Rental real estate offers appealing benefits and the opportunity to diversify out of the rollercoaster stock market. And Guaranteed Rate is offering a discount on loan fees to our investor clients. If you’ve ever considered investing in real estate, read on…
Different types of investing
All real estate is an investment in something. Buying a primary residence is an investment in security, stability and lifestyle. A vacation home purchase is an investment in your lifestyle. An rental property is nearly always, first and foremost, a financial investment.
Benefits of real estate as an investment
The financial benefits of real estate as an investment fall into four categories:
• Tax Benefits
• Cash Flow
Like any other investment class, real estate can lose value. Over the long term, however, real estate values tend to rise. From 1996 to 2018, the Portland-Vancouver-Hillsboro MSA residential real estate has averaged 5.6288% appreciation (source: Case-Shiller).
How does that compare to the stock market? It’s actually fairly lackluster. Over the same period of time, the Dow Jones Industrial Average returned 9.5% and the S&P 500 returned 8.73% (Source: S&P).
Why invest in real estate then? In a word: leverage.
Real estate is a simple ways to take advantage of the amplifying power of investing with borrowed funds. With a proportionately small capital contribution of your own funds, you control the the entire asset — and you own its appreciation.
A 25% down payment on an investment property that appreciates at 5% rate yields a first-year return of 20%.
Leverage carries risk
Using leverage (debt) to purchase an asset carries risks:
Debt service: Failure to pay the payment results in foreclosure and the loss of all funds invested.
Amplified losses: Just as gains are amplified, so are losses. A poorly timed purchase and sale can lead to significant losses. Holding property for a longer period may even out out the natural ups and downs of the marketplace.
Real estate offers numerous tax benefits. To understand how real estate would fit into your tax situation, you’ll want to talk to your CPA or other qualified tax professional (your author knows just enough to be dangerous!). A few topics to add to your list of questions for this meeting include:
From a tax standpoint, a rental property is similar to a small business. You will report your rental income and related expenses to the IRS on a Schedule E (or Form 8825).
The expenses you can write off include all of your real-world costs, such as repairs, taxes, insurance, interest and utilities (things for which you actually wrote checks). In addition, IRS rules allow you to write off the assets put into business use over time. This recapture of capital is called depreciation.
The value of a residential building can be depreciated over 27.5 years, land improvements (garage, landscaping, fence, sidewalk, etc.) over 15 years and personal property (appliances, tools, computers) over 5 years.
The depreciation write-off permitted can offset some or all of the profit from a rental, sheltering it from income tax. Note that real estate income and losses are “passive” under IRS rules which will impact when and how you can claim losses. And the depreciation you’ve claimed can be subject to a “recapture” tax when you sell.
Special write-offs for short term rentals
AirBNB hosts and other owners of furnished short-term rentals may benefit from a a rule established by Tax Cuts and Job Act (TCJA) that expands what are called “Section 179” deductions, permitting the deduction of the entire cost of personal property used to furnish lodgings the year it is put into service.
Qualified Business Income from pass-through entities
The TCJA established a deduction for owners of pass-through business entities like LLCs, S Corporations and Partnerships, frequently used to own real estate. A deduction of 20% of “qualified business income” (QBI) may generally be taken. It may not yet be clear if the QBI deduction can offset rental profits, but be sure and ask your tax professional.
Investment real estate is eligible for a tax-deferred exchange. Also known as a “1031” exchange, these special rules allow you to sell one or more rental properties and defer paying tax on the capital gains realized, so long as you reinvest the proceeds into a like-kind replacement property and follow a few other rules.
Real estate left to heirs is inherited at a “stepped-up” tax basis equal to the value of the property at the time you pass away. No matter how much your capital gains were, your heirs should be able sell with no capital gains tax due.
As your equity in a rental property grows, you may be able to borrow against it by refinancing or taking out a second mortgage or home equity line of credit. Such loans increase your leverage (see above) and should not be subject to tax, as you are borrowing against, not realizing gains.
The secret to financial independence is passive income cash flow. Unless you are lucky and inherit wealth, to retire you’ll need to convert the income you earn while you are working into assets that will generate passive income to support you when you are not working. Investment real estate is an asset that can generate passive income as your tenants pay you rent.
