If you’ve been reading my articles, you may have noticed that I have written a few times on how you should own your real estate, what tenancy you should hold the property under, whether to use an LLC, the advantages of an irrevocable trust, and recently even explaining how you can invest your IRA or 401k funds in real estate.
Of course the assumption I’m making is that you are already investing in real estate. If you aren’t, let me explain today why you should be. And if you already are, after reading today’s article you may be encouraged to invest in more real estate.
When I first started practicing law, I started in Manhattan, New York. It was exciting, I was working at the largest law firm in the world in the financial center of the world. I was doing securities law—working on stock and bond transactions and more sophisticated financial products like derivatives and securitization. (If you don’t know what those are, not to worry. I didn’t either before working on them.) So, when I came back to Hawaii to join my dad’s estate planning practice, I had a natural bias towards the stock markets as an investment strategy.
However, as I met with clients to help them plan their estates to minimize estate and capital gains taxes, avoid probate & guardianship, prepare for nursing home costs, and otherwise create an effective plan to pass their assets to their loved ones and favorite charities in an organized manner, I quickly noticed something very interesting.
Most of my average, middle class clients who had normal jobs and were good savers fell into two categories: Homeowners and renters. Those who rented rather than buying a home, and who saved well, usually managed to put away enough to have a couple hundred thousand dollars in their savings or retirement accounts at the end of their work career. Those who chose to buy a home also managed to put away enough to have a couple hundred thousand dollars in their savings or IRA/401k, but they also owned a home, and had paid off their mortgage. This was interesting to me because I was renting at the time and looked at the cost of renting versus paying a mortgage and thought I couldn’t afford to buy. My assumption had been that if I bought a home, I wouldn’t be able to save very much because renting was so much cheaper, but the facts were staring me straight in the face every time I sat across a retired client to do their estate plan.
In studying how this could possibly work, I’ve developed this list of reasons why we should make real estate investing a part of our investments, retirement plan, and net worth building.
- Tax Deductions – Real Estate is one of the most tax-favored investment asset classes in the United States. Uncle Sam wants to encourage home ownership and so the government makes it easier for us to buy a home with tax incentives. We can take tax deductions for our mortgage interest payments. So in essence, that higher monthly mortgage payment is actually a little closer to the rent amount when you consider how much money you get back from taxes you would have otherwise paid at the end of the year.
- Tax Deferral – As if taking deductions on interest isn’t enough, real estate grows tax-deferred. Your property can increase in value without paying taxes until you sell it. And even then, if it’s your primary residence you can exclude up to $250,000 in profit (or $500,000 if you’re married and filing jointly). If it’s not your primary residence, but rather an investment property, you can sell it, buy a replacement property in a 1031 exchange and defer your taxes until you sell the replacement property. There are also other strategies to defer, minimize, or eliminate the taxes on sale completely. Some of you might worry that we’ve had real estate market crashes recently and so you consider it risky. Like the stock market, the real estate market has its ups and downs, but it tends to trend upward over time and is likely to appreciate in value.
- Tax Depreciation – For an investment property, even though it’s actually appreciating in value, you can depreciate the cost of the home or building and other structures on your land creating a “paper tax loss.” This will often offset any positive income you are earning from the rental and even if there is actual cash going into your pocket every month, on your tax return it legally shows no profits or even a loss, so you get tax free cash flow!
- Leverage – There are very few investments where you can put 10% of the money down (or sometimes less) and have someone else pay the other 90%, but they let you keep all the profit in exchange for a small fee (interest). If you buy real estate with 10% down and then rent it out to break even—covering your costs—and the property values go up by 10% in 2 or 3 years, you’ve just doubled your money in equity, which is a 100% return on your initial investment. (i.e., you just earned another 10% in value, which is equal to what you put down). This leverage is extremely valuable—especially if renting the property pays off the mortgage over time.
- Forced Savings – Most of us Americans who are in a generation younger than the baby boomers are not good savers. In fact, many spend more than they earn, digging themselves deeper into debt constantly. However, having a property with a mortgage that needs to be paid is one way to force us to “save” in a way where we can’t just withdraw the money easily and go spend it before retirement. You will appreciate having the rental income in cash flow and the value of the property if you need it in your later years.
Because of these advantages, I recommend that people buy real estate as an important part of their investment plan. In fact, I encourage buying one new parcel of real property every year! If that sounds like it’s too much and you can’t afford it, there are ways to buy property in the mainland where it’s cheaper to buy and the rents are better. As long as you have a good property manager, it doesn’t matter where you buy. So, for those of you renting, consider the economic advantages of owning a home. For those of you who have a home, consider buying a rental property. For those of you who have a rental property, you already know what I’m talking about: Why not go out and get more?
© OKURA & ASSOCIATES, 2014