion and given back to stockholders as cash dividends.
How Do They Compare?
Real Estate is more familiar in general than stocks. Which means you'll have an easier time of gaining knowledge on it compared to stocks.
Real estate is also tangible, which means you can touch it. If it's not making money for you, you can still make use of it by living in it. Also, due to real estate being tangible, you are less likely to get into a fraud. You can inspect the property, make sure that everything in it is accorded, or make the repairs needed.
With stocks, you have to put faith in the management. Leveraging your real estate properties is also a lot safer compared to stocks and real estate is a great defense for inflation as housing prices are historically going up.
The downside of real estate is that you have to put in more work compared to stocks. It will also cost you money in the form of maintenance, estate taxes, renovations, and unoccupied property means no income for you.
Stocks have been a consistently good option for wealth creation in its 100-year history. You don't have to put in much work and actually own a piece of the company. It's also easier to diversify and liquidate.
The downside of it is that stock markets are very hard to predict. Prices may suddenly go up or down and if you're inexperienced may cause you to make emotional decisions.
4) Mutual Funds vs Real Estate
Mutual funds are an investment vehicle consisting of pooled money from different investors with the intent of investing it in stocks, bonds, and other money market instruments.
How Do They Compare?
Real estate gives you more leverage compared to mutual funds but it can also be risky. However, the difference can be quite large depending on the appreciation of a real estate property. So the return of investment is relatively higher in real estates compared to mutual funds.
However, mutual funds are easier to liquidate compared to real estate. It's easier to sell mutual funds (which can take only a day) compared to real estate. The only time real estate is fast to sell is when there is a high demand for it which rarely happens.
Real estate requires you to regularly check on the property for maintenance and repairs in order to maintain its value. Real estate requires you to be hands-on with your investments. On the other hand, mutual funds allow you to sit back and just monitor it from time to time.
There is more liability in real estate investments compared to mutual funds (which has none at all). Single mismanagement of your property may cause accidents with your tenants. This could mean lawsuits which are a loss for your income. That's the reason why real estate investment is a very hands-on option of investment.
5) Real Estate Investment Trusts (REIT) vs Direct Real Estate Investment
REITs are special companies that operate income-producing real estates. This could range from residential homes, commercial buildings, office space, shopping centers, and etc… They were initially created by the federal government. REITs is unique because it needs to pay 90% of its income to shareholders each quarter as a dividend.
Thus, in order for the REIT company to make money, they place income generating business in the real estate properties. The income is then used to pay for the maintenance, mortgage, insurance, taxes, and etc…
Direct real estate is just your traditional way of doing real estate. REITs have an edge over direct real estate in terms of capital needed. Because REIT is a company you only need a small amount of money to invest in it compared to direct real estate. It's the same as buying a stock of a company but not so. In REIT, you're not buying a part of the company but the income it generates. REITs are also easy to liquidate because they're publicly traded. You also don't have to worry about overseeing and managing the properties because the REIT will do it for you. Basically, REIT is a hands-off way of investing in real estate.
The only downside of REITs is that you have no control over the decisions made over the real estate properties and that you don't have any ownership in it.
This is opposite in direct real estate, you have ownership of the real estate property and have control over what to do with it. You also have tax benefits as stated at the beginning of the article.
Still, the downside of direct real estate is that you have to keep it maintained and keep tenants satisfied. It's also very hard to liquidate and takes a long time because of the large capital fund needed.
6) Real Estate Leverage
Leverage is the use of various financial instruments or borrowed capital to increase the potential return of investment - Investopedia. Leverage, if done properly, yields a great return on investment but at the same time is very risky.
An example would be buying a $500, 000 property. Instead of paying fully, you only pay 20% ($100,000) as downpayment and borrow money from the bank or a lender. If the property appreciates by 5% in 12 months, the borrower stands to gain $525,000. Whereas if you used the $100,000 to buy another property worth $100,000 also and it appreciates to 5% in 12 months, you only stand to gain $105,000. The difference would be $20,000.
If it appreciates yearly then you stand to gain a cumulative amount of income. The market is also volatile which could mean that the property could also depreciate which means a loss for you. Hence, the risk.
Leverage if done right is a good payoff but it doesn't have to be all risky. In fact, it's being done by regular folks buying a home while taking a mortgage. While they pay back the loan over time, they also get to enjoy living in the home they bought. Leverage isn't that risky and stressful depending on the intent.
7) Apartment Rental Income
Apartment rental is the most common real estate investment that regular people do. Basically, you let people, called tenants, use your property for a period of time in exchange for money.
Your rental income is also taxed by its average gross annual income. It's called rental tax because a property is being leased. This is quite different from a sales tax. A rental tax has its own benefits.
The IRS allows you to deduct expenses connected with the rental property in terms of:
- Necessary expenses
You can deduct your insurance, mortgage interests, maintenance costs, and repairs in your property.
Owning a rental property also means you need to be active in maintaining and managing it to keep tenants satisfied. A loss of tenant means no income for you so it's important that your rental properties are always occupied.
8) Long-Term Returns
To understand long-term returns of a real estate investment we must discuss the housing market cycle.
The Housing Market Cycle
Recession - is a drastic decline in economic activity for a long period of time. Sectors affected are industrial production, trade, employment, real estate, and etc...
Recovery - is a period in which the economy regains peak employment and output levels are achieved before the recession.
Housing Bubble - is a period of soaring housing prices due to demand, panic, or exuberance.
If you look at this study done in Bay Area Real Estate. Housing prices have been going up and only went down during the dot-com bubble pop and the 2008 financial market crash. But the prices have been increasing.
There are also things you need to consider to predict housing prices. For example, is the cost of living within the area. California's cost of living has been rising lately due to higher taxes and expensive real estate which has seen Californians moving to nearby states like Texas and Arizona. If left unchecked this could cause housing prices to go down because of the decline in its demand.
Hence, the earlier you invest in real estate the better off you'll be in your long-term returns.
9) Real Estate and Technology
The internet has been used conveniently in the real estate business. You can do consultations online. You can even advertise your rental properties online through various social media platforms. There's also REIT companies and crowdfunding real estate websites around the internet.
One really popular advancement in real estate is the Airbnb website. Airbnb lets you advertise your rental property and have customers rate it. It's a great way to spread popularity for your rental property. Do note that most of the properties posted there are for days use only and are usually for travelers or vacation.
10) Your Options in Real Estate
If you want to know more about your options check out my article about Real Estate 101. You can engage in Selling real estate properties, Rental properties, REITs, or Crowdfunding real estates. It doesn't matter if you have a small or large fund you can have varying options depending on your situation.
Overall, real estate is a great retirement investment option to grow your wealth. Properties have been shown to go up in value in the last 30 years and may well continue to do so as its demand keeps increasing.