Saturday, July 26, 2008

Why Your Home Isn’t A Retirement Account, and Where You Should Be Using Real Estate To Fund Retirement.

The recent downturn in the real estate market has caused many homeowners who were banking on the equity in their house to rethink their retirement planning. Rather than run from the depreciating real estate market, they should consider investing in properties that will carry them through retirement.

There is a defined distinction between property you would consider as a home and property best suited as an investment. Many times, real estate that would make a great home would be a lousy rental, while similarly, property that provides excellent financials for investors would not be real estate you’d be proud to call home. This is exactly the reason why real estate buyers need define exactly what purpose the property they are searching for will serve, and then use a specialized approach to find properties that would make good candidates for that usage.

Lets first consider real estate used as your primary residence. We will first examine things that make the best homes terrible investments and then how these same shortcomings are huge pluses when viewed through a pair of rental property glasses.

Investing in Real Estate That You Want to Call Home
Uncertain Appreciation – Markets change and no matter how highly desired your location is, there is always zero certainty that appreciation will happen within a short window of time.

Illiquidity – Investing in a bigger home, in lieu of acquiring rental property, has the distinct disadvantage of not being able to be turned into quick cash without selling or refinancing. Since the property generates zero monthly cash flow, the only way to collect income is by taking on additional debt (ie refinancing) or an outright sale which can take months to close.

Impractical – Beside being slow to sell, selling your home to cash in on the equity leaves the big obvious problem of “Where will you live?” Your going to have to live somewhere and this usually requires either buying another home or paying somebody rent.

Tax Consequences Spending a large amount of money on your home is a rewarding experience and can increase your homes value. You will not, however, discover any new tax breaks even if your tax liability increases. Remember, you are the one paying the taxes in the first place, and deducting them from your income liability does not completely negate those payments. Even if you extend you loan to keep your interest deductions, that additional monthly payment that you picked up during the refinance may have been better used somewhere else, such as in rental property.

Investment in Rental Property
Cash Flow – Investings polar opposite of appreciation is cash flow. Cash flow of an investment property is the real indicator of its value. In short, cash flow can be defined as the amount of money the property generates in rents after all expenses are paid.

Whether a property appreciates or depreciates is really at the whim of the market and availability of buyers. There is not much a homeowner can do to increase the value of their home without taking on considerable costs that may outweigh any gains in value.
Income property owners, or cash flow investors, have much more control over their properties value. They can increase rents, decrease expenses, or any combination of these to make the cash flow situation better and ultimately increase their property value.

1031 Exchange – An investor’s response to lack of liquidity is found partly in the above explanation of cash flow and partly in a process known as a 1031 exchange. A 1031 exchange allows an owner of rental property to sell their property, identify a replacement property, close escrow on that property, and defer any capital gains taxes until a future date.

From Impractical to Practically Too Easy – If the investor decides they want to completely liquidate the property in the future, there are even strategies for this that will severely limit their tax liability and they won’t even have to worry about finding a new place to live! There are lots of options open to rental property owners, none of which are available to a primary residence owner.

Additional Tax Benefits – Unlike your home, the value of income rental properties is allowed to be depreciated from most owners tax liability. Also, during rougher rental years, owners are allowed to write off losses directly related to their investment property. Even during a bad year, the tenants that you do have are continuing to pay off your mortgage until you owe nothing.

By delaying a little gratification and looking into purchasing rental properties right now, most people will be able to generate a little income, create peace of mind for their own retirement, and have more assets to pass on to their children. We encourage you to start looking this direction immediately. After all, the timing is perfect: rents are up, prices are down, and interest rates are still historically low. Even in a down market, you won’t care if values ever go up because your property continues to generate income and your tenants continue to pay off your mortgage.

Even though the timing is perfect, please do not use your home for leverage in order to get into the rental market. Save some money every month, get a second job, or ask your boss for a raise. Just please leave the ever fickle equity in your home alone!

We are not advocating living in meager homes and never upgrading your property. In fact, if you have your retirement settled then it may make perfect sense to live a little. We’re speaking more to the people who don’t have a clear plan for their retirement, have a little money to spend now, and want to really invest in their financial future. If that sounds like you, forget the kitchen remodel, the time to get in the rental market is now!


William L. Exeter said...

Congratulations on a great post! Right on target and easy to understand. Great job!

FOUST Team Real Estate Services said...

Thanks for the kind words William. Comments from knowledgeable folks such as yourself are always well recieved.