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Pros & Cons of Becoming a Real Estate

Almost everyone loves owning income-generating rental real estate, especially in those early retirement years. What’s not to love? It can provide consistent income, and you may even be able to enjoy it. Inherent benefits aside, it’s vital to understand when taking on such an endeavor that one treats it like a business – because it is, in fact, a business. And like any business, it comes with responsibilities. Whether managing an income-generating property is the right decision will largely depend upon your financial situation, life objectives, and sometimes, even your personality.

It’s a J-O-B

When considering rental Real Estate, the first thing to understand is that it will likely take up a significant amount of your time. This is regardless of if the property is managed directly by you or not. The question is how much time and how exactly that ongoing commitment affects your overall rate of return. You may decide to hire a service, but that expense should still be calculated in your overall “After Everything” (TM) rate of return. I’ve met many people who claim a 10%+ rate on their investment, but after factoring in the expenses and time they are devoting to the property, their “after everything” (TM) rate of return is more like 3% (or less). An individual considering rental real estate must understand the relationship between their investment, the expense, and the actual money going into their pocket. An asset isn’t ideal when it takes up a lot of time but only returns what can likely be achieved through other less time-intensive investments. Of course, qualitative and quantitative factors can still overshadow a lackluster return.

Recommendation: Estate Planning: The Art of the Final Impression

If the net net net rate of return of your property is reliably kicking off income north of 3-4% (and keeping the property is not taking up a lot of your time), then you may have something. However, if your net net net income is hovering around 2%, and the property is taking up a ton of your time, then there is probably a much easier way to make 2%.

Remember, when considering a piece of Real Estate, it should probably be a LONG term endeavor. It should be part of the plan to capture the inherent tax and estate planning benefits that come into play closer to mortality.

What about tax?

Many intelligent people don’t know how taxes work. They go up the most you make. People are not taxed at a specific rate (or bracket) across every dollar. So as a general rule, you want to avoid taxation on the upper tiers. This is especially a consideration with income from real estate while working.
Working and owning property is an interesting dynamic. Many of the people I have met who make earned income and also make unearned income owning a rental property have often not fully considered the long term tax landscape before buying property. Doing something after careful consideration is ok; you are always allowed to break the rules. The caveat is making sure to be fully informed of ALL potential variables, even potentially some unknowable ones. Understand that rental income is, by default, treated as unearned income on your tax return. So, naturally, your accountant will presumably use depreciation to reduce your overall tax liability if working. From a tax perspective, this is a truly great thing. It limits how much unearned income will be subject to taxation on those upper brackets. But hang on, you didn’t ‘get out’ of tax; you likely deferred it using depreciation which lowers the property’s cost basis on the property.

Given interest rates, there is a strong case for owning rental property – if you can find it.

The tradeoffs of using depreciation for the short term are not always crystal clear initially to all individuals when they go off falling in love with an investment property. If, for example, the property ended up not being something you wanted to keep, but the accountant used depreciation – well, then that is how people run into tax issues later if they decide to sell but may ultimately be dissuaded from selling even with a lackluster investment. To be fair, there may be a solution (such as a 1031 like-kind exchange). I like to point out that there should be an extra pause to understand the tax ramifications today and tomorrow. I say this because it usually doesn’t happen.

The issue is the tax basis may end up so low that you owe much more than expected in tax. Also, remember that there are tiers to even the long-term capital gains rate.

 

2022 Investment & Capital Gains Tax Brackets

Unmarried Individuals Taxable Income For Married Individuals Filing Joint Returns Taxable Income For Heads of Households Taxable Income
0% $0 – $41,675 $0 – $83,350 $0 – $55,800
15% $41,676 – $459,750 $83,350 – $517,200 $55,801 – $488,500
20% $459,751 or more $517,201 or more $488,501 or more
Source: IRS

If you have the personality to manage investment real estate, are currently working, and make a good income, it is essential to understand the totality of the decision and establish a realistic timeline of maintaining the investment from start to finish. On the other hand, sometimes it’s just a ‘screaming deal,’ and you might just want to buy it, hold it, and go for the ‘step up’ later.

The One Bedroom w/ an Ocean View

For clients that have the appetite for rental real estate, the period just before or just into retirement often represents an ideal time to obtain property. There are a few reasons for this.
The first reason is capacity. In many cases, individuals are naturally winding down their working commitments. There tends to be more time and a rejuvenated enthusiasm to prepare for retirement. If not, then possibly a significant other in the household can start the hunt for the dream vacation home or future rental goldmine. The point is that the timing is often ideally suited to people’s lifestyles and objectives. Usually, college is paid, the kids are grown, starting new families of their own, and it’s an empty nest. It’s the ideal period for one of the last big enjoyable purchases – just before the long steady ride into retirement. I genuinely enjoy watching people go through this process.
The second reason is tax. There is usually a unique period between the normal retirement age of 65 and 72 (before social security kicks in and RMDs start). I call this the “tax valley” where there is an opportunity to be strategic in distributing savings, take tax hit, prior to turning on income from pensions and social security. This is often where it can make the most sense to de-risk by selling off brokerage assets, employee stock grants, effecting Roth conversions, downsizing, and purchasing supplemental real estate. It’s also the time many want to travel (and possibly not even own a residence for a while). I’ve seen it play out in many unique and inspiring ways, but logically the pattern is that there is a significant dip in income. That is potentially an opportunity you can plan around.

Just before or just after retirement is a great time to visit a few properties on the market. You never know; your timing might be ideal to snap up that ‘screaming deal.’

Go for the Step-Up in Basis

The Holy Grail of rental Real Estate investing (and investing in general) has got to be the ‘step-up in basis’ to fair market value at the time of death. There must not be much more of a satisfying feeling to use and make money on a property, bequeath it at death and wipe away the taxable gains. There are very few legal and ethical ways to get out of tax, but that seems like a pretty good one, and it’s available to any property owner.

The step-up in basis to the fair market value at death is probably the most significant financial benefit to the American property owner. But it is a LOOONG term strategy, and that is why I say to a client… “Just make sure you want to keep it and prove it’s a good investment with math before you buy it.”

Not All Properties Are Equal

Some rentals can be pretty reliable, others not so much. Real Estate ownership requires understanding how changes in the economy can affect property over the long haul and how income could fluctuate. Specific locations may truly be ‘recession-proof’, and it behooves one to attempt to find those options that provide a reasonably reliable income. That, in many cases, should be the endgame. Many retirees have benefited from using rental real estate as their primary supplement to social security. Some retirees would say it’s their version of an annuity, only better. It’s conceivably better because it’s an asset the individual still owns and can even use as a residence (i.e., the backyard rental or apartment complex). Or of course it can be sold off.
However, Real Estate is certainly not risk-free. Real Estate can correlate to the economy and even the stock market itself. A property in a location where people may lose their jobs or other unforeseen widespread economic catastrophes can have a long-lasting effect on the property’s value and income reliability. Be aware of the risk, don’t rely too heavily on one source of income, have a backup plan, and certainly have an ‘exit strategy.’
Proper financial planning should attempt to diversify income sources. In an age where much of our money is directly correlated to the stock market, having other sources of income is an essential consideration in planning.

Editor’s note: This blog offers informal investment and financial planning advice. We know nothing about your unique financial situation. The buying and selling of any financial product or security should only be considered in context. If appropriate, seek the counsel of experienced, ideally objective, financial, tax, or estate planning professionals. Past performance is not indicative of future performance.