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It’s the time of year that I dread the most: tax time. Especially for those of us who live in high-tax states, taxes are just not fun. I know that I’m lucky to have earned a good salary over the past several years, but it still hurts to write that additional check. The jury is still out on the full scope of impact that the revised tax code will have on taxpayers, but I know that either way, I’m grateful for my real estate investments.
You see, over the past six years I’ve been investing passively in real estate, and by doing so I’ve saved more and more of my hard-earned tax dollars thanks to our real estate-friendly tax laws. In short, the U.S. government seems to encourage real estate investing, so there are significant incentives for Americans to participate.
Because real estate investors are able to write off depreciation of the asset (since investing is considered a business), as well as expenses from active and passive real estate investments, we are often able to offset an incredible amount of income and defer taxes until selling the asset. Personally, in many cases where even though I may have made income from a cash-flowing property, the tax deferrals often result in a “paper loss.” That is, I made money, but my tax documents say that I lost money. Eventually, investors in this position need to “recapture,” or pay those losses back after the asset is sold, but the government also provides additional opportunities to continue to defer taxes, provided that money is distributed to a like-kind real estate investment. By taking advantage of our tax code, instead of paying capital gains on mutual funds when in some cases when I didn’t take out any money at all, I have tax-deferred income that I can live on.
So why doesn’t everyone do this?
Many people just don’t know how to go about investing in real estate. I certainly was not always aware, but my primary reason for shying away was that I simply perceived real estate investing as “too risky.” The fact is that every investment carries risk, and the key to successful investing is to understand what those risks are and how to mitigate them.
The big “aha” moment for me was when I realized that although I could theoretically tell you how the stock market works, at the end of the day, whether I invested in a stock or not was a roll of the dice. There was no way that I could understand the risk factors of a particular industry, let alone an individual stock or an even more complicated mutual fund. With real estate, I gained a much better understanding of the risks so that I can mitigate them myself, or make sure that that the general partners in a passive investment are mitigating them for me.
When I first began thinking about investing in passive real estate, I decided to focus on an area that I understood at a high level: residential apartments. In college and during the early part of my career, I lived in several apartment communities in Texas and North Carolina. I know what it’s like to live in one, and I know what I looked for when I shopped for a new apartment, so I decided to start there and learn all I could about multifamily apartment communities.
By studying markets, visiting properties and networking with people who are successfully investing in apartment communities today, anyone committed to it can learn how to evaluate a deal and the questions to ask. By talking to people who have made mistakes and had investments that did not go well, you learn that almost all of them failed because of too much leverage, a riskier loan and/or depending upon market appreciation to earn their money.
It always comes back to what you can do to reduce your risk. For new and seasoned investors, the areas to pay particular attention to are:
• Leverage: Going into an investment with only a small amount of equity leaves you vulnerable if the market goes down. Choose investments that start with at least a 30% down payment, and aim to negotiate a price that will provide even more cushion when the appraisal comes in.
• The loan: The loan should ideally be a fixed-rate, long-term one, but there at least need to be options in place to extend it. The last thing you want is for a loan to come due when you have to sell at the wrong time to repay it. Many real estate investors have lost incredible amounts of money by having to sell when the market is down just to fulfill a loan obligation.
• The market: Stick to growth markets where companies and people are moving. That pretty much knocks out many markets in the state of New York, and frankly, most of the Northeast. Many markets in the U.S. however, especially in the South, offer immediate cash flow as well as potential tax benefits. That’s not to say that you can’t make money in the Northeast, but it’s definitely more of a risk because you will be depending upon market appreciation to make the real money. You may decide to keep your riskier investments in the stock market, like I do, and use real estate investing as a vehicle to mitigate risk and minimize taxes.
While I’m not an accountant or a financial advisor, I’ve personally seen the benefits that real estate investing can have on an investor’s personal net worth, and tax savings have been a key driver. Conservative, cash-flowing multifamily apartment communities in growing markets are the safest, most lucrative retirement vehicle I see out there. The fact that our tax code makes it even more attractive is nothing short of amazing.