Investing in real estate offers you a set of key advantages that you won’t get with any other asset class. They’re what make real estate investing IDEAL (an acronym that’s been floating around for at least twenty-five years).
IDEAL refers to the different ways real estate investing can help you accumulate profits and get rich:
- Add a steady stream of income
- Tax deductions for rental property depreciation
- Increased equity
- Property appreciation
Any one of these would make real estate holdings a valuable addition to any portfolio, and all five in one shot offer you accelerated wealth-building potential.
1. Add A Steady Stream of Income
Investing in real estate is one of the best ways to add a steady stream of income to your budget, whether you own physical properties or REIT (real estate investment trust) shares. Historically, real estate assets tend to generate constant, reliable income, largely due to rent payments.
For people looking toward retirement, this secure income stream can eventually replace salary; other commonly held retirement investments (such as stocks) don’t hold the same promise. Building a portfolio of real estate investments can bring in cash flow from multiple sources, reducing your risk of falling short should any single investment run into problems.
How does real estate–based income (not including growth or appreciation) compare to other types of investments? Consider this: as of December 2018, the dividend yield on the S&P 500 was 1.9 percent. The yield on a twenty-year Treasury bond was 3.01 percent. Yields on REITs easily topped 5 percent, with some ranging as high as 8 percent.
If you own a couple of multi-family rental properties or office buildings, each individual unit sends income your way every month. Once you acquire enough properties and stable tenants, you’ll build up a big enough income flow to replace the income from a regular job, so you can retire (no matter how old you are) whenever you want to.
On top of that, you’re also amassing a huge source of untapped wealth. Should you need a large cash infusion for any reason (to pay for unexpected medical bills or to take an around-the-world vacation, for example), each rental property represents a virtual ATM: you can borrow against the equity or sell a property to get the cash you want.
REITs and Funds
REITs (real estate investment trusts) give investors the opportunity to take part in huge commercial, industrial, and residential real estate deals. Because of their special tax-advantaged structure, REITs are required to pay out the lion’s share of their profits as dividends to shareholders—a guaranteed income stream.
Real estate mutual funds and exchange-traded funds typically hold shares in REITs, and often pass at least a portion of those dividends along to shareholders. With funds, you’ll typically have the choice of reinvesting those dividends to buy up more shares or receiving them as cash payouts.
2. Tax Deductions for Rental Property Depreciation
Depreciation is a special accounting expense that tracks the decline in asset value for things like wear and tear. For most assets, this makes sense: cars lose value as soon as they drive off the lot; machines in use for ten years start to break down.
Most assets don’t last forever. But for real estate, where the value of properties can just as easily increase, depreciation offers a rare beneficial disconnect: an expense on paper that transforms into real-life cash.
Not only does it reduce the taxable profits on your real estate investment asset, it may also offset a portion of your other income (this is a tricky tax area, so work with a qualified CPA to take full advantage).
For example, if you had one property that ended up with a tax loss due to depreciation, and another property that produced taxable income, the loss from the first property could be used to decrease the profit from the second property.
This tax jackpot works for indirect real estate investing (funds and REITs, for example) as well, though not in quite the same way for the investor. For example, because depreciation is not a cash expense, REITs appear to pay out more income than they earn, a boon to investors.
How It Works
Depreciation reduces income annually for tax and accounting purposes but unlike most other expenses it has nothing to do with actually spending money. This paper expense is based on the “useful life” of your investment property, which the IRS has determined as twenty-seven-and-a-half years.
During that time, a portion (determined by IRS depreciation tables) of the property gets deducted from rental income, reducing the income tax bill.
That translates into more available cash for the investor. Here’s a simplified example: say you had taxable rental profits of $100,000 this year, depreciation expenses of $10,000, and the applicable income tax rate was 20 percent.
Without depreciation, you’d pay $20,000 in taxes (20 percent × $100,000). After deducting the depreciation expenses, the taxable income would be $90,000, and you’d owe $18,000 in taxes (20 percent × $90,000), a cash savings of $2,000.
Other types of real estate investments, including mutual funds and REITs, also get the benefit of depreciation expense. They pass those tax savings along to investors either through higher dividends or increased value.
The Recapture Trap
The depreciation advantage comes with a catch: when you sell the property, you have to “recapture” the depreciation expense you took. This can lead to a substantial tax bill in the year you sell. In addition to any regular capital gains taxes on the sale, you’d also have to pay your regular income tax rate (almost always higher) on the depreciation recapture.
So if you had a gain on the sale of your investment property (your property sold for more than you paid), you’d pay tax on that at the lower capital gains rate.
