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Real Estate Returns – Importance of Looking at the Big Picture

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: 

Depreciation 

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. 

Conclusion

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. 

Please contact us toll free at 866 398-1031 or send us an email at info@FGG1031.com for more information.  You can also schedule a free one on one consultation with me here


Help Save 1031 Exchanges
Write to your Member of Congress and Senators urging them to oppose restricting Section 1031 like-kind exchanges. As part of the American Families Plan, the Biden Administration has proposed eliminating the application of Section 1031 for gains greater than $500,000. Like-kind exchanges have been part of the U.S. tax code since 1921 and are one of the tax code’s most powerful economic tools. It is critical that we all vigorously and visibly oppose this proposal. Make your voice heard with a pre-filled letter, which you can customize to add personal anecdotes or powerful client stories to highlight the positive impact of Section 1031 like-kind exchanges. Take action today by clicking HERE.

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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. 

Paul Getty

Paul Getty is a licensed real estate broker in the state of California and Texas and has been directly involved in commercial transactions totaling over $3 billion on assets throughout the United States. His experience spans all major asset classes including retail, office, multifamily, and student, and senior housing. Paul’s transaction experience includes buy and sell side representation, sourcing and structuring of debt and equity, workouts, and asset and property management. He has worked closely with nationally prominent real estate brokerage and investment organizations including Marcus Millichap, CB Richard Ellis, JP Morgan, and Morgan Stanley among others on the firm’s numerous transactions. Paul also maintains a broad network of active buyers and sellers of commercial real estate including lenders, institutions, family office managers, and high net worth individuals. Prior to founding First Guardian Group/FGG1031, Paul was a founder and CEO of Venture Navigation, a boutique investment banking firm specializing in structuring equity investments made by institutions and high net worth individuals. He possesses over 35 years of comprehensive worldwide business management experience in environments ranging from early phase start-ups to multi-billion-dollar corporations. His track record includes participation in IPOs and successful M&A activity that has resulted in investor returns of over $700M. Paul holds an MBA in Finance from the University of Michigan, graduating with honors, and a Bachelor’s Degree in Chemistry from Wayne State University. Paul Getty holds Series 22, 62, and 63 securities licenses and is a registered financial representative with LightPath Capital Inc, member FINRA /SIPC. Paul is a noted speaker, author, and actively lectures on investments, sales, and management related topics. He is author of The 12 Magic Slides, Regulation A+: How the JOBS Act Creates Opportunities for Entrepreneurs and Investors, and Tax Deferral Strategies Utilizing the Delaware Statutory Trust (DST), available on Amazon and other retail outlets.

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