5 Tax Advantages That Make Real Estate Investing So Powerful
How to legally reduce your taxes while building wealth (including one strategy that lets you defer taxes indefinitely)
How to legally reduce your taxes while building wealth (including one strategy that lets you defer taxes indefinitely)
One of the things that makes real estate investing so special is the way it is treated from an income tax perspective. This is true both during your ownership of a property and at the time of a sale.
There are at least five tax advantages of real estate investing:
Depreciation: reduces your taxable income while you own it.
Refinancing: refinancing a property is not a taxable event.
Capital Gains: as long as you own the property for at least one year, the gain from a sale is treated as long-term capital gains.
1031 Exchange: if you sell a property and buy another one of “like-kind” within 180 days, you are able to defer your tax until you sell the second property.
Step-Up in Basis: when you die, your heirs get a new tax basis at the market value of the property.
All of these can be combined to allow you to keep more of your money.
You don’t need to be an accountant or a math major to take advantage of these. You just need to know they exist and work with a qualified tax accountant to put the tax laws to work.
Let’s dig in.
A quick public service announcement before we get into the details.
In these newsletters, I am guiding you through the world of real estate investing. In some areas, I will be able to give you enough detail to be very knowledgeable.
In others, I will give you the high level overview but will not be able to give you nearly enough details to be self-sufficient without an expert.
Tax is one of these areas.
People spend their whole career learning all the details of tax accounting and the changing laws. There is no way to cover this level of detail in a newsletter.
So take this information for what it is: an initial guide to help you identify opportunities and ask the right questions of the experts.
Here we go…
The Basics of (Federal) Income Taxes
In order to understand the tax advantages of real estate investing, we need to cover some basics of federal income tax.
Do you really know how income taxes work in the United States? Maybe you understand the concept, but not the details.
Here are the basics.
The money you earn (income) is treated in four main ways:
Ordinary Income: your salary/bonus.
Passive Income: real estate income, royalties, passive businesses.
Dividends: from stocks.
Capital Gains: from selling stock, real estate, a business, etc.
It can get more complicated than this, but these four are the basics that will affect most people including real estate investors.
Ordinary income is the least tax efficient, which is taxed up to 37% at the highest tax bracket.
For many taxpayers, the long-term capital gains rate is 15%, but it can be 0% for lower incomes.
Big difference.
Note that dividends from stocks are unique. Some are taxed as ordinary income. Some are taxed as capital gains.
Now most of us won’t pay 37% tax on our ordinary income. Federal income tax works on a sliding scale. As of 2025, it starts as low as 10% and scales up to 37%.
Example: if you are single and earn $100,000, your taxes will be:
10% on the first $11,925 = $1,192.50
+ 12% on the amount between $11,926 and $48,475 = $36,550 x 12% = $4,386.00
+ 22% on the amount between $48,476 and $100,000 = $51,525 x 22% = $11,335.50
= Total tax of $16,914 or 16.9% effective tax rate.
Once you have higher income, taxes get much higher. For example, a married couple making $500,000 would pay 22.8%. If they earn $1M, they would pay $29.4%.
You can find the data to do the math on your income here: https://turbotax.intuit.com/tax-tools/calculators/tax-bracket/
But what about passive income from real estate investing?
Passive income generally follows the same tax brackets as ordinary income but has the ability to be reduced by passive losses (example: depreciation). We will get more into this in the next section.
Remember that all of this is only the federal tax, not state tax.
What about state taxes? They are different in each state. Some are zero (Texas, Florida). Some are on a sliding scale (California). You will have to research that on your own.
Now we have the basics of how taxes work, let’s explore the five magical aspects of taxes as they relate to real estate investing.
Depreciation
Key Benefit: reduces taxes on cash flow from real estate investments. You pay less (or no) tax on the cash flow you get while owning the property.
The concept behind this is that you have to pay money to buy the property, but the property will depreciate (i.e. get run down) over time. From a maintenance perspective, it would be better to own a brand new building than one that is 30 years old.
