Real Estate Investing

Investing in real estate can have serious appeal. It not only helps diversify your portfolio, but it can also provide a long-term stream of income. Whether you want to be a landlord or invest in real estate by way of a real estate investment trust (REIT), these are the key steps to get there.

Consider working with a financial advisor to help you find the right real estate investments for your portfolio.

Steps You Need to Take to Start Investing in Real Estate 

Real estate investing does not have to be complicated. If you’re interested in expanding your portfolio, this is how to get started.

Do Your Research

There are a range of options for real estate investments, but these five are the most common:

• Residential
• Industrial
• Commercial
• Mixed-use
• Retail

After you research the market and choose your property, you can then pay for it.

Determine How to Pay

It is generally best to use cash to pay the down payment on an investment property. With cash, you won’t have to pay any interest at all, and you’ll earn more money if your property’s value appreciates.

The other option is to finance the property through mortgages or other loans, but you’ll gradually lose money to interest payments.

Find out now: How much mortgage can I afford?

Consider the Tax Implications

Determine the tax implications of your investment. Taxes vary by property type, so it’s wise to know the applicable tax laws.

A tax professional, such as a certified public accountant (CPA), if you’d like extra help with this step.

Prepare for Risks

Any investment presents some level of risk, so prepare for any unforeseen market fluctuations. For example, if you take the rental property route, you’ll need to account for maintenance, repair and other costs.

Any real estate investment will offer some semblance of uncertainty. Whether your property’s value appreciates or depreciates, it is important to have a solid backup plan.

Manage Your Investment

Closely monitoring both the market and your property will help you to anticipate any sudden market changes.

For professional guidance, a financial advisor can help you with things like budgeting, investment planning and asset allocation.

Our free financial advisor matching service can help you find the ideal advisor.

Investing in Real Estate, the Old-Fashioned Way

The old-school way of investing in real estate is to buy an investment property. Then, you can either find tenants and collect rent or resell the property for a profit.

You can do this once, or as many times as you can afford. You can work your way up to real estate magnate status, be a serial house flipper or simply rent out your vacation home when you’re not using it.

Just remember to factor in maintenance expenses, vacancy between tenants and property taxes when calculating how much money you need to invest.

For most people, saving up to buy one primary residence is hard enough. Additionally, if you own an investment property, you’re responsible for either managing it yourself or hiring a management company.

Are you ready to get calls in the middle of the night when your tenant’s pipes burst? No? Then you’ll need to spring for a management company.

Folks who have their hearts set on early retirement and financial independence may find that owning real estate is a key component of their financial plan. That’s because investing in real estate can create large sums of passive income, the Holy Grail of financial independence.

On the flip side, if you owe more than your investment properties are worth and have trouble finding tenants, real estate investing can backfire. It’s important not to get in over your head.

Real Estate Investing and REITs

Another option for those who don’t want the hassle of buying property outright is to invest in real estate via a real estate investment trust (REIT).

When you buy shares in a REIT or REIT fund, you profit from the dividends that real estate companies pay investors. To invest, you simply buy shares in the REIT.

Another option is to buy a REIT mutual fund, which comes in three forms.

• Actively managed mutual funds
• Passively managed REIT index funds
• REIT exchange-traded funds (ETFs)

REITs can be domestic or international.

There are also specific types of REITs: equity, mortgage and hybrid:

• Equity REITs. Equity REITs are what most people think of when they think of REITs. They own and manage income-producing properties, whether they are commercial or residential. With equity in multiple properties, the REIT can afford to pass part of its income on to investors.
• Mortgage REITs. A mortgage REIT doesn’t have the same kind of equity. It lends money to real estate companies, either via direct loans or by buying mortgage-backed securities. Instead of income from rent, income comes primarily from interest on mortgage loans. This means mortgage REITs are more leveraged, making them riskier than equity REITS. There are also far fewer mortgage REITs than there are equity REITs.
• Hybrid REITs. Hybrid REITs combine the traits of equity and mortgage REITs.

Real Estate Crowdfunding

Recently, the crowdfunding movement has found its way into real estate investing.

Several start-ups now let individual investors make small, medium or large investments in real estate, reaping rewards proportional to their initial investment. Real estate crowdfunding lets you have a little more control over your investments than with a REIT. You can review potential investment properties one by one and choose where you invest.