Any source of passive retirement income that does not outpace inflation will shrink in real terms over time — buying less and less as inflation eats into your spending power. Rent, in most cases, tends to increase over time as the cost of living rises, giving it the potential to be somewhat naturally inflation-indexed.
Amortization is the process of paying off debt over time through regular monthly payments. With each monthly payment, the principal balance of your mortgage shrinks. If all is going as planned, your renters are making this happen. Your planning around your rental property can include managing the amortization schedule to pay off upon retirement or to fund college or other cash flow need.
Consider the risks
As with any investment, there are risks to keep in mind. There is no guarantee that the property you buy will appreciate. And relative to more traditional investment vehicles, real estate offers a few clear disadvantages:
It is less liquid. With stocks, you can hop online, click “sell” and you’ll have money in your account in a few days.
Higher transactions costs
When you hop online and click “sell” the transaction fees are nominal — may be just $10 at a discount broker. Buying, financing and selling real estate costs thousands of dollars that you’ll likely need to spread out over time.
Diversifying your investments is a time-honored strategy to manage risk. An investments doesn’t get much less diverse than a single property on a single street in a single city. Be sure and discuss your overall investment goals with a qualified professional and see how real estate fits into the bigger picture.
Traditional investments in mutual funds, stocks and the like require very little effort. Once you own them, you can hang out and wait for your monthly statement to arrive. Real estate has to be managed, either by you or a manager. If you hire a manager, you still have to communicate with them and make decisions about your property.
It’s hard to imagine a scenario where you would be sued for owning a shares in a stock or mutual fund. This is not so with real estate. Managing the risks inherent with owning investment real estate can take many forms, including extra insurance (landlord, earthquake and/or umbrella policies) and possibly forming a Limited Liability Corporation to hold title to your rental. Again, be sure you consult with appropriate professionals.
Is a real estate investment right for you?
Investing in real estate is not for everyone. If you’d like to get started exploring whether rental real estate is a good fit for you and your financial goals, email (email@example.com) or call (503-799-3711) any time.
We can help you learn about financing options and determine the amount you can qualify to borrow. You can then share this information with the rest of your financial team (investment advisor, tax preparer, insurance agent, attorney, real estate broker). What you learn may put you on the path to owning investment real estate of your own.
Investment Property Loan Bonus
On October 26, 2018 Guaranteed Rate announced an investment property pricing bonus. New rate locks on Fannie Mae and Freddie Mac loans for rental property financing may be eligible for a 0.375% of the loan amount reduction in fees. To qualify you must borrow a conforming loan amount at a fixed rate with at least 20% down. Your debt-to-income ratio must be below 45% and your credit score must be at least 680.
So be sure and give us a call when you decide to buy your first (or next) investment property.
About the author, Julee Felsman:
I have been a residential loan officer for 24 years and have owned residential investment property in Portland, OR and Vancouver, WA for 20 years. With my partner, I currently own 44 rental units in 9 buildings. Over the years, I’ve been privileged to serve many investor clients and work alongside real estate brokers with investment property expertise. The information I’ve shared in this post is drawn from personal experience, collaboration with clients and their brokers, observation and research. I’m not an investment advisor, qualified tax expert, attorney or insurance agent. Also (and alas), I don’t own a crystal ball. All investments carry no guarantee of gain and the risk of loss. Please consider your investment options carefully and seek the advice of qualified professionals before making the decision to buy rental real estate.
All information provided in this publication is for informational and educational purposes only, and in no way is any of the content contained herein to be construed as financial, investment, or legal advice or instruction. Guaranteed Rate, Inc. does not guarantee the quality, accuracy, completeness or timelines of the information in this publication. While efforts are made to verify the information provided, the information should not be assumed to be error free. Some information in the publication may have been provided by third parties and has not necessarily been verified by Guaranteed Rate, Inc. Guaranteed Rate, Inc. its affiliates and subsidiaries do not assume any liability for the information contained herein, be it direct, indirect, consequential, special, or exemplary, or other damages whatsoever and howsoever caused, arising out of or in connection with the use of this publication or in reliance on the information, including any personal or pecuniary loss, whether the action is in contract, tort (including negligence) or other tortious action.