Direct investment involves directly buying and selling residential or commercial property. It may also include managing the property, in some cases. You might consider direct investment for one or more reasons, including the potential income generated from the rent paid by tenants, the capital gains that can be realized when you sell the property, and the tax advantages available through this type of investment. Two separate types of direct investments will be addressed in this discussion: direct investment in residential property and direct investment in commercial property.
Residential property includes many different types of dwellings, any of which can be purchased as investment properties. Residential property includes detached single-family homes, condo or co-op units, multiunit buildings (e.g., duplexes, triplexes, and apartment buildings), and entire apartment complexes. There are many reasons you might consider a direct investment in residential property. You might buy a home or other property to use as a rental property. You might buy an existing home (which may or may not need rehabilitation) with the intention of reselling it for profit. You might buy a large home and convert it into several rental units. You might buy an interesting older home and convert it to office space (if zoning allows) for law firms, real estate offices, or other businesses. One important factor to consider is that many of these projects require you to take on the role of landlord. Make sure you are comfortable with this responsibility before you consider such an investment.
Commercial property includes many types of business property, such as office buildings, nursing homes, shopping centers, and strip malls. Important steps to investing in commercial property include analyzing the market in the geographical area you are considering, establishing a viable rent schedule, advertising your office or retail space, and drawing up lease agreements. You may wish to consult with experts such as brokers and real estate lawyers for assistance with this. Click here to view a Real World Commercial Real Estate Case Study.
What are the risks?
Like all real estate, significant risks are associated with investing directly in either residential or commercial property. In particular, direct real estate investments are subject to market risk and liquidity risk. Political and economic changes can drive down the demand for both residential and commercial property, as well as the values of such properties. Changes in tax laws could reduce or eliminate the favorable tax treatment of investment property. Should you find yourself with an unexpected cash need, you will probably not be able to quickly liquidate your property. Before you consider a direct investment in residential or commercial property, you should evaluate your ability to deal with these risks.
When can it be used?
You understand the risks and responsibilities inherent to real estate investing, and you are comfortable with them.
Like all methods of real estate investing, direct investment in residential or commercial property is highly speculative. Before you consider this type of investment, you should measure your risk tolerance and evaluate your ability to deal with the risks and responsibilities. In addition, asking yourself some of the following questions may help you evaluate the appropriateness of this strategy:
Do I have the financial backing required to purchase investment property?
- If not, is my credit rating good enough to secure financing?
- Do I have the ability and the resources to use my own money if necessary to help the investment survive?
- Would my life’s savings be in jeopardy if I needed cash to help pay bills or prevent foreclosure on the investment property?
- If there were vacancies or delinquencies, would I have sufficient cash flow to pay the expenses until income returned to normal levels?
- Would worrying about my investment property interfere with other aspects of my life?
- If I decide to go into this business and it fails, would I be all right financially? Emotionally?
You have the knowledge and resources required to be successful
In order to be successful with any type of real estate investment, you must have (or be willing to work on acquiring) knowledge of the business as a whole. Books and seminars are a good start. You should also talk to others who have made successful investments in the type of real estate you are considering. In particular, direct investment in real estate requires extensive knowledge of an area and the ability to recognize its trends. Also, a successful real estate investment will require considerable personal commitment and expense on your part. Regardless of the type of property you choose, the costs include mortgage payments, property taxes and assessments, repairs and rehabilitation expenses, utilities, insurance, advertising, legal expenses, building inspections, landscaping, and the like.
Strong growth potential
Like all real estate investments, you will likely make a direct investment in residential or commercial property with the expectation that the property will increase in value during the time you own it. Of course, the downside is that you may face a tax liability on the capital gain when you sell the property.
Excellent income potential if you rent out residential or commercial property
Most direct investments in residential and commercial property involve renting out the property after you purchase it. This creates an opportunity for current income.
Favorable tax treatment available for investment property
Income-producing real property receives certain favorable tax treatment. Your operating expenses are typically deductible against income, and you are also entitled to a deduction for depreciation. The amount of your depreciation deduction varies depending on whether the property is residential or commercial.
