If you’ve been looking for ways to diversify your investment portfolio you’ve probably considered real estate. Unfortunately, not many people actually take the plunge. A recent study done by real estate investment company RealtyShares found that only 15% of Americans are investing in real estate outside of their primary homes.
So, what’s holding people back? Simply put, it’s a lack of knowledge. As a society, we understand that real estate is a great investment but many think there are too many barriers for entry. Even though they understand the benefits, two-thirds of Americans feel real estate is too expensive, too hard or too far beyond their area of expertise. And for some, the idea of becoming a landlord doesn’t excite them. But in the end, real estate is one of the best ways to build wealth when done properly.
We’re going to talk about some of the different ways you can invest in real estate (some don’t even require owning a physical property), how you can get started as a real estate investor and some of the tax implications.
3 Types of Real Estate Investing
Most people know that real estate can be a very profitable investment when done properly. However, many people think purchasing a property and either flipping it for a profit or renting it out is the only way to become a real estate investor. There are actually several different types of real estate investments. Below are some of the more popular.
As of April 2019, 64.2% of Americans own their own homes. Owning your own home is one of the most common ways you can invest in real estate. You’re not going to increase your cash flow by collecting rent each month but over time you’ll pay down the mortgage balance and eventually own it outright. Being free and clear of a mortgage on your primary residence is an important step to achieving financial independence.
- As a homeowner, you are paying down your own mortgage balance instead of someone else’s, like you would as a renter.
- You can make improvements to the home without receiving approval. Plus, depending on the upgrades made, the cost could be returned to you upon selling the property.
- There are several tax advantages to owning your own home. These include the ability to deduct mortgage interest and property taxes from your income taxes each year.
- The equity gain in your home can drastically increase your net worth when the housing market is positive.
- In 66% of U.S. housing markets, it’s cheaper to own a home than rent.
- Unlike when you rent a home, you are responsible for all maintenance as a homeowner. If the repair or upgrade is significant like needing a new roof or furnace, it can be a big hit on your monthly budget.
Best For: Owning your own home is a perfect way to invest in real estate for everyone. It can help increase your net worth and lead to financial independence.
What You’ll Need: Before you purchase your own home there are several things you’ll need. First, you’ll need to find the property you want to buy. Then the biggest and most important step is making sure you have a large enough down payment saved.
Purchasing a rental property is one of the most widely known ways to invest in real estate. The idea is fairly simple. You purchase a property – it could be a single-family home, multi-family, or a condo unit. Then the goal is to rent it for more than it costs you each month. However, when you look at your overall monthly cost, you need to look beyond just the mortgage payment. You need to factor in maintenance on the property and the fact that over time, things break and will need to be fixed. You also need to consider monthly management of the property. Will you handle this, or will you hire a management company? All of these will factor into your overall cash flow. There is a lot of number crunching that goes into finding the perfect rental property but for those who choose to invest this way, it can become very profitable.
- The biggest advantage of rental properties is the monthly income you’ll receive from your tenants.
- Over time, the property will hopefully appreciate in value. If you purchase in a highly desirable location, this appreciation could be even greater.
- If you are a handy person and choose to make upgrades to the unit you will not only accelerate the property’s appreciation, but you might be able to increase the rent you charge.
- If you have issues with your tenants, it’s your problem. This could be late rent payments, problems with neighbors, or neglect of the property itself.
- A lot of people invest in rental properties thinking it’s going to be easy. The reality is that being a property owner is a lot of work. From day one when you’re crunching the numbers to see if a property works financially, all the way up to the work needed to be done to maintain the property. Yes, as we mentioned above you can hire a property management company but that will cut into your profits.
Best For: Anyone looking to start investing in real estate. While this isn’t as hands-off as other forms of investing might be, it’s a great way to build wealth.
What You’ll Need: The biggest requirements of becoming a real estate investor is knowledge and money. It’s not as simple as saying I want that house. You need to understand everything that goes into analyzing the financials of a property. If you understand the 1% rule, how to calculate cap rate and cash flow then you will be well on your way to finding the perfect rental property.
