Investing is the concept of long-term. In general, the IRS views long-term investing as anything more than a year. Day-trading and house-flipping can be lucrative business models, but they are not investments – they’re speculative. In addition to the higher risk, speculators need to continue to work their system to generate income – and they’ll need to pay ordinary income tax on top of it. Long-term real estate investing has the most benefits available to it.
1. Appreciation. For years we have said that appreciation, the increased value of a property, was considered icing on the cake. Don’t rely on it too heavily in your budgeting and calculations but appreciate it (pun intended) when it happens. Supply, demand, and inflation can all have a major impact on the increase or decrease of the value of a property, but owners can force appreciation in other ways. For residential properties, increasing the finished square footage of a house by adding an addition or finishing a basement can increase value, as well as simply increasing the curb appeal of the home. On multi-family or commercial properties that depend on income to determine the value, increasing the rents of existing tenants or adding additional revenue sources, such as paid parking or installing laundry facilities can increase value.
2. Tax Benefits. The tax reform of 1986 brought a screeching halt to all the quick write-offs available to anyone who invested in real estate. While it’s harder to use paper losses from real estate to wipe out earned income, savvy investors can certainly eliminate their real estate gains and in essence earn their rental income tax-free. The most common way to eliminate taxes on real estate gain is through depreciation. Sometimes on properties that you newly acquire or when you spend money on capital expenditures, you can write large amounts off in one year, instead of having to depreciate it over 27.5 or 39 years. However, what the IRS giveth, the IRS taketh away. When you sell an investment property, you are required to pay a recapture tax, based on the depreciation you took (or should have taken). But even then, there are strategies to minimize or delay your tax burden, such as selling the property and acquiring a replacement property using a 1031 exchange. This is a good strategy to roll up into larger and larger properties. Like anything the government offers, there are very strict rules you need to follow to have a successful 1031 exchange to be able to defer your taxes into the future.
3. Cash Flow. This is what most investors think about when investing in real estate – the money that’s left over at the end of every month to be able to spend however you want. A good investor will develop a pro-forma or a budget with projections for a rental property. You will know what the monthly mortgage will be, as well as the taxes and insurance. Some of the unknown and variable costs you may need to guess at are utilities, lawn care, snow removal, minor repairs, and major repairs. If a property is older and has a lot of deferred maintenance, you will want to budget a higher amount for repairs. Where many investors get into trouble is not setting aside any money for repairs. I recommend creating a budget and withdrawing a fixed amount every month as cash flow, like paying yourself a salary. By keeping additional funds in the account, you can still get paid during a vacancy and have funds available for a major repair.
4. Equity Build-Up. Paying down the principal on the mortgage isn’t very exciting for newer investors, but as your holdings and mortgages get larger, it becomes exciting to see how much your mortgage goes down every year. It’s harder to see on a 30-year mortgage, but with a 15- or 20-year mortgage, the rapid paydown is impressive. Newer investors often focus on cash flow, as they want to create a passive stream of income. Seasoned investors who may not need the extra income might purchase a property with terms that focus on building equity while sacrificing cash flow. I was able to do a deal where I was able to negotiate with the seller to finance the entire purchase price for ten years with no interest. My cash flow wasn’t great, but in ten years, I’d own the property free and clear! In addition, being able to purchase real estate with leverage is an opportunity very few other investments allow.
Some real estate investors may only look at some basic formulas to determine whether an investment property is worthy of their money. It’s important to look at the whole picture and take all four benefits into consideration. Oftentimes, what looks like a 10% cash-on-cash return is actually closer to a 28% overall return. When it comes to investment real estate, it’s important to follow the numbers, not your heart.