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A Dozen Reasons for Direct Real Estate Investment

Okay, I am not a direct real estate investment fanatic. Absolutely not.

Further, I get that direct real estate investment burdens investors with some problems. Illiquidity for one. A lack of diversification for another. And then the extra work of owning and managing properties.

But critics of real estate investment absolutely get it wrong when they say real estate investment doesn’t make sense for individuals. Often real estate investment does make sense for these folks. And for at least a dozen reasons…

Reason #1: Illiquidity Sometimes Helps

A first quick thing? The illiquidity of direct real estate investment helps some investors “stay the course.”

For example, in order to get a nice-sized balance in an IRA account or 401(k) account, you and I need to regularly save additional amounts. Maybe every paycheck. Year in and year out.

But it’s easy to become irregular in our savings. And that irregularity will cause the plan to fail.

In comparison, when someone invests in real estate, the investment process often locks in the investor.

One example of this: A landlord using a mortgage must continue to make mortgage payments (which means at the very least building wealth by reducing the mortgage.)

Another benefit of illiquidity? An investor with a big IRA or taxable account balance can be tempted to use that money to buy a bigger house or a more expensive car. An illiquid investment in real estate doesn’t offer the same easy access.

Illiquidity, then can improve the behavior of some investors. And so some investors save successfully with real estate when they can’t successfully save using options like retirement accounts.

Reason #2: No Limit on Investments of Pretax Money

A subtle, second thing people often don’t realize.

As compared to tax-deferred wealth building options like an Individual Retirement Account or a 401(k) plan, direct real estate investment may offer the ability to invest large amounts of pretax income without paying taxes.

To understand this, first remember that tax law limits the amount an investor can save pretax into an IRA or 401(k) account. In 2019, for example, tax law limits a typical individual to no more than $6,000 of tax-deductible contributions to an IRA and no more than $19,000 of tax deductible contributions to a 401(k).

Direct real estate investment vaporizes these limits.

I’ve talked about one example of how this works with vacation rentals. But to use an extreme example, a family that earns $500,000 a year may be able to use, say, $300,000 of this income to invest in real estate before paying income taxes on the $300,000.

A family, for example, might be able to use $300,000 of pre-tax income as a down payment on a $1,000,000 property and then on the first tax return put a $300,000 depreciation deduction.

Lots of complexity exists for people who want to generate giant real estate deductions. But the point is, you can do this with real estate.

Reason #3: No Limits on Sweat Equity

Direct real estate investments often do burden investors with extra work as compared to someone investing in a mutual fund or bond.

But that extra work can be viewed as a benefit. That extra work can increase the return the investor receives.

If you repaint a rental, for example, you do shoulder extra work. But you also probably increase the value of the property and its rental income.

In comparison, you don’t have anyway to increase the value or income of investments you hold inside an IRA or 401(k) account.

Practically, for example, you have no way to increase the value of a mutual fund you own inside an IRA or 401(k) account.

And tax law prohibits you from increasing through sweat equity the value of direct real estate investment you hold in an IRA or 401(k) account.

Reason #4: Inefficient Market Opportunities Exist

Something else to consider—though I want to be careful here…

With real estate, you sometimes get the opportunity to buy property at a price that’s fair to the seller but less than its value to you. That inefficiency, which doesn’t exist for mutual fund shares or bonds or company stocks, sometimes makes for great real estate investments.

One example of this? You might be able to buy your parents’ house at a 6% discount because mom or dad wants to sell but doesn’t need to pay a 6% real estate commission by selling to you.

Another example of this? You might be able to buy a beat-up property  at a $100,000 discount because of repairs the property needs… but then do the repairs yourself for $20,000 because you have a small construction company.

You don’t get these sorts of opportunities with traditional stock and bond and mutual investment choices.

Reason #5: No Required Minimum Distributions

As compared to money held inside an Individual Retirement Account or 401(k), real estate investments offer the advantage of no required minimum distribution.

In other words, if you have 20 years of life left and you’re over age 70 and half, you’re required to withdraw 1/20th of your IRA or 401(k) balance. Regardless of what you need or want, required minimum distribution rules force you to liquidate investments and report the proceeds as income.

With real estate investment, you will need to report the rental income on your return. But you won’t be forced to “liquidate” your properties and pay capital-gains-like taxes on the appreciation and depreciation recapture.

Reason #6: Section 1014 Step-up in Basis

Another tax benefit that applies to direct real estate investment? The Section 1014 step-up in basis.

Section 1014 says the cost basis of any asset (like real estate) that you own when you die gets “stepped up” to its fair market value at date of death. Your heirs can then sell the appreciated or the previously depreciated real estate without paying tax.

Or they can continue to rent the property but begin depreciating the property all over again.

This is a giant benefit.

If you die with a $1,000,000 IRA balance, in comparison, the IRA basis equals zero. And your heirs will pay income taxes on the $1,000,000.

Two notes to clarify. First, stocks held in a taxable account get stepped up too. The Section 1014 step-up tax benefit isn’t unique to real estate. But the thing is, if you leave heirs a $1,000,000 rental property, you have deducted tens or hundreds of thousands of dollars of depreciation over the years.

A second thing to note about the Section 1014 step-up: Married couples residing in community property states get a full step-up when either spouse passes away.

For example, if mom and dad reside in a community property state and they buy a rental property early in their marriage, they can probably fully depreciate it. (Maybe thereby taking a few hundred thousand dollars of depreciation deductions.)

If dad predeceases mom (the usual way of things), the basis will get fully stepped up. And then mom can either sell the property without paying tax. Or she can start over on the depreciation.

