Real estate has traditionally been one of the best ways to build true wealth. The combination of security, leverage, and tax advantages are virtually unmatched in the investment world, yet people devote far more time and energy to developing a long-term strategy for managing their stock portfolio than they do in developing a long-term real estate game plan. This is true even though most people have more money invested in real estate than in any other asset class. Without question, a lot of people do make money in real estate, especially in Silicon Valley, but this is often despite their lack of planning. As is true with any investment plan, the highest level of success in real estate begins with a sound strategy that is proactively developed rather than just stumbled into. Having this sound strategy can lead to substantial rewards.
DETERMINE A GOAL
Generally, people buy real estate with one of three objectives in mind: (1) to have a home in which to live, (2) to build net worth, or (3) to create a safe income stream that will likely grow over time. Unfortunately, many people utilize the wrong type of real estate given their specific objective. This is most often a result of retaining a particular piece of real estate even though the desired objective has changed, such as when owners keep their old home as a rental property after they move up to a larger home.
When the goal is to have a home in which to live, then the buyers should give careful consideration to what their needs will be over the next ten years. If their family or space needs are likely to grow, then they should buy a home that can accommodate such growth or remain particularly cognizant of potential resale value so they can trade-up. Thus, a home that can be expanded in a cost-effective way might be a great choice. On the other hand, buyers who anticipate a growing income may find it more cost-effective to stretch to buy a larger home rather than endure the cost and inconvenience of an additional move.
Real estate investors looking to build net worth, on the other hand, should target homes that are either poorly prepped and/ or marketed, listed during the slow times of the year, such as the winter or mid-summer months, or located in an area with a lot of new construction, which tends to bode well for appreciation. These homes can often be resold a few years later at a significant profit. A well-advised investor may want to find a home that needs cosmetic improvements to enhance the value, make the improvements, rent it out for a year or two, and then sell it at a profit. Practical considerations, such as a usable floor plan, should carry more weight than subjective elements, such as the style of the home.
Buyers looking for cash flow may want to consider multi-family or commercial properties over single-family homes. Rather than holding a former personal residence as a rental property indefinitely, consideration should be given to selling that property and buying something that provides better cash flow. If properly structured, the deferral rules under Section 1031 of the Internal Revenue Code provide for a deferral of capital gains on the sale of the original property.
Clearly, there are tax advantages to buying and holding real estate. First, the gain on the investment is not taxed until the property is sold. Second, thanks to Prop 13 and the historical rate of real estate appreciation in California, long-term holders of real estate generally pay less property tax. As a result, many people resist liquidating investment real estate. However, these same people run the risk of missing out on one of the most generous tax advantages in the Internal Revenue Code which, namely, is the complete exemption—not mere deferral— from tax up to the first $500,000 of capital gains on a couple’s primary residence.
Combining strategies can prove particularly valuable. For example, a couple who expects to start a family in a few years may be open to upgrading every few years. Thus, they may want to buy a home in need of improvement so that they can experience above-average appreciation after they cure the superficial flaws. Over the course of the next three or four years, they can make the improvements necessary to boost the home’s value. Provided they are married and filing a joint return, they should be able to sell the property and exclude up to $500,000 in gain, which becomes available as an additional down payment for the next home. Thus, this couple is able to build a substantial net worth, tax-free, while also enjoying a great home that can accommodate their growing family.
Like any investment, long-term success in real estate starts with knowing your goals, having long-term objectives, and understanding the tax benefits. A good real estate agent should help you develop an approach that works for your long-term investment strategy, not their short-term commission income. Make sure you discuss all of your future plans rather than just your current needs.