In a previous post, we discussed big picture ideas to help think through if owning rental property may make sense for you. If you missed it, you can find it here. In this post, we'll hit on some positive points that can make rental properties attractive. In a follow up post, we'll go through some cons that are worth considering as well. But for now, let's think happy thoughts!
You may not be comfortable having your entire financial well-being tied 100% to the stock market. Owning rental real estate can help provide a different asset that isn't tied directly to the market, though it does come with it's own risks that we'll talk about in a separate post. There's also a sense of control that can come with owning a rental - you can change your rent fees, you get to decide what you do or who to hire, you can change the marketing, and make changes to the property itself.
Tax benefits are one of the widely touted benefits of owning rental real estate. The one that probably gets the most attention is non-cash depreciation. Depreciation is the ability to deduct a portion of the property that you purchased (excluding land) on your tax returns. For example, let's say you purchase a condo for $250,000 and that you exclusively rent it out to a family. You'd be able to take approximately $9,000 in depreciation expense on your tax return and reduce your taxable income.
Aside from depreciation, you're also able to deduct expenses related to the rental property to reduce taxable income. These expenses typically include mortgage interest, property taxes, certain repairs, maintenance, management fees, advertising, and utilities to name a few. Basically, a rental property is its own mini business!
Another wonderful tax strategy is the potential for tax deferral on a sale if you follow certain rules, known as a "1031 Exchange" or "like-kind exchange." It gets its name from the Internal Revenue Code section. When you sell your rental property, using a like-kind exchange allows you to avoid paying capital gains tax and reinvest those proceeds into another property of like kind and equal or greater value within a certain period of time and following specific steps set out by the IRS. This strategy allows you to keep more cash at sale to be reinvested into new properties that may better suit your needs.
Keep in mind that the tax benefits are eliminated if the rental is held in a tax advantaged account such as a self-directed IRA or self-directed 401(k). Also, taxes are complicated and it's recommended that you consult with competent tax counsel to understand the tax ramifications before initiating any transaction.
Leverage is just another way of saying that you can use other people's money to help finance a rental property, typically in the form of a mortgage. Going back to our condo example, it would be challenging for most people to come up with $250,000 in straight cash for an investment. And even if you can, you may have other financial goals or reasons that preclude you from wanting to tie up that much capital. With real estate, it's possible that you may be able to put down say 10%-30% and borrow the remainder through a bank. Certainly the payments are going to cut into your profits so you'll need to run the numbers to make sure it makes sense for you but it could be the difference between getting into the rental business versus having to sit on the sidelines.
One important caveat is that leverage works both ways. While it can help you secure a rental property, the lender is going to want to get paid regardless of how the investment performs. If you can't find a tenant or they flake out on rent payments then you'll likely be on the hook to make those payments to the bank. Check out our previous article which discusses having a strong financial position before taking on rentals.
Seemingly Endless Ways to Get Involved
There are countless books, seminars, and websites devoted to the real estate industry. Buying a rental property is just one small slice and even that slice can be further dissected. Perhaps purchasing a rental isn't in the cards for you at the moment but you still want to get involved. There are plenty of other options such a becoming a real estate agent, an appraiser, property management, fixing and reselling the property ("fix & flip"), buy and hold - our focus of this post, lending, syndication, and the list goes on.
This is an area that I feel gets overlooked or ignored all together. Let me explain. The stock market is constantly in the news; the news gets very loud and is almost impossible to ignore when things are not going well. Contrast that with the real estate market. Indeed, it ends up in the news as well but not at such a deafening level. I get an email periodically telling me the estimated price of my house but even then, it's only an estimate. Detroit can be doing poorly but Denver doing well so I may just shrug it off. You can see the exact value of your investment portfolio 24/7 by just logging into a website as well as the daily ups and downs. When owning a rental, without the constant financial pornography machine blasting in your ear about impending doom then you may be much less inclined to make a rash decision and sell the property.
Another behavioral aspect is that there is a decent amount of friction to buy or sell a piece of real estate. You can easily get online and buy or sell a stock of company in few clicks or taps on your phone. With real estate, there's a whole process with many different players involved before you're even handed the keys. And then you still have to find a tenant. That friction can help put the brakes on panic selling during a time when it feels like the world is melting down around you. Real estate, like an investment portfolio, has a better shot of performing when it's held for the long-term and that friction helps incentivize you to do so.
As we've covered here, owning rental properties have their own unique advantages that can make them an attractive component to your financial plan. It's important to remember that rentals have their own rules so it's best to work with competent legal, tax, financial, and real estate professionals when considering rental properties as an investment. In a future post, we'll discuss some of the drawbacks to at least consider before jumping feet first.
Curious if rental properties make sense in your plan? Let's have a chat!
The above is for general information only. Consult with competent investment, tax, or legal counsel to best understand your unique circumstances before implementing any strategy. There is no assurance that working with a financial professional will improve investment results. All information above is subject to change. Read our firm's disclaimer here: https://www.windingtrailfinancial.com/disclaimer.