On top of that, you’d also pay tax at your regular income tax rate (which topped out at 37 percent in 2018) on the total depreciation deductions you’d taken over the years.
3. Increased Equity
Equity refers to the portion of the property that you own fully; it’s the value of your property minus any outstanding mortgage debt. As you pay down the mortgage loan, your equity (your ownership percentage) increases. At the same time, property values tend to rise (at least over the long haul), which also adds to your equity. As your equity increases, you can use it to build even more wealth.
For example, you can borrow against existing equity to create a down payment for your next investment property. While that temporarily decreases your ownership stake in the original property, you still have the same total equity—but now you have two income-producing properties to show for it.
This also holds true for the underlying properties in indirect real estate investments like REITs. The holding company can use these methods strategically to maximize the value of its holdings and your investment.
There are two ways property values climb: one you can’t control, the other you can. The housing market, both generally and in your property area, rises and falls and your property’s value will probably ride right along with it. With the luxury of time, you can ride out the down trends until the market is ready for another upswing—and with real estate, it’s only a matter of time before that happens.
The second way is to improve your property. Whether the changes you make are substantive, minor, or cosmetic, sprucing up the property will generally increase its market value, and possibly also its income-producing abilities.
For example, you can add on more rentable space or make smart renovations that will allow you to increase the sales price and still attract plenty of buyers.
Debt is the other side of the equity coin, reducing your ownership stake. You can accelerate debt paydown by making extra principal payments. Not only will that immediately add to your equity, it will also reduce the interest portion of payments moving forward (interest is calculated based on the outstanding loan balance, so a lower balance means less interest).
When a bigger portion of every payment is going toward principal, your equity will grow faster. With rental properties, the income you receive from tenants will cover the mortgage—so those tenants are paying to increase your ownership stake.
4. Property Appreciation
Appreciation, where the value of an asset increases over time, is the opposite of depreciation. Real estate is one of the few physical assets that appreciates, which is one of the main factors making it a desirable investment.
There’s only so much habitable land on the planet. Because land is a finite asset, demand will naturally outstrip supply; when demand outweighs supply, prices increase—it’s basic economics. That doesn’t mean property values increase in a straight line; as we saw back in 2008, they can decline dramatically along with a troubled economy.
Property values in different areas rise and fall in their own time. But overall, real estate values in the United States tend to appreciate, and that means tax-free growth for you (you don’t pay taxes on appreciation until you sell, and never if you don’t sell).
Supply and demand play a key role in real estate value: when end-user demand (more people want to buy houses) is higher than supply (houses for sale), market values rise, and the opposite holds true as well.
Changes in an area can also drive demand, such as the arrival of new employers and shopping areas or changes in zoning laws. Real estate investors can track these trends using websites like Realtor.com (www.realtor.com), giving them a clearer picture of what’s up and coming and which areas are cooling off.
Inflation is a key factor that plays a role in real estate appreciation. Over time, inflation pushes up the cost of almost everything. That includes the materials needed to build, renovate, and repair homes or develop land, and real estate values as well. Over the long run, real estate values have at least kept up with inflation, often outpacing it (depending on the specific area).
One of the biggest advantages of real estate investing is the ability to use leverage: putting in only a little of your money and borrowing the rest to buy property.
By coming up with a down payment and taking out a mortgage for the balance, you can invest in real estate for as little as 3.5 percent of the purchase price—a fraction of the cost. That means only a small amount of your money is tied up, but you still benefit as if you owned the whole property outright.
You keep all of the income (like rent) the property generates. You claim all of the tax write-offs. You reap the rewards of soaring real estate prices. You gain all those advantages with just a small investment, which leaves the rest of your money free to invest elsewhere. It’s an important part of building significant wealth: using leverage to buy income-producing real estate assets.
Using Leverage to Create Cash Flow
Unlike other types of investments, direct investment in real estate (other than quick flips) gives you access to tax-free funds when you need to increase cash flow (money coming in) but not income. Here’s how it works (and it works especially well with rental properties): you borrow money against the equity in your property, giving you access to the amount of cash you need.
Because it’s a rental property, the interest portion of loan payments is tax-deductible, lowering your overall tax bill. At the same time, rent paid by your tenants covers the loan payments over time. This works especially well with:
- Properties that are completely or mostly paid off
- Rental properties that have stable tenants in long-term leases
- Fixed-rate loans
As long as the rental income (and your cash reserves) remains strong enough to cover the loan payments, you have access to tax-free cash flow when you need it.