While the I.D.E.A.L. model is a great general tool for wealth building, investing in real estate has some of its own additional rules that do not apply to your usual investments. There are many extra benefits and savings one can capitalize on in real estate.
Within real estate, there are several different categories, each with its own advantages and disadvantages. If you choose to be a real estate dealer, meaning you purchase numerous properties with the intent to sell rather than rent, that would mean paying self-employment taxes, which can be quite high. It is much more beneficial to fall within the category of real estate investor. Under this designation, you would not pay self-employment taxes, but rather you would pay capital gains taxes, which generally have much lower rates. If you go a step further as an investor to qualify as a real estate professional, you will be able to deduct 100% of passive loss from your ordinary income.
Inflation and Rates
Inflation is one of the unavoidable elements of the economy. From fuel to food to the price at your local dog groomer, inflation has made itself a permanent part of our economy, but it isn’t something you should fear as a real estate investor. In fact, if you are renting, you should welcome it, as rental rates do not escape inflation. One thing, however, that does escape inflation is the fixed interest loan you may have out on the property. So, as you increase the income you gain from renting, your loan remains unchanging, allowing you to have a higher cash flow. And if you are categorized as a real estate investor, this additional income doesn’t have the same burden that self-employment taxes would have as a business entrepreneur. Thanks inflation! Keep in mind not all lenders are going to offer fixed-rate mortgages on commercial real estate, but this is another reason to shop around.
Taking out a loan is commonplace when purchasing a real estate, whether you are just beginning or you are a real estate veteran. Although there are many benefits from taking out a loan, they come at the cost of growing interest that eats into your profits. Luckily, because this cuts into your taxable income, this can be declared as a tax deduction. One important note on this, since the new legislation passed in December 2017, interest accrued from home equity loans can no longer qualify as a tax deduction.
It’s a Fair Trade
One dreaded source of tax comes into play we begin considering selling our properties. Rather than simply selling, you can consider doing a “like-property trade” under IRS code No. 1031. Ordinarily, you may have had to pay almost $60,000 in depreciation recapture and capital gains taxes on a $500,000 sale; if instead, you worked under the 1031, you would be able to reinvest your profits into another property increasing your gains. This can be done again and again, ultimately resulting in massive savings. The only catch is that you must be classified as an investor, not a dealer, in order to benefit from the 1031.
Be the Bank
If you decide you aren’t going to use the 1031 route when selling a property, you open yourself to the risk of driving yourself into a higher tax bracket that tax year. This can be avoided by doing an installment sale where rather than receiving the full amount at once, the buyer pays in increments under an owner-financing mortgage. This reduces your chances of being driven into a higher bracket, allowing you to only pay taxes on the profits made yearly. It also gives you monthly income that you can sit on if you are thinking of getting out of the real estate game. The only disadvantage of this method is that the entire amount of depreciation accumulated must be recaptured at the initial sale time.
Commercial Real Estate is a great investment option for many people. There are many strategies, that can easily get overlooked, that help make your commercial real estate an even better investment. Hopefully these concepts outlined give you an idea for a few ways to maximize your investment. Next week we will be discussing several more, so stay tuned!