ere are are going to cover why real estate is still a great option in the era of high interest rate environment of 2022, plus go into 6 perennial reasons why real estate has such great tax benefits.
One of the hidden advantages of owning real estate is the tax advantages. You’ve probably heard in the news of some “rich” people paying little to zero taxes, right? You may even remember famously when Hillary Clinton accused Donald Trump of not paying taxes during the 2016 election?
Well, what is their secret? One of the biggest secrets is owning real estate, plain and simple. The federal government offers a ton of tax benefits to real estate owners. More on that further down in the article.
- 1 Investing in Real Estate in 2022
- 2 6 Great Tax Benefits of Investing in Real Estate
Investing in Real Estate in 2022
The first question you should probably as is, “Why should you invest in real estate in now, especially in a high interest rate environment?” Generally speaking rising interest rates have caused the real estate market to suffer. Home prices may need to be lowered in order to be sold, as higher rates make homes less affordable to borrowers. This has been the trend for much of 2022.
Early in 2022, interest rates remained relatively low. Mortgage rates were higher than they had been earlier in the year, but the Federal Reserve had not yet increased interest rates significantly. The central bank had stated that it would be willing to raise rates significantly in the future. As a result of the lower mortgage rates, savvy buyers looked to purchase property.
The number of homes available for sale relative to the number of buyers was extremely low, with just 1.6 months of supply, according to the St Louis Fed. A lack of homes for sale combined with an influx of buyers taking advantage of low interest rates caused prices to rise rapidly early in the year.
The Fed raised interest rates at an unprecedented pace. Rising rates have made homes less affordable and many sellers have lowered prices in response.
Real estate investing is usually a long-term endeavor, so people considering getting into it should think with that timeline in mind. Even if interest rates are high at the moment, it may be a good idea to save up money for a down payment while waiting for rates to go down again.
With that in mind, here are five top ways to invest in real estate.
1. Buy your own home.
Your first residence may not seem like an investment at first, but many people see it as one. Investing in real estate through a real estate investment trust can offer many benefits.
Paying off a mortgage each month allows you to build equity in your home, as opposed to paying rent which always seems to go up over time. A part of your monthly mortgage payment goes into your own savings. Although experts cannot agree on whether or not it is beneficial to own your own home, they do agree that a home is not worth any price. This was a lesson learned by homebuyers in 2000.
Purchasing a home may be a more affordable option than renting if you plan to stay in an area for a long period of time. In addition, banks are more lenient with owner-occupied properties, resulting in a lower mortgage rate and down payment. You may be able to reduce the amount of taxes you have to pay by deducting the interest expenses.
One idea to keep in mind though is that your own home isn’t necessarily an investment. Robert Kiyosaki famously states (and I’m paraphrasing) that “Assets produce cashflow, so owning your home isn’t an investment”.
2. Purchase a rental property and become a landlord.
If you’re ready to manage a property, you could try a residential rental property, like a single-family home or a duplex. The advantage of this kind of property is that it is easier to gauge the standards of the marketplace, as opposed to commercial properties.
An additional benefit is that it may require a smaller investment to get started, for example, with a single-family home. You may be able to buy a property for as little as $20,000 or $30,000 as a down payment, as opposed to the hundreds of thousands of dollars required for a commercial property. You may be able to buy a property for an even lower price if you are able to find a foreclosure that is visually appealing.
You’ll usually have to pay a large amount of money upfront to begin, often 30% or more of the total price. If you are just starting out and don’t have a lot of money, this may not be a good option for you. A possible solution to this problem could be to purchase a rental property that you would also live in.
As a downside, you would need to manage the property and make decisions regarding upgrades that may need to be made. Although owning property is classified as a passive activity for tax purposes, it could turn out to be very active if you become a landlord. If a tenant does not pay their rent, the owner of the property still has to make the monthly payments, or else they will go into default on the loan.
One alternative here, that I’m strongly in favor of is hiring a property manager to manage your property. This frees up your time and allows professionals to manage the day-to-day work of owning a rental property. This is a key component of my own personal financial freedom plan.
3. Consider flipping houses.
Flipping houses is becoming a more popular way to invest in real estate, but it requires knowing how to spot a good deal and more operational expertise than becoming a long-term landlord. This path may help you realize a quicker profit than being a landlord if you do it right.
The advantage of this approach is that you can make money more quickly than by managing your own property, but it requires more expertise. Flippers typically look for undervalued properties that need to be either cleaned up or completely renovated. They purchase homes at a low cost, make the necessary changes to improve the homes, and then sell the homes at a higher cost than they purchased the homes, making a profit off of the difference in cost.
4. Buy a REIT.
The next two ways to invest in real estate are much more passive than the previous options. A REIT is a good investment for people who want to make money from real estate without having to deal with the complexities of owning property. REITs are traded on stock exchanges, so they are easy to buy and sell, and their prices are set by the market. And you get to collect a dividend, too.
If you are a beginner investor with a small amount of money to invest, a REIT may be a good option for you. However, you will need to put in some effort to research and monitor your investment, as there are still some ways that you could end up losing money on a REIT investment.
5. Use an online real estate platform.
An online real estate platform allows you to invest in commercial real estate deals without having to spend a lot of money. Some platforms help developers connect with investors interested in funding real estate projects with the potential for high returns.
