click Real estate investing can help you to diversify among asset classes. Real estate is an asset that generally appreciates over time. It can therefore be a great hedge against inflation, and may provide long term growth. Negotiating a bargain purchase price will help in this regard.
Real estate investing is also a significant part of the economy. As such, any diversified portfolio should include an allocation to this asset class. This in turn can help you to reduce the risk and volatility of your overall investment portfolio. Not to mention that real estate investing can also provide steady income in addition to capital appreciation.
Real estate investing can also have significant tax benefits. Some types of investments more so than others. Given the steady income potential of real estate investing, the wise use of leverage can amplify investment returns. However, always remember that too much leverage is dangerous.
You may think that you cannot possibly get into real estate investing. That it’s only for the more experienced and higher net worth investors. But that is not the case.
Real Estate Investing Through Your Personal Residence
You may already be invested in real estate in a big way and don’t even realize it. Take your personal residence, for example. If you own your home, then you are already invested in real estate. It may not be throwing off rental income, but you have exposure to your local real estate market. You can potentially benefit from long term price appreciation. Yes, you do have to make monthly payments if you have a mortgage. Property taxes, insurance, and repairs and maintenance are also part of the deal.
But every time you make a mortgage payment, you are also increasing your equity in the property via loan principal reduction. Combine this with any price appreciation, and you can eventually build up some significant equity in the property.
You can also deduct your mortgage interest (within limits) and property taxes if you itemize your deductions on your tax return. If you eventually sell your home, you may be able to exclude all or part of any gain. If you lived in the home for two out of the past five years, you can generally exclude up to $250,000 ($500,000 if filing jointly) of net gain on the sale of the home.
You may also unintentionally be investing in real estate if you have a vacation home. Both vacation homes and main residences can become rental properties as well. For example, you may own a duplex where you rent one half, and live in the other half. Or you can rent a vacation home for part of the year, and also use it personally. Click here for some insight on tax rules concerning property which is rented but also used personally.
Real Estate Investment Trusts (REITs)
Most REITs are publicly traded companies which own and manage real estate and/or real estate loans. Most REITs are Equity REITs, but there are also mortgage REITs. Equity REITs usually buy, sell, rent, and manage actual real estate properties. Their income is therefore mainly rents and any gains from selling property.
Mortgage REITs, on the other hand, generally invest in loans (mortgages) which are backed by real estate collateral. Their income mostly consists of interest and any gains from selling mortgage loans. Some REITs can be hybrids. They can invest in properties as well as mortgages.
REITs must invest at least 75% of their total assets in real estate, and derive at least 75% of their income from such assets. They must also have a minimum of 100 shareholders.
Unlike direct investments in real estate, publicly traded REITs are also liquid. This means that you can sell them easily and quickly at little or no discount to market value. REITs also allow you to invest in certain types of real estate that would otherwise be out of your reach.
Since equity REITs usually own several properties, they also allow you to diversify effortlessly. Both geographically, as well as by property type. For extra diversification, you can also invest in REIT mutual funds or ETFs.
REITs also enable you to start small. As with other publicly traded stocks, once you have an account, there are no minimums when buying through a broker. If buying via a dividend reinvestment plan (DRIP), each plan may have different requirements. However, any minimum investment requirements are usually less than $1,000.
Reinvesting your dividends is also an option. However, as with any other stock transactions, you should monitor and try to minimize your commission charges.
REITs Are A Passive Form Of Real Estate Investing
With REITs, you will not have to worry about looking for a property to buy, qualifying for a loan, screening tenants, collecting rents, making repairs, or selling. All the work is handled by the REIT management team and its employees and contractors. These individuals typically have years of experience in the real estate field.
However, all this comes at a cost. The net income of the REIT available for distribution to shareholders will reflect the compensation of its officers and employees. Also, besides voting your shares each year, you generally do not have any say in the management or day to day activities of the REIT. This passive nature of real estate ownership can be a pro or a con depending on your personal preference. But you may also not have many other options of investing in real estate if your financial resources are limited.