So here is how it works.
You buy a property for $3,900,000. After discussing with your tax accountant, you allocate $1,150,000 of the cost to the land and $2,750,000 to the building. You only depreciate the building, not the land.
If it is an apartment or a 1-4 unit residential investment, you can depreciate it over 27.5 years per the tax rules. Office, industrial, and retail are depreciated over 39 years.
Continuing our example: $2,750,000 allocated to the building divided by 27.5 = $100,000 per year.
This $100,000 is a non-cash expense that you deduct from your income each year.
Let’s say you are earning 7% per year on the $3,900,000 investment = $273,000 per year. You reduce it by the $100,000 of depreciation to $173,000 of taxable income.
$273,000 cash flow - $100,000 depreciation = $173,000 taxable income.
You don’t have to pay tax on $100,000 of the income which would have been taxed at the 24% or even 32% tax bracket. Pretty cool!
It gets even more powerful if you have a loan on the property.
For example, you borrow 50% of the cost of the property. 50% x $3.9M = $1.95M. For simple math, assume your interest rate is also 7% so you have “neutral” leverage.
Don’t worry if you don’t understand the debt part. We will get to it in a later session.
Instead of earning $273,000 per year, you only earn half of this as the other half goes to pay debt service.
50% x $273,000 = $136,500.
Reduce the $136,500 by $100,000 in depreciation leaves you with only $36,500 of taxable income.
$136,500 cash flow - $100,000 depreciation = $36,500 taxable income.
Amazing!
It is almost tax free.
If can get even more powerful if you do a “cost segregation study”, which allows you to depreciate some parts of the buildings like plumbing, flooring, and interior walls faster. We won’t go into the details here. All of this is based on the Modified Accelerated Cost Recovery System in the U.S. tax code.
Can I use depreciation to reduce the taxes related to my salary/bonus (ordinary income)?
No.
You cannot use depreciation (passive losses) from real estate to offset your salary/bonus (ordinary income) unless you meet certain qualifications as a real estate investor. Most people will not meet these qualifications. Consult with your tax accountant to understand if you qualify. Passive losses can only offset passive income.
Key Takeaway: depreciation is a non-cash expense that will reduce your taxable income and taxes from real estate investing each year while you own an investment property.
Most of the income I get from my LP investments discussed in past newsletters is shielded by depreciation, allowing me to keep all of the cash flow I get while paying little to no tax on it. See 5 Ways to Invest in Real Estate (From $60 to All-In).
Refinancing
Key Benefit: proceeds (i.e. cash) you receive from a refinance are not considered a taxable event.
We will keep this one short and sweet.
You increase the value of a property and put more debt on it. Example: you increase the debt from $1,000,000 to $1,500,000.
You payoff the original loan and have a “cash out” refinance of $500,000.
$1,500,000 new loan less $1,000,000 original loan = $500,000 of excess cash you keep.
The IRS does not view this as a taxable event. Wow!
You will still need to pay off more debt eventually, but it is nice to have the cash now to reinvest.
I have had many “cash out” refinances in my investing history.
Key Takeaway: refinances are a tax efficient way to pull cash out of a property that has increased in value.
Capital Gains
Key Benefit: if you own an investment property for at least one year, you pay a lower tax rate on profits from the sale of that property as compared to ordinary income.
This is true for not only real estate investments, but almost all investments. Other examples are:
Sale of a business you created or bought.
Sale of stock.
There are two terms to learn here:
Long-term capital gains relate to investments held for at least one year.
Short-term capital gains relate to investments held for less than one year.
Long-term capital gains have a sliding scale just like ordinary income but it ranges from 0% to 20% depending on income. Higher earners may pay an additional 3.8% (Net Investment Income Tax), making the maximum 23.8%. To geek out on the details, you can go to the IRS page here: https://www.irs.gov/taxtopics/tc409
For the rest of you, just remember that long-term capital gains are what you want when you sell a property as they are almost always lower than short-term capital gains which are taxed the same as ordinary income discussed above, which ranges from 0% to 37%.
