So… You may ask yourself, why should you buy or invest in real estate in the First Place? Because it’s the IDEAL investment! Let’s take a moment to address why people should have investment real estate in the first place. The easiest answer is a well-known acronym that addresses the key benefits for all investment real estate. Put simply; Investment Real Estate is an IDEAL investment. The IDEAL stands for:
I – Income
D – Depreciation
E – Expenses
A – Appreciation
L – Leverage
Real estate is the IDEAL investment compared to all others. I’ll explain each benefit in depth.
The “I” in IDEAL stands for Income. (a.k.a. positive cash flow) Does it even generate income? Your investment property should be generating income from rents received each month. Of course, there will be months where you may experience a vacancy, but your investment will be producing an income for the most part. Be careful because, many times, beginning investors exaggerate their assumptions and don’t consider all potential costs. The investor should know going into the purchase that the property will COST money each month (otherwise known as negative cash flow).
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Although not ideal, this scenario may be OK, only in specific instances that we will discuss later. It boils down to the owner’s risk tolerance and ability to fund and pay for a negative producing asset. In the boom years of real estate, prices were sky high, and the rents didn’t increase proportionately with many residential real estate investment properties. Many naïve investors purchased properties with the assumption that the appreciation in prices would more than compensate because the high balance mortgage would have a significant negative impact on the funds each month. Be aware of this and do your best to forecast a positive cash flow scenario so that you can actually realize the INCOME part of the IDEAL equation.
It may often require a higher down payment (therefore lesser amount being mortgaged) so that your cash flow is acceptable each month. Ideally, you eventually pay off the mortgage, so there is no question that cash flow will be coming in each month, and substantially so. This ought to be a vital component of one’s retirement plan. Do this a few times, and you won’t have to worry about money later on down the road, which is the main goal and the reward for taking the risk in purchasing an investment property in the first place.
The “D” in IDEAL Stands for Depreciation. With investment real estate, you can utilize its depreciation for your own tax benefit. What is depreciation anyway? It’s a non-cost accounting method to consider the overall financial burden incurred through real estate investment. Look at this another way, when you buy a brand new car, the minute you drive off the lot, that car has depreciated. When it comes to your investment in real estate property, the IRS allows you to deduct this amount yearly against your taxes. Please note: I am not a tax professional, so this is not meant to be a lesson in taxation policy or to be construed as tax advice.
With that said, the depreciation of a real estate investment property is determined by the overall value of the structure of the property and the length of time (recovery period based on the property, type-either residential or commercial). If you have ever gotten a property tax bill, they usually break your property’s assessed value into two categories: one for the land’s value and the other for the value of the structure. Both of these values added up equals your total “basis” for property taxation. When it comes to depreciation, you can deduct against your taxes on the original base value of the structure only; the IRS doesn’t allow you to depreciate land value (because the land is typically only). Just like your new car driving off the lot, it’s the structure on the property that is getting less and less valuable every year as its effective age gets older and older. And you can use this to your tax advantage.
The best example of this concept’s benefit is through depreciation; you can actually turn a property that creates a positive cash flow into one that shows a loss (on paper) when dealing with taxes and the IRS. And by doing so, that (paper) loss is deductible against your income for tax purposes. Therefore, it’s a great benefit for people specifically looking for a “tax-shelter” of sorts for their real estate investments.
For example, and without getting too technical, assume that you can depreciate $15,000 a year from a $500,000 residential investment property that you own. Let’s say that you are cash-flowing $1,000 a month (meaning that after all expenses, you are net-positive $1000 each month), so you have $12,000 total annual income for the year from this property’s rental income. Although you took in $12,000, you can show through your accountancy with the depreciation of the investment real estate that you actually lost $3,000 on paper, which is used against any income taxes that you may owe. From the IRS standpoint, this property realized a loss of $3,000 after the “expense” of the $15,000 depreciation amount was taken into account. Not only are there no taxes due on that rental income, but you can also utilize the paper loss of $3,000 against your other regular taxable income from your day-job. Investment property at higher price points will have proportionally higher tax-shelter qualities. Investors use this to their benefit in deducting as much against their taxable amount owed each year through the benefit of depreciation with their underlying real estate investment.