Diversifying Through Real Estate

Diversifying Through Real Estate

We should all diversify our investments over different asset classes. Real estate is an excellent vehicle for diversification.

Real estate rental properties used to be a perfect investment for high wage earners. They were able to deduct all the losses generated by the property – and when you added up mortgage payments, property taxes and maintenance, the losses could be substantial – from their gross incomes.

The IRS has rained on that parade. Real estate rental properties are now considered passive activity, even if you actively manage the property. The only ones who can take full advantage of real estate investing losses these days are the so-called “real estate professionals.”

However all is not lost. Even now you can deduct all the expenses of a rental from the gross rental income. If the losses exceed income, they are converted into passive activity losses which are not deductible against ordinary income, but are deductible against other passive activity income as well as any gain made when the property is sold.

Real estate investing offers several special advantages: the purchase can be highly leveraged, from zero down to the usual 20% down payment; the mortgage payments are generally tax deductible as are the taxes and expenses of maintaining the property; and if you own the property over a year, it is subject to long-term capital gains taxes – presently 15% – minus any accumulated passive activity losses.

Because of the highly leveraged nature of most real estate purchases, investors can afford to own multiple properties. Or you can start small, with one property, and use that as leverage on another house as your equity in grows.

However, real estate is unlike other investments. Unless you buy raw land, it requires management and maintenance, insurance and tax payments. There will even be continuing costs with raw land, property taxes and liability insurance being the major expenses. If you think you can’t be sued if someone trips on a log or falls into a hole on an undeveloped piece of property, think again. Ask your lawyer what the liability laws in your state are.

If you own rental buildings, they must be insured, properly maintained and rented out. Someone has to fix the problems and collect the rent. You can do this yourself, especially if you like being awakened at three in the morning because a toilet won’t flush – I’ve been there and done that. Or you can hire a management company to do this for you. Most work on a cost plus basis.

Because of all of this, you do need to find properties that either throw off good income from rents or have the potential for appreciation, especially if some repairs are done. In other words, you have to work out beforehand how any given piece of real estate will make money for you. If it won’t, keep looking.

Real estate prices are not as volatile as the stock market’s can be, but they do fluctuate. It is better to go into a real estate investment with a long term frame of mind and remember the rule “location, location, location”.

Over time real estate values tend to grow and, because of the leveraged nature of the investment, the growth is magnified. For example, 5% growth on $150,000 is $7500. But if you only have 20% down or $30,000 invested, that $7500 becomes a 25% return on your investment.

Of course you don’t have to own real estate outright. There is also the option of investing in “Real Estate Investment Trusts (REIT)”. These are professionally managed funds that usually invest in larger, commercial projects – shopping malls and office buildings. Your aim is long term capital appreciation. The investments are heavily leveraged and the tax benefits spread among the partners. 

Since real estate does not necessarily move in the same directions as stocks or bonds and also generally tends to hold its value, this is a good diversification move, but you are unlikely to realize the gains you would see with individual real estate holdings.

Also, despite the fact that real estate is booming right now, it can and has fallen, sharply at times. There have been gluts of office space in major cities, overdevelopment of residential housing (remember the S&L; debacle of about 15 years ago), or there could just be a general down real estate market from time to time.

Most of us have already diversified into real estate by purchasing our home. If the equity is preserved, this can turn into a major cash cow after several decades of use. If certain simple rules are met, you can exclude $250,000 ($500,000 if married and filing separately) of any gains you realize. 

As you can see, real estate investing, if done properly, can be quite lucrative. But study the subject intensively before committing yourself.

Also consult with a CPA or tax attorney on how to best structure your business for maximum returns.

For those looking for multiple streams of income, rental real estate is a good place to start.

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