The second thing all real estate investors need is money. Similar to purchasing your own home, you won’t use cash for the entire purchase price. Most lenders will require a minimum of 25% down on rental properties and then you can finance the remainder. However, there are ways around the higher down payment requirement. You could find a multi-family home and live in one unit and rent out the others. Since it would then become an owner-occupied building, you would have access to FHA loan products requiring just 3.5% down.
In 2016, over 207,000 single-family homes were flipped in the United States which was the highest number since 2006. House flipping is a fairly simple concept but can be a very difficult task. Flipping a house requires you to find a property in need of work, renovate it and then flip it for a profit.
Over the years, reality TV has been big on house flipping shows. HGTV’s Flip or Flop has several different versions that take place all over the country. It’s not uncommon to watch these flippers turn a $50,000 or more profit on a home. But that’s what makes reality TV so popular. What they don’t frequently show is the hard work that goes into these deals and the potential downside.
When you purchase a home to flip, time is a crucial piece of your profitability. Because you’ve taken out a loan on the property, every week that goes by means less of a profit once you sell. Successful flippers will purchase a home, get in and do the renovations quickly and get it back on the market. Unfortunately, not all homes come in great condition. Things can go wrong. It might be outdated electrical that needs to be replaced or a sewer issue. These large problems take extra time and money to fix. That means less money in your pocket when you sell. Most successful home flippers will make their profit on the purchase. They find homes they can buy well below market value which will help boost their profit on the sale.
- When done properly, there is the potential to make a quick profit.
- Most home flippers will get in and get their hands dirty on all aspects of the project. This includes analyzing neighborhoods for good properties, budgeting the renovation costs and eventually the labor. By handling these areas of the process, you’ll get a valuable education and it will help you become a more successful house flipper with every deal you complete.
- Losing money. Flipping homes comes with a lot of risk. If you purchase a flip that has a lot of unexpected costs, it could eat away at your profits and you could lose money. The same is true if you don’t have a solid team in place before you purchase a property. If it takes weeks to get different pieces of the project completed, the holding costs can end up ruining your profitability.
- Stress is a real part of flipping homes. Often times the shows on TV make it look like a glamorous lifestyle. However, flipping homes comes with a lot of stress. Because there is a lot of money at stake, everything that can go wrong will just add to the stress you’re feeling.
Best For: Flipping homes is best for someone who understands the local market. As we mentioned earlier, profit can oftentimes be made on the purchase of a home. By understanding neighborhoods and local property values, you will have a greater chance of success.
What You’ll Need: Similar to investing in a rental property, having access to funding will be a must when buying a flip. You’ll need to have at least a 25% down payment. It’s also going to be important that you understand what certain projects will costs. If you go in to take a look at a potential flip and you see that it needs a completely new kitchen, a new roof, and new hardwood floors throughout, knowing what each of those items costs will be helpful. It will allow you to determine an optimal purchase price so you can still make a good profit.
How to Make Money Investing in Real Estate
The whole reason why people choose to invest in real estate is because they are looking to make money. Real estate is a great way to diversify your portfolio. Below, we are listing a few of the most common ways people can make money investing in real estate.
Most people purchase real estate with the hopes that it will appreciate in value, meaning the value in the future will be higher than it is today. However, it’s important to consider inflation when assessing real estate appreciation. The average annual rate of inflation over the past 100 years is roughly 3%. This means if a home’s value increases less than 3% in a year, its value is actually decreasing.
Most people purchase rental properties because they want to generate revenue through rental income. As we mentioned earlier you purchase a rental property and rent it out to a tenant for a fixed monthly rent payment. This amount should be higher than the total expenses (mortgage payment, insurance, taxes, maintenance, etc.). That difference is your monthly rental income.
