Building Wealth: Your Real Estate Asset

Real estate is often purchased as a lifestyle asset (to live in) or as a commercial investment (to generate rental income). It’s also quite common for people to think of their home as both lifestyle and an investment. Certainly, the most common near-term goal for families is home ownership – many think it amounts to a “no brainer” investment (meaning they think their home is a great investment) when it actually costs them much more than they realize.

In our examination of annual return rates on residential and commercial real estate we find that real estate is by no means a no brainer investment. Real estate assets can indeed contribute to wealth creation if the purchaser buys for value, carefully manages maintenance/renovation costs, and the sale is handled with an eye to minimizing taxes on gain from the sale.

Your residence has the potential to be a large part of your wealth, particularly in the Bay Area, but it can also be your largest liability.

Lending institutions have different requirements when lending for an owner occupied residence than for commercial real estate. A primary residence can often be purchased with lower down payments and lower mortgage rates than non-owner occupied real estate. In addition, on the sale of the owner occupied residence the gain will often fall under the capital gain exclusion rules which allow couples to exclude $500K from their income, tax free. This is one of the few opportunities to realize gain completely tax free. Couples who want their residence to be an investment rather than a lifestyle asset should consider selling their home once the gain (market value above basis) in their home approaches the $500K cap gain exclusion. This doesn’t mean you have to buy bigger or smaller or move away from your neighborhood but it does mean that you must sell a property to capture this tax free gain.

If a couple bought a home for $600K, made no renovations and 5-10 years later it is worth $1M they could choose to sell their home and retain the $400K gain tax free. They could repeat this process several times in a couple’s lives and each time a sale is completed the gain can be retained tax free. At the end of 3 rounds (there are residence requirements for each exclusion to be allowed) this couple could have managed to clear (net) well over $1M tax free. Despite this unparalleled opportunity to build tax free wealth, most home owners will buy one home and live in it until retirement. A well purchased property will still yield gain but much of it will be taxed. A home purchased at $600K that sells for $1.8M in retirement will have $500K of the gain tax free but $700K will be taxed at capital gain rates federally and at regular income rates by the state.

A residence can turn into a large liability when the debt burden is too high, when the home renovations do not yield increased value for resale, when the home requires a lot of maintenance, and when the location is no longer appealing (loss of home value appreciation).

Unlike residential home purchases, real estate purchased for investment is first valued on its ability to generate sufficient income and not as much on its appreciation. Before buying an investment property the property is thoroughly analyzed from various perspectives. An APOD (Annual Property Operating Data) is the principal tool to understand the cash flow, return rate, and profitability that can be expected from a prospective property. Once a property passes the APOD test (primarily for risk assessment) then the tax shelter provided by such an investment and the impact of the time value can be used to determine if this is an appropriate investment. Not surprisingly, much of the success of these investments stem from proper usage of tax rules. The value of the annual depreciation (using Schedule E) is well known. An equally important tax tool is a 1031 exchange. In a 1031 exchange the value of the investment property you own can be used to buy a second investment property of the same or greater market value while deferring tax payments on the gain.

In short, both residential and non-owner occupied real estate can be part of your investment plan. Unlike market investments it is more difficult to identify and protect against unexpected events and the illiquid nature of ‘real’ assets. Managing real estate to attain investment value requires thoughtful deliberate actions that may not always be aligned with your personal wishes (far from being a “no brainer”). Investing in real estate can reap big rewards, but entails doing a lot of meticulous research, taking only risks that are necessary, covering for contingencies, working with an experienced team, and then allowing time to do the work.

If you need help deciding whether a real estate purchase fits with your long term goals, give Aikapa a call.