9 Reasons I Want to Invest in Real Estate, Part 2

9 Reasons I Want to Invest in Real Estate, Part 2

This is Part 2 of the 9 Reasons I Want to Invest in Real Estate.  If you haven’t read Part 1 of this post, I recommend you start there.

#5 Control

The next reason I am interested in real estate investing is control.  

Nearly all of our investments up to this point in time are in the stock and bond markets through broad based, low cost index funds.  While these are excellent investments with great returns over time, there is very little that I can do to control how they perform.  At best, all we can do is make sure we choose the right investments that have the lowest expense ratios and then let it ride.  We are essentially at the mercy of the market.  There is not much I can to do to influence how these multi million and billion dollar companies perform, let alone the entire market as a whole.  We will have to weather the ups and downs just like everyone else.  

I can tell you that for someone with my personality, this part of investing is a little tough to swallow.  I tend to want to have as much control as possible to get the best possible outcome.  Neurosurgery is a good example of this.  I have tried to learn my craft to the best of my ability.  I have studied and practiced more hours than I could ever even try to count.  I diligently study the MRIs, CT scans, and x-rays of my patients.  I try to learn all I can about their symptoms, medical history, and perform a thorough physical exam.  Then, I use all of my personal experience, published research and outcomes, and often draw upon the experience of my colleagues, to create the best surgical plan possible.   In the operating room I have the privilege to work with a dedicated, talented, and experienced team with whom I have developed a smooth work flow over hundreds of surgeries.  I have studied and know all of the instruments and techniques we will be using.  Finally, in every surgery I am as thorough as possible to give every patient what I would consider an “A+” surgery, just as I would if it were my own family member.  So, yes, I am someone who likes to have control and influence over outcomes.  

Unlike the stock market, real estate is an asset class that will allow me more influence and control in how the investment performs.  This greatly appeals to me.  We will be able to choose which properties we will purchase.  We can choose how those properties are run.  We can choose who rents those properties and how we interact with them.  We can determine how much rent to charge.  The list goes on.  For these reasons, control is reason #5 I am in interested in real estate investing.  

#6 Tangible Asset

Real estate is something tangible.  It is a physical, real thing you can see and touch.  I like that.  

As mentioned above, right now all of our investments are in paper assets (shares of stock and bond index funds).  While I know these are also “real,”  I cannot see or touch them (seeing them on a monthly statement or webpage doesn’t count).  If the market completely crashes, companies can go out of business and that could potentially leave us with nothing.  While extremely unlikely, that is just part of the risk of investing in paper assets.  I understand that and I’m fine with it, but it sure would be nice to have part of our investment portfolio invested in tangible assets. 

Real estate fills this void.  Even if the market were to crash and we were to enter another great depression, our real estate holdings would still be there.  They wouldn’t disappear.  Sure, their values may drop and the rent rates might fall.  But people would still need a place to live, and you could still collect rent from tenants.  You could even live there yourself if you had to.

#7 Diversification

I’ve written a little about diversification before in my Top Ten Terms You Should Know About Investing.  In every day terms, diversification simply means don’t put all of your eggs in one basket.  Diversification helps you to minimize risk and potentially increase returns in your investment portfolio.

There are multiple different ways you can diversify.  You can hold multiple different investments within a given asset class.  You can also have investments in multiple different asset classes.

Real estate introduces a completely new asset class into our current stock and bond investment portfolio.   I believe introducing this asset class into our investment portfolio lowers our overall risk burden while simultaneously providing opportunities for greater returns.  Hard to say no to that.  

#8 Low Correlation

This is a reason similar to diversification, but important enough to list as a separate point.  

In simple terms, two investments that are highly correlated will perform similarly with market fluctuations.  For example if you were to compare an S&P 500 index fund to a U.S. Total Stock Market index fund, because there are so many identical holdings in these two market cap weighted index funds, they would perform extremely similarly with market fluctuations and would thus be very highly correlated.  

When you are trying to add diversification to your portfolio, it can be very advantageous to add an investment or asset class that has low correlation with the rest of your portfolio.  So if the market is going down and your stock values are dropping, it would be great to have investments that are still holding steady or even possibly going up.  

Real estate is an asset class that does a good job of meeting this criteria, at least individual real estate holdings.  Real estate values and rent rates are based more on local trends than on national or international market fluctuations.  Furthermore, real estate values and rent rates are much slower to change than the stock market.  For example, in a market correction (10% loss in stock values) or a bear market (20% or more loss in stock values) are landlords going to suddenly have to decrease their rates by 20% or lose their tenants?  No.  While it is possible that rent rates may decrease slowly over time, it is not an instantaneous change with the same volatility of the stock market.  

This low correlation that individual local real estate investments have with the stock market make real estate an even more appealing asset class to add to our portfolio.  

#9 Tax Benefits

Finally, let’s discuss some of the tax benefits of real estate investing.  

I don’t like paying taxes.  I’m not sure anyone does.  It’s hard to come to grips sometimes with the fact that nearly half of all the money we earn goes to taxes.  For this reason, I am always looking for ways to decrease our tax burden.

Real estate is an asset class that seems to be favored by the government, at least from a tax perspective, to invest and make money.  Since our single biggest expense every year is taxes, a tax favored form of investing is very appealing.  

Before we discuss some of the tax advantages of real estate investing, it is important to understand a few things.  

First, taxes can get very complicated and tax laws are often a moving target.  Things I write today may change by tomorrow.  