Fix and Flips
Some people want to invest in physical real estate but don’t want to deal with tenants. They typically choose to buy properties with the sole purpose of doing a fix and flip. They will purchase a property that is below market value due to cosmetic reasons. They will fix up the property, list it for a much higher price and usually try to resell the home within 6-12 months for a big profit.
What to Know About Taxes
Taxes are probably one of our least favorite things to think about. But as with any investment, Uncle Sam is going to want to take a piece of the pie when things go well. However, with real estate investing there are a lot of things to consider when it comes to taxes.
- Deductions – Real estate investors have the ability to deduct just about any expense they incur each month. This could be mortgage interest, property management fees, and even a lawn mower you provide your tenants if you require them to do lawn maintenance.
- Capital Gains – Once you choose to sell an investment property, you will realize a capital gain if the sale price is higher than the purchase price. The capital gains tax you pay depends on your income and the tax bracket you fall in. Below is a chart with the long-term capital gains tax rates.
|Taxable Income Range||Long Term Capital Gains Tax Rate|
|$0 – $78,750||0%|
|$78,751 – $488,850||15%|
|More than $488,851||20%|
- Depreciation – Depreciation is the loss of value for an asset because of wear and tear or age. The IRS says the depreciated life of real estate is 27.5 years. As an example, let’s assume you purchase a property that has a value of $200,000. To calculate the depreciation deduction you can claim on your taxes you would use the following formula.
$200,000 ÷ 27.5 = $7,272.72
In the calculation above we determined that each year you’d be able to claim a tax deduction of $7,272.72 on your income tax return.
- Depreciation Recapture – Being able to deduct depreciation each year probably sounds pretty nice. Unfortunately, it’s not all good news. The IRS isn’t in the business of giving away free money. The downside of depreciation is that they will recapture this when you sell the property, plus a little extra. Let’s assume you owned the above $200,000 property for five years. You would have depreciated $36,363.60. Once you sell, the IRS is going to attempt to recapture that amount plus a 25% tax and any capital gains made on the sale. But what if you sell the property for a gain of less than $36,363.60? In that case, the IRS will only recapture the amount up to the gain realized on the sale.
- No Self-Employment Tax – Depending on how your real estate investing business is structured, you might be able to avoid paying self-employment tax on your earnings. This is because the rental income is not considered earned income in most situations.
The United States tax code is complicated and became even more so after the Tax Cuts and Jobs Act. We recommend you always consult your accountant before making any decisions that could affect your tax situation.
How to Start Investing in Real Estate
We’ve covered a lot of information so far. Do you feel like you’re ready to start investing in real estate? If so, here are a few things you need to do before getting started:
- Build a Financial Cushion – One of the most important things you can do before investing in real estate is to build a financial cushion. If you choose to own a rental property, there are a lot of unknown expenses that can pop up. It could be the broken water heaters or the two-month gap without a tenant. It’s because of these expenses that it’s crucial to have a financial cushion in place before purchasing your first rental property.
- Start Small – If you’re unsure if real estate is something you want to invest in, start small. Instead of jumping right into a rental property, invest a small amount in a REIT or use a real estate crowdfunding website like Fundrise.
- Diversify – Most financial experts talk about the importance of diversifying your investments. This is easy to do if your real estate investments are non-physical assets. You can invest a little in real estate, a little in technology, and some more in both banking and retail. This will create a diversified portfolio. However, if you are buying rental properties, a lot more upfront cash is required which can limit diversification in the beginning. As you continue to purchase more properties, you will become more and more diversified.
- Understand the Risks – Becoming a real estate investor might sound like a life of glam but it’s important to understand the risks that are involved. If you’re not careful, you could end up losing everything.
- Make Sure the Time Is Right – Very seldom is there a perfect time for anything. However, there are certain things that need to be in place before you invest in real estate. While it’s not necessary to pay off your primary home, it is important to pay off other debt like credit cards or any other high-interest loans you might have.
As always, any time you’re considering making a big financial move, make sure to consult with a financial advisor who can give you advice based on your unique situation.