Uncertainty seems to be the “new normal,” when it comes to the ways in which people are living, working and investing. But despite rattled markets and short-term economic uncertainty, real estate investments can help manage your portfolio risk through diversification, while aiming to produce returns that can be enhanced with tax benefits.
First of all, while the pandemic is global, real estate is local. Unlike other investment-grade assets, real estate value is based on the unique characteristics of the local community and marketplace.
Second, real estate investment trusts (REITs) are trading at lower valuations, making them a potentially lucrative buy during the current downturn. Furthermore, vacation rental properties are selling at steep discounts, as business and leisure travel have declined.
With these and other factors, it's understandable that today's investors are acquiring real estate in an attempt to diversify and grow retirement accounts, and to help manage market volatility.
Tax Benefits Can Juice Real Estate Returns
At our company, we emphasize two simple, but important rules about U.S. tax laws:
1. It's your money, not the government's money.
2. The tax law is written primarily to reduce your taxes.
One potential benefit of real estate investments is they allow you the opportunity to take advantage of many tax benefits and deductions, such as:
• Closing costs
• Property management and leasing fees
• Maintenance and repair expenses
• Property and business supplies
• Marketing expenses
• Mortgage interest
• Property and rental taxes
• Home office business expenses
• Meals and entertainment (business discussions)
• Travel to and from property
• Vehicle used for business
Two additional ways in which you can reduce, and even defer, payment of taxes are depreciation and the Section 1031 exchange.
Depreciation is a noncash expense allowed by the IRS to compensate investors for property wear and tear. The value of residential buildings and improvements, excluding the land, can be depreciated at a rate of 3.636% over 27.5 years, while commercial property is depreciated at a rate of 2.564% over 39 years.
Property depreciation is a key reason why many wealthy real estate investors have plenty of cash but pay relatively little in income tax. In fact, by strategically increasing basis with debt, after-tax cash flows can remain strong and robust.
The second way to defer taxes on the sale of property is to roll capital gains over into a like-kind asset, via the 1031 exchange. When assets held for long-term investment are sold, the IRS assesses a capital gains tax of either 0%, 15% or 20%, depending on your income level. Through use of the 1031 exchange, you can replace one investment property with another and can defer paying taxes on a capital gain.
While real estate can be an important part of a well-balanced portfolio, there are no absolutes when it comes to any investment. As such, before putting money into an office building, rental residential property or retail center, it's important to consider the following issues.
• Hands-on management. The term “toilets, trash and tenants” is connected with real estate ownership for good reason. Unless your target is passive real estate investments, you can assume that your property will require continuous repair and maintenance, meaning capital in addition to the purchase price. And, even if credit-worthy occupiers are filling the space, long-term tenancy — or cash flow — is not guaranteed. For instance, Covid-19-spurred residential housing eviction moratoriums have placed apartment and single-family landlords in a tough position. Even if their tenants don't pay rent, the owners can't replace them with new tenants.
• Market volatility. At the beginning of this article, I mentioned that real estate is a very local investment. While due diligence is a must with any investment, you'll need to add in-depth research on local market economics, population and competition if you are eyeing real estate assets for your portfolio. Markets are cyclical; the “hot” metropolitan area of today could be tomorrow's blighted urban core. As such, when it comes to where to invest, it's a good idea to take cues from some of the larger, more established local investors, and where they are placing their proceeds. For instance, in targeting the best single-family rentals for investment, be sure to research neighborhood ratings, which are based on household income, home values, employment, school ratings and crime rate, along with newer or recently upgraded houses.
• Asset cycle declines. “Real estate” is a broad category, encompassing everything from a medical office building, to apartment complexes, to warehouses and distribution centers. Returns on investment can differ greatly, based on supply, demand and competition (especially geographic competition). You need to understand real estate assets' economic cycles and accordingly adjust your investment decisions.
• Depreciation recapture and capital gains taxes. Depreciation is a great tool when it comes to real estate investment. But when that property is sold, any realized gain must be reported to the IRS as ordinary income, a concept known as depreciation recapture. This is the case, whether or not you depreciate expenses during your property's hold period. You'll also be responsible for taxes on capital gains, unless you plan to roll those profits into another like-kind property, via a 1031 exchange.
Though no one really knows what the “new normal” will look like, real estate has been a solid investment during low ebbs in the economic cycle. Despite short-term economic uncertainty, high-quality, investment-grade real estate can help you grow your income and retirement portfolios, while allowing you to leverage many tax benefits.