One more thing…
The negative side of depreciation comes into play here. Remember the $3.9M property example from the depreciation section. Let’s assume we held the property for three years and enjoyed the benefit of $100,000 per year of depreciation for a total of $300,000.
Our tax basis at time of sale is $300,000 less than when we originally bought the property.
$3,900,000 minus $300,000 = $3,600,000.
If we sell the property for $4,900,000 we will have $1,300,000 of gain.
$4,900,000 minus $3,600,000 = $1,300,000.
This is $300,000 more of gain than if depreciation did not exist.
But, we are paying a lower tax rate on this $300,000 as compared to the savings we got by not paying ordinary income on that same $300,000. It is more complicated than this, but it typically works to a taxpayer’s advantage.
Key Takeaway: if you are going to sell your investment property, try to hold it for at least one year to make your capital gains long-term, which are taxed at a lower rate than if you held it for less than one year.
Is there even a way to avoid long-term capital gains? Not exactly, but they can be deferred.
1031 Exchange
Key Benefit: if you sell your investment property and buy another one of “like-kind” within 180 days, you defer the taxes from the sale until you sell the second property.
This is pretty cool. As far as I know, this is unique to real estate investing.
Let’s continue with our example.
You bought a property for $3,900,000 and sold it after three years for $4,900,000. You find a new property to buy for $4,900,000 and “1031 exchange” into that new property.
This is not a taxable event because it is not considered a sale for tax purposes.
No sale.
No long-term capital gains.
No tax.
You can do this over and over again from property to property.
Just be careful to follow the rules and meet the qualifications:
It must be of “like-kind”. In simple terms, it must be another investment property.
You must use a “qualified intermediary”. Think of this as a 3rd party you pay to make sure you follow the tax rules.
The new (replacement) property or properties must be of the same or greater value as compared to the one you are selling.
You must identify the new property within 45 days of selling your property. You can identify up to three properties.
You must buy the new property within 180 days of the sale of the old property.
This can be a complicated and expensive process as you will be paying the qualified intermediary, but the tax deferral benefits can be significant.
Additionally, if you don’t do a 1031 exchange when you sell the second property, then your capital gains will be even higher than if you had just bought the second property with “fresh” cash because your tax basis will be equal to the tax basis from the first property.
Said another way, the old tax basis from the property you sold carries forward to the new property you bought.
Key Takeaway: if you buy a new property within 180 days, you can defer the capital gains tax from a property you are selling.
But what if you never want to pay long-term capital gains? There is an option, but it has its downsides.
Step-Up in Basis
Key Benefit: when the owner of a property dies, the heirs (or surviving spouse) get a step-up (increase) in tax basis to the market value of the property at time of death.
I told you that you weren’t going to like it.
You or a loved one are dead.
Here’s how it works:
The property owner dies.
The property is valued at market as of the date of the owner’s death.
The tax basis of the heirs (or surviving spouse) is the market value.
This is true for not just real estate, but anything owned by the person who dies including stocks, a home, a business, etc.
Note that this is different from estate (inheritance) tax. Estate tax is a 40% tax that the estate (not the heirs) pays on inheritance over an amount set by the IRS. As of 2025, it is just under $14M per person ($28M for married couples). This reduces the amount the heirs ultimately receive.
Example: if you and a sibling inherit $20M of assets from an unmarried parent, the math would be:
$20M less $14M IRS allowance = $6M x 40% = $2.4M in estate tax.
$20M less $2.4M in estate tax = $17.6M in after tax inheritance.
Remember that 1031 exchange we did? The tax basis would be increased to the market value at time of death. This is the way to ultimately avoid the capital gains tax from the sale of a real estate investment.
Just remember it comes with a meaningful cost: you or a loved one need to die.
