You may have heard, or read, something similar to: “If you don’t want to pay taxes, invest in real estate.” While this is not entirely accurate, real estate investments are extraordinarily tax efficient. To understand this properly it is necessary to understand the mechanics of a typical real estate investment. For illustration purposes let’s focus on residential real estate. This is usually purchased at a price that suggests a 6% return on investment (this varies by location). This is known in the industry as a “6 Cap.” In English, for every $1,000,000 of purchase price, the building creates net operating income (NOI) of $60,000. NOI for this purpose is rental income less the costs of repairs, maintenance, management, insurance and property taxes.
Making a 6% return however, isn’t that appealing to investors. In an effort to boost returns and create a better return on investment (ROI), an element of leverage is introduced. Instead of investing $1,000,000, you borrow part of the money from a bank. As long as the cost of borrowing, i.e. your interest rate, is less than your cap rate, you are increasing your overall ROI. Using the above numbers and introducing a mortgage of $800,000 at a 5% interest rate, will produce the following result. The building will generate the same $60,000 of NOI. However, you now have $40,000 a year of interest expense ($800,000 x 5% = $40,000), leaving you with just $20,000 of net profit. But your investment is now just $200,000 ($1,000,000 – $800,000 borrowed), for ROI of 10% ($20,000 / $200,000 = 10%). Add to the this any appreciation in the value of the building and your real returns can easily exceed 15% a year.
Here is where the tax advantages come in to play. First, the tax code allows the investor the full benefit of the interest expense. This means that although the building is producing $60,000 of income, the investor can reduce this by the full $40,000 paid in interest. This contrasts with other forms of business whose interest expenses are limited to a percentage of income. Second, the tax code allows the investor to expense the building over a specified period of time. This is known as depreciation. Usually, this affords the investor close to a 3% annual expense against their taxable income. Using the above numbers, this would add a $30,000 expense ($1,000,000 X 3% = $30,000), and will result in the investors reporting a loss of $10,000 on their tax returns. This is despite earning a 10% ROI! Third, any increase in the value of the building is not taxed until the building is sold. Fourth, even the sale of real estate can avoid taxation using a tax-free rollover transaction known as a Section 1031 exchange. The combination of these factors makes real estate a truly tax advantaged investment.