Tax Aspects of REITs
REITs avoid taxation by distributing most (at least 90%) of their net income to investors. As such, their income is not subject to double taxation that your typical publicly traded corporate entity must deal with.
However, because REIT income is only taxed once, dividends are not considered “qualfiied.” This means that they are taxed are ordinary income tax rates. Income distributed is generally reported to investors via IRS form 1099-DIV.
Any losses generated by the REIT cannot be passed through to the shareholders’ income tax returns to potentially offset other income. This is one of the key tax differences between REITs and real estate that is owned directly or via partnership interests.
With regard to tax filings, REIT shares are considered intangible property (publicly traded securities), so you don’t have to file nonresident income tax returns for states where properties are owned.
REITs are also a good investment to hold inside tax deferred accounts such as IRAs and 401Ks. Since REITs usually throw off sizable dividend income, owning them inside a retirement account may allow you to defer the related tax. Further, unlike partnership entities, REITs do not pass through unrelated business taxable income (UBTI). Such income may cause a taxable situation within a retirement account if it exceeds $1,000 in a given year.
Private and Public Non-Listed REITs
Although in the minority and generally less popular, there are also REITs which are private or public but non-listed (PNLRs). These investments are not traded on stock exchanges. As such, they are not liquid like publicly-traded REIT shares. However, without the daily trading, you also don’t have the visible daily volatility in share price that comes with publicly traded securities.
Despite potentially higher dividends, private REITs and PNLRs also generally have higher upfront fees, as well as redemption restrictions. Minimum holding periods vary, but can be several years. Financial transparency may also be lower with private REITs since they do not have mandatory public entity financial reporting requirements. PNLRs, on the other hand, are required to report quarterly to the Securities and Exchange Commission (SEC).
Despite new laws under the JOBS Act, most private REITs are still generally available only to “accredited investors.” An accredited investor is generally someone who has either a net worth of over $1,000,000 or net income of more than $200,000. So the vast majority of individuals may not qualify to participate in these types of investments. Click here for more detailed information on how to qualify as an accredited investor.
Real Estate Investing Via Active Ownership of Real Estate Rental Properties
Buying a property yourself or with partners where you are actively involved in the management also has its pros and cons. Being actively involved can be both a positive and a negative. On the one hand, you have to do a lot of the work of managing the property. On the plus side, though, you also get to keep a greater portion of any profits.
Another benefit is that you can use your own determination, knowledge, creativity, and problem solving skills, to improve cash flow and increase the value of the property. Of course this is only a plus if you have the requisite skills, time, and desire to manage the property.
Alternatively, you can hire a management company to handle some or all of the management. But you are still ultimately responsible. At the very least, you have to oversee the management company to make sure they are doing a satisfactory job.
Besides ultimately being responsible for the day to day operation of the investment and potentially risking more than your investment, there are other potential drawbacks. For one, in order to get into an investment, you have to look for and find a suitable property.
Then, you must usually qualify for a loan, unless you are in the rare position of buying the property in an all cash transaction. All-cash purchases may be less risky, but they do not allow you to use leverage conservatively to boost returns on invested capital.
Tax Aspects of Active Real Estate Ownership
Real estate income or loss is generally considered passive for income tax purposes. This means that any losses can only offset income from other passive activities. Any unused passive losses are carried forward to the next year. Unused passive losses become nonpassive in the year of disposition of the investment.
But if you are actively managing the property, you may be able to deduct as much as $25,000 in passive losses against your other (nonpassive) taxable income. This deduction is phased out for higher income taxpayers. The phaseout starts when adjusted gross income (AGI) reaches $100,000, and is complete if AGI reaches $150,000.
If you spend a substantial part of your time in real estate during the year, you may even qualify as a real estate professional for tax purposes. As a real estate pro, you can deduct losses fully against other income. However, specific rules must be met before you can be a real estate pro.
