In 2009 Tim and Sarah bought their first home with real estate prices at rock bottom. They enjoyed the home several years, raised a family and improved their financial situation. With more savings and income, they looked around and found the perfect home. Rather than sell the first home, they decided to rent it out. It was easy finding a renter and they were excited about the income they would receive. What a great investment they thought.
The value of their first home more than doubled and they enjoyed the rental income but maybe it was time for a change. Their original intent was not to be landlords but here they were. With a quick search online they found a realtor and sold it for top dollar.
After the sale, they decided to call a financial advisor and begin planning what to do with their wealth. They had not considered taxes from the sale but heard real estate offered the best tax benefits. They heard the entire gain could avoid tax through a section 121 exclusion or they could do a 1031 exchange. Both sounded complex enough to work, or so they thought. Upon meeting with their advisor, they learned that it was too late to use a 1031 exchange and a section 121 exclusion was only available if they had lived in the home 2 of the last 5 years; they moved out 5 years ago. In the end, they still made money but paid the IRS $50,000 rather than $0. They wished they had a knowledgeable advisor or tax planner earlier.
Be proactive in your planning and education.
The names are made up but the story isn’t. I have had this exact conversation and ones just like it more times than I can count. The more you know about real estate and how it works before getting involved, the more power you will have in your finances. Nobody wants to find out what they could have done after its too late.
My goal in this article is to provide an overview on how real estate can be a good investment, how to evaluate it and ways to exit paying as little tax as possible. Hopefully, knowing what is available ahead of time will help you avoid missing a key deadline like Tim and Sarah.
Why is real estate a good investment?
When it comes to buying your first home, you will often hear that it forces savings. You are required to make your mortgage payments or risk losing the house. This is a strong incentive to ensure you make your payments. Each payment consists of principal and interest. Principal is the portion of your payment that goes towards paying down the mortgage and building equity in the home, the “savings” component. Interest is the amount that goes towards paying the bank. Over time the equity increases along with the home value if you bought well. This brings me to my next point.
Don’t overpay or buy too much home. I know home values have gone up over the years. First time homebuyers may feel the need to stretch their budget a little. It’s best to avoid doing this. Home values have also gone down in the past, remember 2008? Borrowing 80% or more of the home value and then having that home value go down can wipe out your investment quick. I have met people that have gone broke in the stock market but I have met people that went bankrupt in real estate because of leverage.
Real Estate is illiquid: Buying and selling real estate takes time. In comparison to stocks, people don’t panic sell real estate because of the time it takes. However, this is what people have been doing with their stock portfolios since the beginning of time. They see their portfolio value is down, panic and then sell only to watch the market take off without them. The lack of liquidity in real estate and stale pricing keeps people in their homes longer. In fact, many will say real estate is the only asset that ever made them money. This is often because it is the only asset they ever held long term. I’m highlighting the lack of liquidity as if it’s a positive but be warned, if you need out of real estate ASAP it may come at a steep cost. That is one big negative.
Here is a summary of key pros & cons of owning real estate.
How does real estate fit into a financial plan?
Now that you have some understanding of the pros and cons to real estate ownership, let’s discuss how it can fit into a financial plan. The Elevate Income Plan lists real estate on the income side, specifically, rental real estate. The monthly rental payments go towards supplementing retirees’ income in retirement. Of course, for real estate to fill this role, the monthly cash flow must exceed monthly expenses. This often means that properties should not be financed with a mortgage if holding them in retirement. Initially, a mortgage is fine but not once you are planning to live off the cash flow.
So how do you determine if real estate is a worthwhile investment?
Like most investments, it is about how much the investment returns. With real estate, this return comes in the form of rent after accounting for expenses. The fancy term for this rent after expenses is Net Operating Income or NOI.
Net Operating Income (NOI) = Rent – Operating Expenses
What expenses to include? I will break out the most common expenses in the example to follow. Property maintenance tends to make up 1-2% of the property value. This may not hit every year, but it will build up in the form of a major repair down the road. Saving for this is important when buying for personal use or renting. Vacancy rate is the next big one. This accounts for the times when there is no renter. I used 10% in my example but it can vary. The rest are straightforward and include property tax, HOA fees, Insurance etc.
Capitalization or Cap Rate. After determining NOI, the annual return is simply this cash flow relative to the amount you paid to acquire your property. In real estate language, this is known as the Capitalization Rate or Cap Rate for short.
