Inflation isn’t always a bad thing. Some assets, like real estate, tend to gain value when inflation is high. In 2021, for example, inflation started to climb. Median home sales that year jumped 17%, meaning the average American home gained more than $50,000 in value according to the National Association of Realtors.
Given these jumps in home prices, folks have been asking whether now is a good time to start investing in real estate. As you might expect, the answer to that is rarely as simple as yes or no.
While investing in real estate offers numerous benefits, it also comes with drawbacks and complications that are important to understand. This article reviews the different ways to invest in real estate, the various pros and cons, and some of the tax rules that may help you determine which (if any) approach is right for you.
How to invest in real estate
Many folks assume that you need to buy property to invest in real estate. But owning an investment property will incur costs far beyond the initial price tag, which may not appeal to everyone. Thankfully, you don’t need to buy property to invest in real estate, though it’s certainly a popular option.
1. Purchasing property
Purchasing an investment property generally falls into three categories: residential, vacation, or commercial. With residential properties, you’d purchase a house or apartment building where you might earn income through rent, or hope the property appreciates. Commercial real estate works the same way, just with office, retail, or industrial space.
Vacation properties are like residential properties but offer shorter lease terms. The rules and considerations around short-term rentals can be significantly different from long-term agreements.
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, pooling resources and expertise. You may be able to do this via an actual partnership or via a real estate limited partnership (RELP), which is an investment product structured to offer similar exposure.
3. Real estate investment trusts (REITs)
Real estate investment trusts (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. REITs allow investors to add real estate to their portfolio without large upfront capital requirements.
4. Real estate mutual funds and exchange-traded funds (ETFs)
Real estate funds, which may be structured as either a mutual fund or exchange traded fund (ETF), tend to invest in real estate companies, such as property developers, real estate management firms, and construction companies. They provide diversification within the real estate sector.
5. Mortgage-backed securities
Mortgage-backed securities (MBS) are an investment product that bundles home loans (or other types of real estate debt) together. They’re similar to a complex bond. Large banks that issue mortgages often create and issue MBS which you can buy as an investor.
The pros of investing in real estate
Potential income. Purchasing property to rent out (whether long-term or short-term) may provide you with a stream of rental income. Keep in mind that if you buy physical property, you’ll have to deduct your expenses (loan interest, repairs, taxes, upkeep, professional management, HOA fees, etc.) from your rental income to determine your return on investment. RELPs, REITs, real estate funds and even MBS may also provide income in the form of dividend or interest payments.
Growth. Over time, property values may increase, creating the potential for capital gains. The key word here is “may,” because an increase in value is never guaranteed, especially on homes that are “flipped” (bought, renovated, and sold within a short timeframe). The premise that housing values always increase was, in fact, a primary driver behind the housing bubble that preceded the 2008 Financial Crisis. Of course, if you’re able to hold onto a property over a long period of time, your odds of its increase in value increase, assuming the home stays in good condition.
Capital preservation. A piece of property, whether it’s a single-family residence or apartment complex, is a hard asset (as opposed to something intangible, like a stock). Because it holds intrinsic value, real estate is a common investment vehicle for those interested in preserving capital.
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.
Depending on how you invest in real estate, you may experience a few additional benefits:
Tax benefits. Real estate investors may be eligible for various tax deductions, which can reduce their tax liability. If you rent out a property, for example, many of the expenses associated with the property (maintenance costs, property taxes, insurance, etc.) can be deducted from your taxable income.
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.
Control. Buying property may give you more control over the asset. Depending on the terms of your investment, you may be able to dictate improvements, renovations, and strategic management to help boost value or income. Keep in mind that with a REITs, RELPs, real estate funds or MBS, you won’t have this level of control.
The cons of investing in real estate
Initial costs. Purchasing property or investing in a real estate venture tends to require a substantial upfront investment. It may also involve ongoing expenses tied to management and maintenance and/or making valuable improvements to the property over time.
Illiquidity. Property is an illiquid asset—meaning it’s hard to exit the investment and access its cash value. You can sell a stock fairly quickly, but consider how long the process takes to buy and sell a house. In most cases, you’re lucky if you’re able to find a buyer and sell the home in a couple of months. Depending on the market, it could be even longer. Not to mention, selling a home is expensive for the seller, as you’ll likely have to pay for home repairs, real estate agent fees, and closing costs. Some of the other investment products we mentioned earlier may help you avoid this negative, though it’s important to read the fine print, particularly on RELPs and real estate mutual funds.
Price volatility. As we’ve seen over the last several years, property values can change dramatically based on varied and unpredictable factors. While a new development may drive values higher, an uptick in crime or a natural disaster may collapse values. You can control your own property’s maintenance, upkeep, and renovations, but you can’t always control what’s going on in the neighborhood, especially if you don’t live locally.
Ongoing responsibilities. Many real estate investments require some form of ongoing management, which can be time-consuming if you do it yourself or expensive if you outsource the task. People who own and manage investment properties tend to describe it as a full-time job.
Location. If you’d like to own an investment property in another area, say your favorite vacation destination, it can be challenging to predict the ongoing maintenance costs and potential hurdles (such as bad weather, high crime, lack of available contractors, and so on). If you aren’t within easy driving distance of the property, you may need to rely on another person or company to manage the property and rental contracts.
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. Eviction processes vary by state but tend to expensive and time-consuming.
Complexity. The laws and regulations that govern real estate vary significantly by location and property type. 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
The potential tax perks and/or liabilities associated with real estate investing depend on how you invest. We recommend discussing any real estate investment with a tax professional. Here are a few considerations to help you guide with that conversation.
Income tax
Rental income is generally taxed as ordinary income, and you need to report it on your annual tax return. You may be able to deduct expenses tied to the property, which can reduce any potential tax liability. Dividends paid by REITs and other real estate investments may also be taxed as income, though some may qualify for the lower dividend tax rate.
Depreciation
The IRS allows you to depreciate the cost of an investment property over time, since the government assumes the wear and tear of renting it out 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 tax
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 likely need to pay income taxes on the gain 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 stay informed and seek professional guidance as appropriate.
At Revo Financial, we can help you evaluate how real estate investing might fit into your portfolio and what it may mean for your long-term goals. In addition to helping you weigh your options, we can work with the other financial professionals on your team (like tax accountants and lawyers) to help ensure any real estate investments align with your overall financial plan.
