The vast majority of people spend their lives working full-time jobs to earn a “steady” paycheck. Meanwhile, the wealthy have somehow unlocked the secret to working less while making their money work for them.
So what is it that the wealthy know that the rest of us don’t?
One of the biggest secrets that the wealthy tap into is the incredible power of real estate. Real estate has the ability to generate passive income and provide a path toward building wealth. Your money works for you while you sleep. Every dollar invested in real estate works for you in these five ways:
- Cash flow
- Tax benefits
#1 – Cash Flow
The greatest benefit of investing in real estate is passive cash flow. When an asset is purchased and rent is collected from tenants, the remaining value after property expenses are paid is your cash flow. You are financially independent when your monthly net cash flow meets and/or exceeds your total expenses.
If you put down $50,000 to buy a rental for $200,000, your mortgage payment would be about $1,000 per month. Now let’s say that you’re able to rent the unit out for $2,000 per month.
Upon receipt of the $2,000 rent payment each month, you pay the $1,000 mortgage, use $700 for expenses and reserves, and keep the remaining $300 as passive cash flow (i.e., money in your pocket).
#2 – Leverage
In the example we just discussed, you hypothetically bought a $200,000 rental without paying $200,000 in cash. Instead, you put in $50,000 as a down payment, and the bank contributed the remaining $150,000.
The cash flow you earn is based on the full $200,000 asset, not the $50,000 portion. This is the magic of leverage.
Even though the bank contributed 75% of the money, all you have to do is pay the mortgage and interest, and any excess cash flow or profit is all yours. No need to share it with the bank.
#3 – Equity
As you receive monthly rental checks and use them to pay the mortgage, your equity in the property increases as you pay down the principal. In this way, the rental property generates income to pay for itself.
Imagine buying a laptop that generated money to pay for its own wifi!
Once your rental builds significant equity, you may have the opportunity to use a home equity line of credit (HELOC), which allows you to borrow against your existing asset. HELOC funds can be invested into another asset, which allows you to make your money work even harder for you.
Another option is to refinance the property and do a cash out refinance. If your $200,000 rental property appreciates to $400,000, you could refinance, take out equity from the current value of the property, and reinvest that money to purchase more property. The money you cash out is tax free!
#4 – Appreciation
Real estate values tend to rise over time, which means your money can also work for you in the form of appreciation. In fact, real estate tends to double every 10 to 20 years.
For example, consider a property purchased for $580,000. In time, the duplex appreciates to $750,000, at which point it is sold. The profit at the sale, or $170,000, will have been generated via appreciation, plus any additional equity that you had built through paying down the mortgage.
That being said, while appreciation is nice, it’s not guaranteed, which is why you should always invest for cash flow first and foremost, with appreciation as the icing on the cake.
#5 – Tax Benefits
The tax benefits is probably the best reason to invest in real estate. The tax code was written to provide a series of government incentives and economic stimulus. There are over 5,800 pages of tax law, and 99.5% of it was written to reduce your taxes if you invest in activities that help stimulate the economy, such as: agricultural, energy, job creation, and housing. An investor and big business owner has the most tax incentives, thereby paying the least amount of taxes to legally paying little to no tax.
When you invest in real estate, you get the benefits of depreciation and mortgage interest deductions, as well as a whole host of write-offs for a number of other related expenses. Investors often show losses on paper, while actually making money through cash flow. The losses play a big part in helping to offset other income, which is a major reason real estate is so lucrative. Further, when investing in commercial real estate syndications, you have the opportunity to take advantage of cost segregation and accelerated depreciation, further increasing your tax benefits.
Cost Segregation is a tax planning strategy that accelerates the depreciation schedule of a property. The depreciation is accelerated since the asset is generally held for 5 years. So what does this mean to a real estate investor? Investors get to keep more of their hard-earned money.
According to the IRS, a residential building depreciates in 27.5 years, and a non residential building depreciates in 39 years. Let’s take the example of a residential building. Immediately after acquiring the property, a syndicator or General Partner, will hire a consultant to conduct a cost segregation study, which is an engineer-based study, to break down and reclassify different components of the property. The property is reclassified into 4 groups for tax reporting purposes: personal property assets, real property assets, land improvements and land.
The reclassification of the property accelerates the depreciation, which can be deducted against the taxable net operating income in the current tax year. Overall tax liability is reduced, and investors benefit from the immediate increase to cash flow. The Tax Cuts and Jobs Acts of 2017 (TCJA) provides a boosted tax shelter to real estate investors. TCJA allows for bonus depreciation, which is essentially accelerated depreciation on steroids. Properties acquired after Sept 27, 2017, can depreciate certain 5, 7, and 15 property assets immediately. Bonus depreciation was accelerated from 50% to 100% on certain qualifying assets. This IRS tax tool reduces the tax burden, which translates to more mailbox money to the real estate investor.
Advantages of Investing in Real Estate
With each dollar invested in real estate, you have the opportunity to take advantage of cash flow, leverage, equity, appreciation, and tax benefits. This is true regardless of whether you invest in single-family rentals, large syndications, or anything in between.