Reasons to Invest in San Diego Real Estate
There are many books written on the subject of real estate investing, and I’ve read many of them. In this article I’ll try to summarize them for you, and explain why real estate beats investing in the stock market or interest bearing notes like CDs or T-bills. But no matter how good it is, your investments should be diversified across asset classes, of which real estate is only one. Solomon, one of the world’s wealthiest and wisest men said, “Divide your investments among many places, for you do not know what risks might lie ahead” (Ecclesiastes 11:2).
So let’s look at the advantages of owning some real estate:
Real estate tends to go up in value, and as the saying goes, “They aren’t making any more of it”. As long as the population in the USA continues to rise, more housing will be needed, and every year it gets more expensive to build a home as natural resources and energy become more espensive. Sometimes appreciation can go too far too fast, and then a correction is needed. However, real estate tends to follow a long term upward trend line.
Stocks also go up and down, but I fear that most people are treating their 401K like a savings account, and it is anything but. Did you know that at age 70 1/2 you MUST start withdrawing money from that account? What do you imagine might happen to the value of the shares when huge numbers of people start selling? Do you know in what year the baby boomers start turning 70 1/2? That’s something I would sure know if I had a lot of money in the stock market.
If the price of your real estate doesn’t go up fast enough to suit you, you can increase the value through wise improvements to the property. For example, spending $2000 on paint and some landscaping might incease the home’s value by 4 or 5 thousand. This is called “sweat equity”.
Owning investment real estate generates rental income. If the rental income covers all the expenses with nothing left over, this is called “break-even”. If the rent exceeds the expenses, you have “positive cash flow”. And if the expenses are higher than the rent you receive, this is called “negative cash flow”. There is a place for all of these situations, it just depends on what you’re trying to accomplish.
By the way, rents tend to go up over time, would you agree? This gives your real estate investment a growth component that pure “interest only” investments like CDs lack. Over the course of time, the purchasing power of that nest egg you retired with actually shrinks due to inflation. For this reason, everyone needs to have a growth component in their retirement plan, and not rely on just cash.
You can use “Other People’s Money” to invest in real estate. Banks are more than willing to loan you the money to buy real estate. In fact, you can even buy with “nothing down”, meaning no money of your own, given the right circumstances. The good news is that even though you only may put 5, 10, or 20% into the property, and the bank has put all the rest, you still get 100% of the appreciation and cash flow. The bank doesn’t get any of that, you get to keep it all!
When property has appreciated, you can sell it and buy two. Let’s say you put $10,000 into a new house. A few years later, it has gone up in value such that you could sell it and net $20,000 from the sale. You could then buy 2 properties with $10,000 down on each one. This process can be repeated until you reach your investing goals. So 1 becomes 2, 2 becomes 4, 4 becomes 8, etc.
A rental property runs like a business, and every expense involved with it is tax deductible. That means all repairs, interest, HOA dues, just about everything (except principle reduction) can be deducted. The gardener, the yard tools you bought, the new fruit trees you planted, anything you do to the property is deductible. So Uncle Sam is helping you fix up the place and make it more valuable! You’re buying supplies for the property at 60 or 70 cents on the dollar, based on your tax rate.
And get this – all travel, lodging, and meals are deductible when going to the property! Some investors I know buy property in areas where their kids live, so the trips can be tax deductible. We personally own properties in areas we like to visit, or may retire some day. Nothing wrong with that.
When a business buys an expensive piece of equipment, let’s say a printing press, the IRS doesn’t let you deduct the whole thing in one year, but over the life of the press, maybe 5 or 7 years. Well, your investment house is a business, and the IRS says the life of the house is 27.5 years. That means you can deduct 3.63% of the value of the house (not the land) every year you own it. Yes, you heard me right, the IRS says the value is going down, when in fact it’s going up! This is called a “phantom loss”.
Let’s put some real numbers to this. Say you buy a house for $135K in Hemet, and the land is worth $35K, and the house $100K. In addition to whatever other expenses you deduct, you would also deduct $3636 a year as depreciation. So if you were in a 30% tax bracket (Fed+State), you would actually save around $100 a month in taxes.
So picture this – let’s say the property breaks even. You take in a rent check, and pay a mortgage payment. It looks like a wash, nothing happened. But what really happened is you just saved $100 that you would have sent to the IRS, and you paid down the principle maybe $100 or $150. Maybe that doesn’t sound like a big deal, but when you start talking about multiple investment properties over the course of time, this is how fortunes are made!
You can sell your rental property and exchange it for a more expensive one (or two, or whatever) and defer the taxes on the capital gains. So if an investment is not performing the way you’d like, or you want to increase your leverage and free up some “dead equity”, you can do a 1031 tax deferred exchange and pay no taxes.
Tax Free Cash Out
When the rents increase and are providing you with positive cash flow, you might want to free up some money to do other things. You can refinance and do what’s called a “cash out refi”. For example, if you had a $100,000 mortgage on the property, you might take out a $150,000 mortgage, pay off the old $100,000 one, and put the $50,000 in your pocket. This is TAX-FREE money, as unbelievable as that sounds.
Sale of Primary Residence
There’s one more tax goodie that doesn’t really apply to investment property, but it might fit into your investment plan. If you live in a property for 2 years it magically becomes your “primary residence”. So after the two years you can sell the property and pay no capital gains, even if it was a rental property before.
Putting It Together
So to understand how real estate is head and shoulders above any other investment, imagine going to your stock broker’s office and saying something like this:
“I’d like to buy some stock, but I only want to put 10% down. I’d like the stock to go up over time, and pay dividends that also go up over time. When the stock goes up, I might want to pull tax-free cash out of it, and still keep the stock. Or I might want to sell it, but pay no taxes, and buy other stocks. And I’d like to get a tax deduction every year I own the stock, for the next 27 1/2 years.” What do you think the stock broker would say? Other investments don’t even come close to real estate for capital gains, cash flow, leverage, and tax advantages.
The bottom line for me is one of control. With real estate I can control what I buy, where I buy it, and when I sell it. I can increase its value or the income it generates. Let me tell you, I lost six figures following stock brokers’ canned advice of “hold for the long term, dollar cost average, and diversify”. With real estate, there will be no funny bookkeeping or scandal that causes the value of my investments to plummet. No chairman of the Federal Reserve telling me what my cash flow will be. And best of all, no IRS taking my money and giving me what’s left over.
I hope you found this article educational. If you’d like to discuss some strategies for your real estate investments, call me any time at 760-889-2272.