Second, I am not going to get overly specific or complex in the following discussion.  The deductions and numbers we review may change based on if you hold your properties as a proprietorship, partnership, or corporate entity.  It also depends if you claim Schedule E vs Schedule C tax deductions.  The 2018 Tax Cuts and Job Act has also added layers of complexity beyond the scope of this blog post.  My goal is to just discuss the principles, not the specifics or exact numbers.  

Third, I am not a C.P.A. and I am not licensed to give professional tax advice.  If you move forward with real estate investing, I highly recommend a competent C.P.A. to help with filing your taxes.  

With that out of the way, lets discuss some of the tax advantages of real estate investing in the context of our previous example.

We previously discussed a hypothetical 2 bedroom, 2 bathroom single family home with a purchase price of $100,000.  

We assumed you paid $20,000 as a down-payment and obtained an $80,000 mortgage from the bank.  This was a 30 year mortgage with a fixed interest rate of 4.5% with monthly payments of ~$400.  

Based on similar properties in the area, we also assumed you would be able to charge $1000 per month in rent, which is $12,000 in gross rental income for the year.  

Of the $1000 per month you collect in rental income, $500 per month goes towards expenses including property taxes, home insurance, maintenance, vacancy, property management, future capital expenditures, etc.  That leaves $500 per month to cover the ~$400 mortgage payment.  This leaves you with ~$100 per month in positive cash flow.  

Let’s also assume you are single and make $90,000 per year at your regular job.  In 2020 this puts you in the 24% marginal tax bracket for federal income tax.  This means that for every extra dollar of income you earn in rental income, you owe 24% in federal income tax.  

Since the gross overall rental income of the property is $12,000 per year, without any of the tax advantages you would owe 24% of this, or $2,880 in federal income tax.  

Keeping this scenario in mind, let’s now discuss 3 general tax advantages to owning rental property.  

Deduction of Expenses

The first major advantage is that you are able to deduct most of your expenses, thereby lowering your taxable income.  This includes property tax, insurance, cleaning and maintenance, property management fees, marketing, legal services, etc.  

In the above example, monthly expenses are $500, totaling $6,000 for the year.  Let’s assume that $5,000 of these expenses are deductible.  This decreases the taxable income from $12,000 to $7,000.  

Mortgage Interest Deduction

You are also able to deduct any mortgage interest you pay on the property over the course of the year.  Remember, with every mortgage payment you make, some of that money pays interest to the lender, and some is applied to the principal loan balance.  

Although the monthly payment stays the same, over time the amount paid in interest and the amount paid to the principal changes.  Early in the life of the mortgage, more money is actually paid in interest than goes to the principal.  As time goes on and the principal is paid down, the amount of interest each month actually decreases, leaving more to be applied to the principal.

In our example, there is an approximately $400 monthly mortgage payment, totaling $4,800 for the year.  For simplicity, let’s assume you are somewhere in the middle years of paying back the mortgage,  We will assume that half of what you paid this year, $2,400, is paid in mortgage interest.  We can further deduct this amount from the $7,000 listed above, dropping the taxable income to $4,600.

Depreciation “Expense” Deduction

This is probably one of the best tax advantages of real estate investing.  When I first learned about this it was a little counterintuitive, since I always thought of the value of real estate as going up.  But from a tax perspective, the actual structure of the home is a depreciating expense.  

Let’s break this down.  Basically, the government is saying that a rental home has a useful life span.  For residential real estate that has been set by the government at 27.5 years (39 years for commercial real estate).  It takes a certain amount of money to acquire the property, which is an expense for your rental business.  Rather than deducting that business expense all at once, you are spreading out that expense over the useful life span of the expense, in this case 27.5 years.

Let’s apply this to our example, in which we have a 2 bedroom, 2 bathroom home purchased for $100,000.  The depreciation expense only applies to the house, not the land.  Let’s assume the land is valued at $20,000 and the home at $80,000.  We now take $80,000 and divide it by 27.5, which is $2,909. This is the amount we can deduct from the taxable income each year.  This further reduces our taxable income from $4,600 above to $1,691! 

So with just these three tax benefits we have reduced the taxable income on the rental property from $12,000 to $1,691.  Using the 24% marginal tax bracket, the federal income tax bill on this property has dropped from $2,880 to $405.84. Not too bad!! 

And these aren’t even all the tax advantages of real estate investing.  If you sell the property after you have had it for more than a year, the profit is taxed at your long term capital gains rate, which is much lower than your ordinary income tax rate.  And if you use the money from the sale to buy another property (following certain rules) you can do what is called a 1031 exchange and avoid paying any taxes at all, a strategy that is beyond the scope of this post but something I plan to write about in the future.

While this is an oversimplified example, and we haven’t discussed some finer points such as the depreciation recapture tax if you sell the property, I hope it demonstrates that there are significant tax benefits to real estate investing.  And at the end of the day, that means you get to keep more of your hard earned money.  

Conclusion

There are many benefits to real estate investing.  It’s no wonder so many people use real estate as part of their wealth building strategy. I have discussed 9 reasons that I want to invest in real estate, in no particular order:

• Cash Flow
• Leverage
• Equity
• Appreciation
• Control
• Tangible Asset
• Diversification
• Low Correlation
• Tax Benefits

Hopefully, for some of you that have never thought real estate investing, you might see some reasons to consider adding it to your investment portfolio.  I will keep you updated on our real estate investment progress as we get closer to pulling the trigger on our first property.

Thanks for reading.  I hope you are doing well in your progress towards reaching FI.  If you have any questions or comments that might help other readers, please list them below.  In the meantime, keeping working towards Freedom Through FI!

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