With all of that said, here are 6 great benefits of
6 Great Tax Benefits of Investing in Real Estate
1. Capital Gains Home Exclusion Tax Benefit
If you’ve owned and lived in your home as your main residence for at least two of the past five years, you can exclude part or all of the gain on its sale.
According to the IRS, if you sell your main home, you may be able to exclude up to $250,000 of the resulting capital gain from your income (or up to $500,000 if you file a joint return with your spouse).
2. No Self-Employment or FICA Taxes Paid on Rental Income
Rental income does not have to pay social security and Medicare taxes. The percentage of FICA tax you pay on other income depends on whether you are employed or self-employed. The rate ranges from 7.65% to 15.3%. You will be taxed 15.3%, with 50% being taken out by your employer and the other 50% being taken out by you. If you are self-employed, you are responsible for the full 15.3% of taxes, which is known as self-employment tax.
This could be a significant amount depending on how you classify self-employment. This indicates that not all forms of income are seen as equal. The IRS designates some income sources as passive, which is a reason to try to earn more passive income.
There is another large deduction for depreciation, which is when the IRS lets you deduct the cost of business items that have a limited time frame, such as the building itself. Many people view the ability to deduct mortgage interest from their taxable income as the most beneficial tax perk of investing in real estate.
The real estate you’ve invested in will start showing signs of wear and tear over time. If you own an income-producing property, you can write off any wear and tear on the property.
So how exactly does depreciation work? Here is quick summary.
You have to first determine the value of the building itself, rather than the value of the land it is built on. Then, divide that number by the amount of time the property is expected to be useful. The average lifespan of a warehouse or commercial property is 39 years, while the average lifespan of a residential property is 27.5 years, according to the IRS. Then, you deduct that precise amount each year.
This is an example of how you would calculate the depreciation of your rental property. If the property is valued at $500,000, you would divide that by 27.5 years, which would be approximately $18,000. This means that you can reduce your taxable income by $18,000 each year for 27.5 years. This deduction lets you tell the IRS that you made less money than you actually did, which lowers the amount of taxes you have to pay. In this way, you can offset the gains.
If your business depreciation results in a loss on paper, you can only use it to offset passive gains from other properties or investments. Withmake less than $100,000/year, you can subtract $25,000 from your taxes. If there is a loss in excess, it has to be carried over to the next year.
The two exceptions to this are as follows: 1) You are able to deduct all of the cumulative passive rental loss against non-passive income the year you sell the rental property. If you or your spouse are in the real estate business, you may be able to deduct your income.
So what can depreciation do for you? The short answer is it functions as a major lever in allowing the positive cashflow from your rental properties to come to you tax free. It’s sort of like adding an additional 20%-30% on your revenue. Who doesn’t like paying less in taxes?
4. 1031 Exchange
This exchange allows taxpayers to exchange one investment property for another without paying any federal capital gains taxes on the selling price of the original investment. The 1031 Exchange is a way for taxpayers to avoid paying federal capital gains taxes on the selling price of an investment property by exchanging it for another investment property. A taxpayer may defer recognition of capital gains and related Federal income tax liability on the exchange of certain types of property, including real estate. Capital gains taxes are only paid when a property is sold without an exchange. Otherwise, these taxes are deferred.
The deduction for capital gains on investment properties allows investors to avoid being taxed on the sale of the property by rolling over the gains to the next property.
There are some specific rules, however. The replacement property must be at least as valuable as the existing property. The second condition for the exchange is that it should be for an asset, such as a real estate investment trust. The third requirement for like-kind exchanges is that the property must be held for productive use in a trade or business or for investment, and it can be exchanged for similar property.
If you die while owning the property, whoever inherits it will not be responsible for the taxes you owed on it. This means that they will be taxed on the property as if they had bought it at the current market value, rather than the purchase price. The amount of taxes they pay is based only on the current value of their property.
Estate taxes only come into play if your estate is greater than $5 million. This is a good problem to have. For further info and to talk to a professional about 1031 exchanges, head over to ApiExchange.com. Talk to Scott there, he is a wealth of knowledge.
5. Tax-Free Borrowing (Refinancing)
If you refinance, you can borrow money against the increased value of your property without having to pay taxes on it. The funds can be used to invest in other areas and acquire more units if that is the goal.
If, for example, you bought an apartment building for $500,000, The property is now worth $1 million. You refinance your mortgage for $500,000 cash to put towards the purchase of the next building. If you take advantage of this tax-free situation, you can keep growing your income from sources that don’t require active work, without paying more taxes.
Very famously, Robert Allen is a huge proponent of this. Buy two houses a year for 10 years and then start doing a re-cash out for income for snowballing your investments.
6. Opportunity Zones
It’s called the “pass-through deduction.” The “pass-through deduction” is a new part of the Tax Cut and Jobs Act of 2017. The US government has created special tax zones called “Opportunity Zones” in an effort to encourage economic growth and investment in specific areas of the country. They’ve decided to do so mainly through tax incentives.
I talk about the benefits of investing in Opportunity Zones in my post Investing in Opportunity Zones: What’s This Amazing Opportunity All About? This text is discussing the merits of a tax-deferred exchange, which is a way to delay paying taxes on capital gains for a period of time.
The fact that people are just beginning to figure out how to take advantage of it can be a great motivator. New investment opportunities are becoming available frequently and it is expected that even more will be available as the year progresses.
Real estate is still a great investment in 2022 (and beyond), even in a high interest rate environment. Particularly so when you wrap in the tax advantages that come with real estate.