Using Rental Real Estate to Build Wealth
Using Rental Real Estate to Build Wealth
June 22, 2023
Owning rental real estate can be a powerful tool for building wealth. Real estate has a strong track record of appreciating over time. Every mortgage payment made by a tenant builds additional equity in the property. Owning high quality, cash flow positive properties opens up opportunities for additional bank financing, and the tax code has many favorable provisions for real estate investors like the 1031 exchange, active participation exception, qualified business deduction, and maximizing depreciation expense via cost segregation.
It is also a complicated financial endeavor. You are borrowing money to buy an asset via an expensive and time consuming transaction. Typical closing time is 30 - 45 days and closing costs in Maine average about $4,4001.
The goal of rental real estate is to generate enough rental income to cover operational costs, both fixed (taxes, insurance, management, etc.) and variable (utilities, repairs, vacancy, etc.) and make a profit.
The profit is taxed as income but doesn't count towards your social security in retirement (assuming you are not a real estate professional). The building needs to be depreciated every year. Depreciation, may save you money on taxes in each year but the IRS may "recapture" those tax savings when (or if) you sell the property. If you sell the property at a gain, there may be federal and state capital gains tax (if your state has cap gains tax) and potentially also the net investment income tax.
If you don't make a profit from the rental income, you may not be able to use those losses to offset other taxable income.
Price appreciation historically has been consistent, except for when it's not. All real estate is local and it is dangerous to rely on national price trends and data. Appreciation is most consistent over long periods of time, except when you choose to or are forced to sell into a bad market such as the late 80's or during the financial crisis of '08 and '09.
Personal financial health is important because of the difficulty and expense of selling a property. As a rule of thumb, you never want to be forced to sell an asset because you need the cash. That goes for all assets, whether stocks, bonds, commodities, or real estate. To put yourself in a position to not be forced to sell, a strong financial position and careful planning is essential.
A strong financial position means cash reserves, insurance, and access to credit. Careful planning means doing the math on things like the debt coverage ratio, cap rate, and cash on cash returns and being conservative with estimating unforeseen expenses like vacancy and eviction.
The opinions voice in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
To determine which investment(s) may be appropriate for you, consult me prior to investing.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
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