Reason #7: Section 1231 Supercharges Tax Loss Harvesting

A tax benefit real estate offers but which stocks and bonds and mutual funds don’t: Supercharged tax loss harvesting.

Here’s the deal: If you lose money on a stock or bond or mutual fund, you do get to deduct the loss eventually. Probably. But tax law delays or limits your deduction in many cases.

The usual rule on capital losses is that you can use them to reduce capital gains for the same year and then also another to shelter another $3,000 of ordinary income.

You carry forward any leftover “unused” capital losses to the subsequent year. In that subsequent year, you use the carry forward to shelter capital gains and then another $3,000 of ordinary income.

And then? Any still “unused” capital losses get carried forward again to the next subsequent year.

In comparison, real estate investment losses don’t get limited. If you purchase a $100,000 rental property and, heaven forbid, you lose $100,000 when you sell, that $100,000 gets deducted as something called a Section 1231 loss on your tax return in the year of the loss.

In other words, with a Section 1231 loss you probably immediately harvest the entire tax loss. And you can use the tax loss to shelter any other type of income.

Reason #8: Production of Income Deductions

Another real-estate-y tax benefit. The expenses related to direct real estate investment become tax deductions (either currently or eventually).

Real estate expenses are Section 212 deductions which, like business expenses, just need to be ordinary and necessary for the production of income activity in order to be tax-deductible.

Investment portfolio expenses, in comparison, aren’t deductible. At all.

Just to hammer home this point, if you consult an attorney or accountant about a rental property investment you own, that expense is deduction. Similarly, if you take a class to better manage your rentals? Deductible. If you buy a computer for your rentals? Deductible.

These sorts of expenses, however, don’t become deductions if they’re connected to your investment portfolio of stocks, bonds and mutual funds. Instead, the deductions are nondeductible investment expenses.

Reason #9: Avoidance of Section 1411 Net Investment Income Tax

A potential real estate tax benefit for many young investors…

At some point in the future, many investors will pay the Obamacare “net investment income tax” on investment income from taxable accounts: interest income, dividend income, capital gains and so forth.

Why? The $200,000 and $250,000 thresholds for subjecting investment income to the Obamacare tax aren’t indexed for inflation. Accordingly, younger workers who build investment wealth will eventually pay this tax on at least some of their portfolio income when inflation pushes incomes up.

Note: Retirement income flowing out of a IRA or 401(k) is not subject to net investment income tax.

However, real estate investors can avoid the net investment income tax if they’re active enough. I’ve got a longer blog post that explains the details, Real Estate Investors and the Net Investment Income Tax. So I’ll point you there rather than repeat that discussion.

Reason #10: The Section 199A Deduction

Another benefit for direct real estate investment as compared to some taxable investments that produce ordinary income?

Under current tax laws, specifically, Internal Revenue Code Section 199A, real estate investors whose activity levels rise to the level of a trade or business don’t have to pay income taxes on all of their rental income. They only need to pay income taxes on 80% of that income.

Unfortunately, Congress and the IRS wrote complicated rules for Section 199A. But good news, we provide tons of detailed information here at the blog about how Section 199A works for real estate investors. One useful read? The Real Estate Investor Section 199A Deduction. And another blog post you should find useful? Section 199A Rental Property Trade or Business Definition.

Reason #11: Direct Real Estate Investment Provides a (Relatively) Safe Way to Leverage

I want to end with a couple of more general “financial theory”-type benefits of real estate.

A first theoretical benefit? Real estate investment allows you to pretty easily and relatively safely leverage your investing.

You can, for example, borrow much of the purchase price using a long-term mortgage. And you can even borrow using a fixed-interest-rate mortgage.

Yes, yes, you can use leverage to invest in other investments too. But you may not be able to borrow as easily or for as long or for a fixed interest rate.

This ability to leverage, while risky, may amplify your returns.

In case you’re interested? We’ve got a discussion here, Six Common Formulas for Small Business Success, that describes how to semi-prudently use financial leverage. And then this blog post, Portfolio Leverage Modeling with cFiresim and FireCalc, explains how to use a couple of popular financial planning calculators to experiment with leverage.

Reason #12: Real Estate Investment Plays Well with Other Investments

A final theoretical benefit. Direct real estate investment appears to do good things to your overall investment portfolio.

Real estate, for example, appears to deliver investment returns similar to stocks though with lower volatility. (That lower volatility should bump returns and dial down your investment risk.)

Further, real estate investment returns poorly correlate with equity market returns. You and I therefore dial down our investment risks by combining things like stock index funds with rental properties.

We’ve talked about this subject before in another blog post: Lessons from the Rate of Return of Everything. If you’re interested in more details and the hard data, refer there. (You might also want to peek at this short blog post which displays graphs of stock, housing and bond returns over the last century for about a dozen countries.)

But the point is, real estate shows poor long-term correlation with stocks and bonds. And this is good.

For example, the worst case 30-year retirement scenario for U.S. investors starts in 1966. The three decades after 1966 subjected these folks to a sagging stock market and high inflation. Holding 25% of a portfolio in rental property investments, however, would have protected their retirement plans from failure.

Summing Up the Case for Direct Real Estate Investment

Full disclosure: I did not myself prepare financially for retirement using real estate investment. I used tax-deferred retirement accounts stuffed full of cheap index funds from Vanguard.

However, though that approach worked well for me and many in my generation, it seems pretty obvious direct real estate investment offers some attractive and unique benefits.

Not everyone will want to get on the real estate bandwagon. Not everyone should. But the critics who say direct real estate investment doesn’t make sense don’t know enough about real estate’s unique tax features and financial character.

If you think real estate investment might work for your financial plan, you ought to consider this option…

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