When comparing investments of different income producing investments, it is very common for investors to initially focus on looking at current cash flow as a percentage of their investment. Using this approach solely would result in selecting an investment yielding a 5% annual return over one with a 4% return.
While this approach may be adequate in screening very similar types of investments such as CDs, interest bearing bank accounts, bonds, etc., it can result in less than optimum investment selections when comparing more complex investments such as real estate.
In this blog post I would like to share the process used by many of our more experienced real estate investors to compare overall returns from various income investments.
After Tax Cash Flow
One of the major reasons investors are attracted to real estate is due to significant potential tax savings benefits relative to other asset classes. In comparison to income received from stocks, bonds, CDs, etc. which is generally taxed at normal income tax rates, income received from real estate investments can potentially be sheltered through applying allowed deductions that can significantly lower taxable income resulting in lower tax liabilities. Here are several of the major types of allowed deductions:
Real estate investors may reduce their taxable income by writing off or depreciating a portion of the useful life of their buildings each year. For example, the IRS permits residential buildings to be generally depreciated over 27.5 years and commercial buildings over 39 years. Note that only building portion of the investment can be depreciated – not the land.
Using a simple example, let’s presume you purchase a residential rental property for $1,000,000 and that the building portion is valued at $800,000. Dividing the $800,000 value of the building by 27.5 years will provide a deduction that will reduce your taxable income by $29,091.00 each year until the property is fully depreciated!
The IRS also permits ways of further increasing these deductions through utilizing accelerated depreciation techniques which many of our clients take advantage of.
Mortgage Expense Deductions
Interest expenses on investment properties that have mortgages can also be deducted to further reduce taxable income. Unlike limitations on interest deductions for mortgages in personal residences, there are no limits to the amount of interest that can deducted from investment properties.
Miscellaneous Real Estate Business Deductions
There are many other potential deductions available to real estate investors such as business travel to inspect investment properties, advertising and marketing expenses, home office expenses among many others.
Bottomline: since income from real estate investments can receive very favorable tax treatment relative to income from many other types of investments, it is very important to compare income streams of different investments on an after-tax basis. Investors should consider that an annual 5% cash flow return from real estate can yield greater after-tax income than a 5% return from stocks, bonds, etc.
Favorable Treatment of Capital Gains
In addition to potentially enjoying the favorable tax treatment of income, real estate investors can be further rewarded by taking advantage of IRS approved techniques for reducing or even avoiding tax obligations related to gains in the equity value of their properties. These gains can result either from either appreciation of a property over time or the pay-down of debt or both.
When non-real estate assets are sold (e.g., stocks and bonds), the appreciated value is generally taxed at the applicable capital gains rate and options to defer payment of taxes are generally limited.
Real estate investors however can take advantage of powerful tax deferral options such as the 1031 exchange which allows up to the full gain in a real estate sale to be deferred into the future and permits investors to re-invest up to 100% of their capital into qualifying replacement properties.
And, while not unique to real estate investments, keep in mind that, when we pass, our heirs or surviving spouse can inherit our investment properties at then current market value and receive a “step-up basis” that forgives all past capital gains liabilities.
Total Return on Investment
Experienced investors will therefore consider the combination of both after tax cash flows and capital gains when comparing investments.
For example, a real estate investment in a rapidly appreciating area that has a starting annual cash flow of 4% might be viewed as more attractive than a property with a higher starting cash flow located in an area of more modest projected appreciation.
Considering the Time Value of Money
Due to inflation and interest rates, a simple truth is that a dollar today is worth more than a dollar tomorrow. Investing money today in assets that appreciate over time has proven to be a sound strategy to protect the value of your equity against inflation and, in combination with sound tax strategies, will help ensure that your real net worth will continue to grow.
So, a higher total return over a shorter period time will be more attractive than the same total return over a longer period. Everything else being equal, all of us would likely prefer doubling our investment over 5 years versus 10 years.
Evaluating investments can be much more complex than summarized in this blog and we urge you to consider the previous concepts of looking at after tax returns and considering the time value of money only as a starting point.
Our team at First Guardian Group is pleased to help you evaluate investment options to find those that may be most suitable to meeting both short- and long-term objectives.
Help Save 1031 Exchanges
1 Depreciation deductions for residential properties can be more favorable than for commercial properties due to differences in allowed depreciation schedules. Investors who are comparing residential commercial investments should consider after tax cash flows.