Real Estate Limited Partnership (RELP) Interests
Real estate investing via partnerships as a limited partner is another option for some. But as with private REITs, the majority of these types of investments are still generally available only to “accredited investors.”
As a limited partner, you generally do not have any say in the operation of the partnership. However, you also cannot lose more than what you invest. A real estate company employing experienced real estate professionals typically manages the partnership as the general partner. The compensation of the general partner is subtracted from the partnership profits before allocation is made to the limited partners.
Besides limiting the amount of money you have at risk to your investment, limited partnership interests have other key benefits as well. They can allow you to invest in large properties which otherwise may be out of your reach. Granted you will only own a fractional interest. But you will have exposure to the profit potential of professionally managed larger, often commercial, types of properties.
Less Liquidity With Higher Fees and Investment Minimums, But Also Potentially Higher Returns
Although RELPs may potentially offer relatively higher returns, as private investments, they do not have the liquidity or transparency of publicly traded REITs. Fees may also be higher. However, RELPs also do not have the restrictions that REITs usually have.
The general partner typically has more flexibility. The RELP can own one property or several, it can have a relatively small number of investors, and is not required to report to the SEC. RELPs typically own fewer properties than REITs.
RELPs are more suitable for those with a long term investment horizon. Redemptions may only be available at certain specified dates, and may be years from the time of the original investment.
RELPs also generally have higher investment minimums than REITs. They can be as little as $2,000 or so, but can also be substantially higher. Still, they are lower than buying real estate outright.
Tax Aspects of RELPs
Partnerships report income or loss to partners on IRS form K-1. Any losses they generate may pass through to potentially offset other income of the partner. However, as a real estate limited partner, the passive loss rules will limit the offset only against other passive income.
You can carry nondeductible passive losses forward to future years. Any accumulated unused passive losses may be used against nonpassive income during the year of the investment’s disposition.
With partnerships, it is also possible to earn income for a particular year via the K-1 form you receive, but not receive a corresponding cash payout immediately. While relatively uncommon, this may result in greater taxable income without a corresponding cash distribution to help pay the tax. This is often referred to as “phantom income.”
Investors in real estate partnerships may also have to file nonresident income tax returns for states where they own properties.
Publicly Traded Limited Partnerships
Most RELPs are private investments. But there are also some real estate partnerships that are publicly traded. These are referred to as master limited partnerships or MLPs. Such investments trade like stocks and have similar SEC reporting requirements. This provides both liquidity and transparency.
As publicly traded securities, these investments are available to non-accredited investors. MLPs may also trade at a premium or discount to their underlying intrinsic value due to external market forces, such as interest rates. The tax aspects of MLPs are the same as those for private limited partnerships.
Real Estate Investing Via Crowdfunding
There has been a proliferation of online real estate investing crowdfunding platforms in recent years since the passing of the JOBS Act. This has made it relatively easier for investors to gain access to non-listed REITs and limited partnership investments. Examples include, AHP Fund, Realtyshares, Fundrise, Realty Mogul, Groundfloor, and CrowdStreet.
Whether you buy a home to live in, a rental property, a REIT, or a limited partnership interest, you must do your own homework. When you buy directly, your due diligence should include things such as inspections, negotiating a bargain price, projecting cash flows, etc.
When looking at REITs and LP interests, the management team should be a main focus. Look into their credentials and track records, and how much debt they are using. Overleveraged properties can put your investment at greater risk.
With REITs, as publicly traded companies, you will have much more information at your disposal. You can see management bios and compensation, their ownership percentage of the REIT’s shares, properties owned in the portfolio, etc.
With LP interests, you must read the prospectus or offering documents carefully before investing. Learn as much as reasonably possible about the investment. This can include the partnership’s investment strategy, cash distribution policy, exit options, fees charged, etc. Also look at how much of their own money management is investing in the LP.
Finally, whether it’s a REIT, RELP, or other investment, always look at several different investment opportunities. This way you can compare their features and terms in analyzing which is best for you.