Recently, there has been quite a bit of posting on both professional finance websites and personal finance blogs regarding whether one is better off purchasing a home or renting and investing more in the stock market. To be clear, I am not addressing using your primary residence as a means of building your networth and becoming a millionaire. Instead, this post is aimed at how real estate investing, i.e., purchasing rental property can help you become a millionaire.
To begin, the following steps are going to be of most use to those that have their financial house in order and perhaps have a reserve of cash available with which they could begin investing in real estate. As part of this group writing project, Free Money Finance has written a great post on Top 5 Ways to Improve Your Network and Generation X Finance posted on The Top Five Ways to Become a Millionaire both of which should help you get on track with your finances and put you on the path to being able to afford real estate investing.
1. Real estate is one of the only investments for which you can loan money at a reasonable interest rate. What this means is that you can build wealth by only making a limited down-payment and then using someone else’s money to build your wealth. Right now if I wanted to take out a $100,000 fifteen year fixed rate mortgage, the going rate is less than 6%. However, if I wanted to borrow $100,000 cash on margin from my stock market account to invest in the stock market, I would have to pay somewhere in the range of 9.5-10.75%. Similarly, if you want down to your local bank and said you wanted to borrow $100,000 to invest in the stock market, they would laugh in your face and then show you the door.
2. The rents provided by rental property will pay your mortgage, thus building equity for free, and provide positive cash flow. For this to be true, it is imperative that you do your market research before jumping into real estate investing, as real estate markets can vary from place to place. If the market is such that renting is not going to provide you with a positive cash flow, then you will seriously need to think twice about whether the other benefits discussed in this post will provide a return sufficient for the property to still be a worthwhile investment.
When calculating the cash flow, don’t forget to take into consideration property taxes, insurance, maintenance expenses and any utilities not paid by the tenants. With residential leases, the landlord is typically responsible for taxes, maintenance, insurance, and sometimes, utilities. Commercial leases are typically what is referred to as “triple net” leases, meaning that tenant is responsible for paying the taxes, insurance, maintenance and utilities.
3. You can use a depreciation deduction to offset any expenses related to the property. The Federal tax code permits the improvements (i.e., the building but not the land) on rental properties to be depreciated over a period of 27.5 years for residential property or 39 years for commercial property. Each year you are permitted to deduct up to one year’s worth of depreciation.
This means that if you purchase a piece of residential rental property for $150,000 of which $50,000 is attributed to the land and $100,000 is attributed to the building, you may be able to take a depreciation deduction of up to $3,636 per year ($100,000 divided by 27.5).
The depreciation deductions that you write-off in any year reduce your taxable income thus increasing your profit for that year. An ordinary person is limited to a maximum annual $25,000 realty investment property loss deduction against their ordinary taxable income. Any undeducted real estate investment tax loss is rolled over for future use, such as at the time the property is sold at a profit. Then you may subtract the unused tax loss from your capital gain to lower the taxable profit.
You may want to seek professional advice from your C.P.A. or tax attorney with respect to depreciation deductions.
4. You can use a “Tax-Deferred Exchange” to roll your capital gains into your next investment property. Many refer to these as “Tax-Free Exchanges,” which is somewhat of a misnomer. Many people are familiar with the current rule with respect to personal residences: if you sell your personal residence at a profit, you do not have to pay any capital gains on the sale as long as your capital gains are less than $250,000 for individuals or $500,000 for married couples. With investment property though, if you sell the property, you are required to pay capital gains taxes, which will take a substantial bite out of your profit. However, Internal Revenue Code §1031 permits what are referred to as “Tax-Deferred Exchanges.” If you are selling one or more pieces of investment real estate and plan to purchase different investment real estate, then using a Tax-Deferred Exchange, you can roll your capital gains into the new purchase and not pay any taxes at the time of sale.
