As I mentioned in Invest Overview: Fueling Your Net Worth and My Plan for Total Financial Freedom (AKA My Retirement Plan), real estate is a key part of both my investment and financial freedom plans.
In a future post I’ll share details and the financial performance of my rental properties.
Before I do that, I wanted to highlight my objectives for investing in rental real estate in the first place.
To note, I bought three rental properties several years ago shortly after the financial collapse in the U.S.
The goals below were my motivation and the strategy is what I used. I haven’t purchased any additional properties for a couple years as prices skyrocketed and made it hard to hit my return goals.
My Goals
Here’s what I wanted to accomplish by investing in rental real estate:
- Help me get to financial freedom. Vital to this effort is covering my annual expenses with something other than my salary. Rental real estate is a key part of this effort.
- I want to diversify my investments and not have everything in stock and bond mutual funds.
- My financial objective is to earn 10% (before taxes and depreciation) on money invested in rental real estate. This includes ALL monies invested. For example, if I buy a place for $80,000 and invest another $20,000 fixing it up, I want the operations from the place to earn at least $10,000 annually after all expenses are covered ($100k * 10%).
- I’m ok with getting some capital appreciation (who wouldn’t be?). But I am not counting on this in any way. Any appreciation I eventually realize will be gravy.
My Strategy
Now that you know my objectives, here has been the general framework of my strategy:
- Identify value properties that have decent cash flow. For example, many of the properties I considered already earned 5% to 6% before I purchased them. These were much easier to find in 2010. Since then prices have gone up dramatically and make it difficult to find the values/returns I want.
- Look for properties where, for a reasonable investment, rents can be significantly increased.
- Buy the places, make the improvements, increase the rents, and fill them up.
I know it sounds simple, but it takes a lot of work and effort to make something like this happen.
If you want to see the properties I purchased and how the investments worked out, read Financial Details of My Real Estate Investments.
Danny says
Real estate will hopefully be the next asset class I add to my portfolio. I’ve got roughly a 32/60/8 split right now between cash, stocks/bonds, and P2P lending so I’m looking for more diversification and “passive” income. Maybe non-W2 income is a better way to put it instead of passive. I dove head first into bigger pockets and a few other resources recently to start learning and my real estate plans will likely be much more defined by 2017. Always looking to consume more information from those who have done it before me so I’ll be looking forward to your next post.
Chris Colter says
Great post. I’m just getting started in real estate, and interested in hearing more.
ESI says
@Danny and @Chris —
You’re going to love my two posts next week. 馃檪
TL says
I’d love to hear how you’ve structured your real estate business. I currently have two rentals that are in my name, but my goal this year is to structure them for asset protection. Then continue to slowly add to the portfolio.
Any comments would be appreciated. I know that everyone’s situation is different, but mine seems to be similar to yours.
ESI says
I started them in an LLC and still have them in one today.
That said, this article makes me wonder if I should arrange them differently:
http://www.mrmoneymustache.com/2016/02/10/should-you-do-your-own-taxes/
Apex says
Changing to an S-Corp as suggested in that article is an obvious improvement for a schedule-C based business with significant income that can be partially reclassified as non-wage income. It is one of the rare and few cases when a CPA can clue you in to a one time classification change to save you real money on your taxes. Schedule-C based businesses generate wages and are subject to the FICA taxes he mentions. And when you generate wages then you have options to do SEP IRAs etc as well, but that does not compensate for the 15.3% cost of paying the FICA taxes.
However, you don’t have a schedule-C based business. You have a schedule-E based business, rental income. You will notice all your rental income as prepared by your accountant is filed on Schedule-E on your 1040 and you will also notice that no social security or medicare taxes were paid on that income. (As a side note – if you have any income above 250K from all sources combined then the 3.8% obamacare medicare tax hits that income and that is on all income, earned or otherwise, and no entity escapes it, including an S-Corp entity, because the tax applies to all income not just wages so the S-Corp trick of declaring some of the income a dividend does not change how it gets taxed for the obamacare medicare surtax).
So since your schedule-E is not wages, lucky for you it is already not subject to FICA taxes so you pay none of the 15.3% FICA taxes on that income anyway. Since it is not wages you can’t do SEP IRAs on that income either. It is all considered unearned income which is classified differently.
So there are no tax savings for you in your real estate business by switching away from the LLC.
Sometimes tax guys can do tricks to save money. But they exaggerate their powers. There aren’t that many legal tricks to avoid taxes.
ESI says
GREAT response! Maybe I should have you do my taxes… 馃檪
Apex says
I’m not an accountant. I just play one on blogs. 馃檪
TL says
Apex – do I remember correctly you are in MN? Any recommendations for an RE attorney? Not sure if this is appropriate or not, but ESI can share my email with you or delete this.
Apex says
ESI,
If you want to share TL’s email with me I can offer him a recommendation.
TL says
ESI – you should listen to the BiggerPockets podcast from last week (#162). They talk taxes and structures. It is worth listening.
TL says
@ESI – sorry for the rapid fire responses, but that podcast also has interesting strategies for income shifting (to kids). My son is becoming an employee (or contractor) this year. Then I’ll fund a Roth IRA with his earning. He’ll thank me when he’s an adult.
ESI says
No problem at all.
I’ll check out the podcast. I used to listen to it but they always took too much time getting to the point so I stopped. That’s been a while ago, so I’ll give them another try.
jc says
I get the income diversification aspect with real estate, but why rental property as opposed to a REIT? (And I don’t mean theoretically or in general, but why specifically do you choose this approach?) You will get lower returns with a REIT, but better diversification, liquidity, no carry costs, and zero work.
ESI says
You said it yourself — higher returns.
I’m earning close to 10% in income alone — cash flow is higher as there are no hard depreciation costs.
Then I have appreciation as well, which is substantial (I have a post coming up on that).
If I didn’t have the higher earnings I couldn’t have retired early…
Alex says
Hey Steve – I’ve read a lot about posting goals online in the vein of accountability. Do you find that this works or helps you keep course?
Alex
Sean @ FrugalMoneyMan says
Real estate is going to be the next addition to my families portfolio. Being fairly young (25), all of my families portfolio has been built thus far in 401(k)’s and Roth IRA’s. Within those retirement accounts we have our money solely in stock index funds. We will FINALLY be added an REIT Index Fund this year to our holdings, and we will finally begin saving for our starter home!
Thanks for the insights!
Brad says
The 100 million dollar question then is if this crazy hyper inflated real estate market is the new norm? Or will there be and adjustment? Will Cap rates on quality property in desirable areas ever see the 8’s again?
Many investors are sitting on the sidelines waiting it out while others are bidding prices higher and higher with the mind set that values will only continue to rise……Is it just me or does that sound like the late 90’s stock market? Or maybe even today’s!