In the first of this four part series, I talked about using your equity to renovate and update your home. Part two discussed taking your equity out to buy a 2nd home. In the third installment of ways to put your equity to work for you, I will discuss starting an investment portfolio.
Invest in a diversified portfolio – what does this mean?
If you speak with a financial advisor / planner, they will tell you to be diversified. The best ones will tell you that that includes investing in real estate, businesses and other things that they don’t offer. My experience has been that when a financial professional talks about diversifying, they mean within investments that they sell. For instance, you should have some money in the tech sector, some in the healthcare sector, some in international stocks, some in small cap, mid cap, and large cap, some in bonds, etc. I think this is all good advice, but I also think it is extremely important to invest in real estate.
Advantages of investing in real estate
Real estate investing has a few significant advantages over investing in stocks, bonds, and mutual funds. The first among these advantages is leverage. If you buy a house with cash or pay a lot extra each month to pay off your mortgage faster, you reduce or completely eliminate the advantage of leverage. Here’s an example: if you buy a $200,000 investment property for cash and the home appreciates 4% to $208,000, you made a 4% return on investment (plus the tax benefits which I’ll discuss later). If, however, you buy that same investment property with 20% down, you have invested $40,000 (instead of the full $200,000) and you still control / own an asset worth $200,000. Assuming the same appreciation, you’re return on investment is 20% (plus the tax benefits) – 5 times greater than if you had paid cash. If you use the Rule of 72 to figure out how long it would take your money to double, it would take about 18 years in the first scenario and about 3.6 years in the 2nd scenario with leverage. Rental income would come into play as well but I’ll address that later; for this part, I’m just talking about dollars invested and appreciation. Let’s take this a step further, if you had $200,000 in cash to buy one property outright, you could, instead, put 20% down on 5 properties and have $1,000,000 in hard assets. I’ve put together a detailed spreadsheet for (potential) investors to get an understanding of what their numbers can be like – just fill in the yellow highlighted fields to see who real estate investing can help you prepare for retirement: http://thewunderliteam.com/mortgage-calculators/roi-leverage/.
While most financial professionals would tell you to never make a decision based solely on tax benefits, it is important to factor them into the equation. I think that too many people forget about the tax consequences of investing – buy a stock low, sell it high a year or more later and you pay long-term capital gains. If you do that same transaction within a year, you pay ordinary income tax on the gain (unless you are trading in a tax-advantaged account like an IRA). Taxes can have a significant impact on how much you will have for retirement so it is crucial to diversify with regard to tax-advantaged investments as well as across asset classes. Here are some main tax benefits of investing in real estate.
You can depreciate the improved portion of your property. In the above example of investing in a $200,000 home, if the land is worth $50,000 and the home is worth $150,000, then you can depreciate the value of the home over a 27 year period (as of today’s writing). This is a tax write-off of about $5,555 per year. Additionally, you can write off just about everything else associated with the investment except the portion of your mortgage payment that goes to principal. That means you can write of the closing costs, taxes, insurance, marketing expenses to get the home rented and just about everything else. Repairs can either be written off or capitalized depending on the size / scope of the repair. Check with a tax professional to be sure your tax filings are in compliance with the current tax laws.
Defer Capital Gains
The 2nd main tax benefit is the ability to defer capital gains. If you sell a property and have $100,000 in capital gains (depreciation write-offs are included in this), you can defer them by doing a 1031 exchange where you invest all of that money back into real estate of equal or greater value. A $100,000 gain in the sale of stocks would mean you owe the IRS about $20,000 and now the asset you own is that much smaller. If you want, you would never have to pay any taxes because you can continually roll capital gains / all of your money into real estate assets of equal or greater value and it doesn’t matter whether you are invested in residential real estate and decide to get into commercial real estate or the other way around.
2-in-5 Home Sale Gain Exclusion Rule
A 3rd main tax benefit comes in the form of the 2-in-5 Home Sale Gain exclusion rule. An investor can take advantage of this by buying a move-up home and keeping his / her original home as an investment property. If he / she has lived in it for at least two years before moving into the new home, he / she can sell the home within three years of moving out and be exempt from capital gains up to $250,000 for an individual or $500,000 for a married couple filing jointly. This is a great way to help diversify your portfolio once you sell your home – you can take some money and fund your IRA (I like Roth IRAs because while there is no tax benefit on the investment / seed portion, the money coming out / harvest is tax free) and other liquid investments while using a chunk to buy another investment property so that you can take advantage of the first two benefits discussed above. For the record, I recommend fully funding a Roth IRA every year and, if possible, not taking any withdrawals until you are required to – at this point, that is the April 1st after you turn 70.5.
Another benefit of real estate investing is income. Typically, if the income covers the mortgage payment, that’s a good thing. If there is a surplus, that’s a bonus. Here’s my thought on this. I look at real estate investing much like investing in stocks and bonds. Generally, you buy stocks for growth / appreciation and you buy bonds for income. The strategy by financial advisors is for their clients to have more money in stocks while they are working so that they can grow their assets. When they are working, their job should provide the income for them to live so they don’t need income from their investments. When the client gets close to retirement, they can start shifting their assets to bonds so that they will have the income they need when they retire – of course, as they sell off assets that have appreciated in a non-tax-advantaged account, they will have to pay capital gains which will reduce their asset size. If you look at this strategy as it applies to real estate, an investor should invest in assets that will provide the most appreciation while they are working – single family homes in good locations / areas of town. I recommend selling these investment properties every 5-7 years (depending on appreciation rate) so that the assets can be maximally leveraged – this also means the investor is taking advantage of the 1031 exchange tax benefit so that all of their money is working for them. As the investor get’s closer to retirement, he can start converting his assets into properties that are oriented more toward income than appreciation such as multi-unit properties (duplexes – 4-plexes or commercial properties).
I think it’s important to protect yourself from liability and the more wealth you create, the more people will be inclined to sue you if they have an accident on your property (personal property or investment property) or if you are in a car accident or some other situation that puts you at risk. The more equity you have in your home(s) the more likely it is for someone to come after that asset. Putting your non-retirement assets in a trust is a good way to limit your liability. Setting up LLCs to hold your investment properties and then have them owned and managed by the trust adds another layer of protection. Having proper insurance is also important.
Finally, you can set up self-directed IRAs that allow you to use the money any way you want, such as a down payment on investment real estate. Whatever you decide to do when it comes to investing, make sure you have a good CPA to maximize your tax deductions and a good attorney to make sure you and your assets are properly protected. It’s also important to have a great Realtor and a good mortgage guy who understand the ins and outs of real estate investing. Watch my video series on my site for more detailed information regarding real estate investing. Here’s the introductory video: