Real estate is one of the most tax preferred investments a person can buy. The preferential tax treatment to this asset class and strategies for owning this type of asset are described in this article.
The biggest advantage of real estate investment is leverage. What other asset can you put 10% to 20% down yet have 100% right of ownership? For example, if you by $10,000 in stock or bonds, then you need to have $10,000 up front to control those assets. If the stock market goes up by 10% in one year then you will have made $1,000. Real Estate is one of the few assets you can buy and have ownership of with a relatively small down. If you put $10,000 down and borrow $90,000 then you can own and control a $100,000 piece of real estate. If real estate goes up 5% per year, then after the 1st year you will have made $5,000 in equity, minus the cost of the loan. That is a 50% gain on your initial investment.
In the USA, loans on real estate are readily accessible to most people, they are low cost and also have tax advantages. If you borrow money on your primary residence the interest, you pay on that loan is counted as a tax deduction on your total income for loans up to $750,000. That means if you pay $50,000 in interest on a $750,000 loan, your taxable income goes down by $50,000. If you have a loan on an investment property, the interest you pay on that loan is considered a cost of the investment and decreases the gains. If you own a rental property that makes $2,000 per month, you would have $24,000 per year in gross income per year. If you pay $15,000 in interest over that year, then you will only have to pay taxes on $9,000 minus any other expenses. Many people can invest in real estate and pay little to no taxes on that property.
Real estate also has huge tax advantages, the primary being that al the equity that is gained is tax deferred until you sell the property. In the case of a primary residence may be able to sell your property and pay no tax. For example, if you purchase your primary residence and it goes up in value, you can take the first $250,000 of those gains tax free if you are single and $500,000 of those gains tax free if you are married.
Real Estate that is not sold but rented requires no tax be paid on the equity that grows overtime from the principal pay down and any value increase in the property. That profit can now grow tax deferred until the final sale of that property. Gains on investment properties do have to be paid when those properties are sold however the tax rate will vary depending on how long you have had the property. If you have owned the property for less than 1 your, you will have to pay ordinary income tax. If you hold the property for longer than 1 year, you will pay long-term capital gains tax which is currently 20%.
One-way real estate investors avoid or defer paying tax on their sold investment properties is to do a 1031 exchange. This allows a real estate investor to sell an investment property and take all the gains tax free if they purchase another investment property of greater value than what they sold. This ability to roll equity into other assets can be a very powerful investment strategy and will allow the borrower to pay no tax.
No other asset allows you to borrow against the gains you have made. If you want to get cash in exchange for a stock or bond, then you need to sell it and pay the taxes before you can have access to your money. Real estate is different in that you do not need to sell the asset to get access to your stored capital. Instead of selling real estate many investors choose to borrow against the equity in their property. Why sell a property that you have to pay tax on, when you can borrow that money at a low interest rate and pay no tax.
This is a person who purchases a property and then rents it out. The landlord controls the property, sets the rent, and gets the increased equity in the property as it goes up overtime. Rental properties can provide monthly income and the increasing value of the property can grow tax free. Also, expenses like interest on a loan against the property or costs associated with managing or maintaining the property are tax deductible. The downside is that rentals can take time and effort to rent out and managing tenants can be a burden, especially if they don’t pay on time or are destructive to the property. Vacancies (times where the property is not rented) are also part of the game and should be factored in when owning investment real estate. Taxes on real estate equity gains are not paid unless the property is sold.
The basic strategy of a Fix and Flip is for a real estate investor to purchase a property at a discounted price. Then fix up the property to either meet conventional lending standards or renovate the property with the goal of selling for a profit. The same is true for a fix and hold except the investor after renovating the property gets their own conventional loan so that they can hold the property long-term as a rental or primary residence.
While there can be great profits to be made by flipping a home it is by no means easy. You have to buy well, rehab inexpensively and do so quickly. You will also need a significant capital. Not only do you need funds to acquire the property you will also need money to rehab the property, pay your people, property taxes, utilities, insurance and carry the cost of any loans you have taken out. After that you will have to pay taxes on the profits made from the sale. It has been said that you need to have money to make money and that is certainly the case if you are in the business of renovating real estate for a profit.