These days, an investor looking for a fully passive return has a lot of options. One of the most common approaches is to put money into an index fund and let it grow. Then, when you need a stream of income, you can start drawing down the funds with the 4% rule giving you guidelines as far as how fast you can safely pull out the money. This is the approach favored by Bogleheads[1] and many others who believe that alternatives such as real estate are either too risky or too much work. It is clear that some people can be extremely successful doing this. One needs to look no farther than Warren Buffet for clear evidence that there is money to be made in the stock market as an investor.
I definitely have a share of my portfolio in the stock market, primarily in index funds. However, I have been putting most of my investment money outside of retirement accounts into real estate for years now. Some of the reasons for this are outlined below. Just a reminder, however, that I am not a tax, financial, or legal professional and this is not advice – please consult with your own team of experts before making any financial decisions.
Money in a retirement account can’t be easily accessed until after age 59.5. I am aware that you can pull money out under certain circumstances, but the structure of retirement accounts strongly discourages that. Ideally, I would like to retire before I turn 60, which means I need money outside of a retirement account to support me until I hit retirement age. As a result, I have to factor in the impact of taxes on any investment I make, since I will be paying taxes on any income (e.g. wages, dividends) and capital gains (e.g. appreciation) that I incur on these assets. Even after I reach 60, I am expecting my current standard of living to be maintained, which means that my income would need to remain at a reasonably high level – so being tax efficient is going to be important to me.
There are a number of tax advantages to investing in real estate over the stock market. When I invest in real estate, I get to claim expenses associated with the business against any income. For active real estate investors, this includes things like property taxes and insurance on the property, as well as supplies (e.g. computer, phone) and a (home) office. Fully passive investors such as LPs don’t get all of those expenses to deduct since they aren’t running a business, but both active and passive investors benefit from depreciation. Depreciation is a paper expense – that means that you deduct an expense you don’t actually pay out of pocket against the income you receive. As a result, even when you are actually making money on the investment you can end up showing a loss on your tax return. Furthermore, if you don’t use all of your depreciation expense in one year, it carries forward indefinitely until you do use it. The amount of deprecation you claim is based on a variety of factors, with one of the most important being the total value of the asset purchased (which is commonly referred to as your basis).
Real estate uses leverage (other people’s money) to increase the value of the assets that you can purchase with a fixed amount of cash. This is similar to buying stock on margin, without the risk of a margin call. By using leverage (i.e. a mortgage) you are able to purchase real estate worth 2x to 4x the amount of cash that you are investing with. And, since depreciation is based on the asset value at time of purchase, that leverage leads to a much bigger deduction than you would get if you were constrained to purchasing just with cash.
Real estate typically generates positive cash flow within the first year of ownership. For me, this is huge, since I am looking for income streams, not just building net worth. By having income streams, I can live off of the investment forever instead of having to worry about running out of money because I have to sell my assets in a down market. In this way, real estate is like a pension plan that you have bought into – you just keep getting checks deposited into your bank account. To understand how this works, you need to realize that real estate has two major ways to make you money – appreciation of the underlying asset and an ongoing stream of cash flow from the operating income. The appreciation is similar to stocks going up and is impacted by the market and by improvements you make to the property, for example the price of a rental property may increase because you added new amenities like a pickle ball court. Cash flow is what is left from the monthly rental income after you pay all of the expenses, including the mortgage and reserves. While some stocks do pay dividends, index funds typically do not. The operating income from well selected real estate investments typically provide cash-on-cash returns from 4% to 9%, growing over time as the rents increase faster than the expenses. You can get a similar yield from some of the dividend kings [2], but most pay well below that.
The depreciation will completely offset the cash flow from the property for multiple years. There are a variety of ways to calculate the depreciation you can take on a property – from a straight line depreciation of 1/27.5 of the value of the property (or 1/39 for commercial property) to using a cost segregation to determine how long each component will last and depreciating the assets at different rates. In practice, for people who aren’t real estate professionals, the differences between the strategies aren’t always significant. However, what is significant is that the paper loss generated by the depreciation will offset your cash flow from the asset, typically for most of the time you hold the property. Eventually, with enough income, your cash flow will exceed the available depreciation so you will need to pay taxes on the income at that point. Alternatively, if you sell the real estate, any unused depreciation can be used to offset the capital gains tax that you need to pay. The difference of taxed vs tax free income over 10, 20, or 30 years can be astounding, literally millions of dollars.
Next week, I will dive into the numbers and show the difference between an investment in an index fund and real estate over a 30 year time horizon. If you are a hard-core index fund investor, I think you will be surprised at the results.
In the meantime, if you have any questions about this post, please email them to me at terence@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts
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