Key Takeaway: when someone dies, all assets they pass on to their heirs or surviving spouse (including real estate investments) gets a “step-up” in tax basis to the market value at time of death.
Summary
We have covered a lot.
Let’s recap the summary we started with:
Depreciation: reduces your taxable income while you own it.
Refinancing: refinancing a property is not a taxable event.
Capital Gains: as long as you own the property for at least one year, the gain from a sale is treated as long-term capital gains.
1031 Exchange: if you sell a property and buy another one of “like-kind” within 180 days, you are able to defer your tax until you sell the second property.
Step-Up in Basis: when you die, your heirs get a new tax basis at the market value of the property.
You don’t need to be an expert in any of this. You just need to remember that they exist and work with a tax accountant who understands real estate investments.
Side note: as a real estate investor, you want to assemble the right team. Turbo Tax or the tax accountant you are currently using as a salaried employee and stock investor may not be the right fit for you as a real estate investor. Ask around and take the time to find the right accountant.
Most important: remember that real estate investing has many tax advantages that will benefit you both during your ownership of a property (depreciation reduces taxable income) and when you sell a property.
Are there more tax advantages I am missing? Email me at bateman@creprofessor.org to let me know. As a life-long learner, I am always looking to grow.
Professor Bateman
Special thanks to my anonymous friend and real estate tax specialist who helped me fact check this and add clarity where needed. You know who you are. I appreciate you!
5 Ways to Invest in Real Estate (From $60 to All-In)
Which investor are you: Hands Off Harry, Rockstar Reggie, or All-In Alex? Here's how to choose your path.
Which investor are you: Hands Off Harry, Rockstar Reggie, or All-In Alex? Here's how to choose your path.
By now you may be getting excited about making your first real estate investment.
Good news!
If you are reading between Monday and Friday 9:30 a.m. to 4:00 p.m. Eastern time, then you can invest right now.
How?
The most passive and liquid way to invest in real estate is by buying shares of a real estate investment trust (REIT). By buying shares of a REIT you will own a small piece of a company that owns and operates real estate.
REITs are just one of the many ways to invest in real estate.
Let’s dig in to the many options.
Ways to Invest in Real Estate: From Passive to Active
Owning shares of a REIT.
Investing as a limited partner (LP).
Buying a property by yourself.
Buying a property with someone as equal partners.
Buying a property as the general partner and raising money from LPs.
Option 1: Owning Shares of a REIT
REITs are public companies that exclusively focus on real estate. They are required to distribute 90% of their taxable income to shareholders (i.e. you) as dividends.
An example of a REIT headquartered here in San Diego, CA is Realty Income Corporation (NYSE: O). As of this writing, their stock price is trading around $61 per share and they have a 5.28% annual dividend ($3.24 per share) that is paid monthly.
A benefit of REITs is that they are public stock, so you can sell them at any time. If you are investing in an S&P 500 index fund, then you have exposure to around 30 REITs.
Who knew you were already a real estate investor!
Option 2: Investing as a Limited Partner (LP)
Investing as a LP is another passive way to invest in real estate. The general partner (GP) does 100% of the work and makes all decisions*. In exchange for doing all the work, the GP earns fees and often collects an oversized share of the profit if the deal does well (this is known as “promote”).
So what is the tradeoff of being a LP? Control and liquidity.
You don’t have any control over decisions.
You can’t access the money until the property is sold.
The fees and promote paid to the GP reduce your returns.
But on the positive side:
It is totally passive. A pipe bursts at a property at 3am? The GP has the deal with it.
I have made 20+ of my investments as an LP. In my experience it is a great way to invest in real estate while keeping focused on your day job.
So how do you find these opportunities?
In my case, I met people through working in the industry. When I heard of people or companies buying the types of properties I was interested in, I asked if I could invest. Some said no. Some said yes. Over time I built up a portfolio of LP investments.
There are also crowdfunding groups out there that connect GPs and LPs. A couple examples are Realty Mogul and Crowd Street.