Cap Rate = NOI / Property Value
Cap rate is similar to the annual returns you quote when looking at your investment portfolio, whether it be a bond or stock. For reference, today you can earn around 4% risk-free if you buy a government treasury. Earning anything less than this while also managing the property would not sound very appealing. On the flip side, earning more than this can look attractive. Note, this annual return excludes the value of the property when you sell which can go up or down.
Maybe an example will help:
This beautiful home is on the market for $550,000. You see the “For Sale” sign and your mind automatically sees the potential rental dollars you could receive. You estimate it could easily bring in $2,500 per month which is $30,000 per year. FYI, Zillow provides estimated rents on properties for a good starting point, but their accuracy is subjective.
Sitting down with your excel spreadsheet, you work out the following projections over the next 10 years and account for rent and expenses increasing along with inflation.
How does it stack up?
The cap rate is a good place to start. Dividing this property’s NOI of $16,604 by purchase price of $550,000 produces a 3% cap rate which is less than what you could earn from clicking a button to buy US Risk-Free Treasuries, hardly worth it. But what if you expect the home value to increase over time or maybe you can get a higher rent? This should be considered and if you expect values in an area to increase significantly this can make the investment more appealing. In this case, the house is expected to sell for $895,892 after 10 years equating to a 5% annual gain on price alone.
Buying a home to live in? The Cap Rate can help. Run through this same analysis to determine the theoretical cap rate. If the rate is low, meaning rent would be low relative to the home value this could indicate the better financial decision is to rent the home instead of own. This is especially true if multiple properties look this way. There is nothing worse than paying too much, straining your budget and watching the price fall. Add a major home repair/renovation on top of this and it can make you house poor quickly. A cap rate of less than 5% makes renting look like the better decision.
What about taxes?
Rental real estate has two types of income that will be taxed. There is the income received from rents and then there is the income received when the property is sold. Renting out real estate is known as a ‘Passive” activity in the eyes of the IRS. The only exception is for licensed realtors which may classify it as an “active” activity. This matters because passive income CANNOT be offset against active income for taxes. People often state how they love rental real estate for offsetting their income from employment. This is not true. Again, the only exception to this is with realtors.
While you own the property, rent is taxed as ordinary income. This is the highest of tax rates. Thankfully, real estate can be depreciated. This means the cost of the property, excluding land value, is expensed over 27.5 years. This expense offsets income and provides a nice offset to taxes. In the analysis above, depreciation is around $16,000 annually and almost zeros out the income. There are ways to depreciate the property even faster through cost segregation studies. I won’t get into the details for now but it’s good to know the option is out there.
When you decide to sell your property there will be a tax bill. Remember the depreciation you used to reduce your income and avoid paying taxes? All that depreciation was not free. The IRS recaptures all the depreciation by taxing it at 25%. This depreciation recapture is in addition to the gain in property value that you will be taxed on. However, the appreciation is taxed at the preferential long term capital gains tax rate. High earners can expect another 3.8% in the form of Net Investment Income Tax.
Continuing with our example, the total tax owed on the property sale is $112,115, broken out as follows.
The tax bill is not small but thankfully, there are ways to cut down on taxes with a little planning. Without going into too much detail, here are some of the top ways to reduce the taxes owed before selling. As with all things planning, it helps to plan well in advance!
What are ways to reduce the tax bill upon sale? There are a number of ways to reduce your tax bill with a little planning and they have been summarized in the following table. The most common is the Section 121 exclusion which provides for excluding $250,000 of capital gain for a single person, or $500,000 for a married couple. This would apply if you lived in the home 2 of the last 5 years. A 1031 exchange kicks the tax bill down the road by transferring the sale proceeds of one property into another that is identified ahead of time, tax-free.
Is Real Estate right for you? Monthly cash flow is important to any financial plan and there are multiple ways to get it. If finding and keeping tenants doesn’t bother you it may be a fit. Also, if you find it hard to hold onto stocks long term, real estate may be a suitable alternative. If you just want real estate exposure without the headaches, there are options such as Real Estate Investment Trusts (REITs). The answer to this question truly depends on you.
Hopefully, this article will benefit you, a friend or family member.
Thank you for taking time to read this planning commentary. I pray it helps you or someone you care about.
Kyle Lottman, CFA, CMT, CPA
Wealth Management Advisor
Elevate Capital Advisors
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