As you build wealth, real estate can be one of the most important assets in your portfolio. It’s one of the few asset classes that can offer diversification during periods of inflation and that tends to move independently of the stock and bond market. While investing in real estate may not be right for everyone, we want to share an overview on the different pros and cons, as well as the different ways to approach real estate investing.
How to invest in real estate
Depending on how you invest (you don’t necessarily need to buy property) the pros and cons may shift, and you may need to consider different tax implications. Here are five methods to invest in real estate (including direct ownership) worth considering.
1. Purchasing property
Purchasing an investment property generally falls into three categories: residential, vacation, or commercial. With all three, there are two primary ways to earn money: growth and income. The value of the property may increase over time, and you may be able to generate income by renting the property out to tenants. As the names imply, residential properties refer to homes, apartments, and apartment buildings. If you plan to rent these properties out short-term, they’re usually considered vacation rentals. Commercial real estate refers to any type of office, retail, or industrial space. The specific classifications are determined by both the IRS and state laws.
2. Partnerships, including real estate limited partnerships (RELPs)
Forming partnerships with experienced real estate investors or developers allows you to invest in larger, more complex projects by pooling resources and expertise. If you don’t know anyone who might want to partner on this venture, or would prefer to work with experienced professionals, you may be able to do this via a real estate limited partnership, which is an investment product that offers similar exposure.
3. Real Estate Investment Trusts (REITs)
REITs are companies that own, operate, or finance income-producing real estate across various sectors. They trade like stocks (you may not even know that a certain company or ticker is classified as a REIT), so investors can access the real estate market without investing directly in physical properties. REITs often pay dividends based on rental income and capital gains.
4. Real Estate mutual funds and exchange-traded funds (ETFs)
These mutual funds invest in the stocks of companies involved in the real estate industry, such as property developers, real estate management firms, and construction companies. They provide diversification within the real estate sector.
5. Mortgage-backed securities (MBS)
MBS are an investment product that bundles home loans (or other types of real estate debt) together. They’re similar to a complex bond, and ratings agencies grade their quality based on the underlying loans. Large banks that issue mortgages often create and issue MBS which you can buy as an investor. When mortgage rates rise, these products tend to pay higher rates as well.
The pros of investing in real estate
As you might expect, the benefits and drawbacks vary based on how you choose to invest in real estate.
Potential income
Purchasing property to rent out may provide you with a stream of rental income. Similarly, many real estate investment products may pay dividends, distributions, or interest.
Growth
Over time, property values may increase, creating the potential for capital gains. You may be able to defer tax payments on any capital gains via a 1031 Exchanges.
Diversification
Real estate tends to behave differently than other asset classes. This lack of correlation means investing in real estate may help diversify your portfolio.
Inflation protection
Because property prices tend to increase alongside other consumer goods, real estate often gains value when prices rise, creating a hedge against inflation.
Tax benefits
Real estate investors may be eligible for various tax perks and deductions, which can reduce their tax liability.
Leverage
Depending on the type of real estate you invest in, you may be able to finance a significant portion of the initial investment. This leverage may help amplify potential returns on your initial investment.
The cons of investing in real estate
Many of the pros we mentioned have associated cons, and vice versa.
Time
Whether you manage the properties yourself or need to coordinate with the property management company, direct investments and real estate partnerships may cost more time to manage.
Cost
You can save time by outsourcing management, but that adds cost to the investment. You may also incur maintenance costs for wear and tear. Beyond that, investing in a real estate venture may require a substantial upfront investment.
Tenant problems
If you plan to rent out your investment property, you may deal with vacancy as well as bad tenants, both of which may affect the property’s overall value.
Illiquidity
Real estate investments are relatively illiquid, meaning it’s hard to exit the investment and access its cash value. There may also be costs associated with exiting a real estate investment.
Price volatility
Property values can change dramatically based diverse, often unpredictable, factors. While new developments may drive values higher, for example, an uptick in crime or a natural disaster could collapse prices.
Complexity
That laws and regulations that govern real estate vary significantly by location and type of property. Investors need to learn about, and comply with, these regulations. They must also understand local markets, property trends, and overall economic conditions.
Tax considerations when investing in real estate
These considerations may or may not apply to you. We recommend discussing any real estate investment with a tax professional.
Income tax
Rental income is generally taxable as ordinary income, and you need to report it on your annual tax return. The good news is, you may be able to deduct expenses tied to any rental property, which can help reduce the amount of income that’s taxable. Any dividends earned from REIT investments are typically taxed as ordinary income as well, though some may qualify for the lower dividend tax rate. REITs may also carry additional tax complexity with return on capital (ROC).
Depreciation
The IRS allows you to depreciate the cost of an investment property over time, since the government assumes wear and tear will reduce its value. This is separate from the property’s market value. Additionally, any money you spend on improvements—new appliances, landscaping, remodels—may also count as depreciation. You may be able to spread depreciation and expenses out over several years.
Capital gains
When you sell an investment property, you’re subject to the same capital gain (and loss) rules as any other investment. If you own the property for less than a year, you may need to pay income tax instead, and the IRS may classify you as a real estate dealer; if you own it for more than a year, long-term capital gains kick in. You may be able to use a 1031 exchange to reinvest any profits into another property, thereby postponing taxes.
Passive activity loss
If you invest in a real estate property and you lose more money than you earn via the passive income stream, you may be able to deduct the loss against other forms of income. The parameters around these deductions may expand if you qualify as a real estate professional with the IRS.
State and local taxes
Property tax laws can vary by state and locality, so it’s essential to be aware of specific tax regulations in your area. Remember: The rules for an investment property may be different than those for a primary residence.
It’s crucial to consult with a qualified tax advisor or CPA who specializes in real estate to help you navigate these tax considerations effectively. Tax laws can be complex and subject to change, so staying informed and seeking professional guidance can help you optimize your real estate investment strategy and minimize your tax liability.