One of the challenges that you will need to work through is that most of these groups require you to be an “accredited investor” as defined by the SEC. Generally, you need to have a net worth over $1 million (excluding your primary residence) OR have earned $200,000 (or $300,000 jointly) in each of the two most recent years. Not everyone can meet these criteria.
If this is your situation, don’t be discouraged.
Options 1, 3, and 4 don’t have these restrictions.
Many successful real estate investors started by focusing on increasing their earnings through their day job or with a single property investment (option 3) and built their way up to becoming an accredited investor over time.
Option 3: Buying a Property by Yourself
There are no SEC requirements for buying a property by yourself. It is effectively like becoming a parent: not everyone is qualified, but anyone can do it.
This is more work than investing as an LP, but you can figure out ways to make it relatively passive so that you can focus on your day job.
The Remote Investor Approach
In this scenario, you find a company that is both a broker and property manager. They show you lots of properties to buy. You select one and they help you with the due diligence, closing, loan, inspections, etc. Once you close on the property (i.e. you own it), they handle all the day-to-day and reporting. All you do is tell them what decisions you want to make.
You could take this approach in the local market you live in or even out of state.
I know someone who bought a number of rental homes in another state this way and didn’t see the properties for the first two years of ownership.
This is not for everyone.
I don’t think I could handle not seeing the properties before I bought them, but for others this is fine. If you go this route make sure you find a group you can trust.
There are many examples of people who bought homes in the Midwest US for $100,000 ($30,000 of equity/cash) interviewed on the Bigger Pockets podcast.
Keep in mind that this is only a “passive” version based on the amount of your time it takes. For some this would be an “active” version because of the stress it could cause.
The Hands-On Local Approach
In this scenario, you buy a property in the same town you live in. You can see it, touch it, get to it within an hour if needed.
You minimize the support you get from 3rd parties (brokers, property mangers, accountants, etc) because you don’t want to pay any fees so you can maximize your cash flow and profit. You don’t trust anyone to pay attention to the real estate like you will.
So far so good.
And then something goes wrong at the property. Eventually something will ALWAYS go wrong.
Here’s an example: You own a duplex. A pipe bursts and floods the property. The tenant calls you at 3am or when you about to deliver a presentation at work. Even if you have a group of great vendors, you still have to figure out how to deal with it.
I experienced dealing with a roof leak at a property I own while on vacation with my family over the winter break. It sucked. As soon as I returned from vacation, I hired a property manager to get me out of the “front line” of managing the property. I happily pay them each month for this peace of mind.
So which is the best option?
There is no right answer. It is all tradeoffs. You need to understand what is important to you.
There is nothing wrong with deciding that investing in REITs and as an LP (options 1 & 2) is best for you right now. You can always change options over time.
Option 4: Buying a Property with Someone as Equal Partners.
Let’s continue up the scale of becoming a more active investor.
In this case, you and a friend decide to buy a property 50/50. Ideally you have complimentary skill sets and pre-agree to how you will divide up the work.
You only have to come up with 50% of the equity/cash and you have a partner to brainstorm with.
Partnerships can be excellent.
They can also be very challenging.
They are like a marriage. You are together for the life of the investment. Remember: real estate cannot be converted to cash instantly. It takes time to market and sell a property. See lessons 14 & 15 from my previous newsletter.
My advice: only partner with someone you really trust. This should be someone you would trust with your bank account. And always, ALWAYS have a written partnership agreement that clearly documents decision making, including the right to sell the property.
When you have an equal partner, you both need to agree on what to do. Decisions that will come up:
The roof is leaking. Do you patch it or replace it?
A tenant pays late each month, but always pays by the end of the month. Do you renew them at the end of their lease or vacate the property and try to find a better tenant?
The property has increased in value by 50% since you bought it. Do you sell it? Refinance? Do nothing and enjoy the higher cash flow?
There are many, many issues that will come up. When you have a partner it is not just your decision. You and your partner need to agree.
