Leverage - a misconception and why it can be powerful!

Normally, an investor will buy stocks with cash and purchase investment real estate (RE) with leverage or "OPM" (other people's money), using a bank's money or some other lender's money.

• Fixed Rate of Interest
  • A typical RE loan is often obtained at a fixed interest rate. 
  • The rate of interest to pay back the loan is locked-in at a rate established at the time the loan was secured.
  • Even if the dollar value changes over time, an investor will not pay the bank or lender more/less as a result of the change in dollar value. 

• Minimizes the Impact of Rising Interest Rates
  • Leveraging allows the investor to take advantage of fixed interest rates. 
  • Significant to those who are concerned about rising interest rates.
  • A borrower's payment to the bank does NOT inflate over time.
  • As inflation rises, the dollar's purchasing power diminishes over time.
  • To illustrate, if real inflation is 10% and the RE investor is paying a constant interest rate at 5%, the investor is in a better position with a locked-in rate that is 5% below the inflation rate.  The payment to the bank remains the same for XX years, BUT the purchasing power of the dollar weakens (in the banks hands).

• Leverage is tax deductible.  
  • To find your true interest rate, use the formula: Interest Rate x (1-Tax Rate)
  • Example: You have a 37% tax rate and the current interest rate is 5%

                        5% Interest Rate * (1-37%) = 3.15% true interest rate

Stocks/Equities
Although it is possible to buy public equities and stocks with leverage, it is very rare and generally reserved for sophisticated investors buying in the private markets. 

What is Depreciation?

Depreciation is cost recovery. It is a tax deduction that the government allows investors to write-off the cost or basis of their asset(s) over time. The period of time is dependent on tables the IRS publishes.  For example, a building is depreciated over 39 years while a machine is depreciated over 5 years.

Depreciation in Real Estate

• A powerful "paper" deduction for RE investors
• The IRS allows for depreciation of the full value of an asset, regardless of how much equity a RE investor has in the asset!  Leverage!
• Less could be more, for example:
  • If an investor purchases a $500,000 investment property with a down payment of $80,000, the depreciation is calculated on the $500,000 value of the property not the amount of the down payment. 
  • A lower down payment could be a wise tax strategy. 
    • The more you can leverage OPM in this situation, the better.
• Utilizing advanced tax planning strategies may allow a RE investor to write-off more in a given year.  
  • How? Cost Segregations and Bonus Depreciation allow real estate investors, meeting certain criteria, to expediate there depreciation expense and possibly offset OTHER income in their lives!  

Depreciation in Stocks?  We Wish!  

• The key difference between RE depreciation and stock depreciation is that an investor does not have the ability to depreciate a stock. 
  • A stock will appreciate over time (as does real estate)
  • The investment basis of a stock cannot be a write-off though
• Stock value may decrease over time, however:
  • An investor cannot write down an asset using depreciation.
  • An investor is entitled to a Capital Loss (capped at $3,000 annually)  ONLY IF the stock is disposed of.  

Cashflow in Stocks

• Cashflow in stocks comes from the dividends they produce.
• Dividends from stocks are taxed
• You generally are NOT allowed to deduct expenses against any dividends or cash flow.  

Cashflow in Real Estate

• A good RE investment will almost always realize cashflow. 
• RE investors the advantage of having a variety of tax deductions at their disposal to 100% offset their taxable income.
  • Use of leverage and "juicing" or tapping into rental property equity - interest paid to lender is a deduction
  • Asset Depreciation
  • Many other business deductions that are not legal and allowed for stock investors
    • Qualified Small Business Income Deduction - a hidden gem where you can get an automatic 20% deduction by structuring the properties correctly
• With the wide array of deductions available to RE investors, many have the opportunity to pay zero taxes on their cashflow and in some cases, create a "paper loss" to offset their W2 or business income. 
  • Advanced tax planning strategies could set a RE investor up to create tax losses year after year that can be deductions against other taxable income they have. 

Stock Appreciation vs. Real Estate Appreciation

Both classes of assets have the ability to appreciate.

• Stocks
  • Tend to be more volatile in the current economy. 
  • Have the ability to go from one extreme to the other.
  • Popular tech stocks tend to sway a lot. 
  • Historically, stocks appreciate over a period of time.

  

• Real Estate 
  • Huge gap in supply & demand means there is a lot of opportunity for investors
    • Statistics show there are approximately 400,000 homes for sale at any given time in the United States. 
    • Current trends show that 900,000 to 1,000,000 homes are needed to meet the demand. So there's a huge gap in Supply-demand. 
  • RE appreciation could continue with the high demand and lack of inventory
  • Although inflation is going up, RE can be an inflation hedge counting on the pool of buyers to drop as interest rates rise.
    • For example, as the real rate of inflation continues to rise, so will mortgage interest rates.  The pool of buyers that can afford a given investment drops.

And the winner is... 

It is our belief that Real Estate, with proper structuring and leverage, is a superior asset class over public equities.

We are excited about the opportunities real estate investing affords and are happy to explore with you how to add real estate to your investment portfolio. 

If you are interested in learning more about real estate investing and how to create a plan of action, please reach out to your GO CPA Team in Soraban. 

Services we can assist with include:

• Structuring your real estate investments, including setting up applicable entities
• Exploring whether you can qualify for the "Short Term Rental Loophole" to be discussed in a future article
• Exploring whether you can qualify as a "Real Estate Professional" and create 100% tax free wealth
• Discuss lending strategies, including leveraging business assets
• Family integration strategies to increase business tax deduction
• +More!