Investing in Real Estate: An Overview

When people think of investing their mind typically goes straight to the stock market, but investing is really just devoting your money to something today, with an expectation of benefiting financially in the future. Real estate is often an attractive and potentially lucrative investment vehicle.  There are several ways to get into real estate investing, and thankfully you don’t have to be a real estate mogul to make a profit doing so.

But beware – just as investing in the stock market, there are no guarantees when you invest in real estate. Before committing to any investment decision you should be aware of all the risks and what can go wrong. Real estate investing is not fool-proof.

Flipping Real Estate

Flipping property for a profit has become rather popular thanks to the likes of HGTV and their many shows that document the behind the scenes process. It’s certainly an entertaining process, and can be incredibly profitable. With this method you won’t have to worry about hiring a property manager or being a landlord to potentially difficult tenants. It’s simply a short term plan to make a profit with no real long term ambitions.

Flipping real estate isn’t necessarily just repairing homes, remodeling and selling them turn-key ready. With how dynamic the real estate market can be, a lot of real estate investors focus on the timing as opposed to purchasing a fixer upper. If you have the capital, buying property during a buyer’s market and patiently waiting to sell during a seller’s market can lead to a large profit.

Using leverage could be beneficial when flipping real estate. Borrowing money from the bank to purchase investment properties can allow for a bigger gain (or enable you to use funds in other profitable ways), especially when there are favorable interest rates for borrowing. A major risk of this method is failing to convert the property for a profit and having to pay off the loan.

Renting Out Property

A common way to invest in real estate is to purchase property, whether commercial or residential, and lease it to tenants. This comes with more responsibility and work, which is why many rental property owners end up hiring a property manager to take care of the day-to-day oversight.

The main goal of owning rental properties is to generate steady, recurring rental income, but the property may also appreciate in value long-term.  The downside, however, is that you are reliant on tenants to pay their rent, so if the property sits vacant or you have tenants who are frequently behind on rent, the cash flow might not be as steady as you initially desired.

1031 Exchange

One of the primary problems with real estate is the capital gains tax. Capital gains tax comes into play when you sell an asset that has appreciated in value, whether it’s a stock, a piece of artwork, or, in this case, real estate. Generally speaking, capital gains tax is assessed on the difference between what you paid for the asset and what you sold it for. There are two different types of capital gains – long-term and short-term. Long-term capital gains are applied to assets you’ve owned for more than one year; conversely, short-term capital gains are assessed on property you’ve owned for less than a year. The long-term capital gains tax rate is anywhere from 0-20% depending upon your income, and the short-term capital gains rate is much higher at your regular tax bracket rate.

However, there is a special tax code for real estate investors, called a 1031 exchange, which allows you to swap one investment property that you just sold for a “like-kind” property. Under a 1031 Exchange, you kick the tax-can down the road, not paying capital gains tax until you eventually sell the second property you swapped for.

The “like-kind” exchange rules should be taken seriously, as any misstep along the way could disqualify you from favorable tax treatment. While the “like-kind” rules aren’t incredibly limiting (you don’t have to exchange an apartment building for a different apartment building the same price), timing is important as you have just 180 days to close on a new property after the sale of the old. Additionally, you have 45 days to declare which properties you are attempting to replace the previous one with, and a 3rd party intermediary must hold the funds until the exchange is completed.

Real Estate Investment Trusts

It certainly helps to have a large amount of capital when getting into real estate but you don’t always have to. Real Estate Investment Trusts (REIT) are a great option for those looking to get into the game that may have less capital or “know-how.” Not unlike mutual funds, REITs pool capital from thousands of investors to invest in real estate properties. Each REIT fund might have its own objective, such as investing in commercial properties only, or residential properties for example. REITs can be equity (actual managing of real property), mortgage (rather than owning property these focus on mortgages and loans to owners; mortgage-backed securities), or a combination of the two.

The benefit of investing in a REIT is that it saves you time and money. It is a quick and easy way to invest in real estate. It also tackles one of the bigger cons of investing in real estate: liquidity. Real estate isn’t something you can decide to buy or sell on a daily basis, simply because of how complex it is. Since REITs are often traded on the major exchanges much like a mutual fund or ETF they are much more liquid than traditional real estate.

Key Point

While liquidity is a major issue with investing in real estate, control of the property, appreciation, and diversification can make it worthwhile. Talk to one of our advisors to see whether real estate investing is right for you.

Check out some of our other helpful articles such as paying off your mortgage early, and determining how much house you can afford.

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