Things may start out well, but you and your partner may have very different circumstances a few years into owning the investment. Examples:
Your partner gets married and wants to sell the property so she has cash to buy a house. You are still single and like the flexibility that the cash flow from the property provides.
You want to invest the cash flow into the property to make it the best in the neighborhood. Your partner wants to squeeze every penny from the property, making you feel like a slumlord.
Bottom line: decision making will be more complicated by having a partner than if you own the property by yourself.
BUT the right partnership can give you an ally and sounding board as you begin your real estate investing journey.
Option 5: Buying a Property as the General Partner and Raising Money from LPs.
This is the opposite of option 2: investing as a limited partner (LP) where someone else does all the work. In this case you are the general partner (GP). You do all the work.
You find the deal and operate it. You find LPs to invest in the deal. You collect fees and earn an oversized share of the profit if the deal does well (the promote).
Fees and promote? Sounds pretty good.
So what’s the catch?
It is a TON of work.
Here’s some examples of what you will need to take on if you are the GP:
You do all the work.
You typically enter into a purchase agreement to buy a property before you have raised all the equity/cash required. Although you still have the right to back out before your due diligence period expires (typically 30 day), you are still putting your reputation on the line. You don’t want to earn a reputation of someone who always backs out of deals.
You will need to “dial for dollars” to find the LPs. This will occur simultaneously with performing the due diligence AND finding a loan. You will feel stretched in many directions.
You will need to keep the investors up to date on the deal. Even when you do this in a structured way, it can consume your time in unintended ways. Example: you are out for a walk and coffee with your spouse on a Saturday morning. You run into an investor who wants an update on why the deal is not performing as planned. So much for your peaceful morning...
There are many more things you will do as a GP. It can take up a ton of time and is tough to do if you have a traditional W2 job.
Putting together deals as a GP is not for the faint of heart. You need to be all in and stick with it for the long haul.
So Which is the Right Option for You?
It all depends on your goals and needs. Here are some examples I created to help you think about it.
The Passive Approach (Options 1 & 2)
“Perfectly Passive Penny” - Penny invests in real estate exclusively by buying shares in REITs. She holds these shares for the long term.
“Hands Off Harry” - he invests exclusively as a LP with people he trusts. He stays focused on earning money in his day job, while regularly investing in both real estate and the stock market. His tax returns are made more complicated by his LP investments, but he feels this is an acceptable trade-off. See lesson 16 from my previous newsletter.
The Side Hustle (Options 2, 3, & 4)
“Freakout Frank” - just like Harry, he invests as a LP. Unlike Harry, he constantly calls the GP for updates and ask confrontational questions. He invests as a LP, but acts like a GP. Note: if you go the GP route, avoid taking money from a Frank.
“Active Alice” - she buys a duplex and lives in one half. She does all the home improvements at nights and on the weekend. Eventually she will sell her duplex and buy a four-plex.
“Patient Peter” - he uses money he has saved from the last two years of bonuses in his day job to buy a rental property out of state. It doesn’t take up much of his time because he hires a team to manage it. As the property increases in value, he refinances it and uses the refinance proceeds to buy another property. Over time, he assembles a portfolio of properties that provide him passive income equal to his salary.
All In
“Rockstar Reggie” - Reggie works for a real estate company. He is humble, driven, and constantly looks for ways to add value to the company and the properties. His work has been recognized, and he is now able to invest alongside the owners as a GP and participate in a small portion of the promote.
“All in Alex” - Alex creates her own real estate company and raises money from LP investors. She has saved up money to live frugally for two years while she gets her real estate company off the ground.
So Who are You?
You don’t need to pick just one.
I started as a Harry, soon became a Reggie, and then took money I made as a Reggie to become more of a Harry. Passive to active to passive.
Be a student of yourself. Don’t try to get rich quick. Successful real estate investing is best done as a long game. See lesson 3 from my previous newsletter.