For example, say I purchase a residential rental property for $80,000. A few years later, I decide that I would like to sell the property for a different rental property. The property is now worth $100,000. If I sell the property outright, I would be obligated to pay capital gains tax on my $20,000 gain (for the sake of simplicity, I’m assuming there were no expenditures related to the property and no depreciation deductions). However, since I am purchasing another piece of investment property, I can defer paying the tax by rolling the entire $100,000 into my purchase of the new rental property.
The reason why this transaction is considered tax-deferred, is that if I ever sell the property and do not replace it with other real estate, I will be required to pay capital gains on all of the gains from each exchange transaction. For example, continuing from the prior example, I use the $100,000 to purchase another piece of real estate. In five years, I decide to sell and it is worth $150,000. Thus, I have a capital gain of $50,000 on the second piece of property. However, since I didn’t replace it with more real estate, I will have to pay all the deferred capital gains as well, meaning that I will have to pay capital gains tax on $70,000 ($20,000 from the first transaction and $50,000 from the second transaction.
But notice the advantage of being able to delay the capital gains. Assume in the first transaction that I had had to pay capital gains tax on my $20,000 gain. If we assume a 20% capital gains tax, I would have to pay $4,000 in taxes. So if I then wanted to purchase a new investment, I would only have $96,000 available to invest rather than the full $100,000.
Note: There are some very rigid requirements to properly executing a Tax-Free Exchange. Thus, it is imperative that you seek proper legal guidance if you plan to use such a transaction. If the transaction is done improperly, it cannot be fixed after the fact and you will be obligated to pay the capital gains tax.
5. Use a Limited Liability Company to Hold Your Real Estate and Insulate Yourself from Liability. This isn’t really a way that real estate can help you become a millionaire, but it is a way to protect your assets and keep you a millionaire (or however wealthy you may be). Real estate ownership does come with some exposure to liabilities. However, you can protect yourself by holding the real estate in a limited liability company (LLC). If you own multiple properties, it is often wise to hold each property in a separate LLC. Thus, if someone is every injured on your property and the injured party attempts to sue, the only property that will be at risk is that one piece of property but the injured party will not be able to make a claim against your other pieces or property or your personal assets such as your own home or your bank accounts.
Note: Again, there are some formalities involved with properly forming and maintaining an LLC. If you are unfamiliar with how to properly form and manage an LLC, consult your legal advisor.
Putting it all together:
The following numbers are from a parcel of property that was recently on the market. The property is currently for sale for $120,000. It has 3 rental units. Together the 3 units provide a monthly rental income of $1,850 or $22,200 annually. The annual property taxes are $920. Utilities are about $5,280 per year.
Assume that I take out a $100,000, 15 year fixed rate mortgage with a 7% interest rate. I pay the other $20,000 in a cash down-payment. The monthly mortgage payments would be $899 or $10,788 over the course of a year.
Annual Rental Income: $22,200
Less Mortgage Payments: ($10,788)
Less Utilities: ($ 5,280)
Less Property Taxes: ($ 920)
Positive Cash Flow: $ 5,212
Positive Cash Flow: $ 5,212
Equity after 1 year: $ 3,909
Total 1st year income: $ 9,121
This is a 46% return on the initial $20,000 down-payment! Now, I did not factor in any expenses for improvements and maintenance to the property, but I figure it is a reasonably fair assumption that these will be offset by depreciation deductions and market appreciation.
The above numbers just reflect the 1st year. The longer the property is held, the faster than equity will build and after 15 years, the mortgage will be fully paid off creating an even higher positive cash flow.
Assume I hold the property for the 15 years and the mortgage is fully paid off. In the interim years I have been creating positive cash flow which I can invest in other avenues such as the stock market or other real estate. After the 15 years, I have built up $120,000 in equity in the home (not accounting for any appreciation). I could then use this as a down-payment on a new real estate investment. If I figure on making a 20% downpayment, I would then be able to purchase a $600,000 mortgage and begin the equity building process all over again.
Now, like I said above, the real estate market can vary in different regions but if you do your homework and properly follow the rules, real estate investing can put you well on your way to becoming a millionaire. In fact, many of the clients that my law firm works with on a regular basis have built their wealth through real estate investing.
