When Charles first entered the real estate field while attending college decades ago, his father, a prominent real estate investor, advised that he use his monthly income primarily to pay day-to-day living expenses and allocate money each month into long-term financial investments like real estate. This solid advice has served Charles well over the years.
For many people, a comprehensive wealth-building strategy can help with the challenges of funding future education for children and ensuring a comfortable retirement. However, this requires a lot of planning and discipline, especially where you intend to invest in real estate. Contacting an investment company and purchasing some shares of your favorite mutual fund or stock is a lot easier than acquiring your first rental property, but with a financial and real estate investment plan, a lot of patience, and the willingness to do some hard work.
Compared with most other investments, good real estate can excel at producing current income for property owners. So in addition to the longer-term appreciation potential, you can also earn income year in and year out. Real estate is a true growth and income investment.
Major benefits of investing in real estate
- Tax-deferred compounding of value: In real estate investing, the value of your properties appreciates at compound interest, while tax payment is deferred during your years of ownership. You don’t pay tax on this profit until you sell your property, and even then you can roll over your gain into another investment property and avoid paying taxes.
- Regular cash flow: If you have property that you rent out, you have money coming in every month in the form of rents. Some properties, particularly larger multiunit complexes, may have some additional sources, such as from facilities management fees. When you own investment real estate, you should also expect to incur expenses that include your mortgage payment, property taxes, insurance, and maintenance. The interaction of the revenues coming in and the expenses going out is what tells you whether you realize positive operating profit each month.
- Reduced income tax bills: For income tax purposes, you also get to claim an expense that isn’t really an out-of-pocket cost — depreciation. Depreciation enables you to reduce your current income tax bill and hence increase your cash flow from a property.
- Rate of increase of rental income versus overall expenses: Over time, your operating profit, which is subject to ordinary income tax, should rise as you increase your rental prices faster than the rate of increase for your property’s overall expenses. What follows is a simple example to show why even modest rental increases are magnified into larger operating profits and healthy returns on investment over time.
Despite all its potential, real-estate investing isn’t lucrative at all times and for all people, here’s a quick outline of the biggest caveats that accompany investing in real estate:
- Ups and downs: Although you have the potential for significant profits, you’re not going to earn an 8 to 10 percent return every year. Like stocks and other types of ownership investments, real estate goes through down as well as up periods. Most people who make money investing in real estate do so because they invest and hold property over many years.
- Relatively high transaction costs: If you buy a property and then want to cash out a year or two later, you may find that even though it has appreciated in value, much (if not all) of your profit has been wiped away by the high transaction costs. Typically, the costs of buying and selling, which include real estate agent commissions, legal fees, title perfection, and other closing costs could amount to up to 30 percent of the purchase price of a property. So, although you may be elated if your property appreciates 15 percent in value in short order, you may not be so thrilled to realize that if you sell the property, you may not have any greater return than if you had stashed your money in a lowly bank account.
- Tax implications: Last, but not least, when you make a profit on your real estate investment, the federal and state governments are waiting with open hands for their share in the form of capital gains tax, assessment taxes, land use charges, legal fees, tenement rates and such other taxes as may arise from time to time on real estate. What really matters is the profit you have left after the government takes its bite, not your pretax income.
These drawbacks shouldn’t keep you from exploring real estate investing as an option; rather, they simply reinforce the need to really know what you’re getting into with this type of investing and whether it’s a good match for you.
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