Remember, patience is a superpower.
Combine that with self reflection, clarity of thinking, focus, and hard work…then you have a magical combination.
Good luck on your journey to becoming a real estate investor!
Professor Bateman
23 Lessons Learned from 23 Years of Investing in Real Estate
23 years ago I made my first investment into real estate. It was in a hotel that my friend was buying. It was both exciting and scary. Although I understood concepts like cap rate and IRR, I had no real sense of my goals other than “to make money”.
Since then, I have personally made 59 additional investments into real estate. They have varied in size and scope:
Amount per deal: $5K to $200K+.
General partner (GP) vs limited partner (LP): both. [Note: A GP puts the deal together and runs the day to day. An LP is more of a passive partner.]
Individual deal vs a fund: both.
Asset Type: industrial, apartments, office, retail, and hotels.
Target Hold Period: 1-3 years all the way to “hold forever”.
Loan to Value: 0% to 80%+.
Risk Profile: value add all the way to core (ie high to low risk).
Goal: long term income, shorter term equity multiples, and many deals in between.
Some deals have gone very well. For others I have lost some of my investment.
Here are the key lessons I have learned so far. Use or modify the ones you want. Discard the rest. In the weeks and months to come, I will dive deeper into many of these topics in individual newsletters. My goal is to share information I wish I knew when I got started as a real estate investor.
THE FUNDAMENTALS
#1 - Investing in real estate is an excellent (and tax efficient) way to (a) provide passive income aka mailbox money and/or (b) grow your net worth. Seeing money come into your bank account on a regular basis from investments you have made feels incredible. Once you have a multitude of individual investments, “chunks” of money come in fairly regularly from refinances and sales.
#2 - Being a real estate investor has given me a sense of engagement and agency that I have been unable to find in stock investing. Even as an LP, I have been able to craft a portfolio that meets my goals.
#3 - Real estate investing is not a quick path to wealth. I didn't make my first investment until I was 30. It takes time. Patience is a super power.
#4 - The power of compounding is magical. This applies to all types of investing and almost everything else in life, including learning. Stay consistent. Trust the process. The money will come. Just don’t put yourself in a situation where you may lose all your money and knock yourself “out of the game”.
THE NUMBERS
#5 - The math you learned in Algebra I is effectively all you need. Understand the concept of return on cost (aka cap rate): NOI / Price. I will be doing a newsletter on this subject very soon.
#6 - There are more tax advantages than I originally thought (depreciation, long-term capital gains, refinance proceeds, 1031 exchanges, step up in basis).
#7 - It is easy to distinguish the good deals from the bad. The “home runs” from the just “OK” deals. But you can only do this after the deal is done. As much as you can try to only pick the winners, I have found this to be nearly impossible. Of the deals I have done that have come full cycle (ie been sold already), roughly 25% have been home runs, 40% have been good, and 35% I have lost around 20% of my equity. Going in to these deals at time of acquisition, I thought they would all be good or great deals. There are just too many things outside your control. Here’s the important part: This batting average is normal and acceptable - you don’t need to hit 100% to build wealth and achieve your goals.
ASSET TYPES & DEAL STRUCTURE
#8 - Asset types have different characteristics. Multifamily tends to have the most consistent cash flow. Office is a “capital pig”…tenant and building improvements can be huge making it very challenging to achieve cash flow. I will write a more extensive newsletter on my take on each of the asset classes.
#9 - Debt can be a wonderful tool and your worst enemy. There is a reason they call it “leverage”. It can turn a good deal into a great deal and a bad deal into a train wreck.
#10 - There is a place for both GP and LP investing. I have done both. LP investing will take little to none of your time. The cost you pay is in fees and promote. GP investing will take a ton of your time (running the property, working with investors), but the upside can be significant.