Just beware of the risks. Be sure to invest with a reputable company and confirm how to report the income you earn at tax time. And remember that because you’re choosing individual properties, you’re not getting the same level of diversification.

How to Finance a Real Estate Investment

For most investors, buying an investment property means taking on a mortgage rather than paying cash outright. Investment property loans work differently from the mortgage you may have used to buy your primary residence, with terms that are generally less favorable.

Lenders typically require a down payment of 15% to 25% on investment properties, compared to as little as 3% on a primary residence. ¹ The higher requirement reflects the added risk lenders take on, since borrowers are statistically more likely to default on an investment property than on the home they live in.

On a $400,000 property, that means bringing $60,000 to $100,000 to the table. You would then finance the rest ($400,000 x 0.15 = $60,000; $400,000 x 0.25 = $100,000).

Interest rates on investment property loans also run higher than primary residence rates. This is often by 0.25 to 0.875 percentage points or more, depending on your credit profile, the property type and the lender. ² Over a 30-year loan, that difference compounds into a meaningful cost.

Beyond conventional loans, some investors use debt-service coverage ratio (DSCR) loans. Instead of using a borrower’s personal income, it qualifies borrowers based on the rental income the property is expected to generate. This can make financing more accessible for investors who are self-employed or who own multiple properties.

The central appeal of financing a real estate purchase rather than paying cash is leverage. If you buy a $400,000 property with $100,000 down and it appreciates 10% to $440,000, your return on the cash invested is 40%, not 10% ($40,000 gain on $100,000 invested).

The same leverage that amplifies gains, however, amplifies losses just as quickly if the property declines in value or sits vacant longer than expected.

Real Estate Investing and Taxes

The tax side of real estate investing is more complex than most beginner investors expect. However, several rules work in investors’ favor when used correctly.

Property Classification

Your property’s classification determines which taxes apply.

• When you sell a property held for less than a year, any profit is subject to the short-term capital gains tax, which is taxed at ordinary income rates.
• If you hold the property for at least a year before selling, the profit qualifies for the long-term capital gains rate, which is generally lower.

Where you fall within the federal income tax brackets will determine exactly how much you owe in either case.

Depreciation

Rental property owners can also benefit from depreciation. This lets you deduct the cost of the structure over 27.5 years for residential properties. ³

For example, a $300,000 building (land value excluded) would generate an annual deduction of about $10,909 ($300,000 / 27.5 = $10,909). This deduction reduces taxable rental income each year even when the property is gaining value.

Because of this, depreciation serves as one of the more favorable provisions in the tax code for real estate investors.

1031 Exchange

Investors looking to sell one property and buy another can use a 1031 exchange to defer capital gains taxes. This is done by rolling proceeds into a replacement property of equal or greater value.

However, the IRS imposes strict deadlines:

• 45 days to identify the replacement property
• 180 days to close on the property

Missing either window disqualifies the exchange and makes the gain immediately taxable.

Rental Income

Rental income generally falls into the passive income category under IRS rules, limiting how losses can be used. In most cases, rental losses may only offset other passive income.

Investors with a modified adjusted gross income (MAGI) below $100,000 who actively manage the property may deduct up to $25,000 in rental losses against ordinary income. However, this allowance phases out completely at $150,000. ⁴

Depreciation Recapture

One liability that catches many sellers off guard is depreciation recapture.

The deductions taken over the life of the property do not disappear at sale. Instead, the IRS recaptures them at a rate of up to 25%, applied separately from the capital gains rate on the remaining profit.

Accounting for this cost before listing a property, rather than after closing, gives you a more accurate picture of what you will actually net from the sale.

Bottom Line

Real estate investing can build long-term wealth, but it also presents risks. That is why it’s important to understand the different property types and their applicable taxes. The real estate sector is just one sector of our big, complicated economy. Investment strategies like portfolio diversification can help you take a proactive approach to market volatility. If you only invest in real estate, you could be in trouble if there’s a downturn in that sector.

Tips for Investing 

• Whether you want guidance on whether real estate investments are right for your portfolio, or you need help monitoring your existing investments through the market’s ups and downs, you might find it helpful to work with a financial advisor. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• If you’re already diversified across stocks and bonds, you’re on track to meet your retirement savings goals and you have a fully stocked emergency fund, you may be looking to branch out. Real estate investing is a great way to chase returns, and because real estate often performs differently from stocks and bonds, it can add diversification. Just be prepared for some ups and downs if you’re investing for the long term.

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