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Building Wealth Through Real Estate

The Power of Leverage
Real estate loans give us the opportunity to purchase property while putting very little, if any, of our own money down. Here's how leverage works: If you purchased a $100,000 property with no money down, and the appreciation rate stayed at the national average of 6.4%, your property would be worth $106,400 at the end of the year - a $6400 gain. If you purchased $1,000,000 worth or property, that would be a $64,000 annual gain - all on borrowed money. Most investments do not provide this kind of leverage. You wouldn't ask your stock broker if you could borrow money to buy stock, yet banks lend millions of dollars every day to real estate investors. Applying for a business loan can be much more difficult than getting a mortgage. It appears that banks believe real estate is a safe investment.

In addition to bank leverage, the real estate investor also gets leverage from tenants. The investor using OPM (Other People's Money) to purchase the property then uses OPM to pay off the debt through rental income. The investor who bought that property for $100,000 with borrowed money now rents out the property to a tenant who helps pay the mortgage, taxes and expenses. This is the ultimate leverage, while at the same time. providing needed housing.

Tax Benefits for Real Estate Investors
A second major reason investors purchase real estate is for the big tax benefits You can deduct up to $25,000 of your investment property losses against your ordinary taxable income if your adjusted gross income is less than $100,000. Most investment property losses are known as a "paper loss" (rather than an actual cash loss) because they are not cash-out-of-pocket losses.

The reason is that most investment property paper losses come from the depreciation deduction. Depreciation is a non-cash allowance for "wear, tear and obsolescence" of the rental property building. Residential rentals must be depreciated over 27.5 years, but commercial properties are depreciable over 39 years on a straight-line basis. In other words, even though your investment property is appreciating, you can claim depreciation losses on your tax return.

In addition, depreciation is allowed over shorter five-to-ten-year terms for personal property used in the rentals, such as apartment building washers and dryers. However, land value is not depreciable because it never wears out. Your car or truck used to operate your investments can also qualify for tax deductions. In addition, equipment purchased to operate your investment property is also eligible for generous tax breaks, including first year expensing, subject to limitations.

The best tax breaks go to "real estate professionals." If you are a "real estate professional," such as a broker, sales agent, property manager, builder, contractor or leasing agent, you can qualify for unlimited tax deductions from your investment property against your ordinary income. To qualify for the real estate professional unlimited investment property tax deductions, you must spend at least 750 hours per year, or more than 50 percent of your working hours, involved in real estate activities. One way to meet this requirement is by getting a real estate license.
Don't forget depreciation recapture when selling. The only downside of the depreciation tax deduction, which saves income taxes during investment property ownership, is at the time the property is sold Uncle Sam is waiting to "recapture" and tax the total depreciation deducted during the years of ownership. To make matters worse, Uncle Sam imposes a special 25 percent recapture tax, with a very few exceptions. This tax rate is considerably higher than the current 15 percent long-term capital gains federal tax rate.

However, if the investor dies while owning depreciable real estate that would have been subject to the depreciation recapture tax rate, then Uncle Sam completely forgives all taxes that would have been due if the decedent sold the property before death. In other words, death is the ultimate tax shelter of all.

1031 Exchanges
Capital gains taxes, and the recapture of depreciation tax, can be fully avoided by making an Internal Revenue Code 1031 tax-deferred exchange. To qualify, the replacement property must equal or exceed the old property's equity and cost without taking out any taxable "boot" such as cash or mortgage relief. The investor who bought that $100,000 home finds his home is now worth $200,000. He can sell the property and use the profit to buy several more properties without paying any capital gains tax. The 1031 exchange must be done according to the tax law and through a qualified intermediary. Be sure to hire a good 1031 company to handle your transaction.

The Real Estate Market
While real estate is expected to keep slowing down in some over-priced areas, it is actually expected to pick up in under-priced areas. Investing near large cities where the real estate appreciation has been slow in the past, but the area shows strong job and population growth and a solid rental market is a conservative investing approach is these changing economic times.

There is still a shortage of housing. The oldest of the 87 million babyboomers are just now reaching retirement age. Many of these retirees are purchasing 2nd homes. They are also expected to live longer, and therefore live in their homes longer. Meanwhile, their children are just now entering the housing market. This huge wave of buyers has created a shortage in homes. Foreign investors are also adding to demand, as they see that real estate in the United States is a viable investment. The many financing options in the United States, including the 30 year fixed mortgage and no-money-down programs are virtually unheard of in other countries. Interest rates are expected to climb again this year, but they still remain at historic lows.

If the market does slow down in the over-priced areas, the trend shifts from seller's market to buyer's market. It could be an excellent time to negotiate and find bargains, while locking in a low fixed rate mortgage.

Real estate shows its power over time. Regardless of the cycles, real estate values continue to climb over the long haul. Looking back in time when we had the last slow down in real estate, we can see that today, the value of property is much higher than the last "bubble.". In other words, slow downs are temporary. The key to real estate success is having the reserves to hold on to your property through the down cycles.

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