MINDSET & STRATEGY
#11 - Be clear on your goals. Many people want to invest in real estate, but only some of these people know what they want: recurring cash flow vs quick flip to double (or more) your equity vs something in between. Understand the goals of the GP and make sure they align with your goals. If you want long term recurring cash flow but the GP wants to sell the property in two years, that may not be the right fit for you - even if it is a “great” deal.
#12 - Your goals may change over time. For the first 15 years, I was focused on turning $1 into $2 as fast as possible. I didn’t have much equity, so I needed to grow that equity. Once I did, then I focused more on investing for passive, tax efficient income in “hold forever” assets to reduce my dependence on my salary.
#13 - Be emotionally (and financially) OK losing money on a deal. Investments are unpredictable. Real estate goes through cycles. The unexpected happens. Being a real estate investor requires mental fortitude (true for most types of investments). Fear is real, especially if it is your first deal and feels like a lot of money to you. Use this fear as a way to develop better self awareness and an understanding of the types of investments that are the right fit for you - not only your financial goals but also for your ability to sleep well at night. Don’t ignore the importance of peace of mind.
#14 - You have to get comfortable with a lack of liquidity. If you own public stock, you can convert it to cash in 24 hours. Not true for real estate. The lack of liquidity can be a real downside. Need the money to pay for your kids college now? Too bad. You have to wait. But…there is a positive side to the lack of liquidity - you can’t panic and sell at the market bottom. Your only choice is typically to ride it out.
#15 - Never do a deal with someone you don’t trust, no matter how good the deal looks. If you don’t know them, ask around and find someone you trust who can vouch for them. See lesson #14 regarding liquidity - there is no quick exit.
PRACTICAL REALITIES
#16 - You will likely need to extend your tax returns. Unless you are buying deals yourself without a partner, you will be issued a “K-1” reflecting your percentage of ownership of the deal. These take a lot of time to prepare and often show up at or after the April 15th tax deadline.
#17 - Budget more money for paying your tax accountant. Long gone are the days of my tax return consisting only of a W-2 (salary) and a 1099 statement (interest, stocks). I have 25 active investments that each issue a K-1. It is logistically complicated for both me and my tax accountant. Want to keep your tax return simple? Stick to public stocks.
SHOULD I QUIT MY DAY JOB?
#18 - It takes a LOT of money to replace W-2 income. Let’s say you make a salary plus bonus of $100,000 per year before tax. If you want to replace this with a real estate investment that yields 5% cash on cash, you would need $2,000,000 ($2M x 5% = $100K). Even a 10% cash on cash deal would require a $1,000,000 investment. The path that has worked for me is to find a place where I can meaningfully contribute AND earn a salary AND get my healthcare paid for AND invest on the GP side AND invest outside of the company as an LP. It would have been much harder to have made the investments I made without a salary/bonus. My family and I would have had to make more financial sacrifices along the way.
#19 - Working as part of a team at a company can be a ton of fun and a fantastic place to learn. You get much more exposure than you would on your own. Your learning curve is measured more by deals per time than almost anything else. You want this ratio to be high. As I read somewhere, think of a salary as a trust fund that pays you to learn.
#20 - Understand your own skills, interests, and weaknesses. Put yourself in a situation that leverages your skills and interests. Build your own team around your weaknesses and areas of little interest.
#21 - No one will (nor should) pay as much attention to your money as you will. Talk to lawyers, consultants, tax advisor, and others but know that you should be the one who makes the final decision for your money.
THE ULTIMATE GOAL
#22 - Size matters more than percentages. A 10% return on $10,000 is $1,000 per year. A 5% return on $500,000 is $25,000. It is easy to get caught up in percentages. I have found it is more important to pay attention to the total dollars.
#23 - Owning an asset without a partner and debt-free is the ultimate form of freedom. You call the shots. Combine this with having enough passive income to cover your expenses and you have achieved financial independence. This doesn’t mean you have to retire to play golf. It just means that you call the shots in how you spend your only non-renewable resource: your time. Life is short. Being able to do what you want to do when you want to do it is the ultimate freedom.
Professor Bateman