Real estate investments don’t work like any other form of investment business. They involve investing in physical properties at various stages of development. This distinction creates some unique opportunities for entrepreneurs and investors working in this industry. To get the most out of your investments, you need to understand how income from real estate investments can be earned beyond the simple act of buying and selling a home. You also need to understand how diversifying your real estate investment approach can bring you tax benefits, and which tax advantages are available for those looking to develop properties.
Diversifying Your Real Estate Income
There are two ways that most people move into real estate. Either you start by buying, improving, and selling properties or you start out as a landlord, taking care of rentals. Either way, it is a good idea to diversify your investments and to make use of both approaches. In terms of real estate investing and taxes, the income properties will create a steady cash flow that can be used to pay expenses like your contractors and your tax bills. The sales can then be used to increase your overall portfolio size and to create working capital for large investments.
There are also often local incentives to provide certain types of housing or business space, especially if there are renewal or Renaissance zones in your city. Strategically taking advantage of development opportunities with those kinds of tax benefits can lower the tax obligations of your whole operation through the judicious use of one or two investment opportunities. Look for opportunities in all these areas:
- Public-facing commercial real estate like restaurants and retail spaces
- Industrial and professional spaces
- Single family rentals
- Multifamily rentals
- Condominium developments
It’s also a good idea to look at the opportunities available through crowdfunding and other real estate investment platforms, since that is another way of receiving income from real estate investments with their own tax opportunities and complexities.
Like-kind exchanges, also known more formally as 1031 exchanges, have been a vital part of the real estate sector for years. They allow investors to defer capital gains taxes owed on the profits from a property sale into the purchase of a new property. This essentially provides an interest-free loan to the investor for the value of the taxes, which is then due when the new property is sold.
The exciting thing about 1031 exchanges from a real estate investment point of view is the fact that they can be chained together. That makes them one of the most effective real estate investing tax strategies, because you can essentially continue the chain of like-kind exchanges as your portfolio grows, using the properties you are holding while they appreciate as rental income for cash flow while you wait to roll the property over to a larger investment. You will pay taxes on the rental income, but that can be managed through the use of tax programs and other deductions.
Business Expenses And Itemized Deductions
One of the reasons why it’s wise to go into the rental business as part of your tax strategy and part of your business plan is because of the opportunity to use the associated business expenses. From deducting mileage when you visit your properties to having the opportunity to count marketing expenses incurred while advertising vacancies, there are a number of opportunities that are easier to take advantage of when you have a regular day-to-day operation that is making a consistent income.
Understanding Internal Rate of Return
Internal rate of return is a measurement you can use to determine which of your investment opportunities are most likely to be the most lucrative. Its formula involves calculating the relationship between investment costs, net cash flow, and the time the investment will operate. It takes some research to calculate it correctly, but basically the higher the value, the better the investment opportunity.
When using internal rate of return, it is important to know all of your tax liabilities and the available real estate investment tax deductions going into the calculation, because that knowledge is part of the calculation of your net income or profit. The lower the tax burden presented by that option, the more it will positively impact the internal rate of return.
Putting It All Together
The question becomes, with all this knowledge about the ins and outs of real estate investment, what do investors need to do to be successful? To put it all into an easy to manage process, consider the following, a step-by-step checklist for investing:
- Locate diverse opportunities that involve both rental income and sale income
- Identify the available tax obligations and the deductions that exist to mitigate them
- Identify other overhead and operating expenses
- Calculate the term of the investments
- Use these items to calculate your internal rate of return
- Compare rates of return to find your best investments for the time being
It sounds simpler than it is, but having a clear guide is the best way to start organizing complex information.
Make sure to learn all about the tax implications of real estate crowdfunding in our free eBook before you start investing.