This is a simple overview of the basics of real estate, with a useful framework to begin by understanding: The value of leverage, Tax Benefits, and Depreciation.
In this post, we’re going to cover each of these, beginning with the value of leverage.
What You Need to Know Before Investing in Real Estate – Apply Leverage
Unlike other investments, you can purchase real estate without having the full amount of the purchase price in cash. With $100,000 to invest, you can buy an investment property for $400,000 when you utilize debt (a mortgage) to complete the purchase. Or, you could break that $100,000 down and use it to purchase two properties or four properties, in the same way – down payment and mortgage for the balance.
Once you own the investment property, the rental income it generates will be used to pay the expenses of the property, including the mortgage payments. And the value of the property will increase over time, and you’ll own 100% of the appreciation. You’re not limited to the percentage of your original down payment. In other words, putting 25% down on a real estate investment doesn’t limit you to 25% of the appreciation.
If the property’s appreciation percentage is higher than the cost of the mortgage on the investment property, this is known as positive leverage. Add in the tax benefits of owning an investment property, and the value of your initial investment grows.
What You Need to Know Before Investing in Real Estate – Tax Benefits of Real Estate Investing
Let’s break down the tax benefits that come with owning rental property, beginning with the mortgage interest deduction. Like the interest you pay on your primary residence, the interest paid on a rental property is also deductible from the gross income on the property. Unlike your primary residence, the 2017 Tax Cuts and Jobs Act didn’t limit the amount of mortgage interest or property taxes deductible on investment properties.
Operating expenses are the other costs that are deductible from the income produced by the rental property. These include repairs, maintenance, upkeep, utilities, yard care, association fees, property management, and legal consultation. If you own investment property in a different city or state than where you reside, you’ll also be able to deduct travel expenses.
What You Need to Know Before Investing in Real Estate – Depreciation and Other Taxes
One of the most significant tax advantages to owning investment property is the ability to depreciate the asset over time. Depreciation is an operating expense that doesn’t cost money. The IRS recognizes that an asset will wear down over time and allows a portion of the cost to be deducted over 27.5 years as if it were an actual expense.
When you sell your property, depreciation must be re-captured, and the tax calculated at ordinary income rates that max out at 25%. However, this is only triggered if you sell and there are strategies available to avoid that altogether such as a 1031 exchange.
A 1031 exchange will also help you avoid paying capital gains tax on any of the appreciation the property experiences. While capital gains taxes run between 0-20%, even at the highest rate it’s still less than ordinary income tax rates. Instead of looking at capital gains as something to avoid at all cost, view it as a less costly tax on a different type of income. Or utilize the 1031 Exchange to avoid paying it at all.
You can see a full explanation of the 1031 Exchange in this previous post, but in brief, as long as you identify another like property to exchange your current investment property for – you defer the profits from appreciation and the depreciation recapture. It means selling your existing investment and purchasing another similar property.
What You Need to Know Before Investing in Real Estate – Know Your Ultimate Investing Goal
All real estate investors don’t have the same goals for investing. Some want to build up a positive stream of income from the cash flow produced by their investment properties. Some are in it for the long-term appreciation and equity building. And some want a combination of all these. It’s essential to every real estate investor to identify what they intend to get out of the property they purchase – and they need to know it before they begin to look for a property.
You also need to know the time frame you intend on investing in real estate and your tolerance for risk before you begin. These may change over time, as can your ultimate goal, but having a vision will undoubtedly influence the properties you choose to purchase.
One final aspect of real estate investing that’s important to keep in mind is its value as an inflation proof investment. Inflation impacts every other investment with the cost to purchase them increasing over time. While rents typically rise with inflation, the mortgage payments on the property aren’t affected by it (assuming you took a fixed rate mortgage), which increases your cash flow. At the same time, inflation can also impact property values – positively impacting your asset in another way, as well.
Use this information to build your understanding of the process and benefits of investing in real estate. But there’s so much more to learn before you jump in and having a conversation with a knowledgeable mortgage professional and realtor is critical as you gather as much information as you possible.