Real estate has been in the news a lot lately. Rising interest rates and a tight housing market are conspiring to make homebuying a lot more expensive than most are used to. Many potential home buyers have instead been pushed into renting. A lot of experts think this situation will continue for the foreseeable future, as home stock still hasn’t recovered from the lack of construction following the housing market bubble burst in 2008.
What this means for retirement savers is that there’s a potential opportunity on the horizon. Rent is climbing. Homeowners with an eye toward profit are strongly motivated to sell because they think the real estate market is at or near its peak; that will create more renters, which will increase rent prices further. In short, rental property owners have the potential to make money!
Of course, nothing is as simple as you might think. There are a number of pitfalls and hassles to owning real estate that should be carefully considered before you take the plunge. Perhaps chief among those is timing.
As already noted, prices are high, as are interest rates. “Buy low, sell high” applies to real estate just as it does to investing in the stock market. It would not do you much good to spend more on a property than you would make inrent, especially if property values should decline and make it harder to recover your losses via a sale.
However, those high interest rates can often cause price reductions over time. As potential buyers grow weary of waiting for rates to come down, they exit the market. Less demand can cause a softening in prices. In short, sometimes a high-rate environment is a good time to buy, as long as the price is right. That may not be now, but in a year or two, the patient investor could see more favorable pricing opportunities.
Once pricing is right and you acquire investment properties, the benefits are significant. Real estate can be one of the better ways to build generational wealth, largely because of its impressive tax efficiency. Income generated by rental properties can be offset by tax deductions such as depreciation, which gives you 27 years worth of tax deductions alone.
This tax efficiency combines with another tool you can use with investment property to make a generational-wealth powerhouse: the step up in basis. Property often increases in value between the times it is purchased and sold. Usually, the property owner owes taxes on those gains when the property is sold. Gains are calculated based on the value of the property when you buy it, also known as the property’s basis. For example, if you buy property for $500,000, and 20 years later it’s worth $750,000, you would owe taxes on the $250,000 gain in value when you sell.
However, if you buy that $500,000 property, then 20 years later pass away and your child inherits it at its new value of $750,000, the inheritance causes a step up in basis. When your child sells the property, taxes will be owed on gains that happen after they inherit it rather than when you bought it. In this example,$250,000 in gains is no longer taxable.
Be Ready for Inconvenience
It almost goes without saying that you generally don’t buy a property, then sit around waiting for it to make you money - you have to take in renters! Renting properties involves hassle that you need to be ready for. When something at the property breaks, you have to fix it. That will cost you money, and, unless you hire a management company, time. Plus, not all renters are ideal tenants; some cause damage which you will also have to repair, or neglect to pay rent which could force you to take legal action to evict them.
Those headaches aside, some of my wealthiest clients have significant real estate holdings among their investments. As an important part of a sizable portfolio, real estate is worth considering if you want to build wealth.
However, real estate can also lose money if you don’t invest wisely. It’s important to work with an experienced financial advisor such as the ones at Asset Preservation Wealth & Tax to make sure you’re approaching property investments prudently.
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
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