Real estate investments can be speculative
It is imperative that you understand the risks you are undertaking when you invest directly in real estate. There is no guarantee you will realize a profit on a real estate investment. In fact, there is no guarantee your property will even retain its current value. What makes real estate investing so challenging is that so many of the factors that determine the success or failure of a given real estate investment are outside of the investor’s control. Changes in the tax code could reduce or eliminate the tax advantages of real estate investing. Zoning law changes and alterations in traffic patterns can directly affect a real estate investment. Economic changes in an area (e.g., the failure of a major business) can adversely affect property values as the real estate market is flooded. Financial markets can also affect the value of real estate investments as interest rates fluctuate. These are just a few of the many risks to consider if you are thinking about a direct investment in real estate.
Direct investment in real estate typically requires a large outlay of capital
Whether you are considering an investment in residential or commercial property, you will need a relatively large sum of money to get started. In fact, many investors do not even consider getting into real estate because of the large sums necessary to acquire and maintain property. Of course, you can borrow the money to make your investment, but you could run into trouble making your loan payments if the investment is not successful. In addition, loan payments and interest can substantially reduce the income you receive from your investment property. If you are not prepared to lay out the money for a direct real estate investment, you might want to consider a different form of real estate ownership.
You could incur capital gains and/or investment tax liability
You may be required to pay capital gains tax if you make a profit when you sell the property. Also, net rental income (income minus expenses) and net capital gains from the sale of property will be included when calculating whether your total investment income is subject to the 3.8% tax that applies to individuals with an adjusted gross income (AGI) above $200,000 and couples filing a joint return with more than $250,000 AGI.
How to do it
Since there are many types of direct investments (e.g., single-family homes, apartment buildings, office buildings, retail space), there are also many ways of investing. In addition to the traditional methods of buying property (e.g., through brokers), you might want to consider shopping at real estate auctions or foreclosure sales. You can often get property well below market price by shopping this way, although you may encounter liens against the property as well as other problems that you will not know about prior to purchasing. Another way of investing in residential or commercial property is to purchase rehabs or “fixer-uppers.” Property in various stages of disrepair is often sold below fair market value, and your repairs could dramatically increase the selling price of the property. These are just a few general ideas for direct investment in residential or commercial property. You will need to consult other resources to find out the specific steps involved in purchasing the type of property you eventually decide on.
Operating expenses are typically tax deductible
Income-producing real property is typically considered business property. As such, it receives certain favorable tax treatment, in that your operating expenses are typically deductible. Here are the general rules regarding deduction of operating expenses:
- All operating expenses (including interest on property loans, property taxes, insurance, utilities, advertising, maintenance, and so on) can be deducted against income received from the property
- If the total operating expenses are less than the gross income, the resulting profit is taxable income
- If the total operating expenses exceed gross income, the resulting loss can be used to offset other investment income
Operating expenses include a wide variety of items that you might not ordinarily consider. However, as long as these items are truly used in the course of business, they are perfectly legitimate deductions. Here are a few examples of items you might be able to deduct as operating expenses:
- Tools and hardware
- Cleaning supplies and expenses
- Lawn equipment
- Office supplies
- Office machines (e.g., typewriters, fax machines, copiers)
- Computers and management software
- Payroll taxes
- Books and subscriptions
- Seminars and meetings
- Legal fees
- Travel costs to and from the property
Depreciation is also deductible
Another tax benefit of investment property is the ability to deduct depreciating assets. Investment property is assumed to decrease in value over several years, due to wear-and-tear and other factors. Although this is not necessarily the case, you are allowed to deduct depreciation as a way to recover this assumed loss of value. Rental houses and apartments placed in service after January 1, 1987, depreciate on a straight-line basis over 27.5 years (approximately 3.63 percent per year). Thus, if you purchase residential rental property this year for $275,000, your depreciation deduction would be $10,000 per year for the next 27.5 years. Nonresidential real estate depreciates on a straight-line basis over 39 years (approximately 2.564 percent per year). Thus, if you purchase an office building for $780,000, your depreciation deduction would be $20,000 per year for the next 39 years.
Capital gain or loss may result from the sale of the property
Your gain or loss realized from a sale of real estate is usually a capital gain or loss for tax purposes. Capital gains must be included in gross income. Generally, capital losses can only be used to reduce or offset capital gains. Capital gain income and loss can have a substantial impact on your net return on your investment.