- June 4, 2021
- Posted by: Gunveen Bachher
- Category: U.S. Taxes and Real Estate
Real Estate Investing can be classified under 4 types: residential, commercial, industrial and land,
Residential can be both single and multi-family homes, townhomes, condominiums. Commercial can be offices, retail space, restaurants, and large multi-family homes. Industrial includes warehouses, factories, powerplants generally used for industrial businesses. Land comprises of unused or used primarily as undeveloped land. Examples of land can be farming, ranching, unused.
In Real Estate, there are three main ways to make money- interests from loans, appreciation and rents.
- Interest from real estate loans: A real estate loan is when investors lend money to a real estate developer and earn money from interest payments on the principal amount of the loan. This is a form of Debt Investment and can provide regular cash flow for an investor. Debts can be of various types including both secured and unsecured amongst many others. A loan happens to be a passive form of investment and is used by REITs( Real Estate Investment Trusts), private equity firms and real estate investment platforms. Earning interest payments offer a lucrative way to earn passive income from real estate investments.
- Appreciation: Is a form of Equity Investment. A real estate investor earns money from sale of ownership of land. It is generally assumed that the value of a property always appreciates over a period of time. An investor makes profits once he sells off his property/land. Equity ownership can be both active or passive forms of investment.
- Rental Income: Income earned from leasing the property to tenants for a period of time. Rental cash inflows can be a source of regular income. Owner/investors sometimes like to manage their properties themselves though sometimes they hire property management companies to do the job as well. Rental payments happen to be a great source of passive income.
Some of the most common metrics that investors like to use is the projected rate of return, gross yield, or annualized return but capitalization rate or the ‘cap rate’ happens to be a preferred way to assess the profitability of the property before investing.
Real estate investments can be both Active and Passive depending on the involvement in the day to day running of the property.
ACTIVE FORMS OF REAL ESTATE INVESTING:
- Flipping: Starting from the most active, House flipping is the most hands-on way to invest in real estate. An investor buys a home, upgrades it by making renovations and then sells it for a higher price. He earns profits in the form of capital gains that might be subject to ordinary tax rates. These are generally short-term investments and therefore, the profits he makes gets taxed at high rates. However, if he decides to hold onto the property by renting it out, and then sells it off after a year or so, he can avoid those high tax rates for sure.
Behind all the glamorization that HGTV shows and also the high profits( which is true) that are associated with it, flipping involves a whole lot of effort, time, budget and labor constraints, therefore making it a high-pressure job.
- Wholesaling– Under it, an investor buys a property that is slightly distressed or is priced below market value and sells it off to another investor at a higher price for a profit. He earns a ‘fee’ for the whole deal/contract. You might have come across a sign that says “we buy all types of houses”. That is probably a wholesaler doing his job.
A Wholesaler makes an earnest money deposit, buys the property and then sells it really quick to a flipper for a profit. The Flipper then fixes that property and sell it off for more profits. A wholesaler gets a finder’s fee for brokering a home sale to a house flipper.
Wholesaling comes with its own risks. It requires access to a network of potential buyers in order to sell the property within a short time frame at a profitable price. Otherwise, you risk not earning a profit or worse, losing money.
- Rental Properties: a more hands-on form of an investment that is if the investor decides to manage the property himself. These can be long term investments. Investor earns not just income in the form of rental payments but also earn appreciation as well.
Pitfalls are tenant screening, managing rent repairs, maintenance, evictions, recordkeeping and ensuring compliance with the authorities at all times. Depending on how small or large the size of the rental property portfolio is, property management can be a part time to a full-time job. That is where the role of a property management company comes in. Some investors do not like to deal with the tenants themselves and therefore hire property management companies.
- Short term rentals: This active form of real estate income follows the Airbnb and VRBO model where residents rent out their space on a nightly basis. Though the owners are required to furnish and maintain the home for renters.
Pros of short-term rentals is that it requires less supervision, third party websites such as Airbnb facilitate bookings and create contracts and manage some of the risk.
Short term rentals can be a very lucrative form of income. Though before you decide to list that spare bedroom, check laws with the home owner’s association(HoA), or your apartment building. Some HoAs and apartments do not allow temporary subletting.
PASSIVE FORMS OF REAL ESTATE INVESTING:
A more hands-off way of investing in to real estate.
- Private Equity Fund: A bunch of investors pool their money together into a single fund to make investments in the private market. Private equity funds are usually managed in the form of Limited Liability Partnerships with a designated manager or a management group. Investors might not be required to participate in the day to day running but are required to have financial and real estate knowledge in order to understand and assess the risks and potential of investments.
Private Equity Funds are generally associated with high-net-worth individuals who are ready to make a minimum investment of $100,000 or more.
Private equity funds typically use a “two and twenty” model, in which they charge an annual management fee and an additional 20% fee on profits that the fund earns beyond a specified return. Private equity funds are generally illiquid as well, and therefore limited to investors who can afford to tie up large amounts of money for long periods of time.
- Real Estate Mutual Funds: It is a mutual fund investment vehicle structured as a company, which pools its clients’ money together and invests on their behalf. The investors own shares of a mutual fund and the fund itself owns the investments that it acquires and manages. Investors earn dividends during ownership and appreciation upon the sale of fund shares. Typical investment types for real estate mutual funds are real estate stocks or REITs, but can also invest directly into real estate assets. They can also focus on any type of real estate or offer a mix of residential, commercial, and industrial.
Mutual funds are forms of passive investments requiring only capital from their investors and many also carry a low investment minimum. Due to these characteristics, real estate funds offer easy entry for ordinary investors to access professionally managed real estate investments.
However, mutual funds are dependent on the stock market and can therefore be one of the most volatile real estate investment strategies.
- REITs -A real estate investment trust (REIT) is a company that makes debt or equity investments in commercial real estate. Generally, REITs offer a portfolio of income-producing real estate to investors. Investors buy shares of the REIT and earn income from its debt and equity investments in the form of dividends. Like mutual funds, REITs were created as a way to give ordinary investors public access to real estate investments. By law, a REIT must earn at least 75% of its income from real estate and invest at least 75% of its assets in real estate. Additionally, it must distribute at least 90% of its taxable income to shareholders each year. REITs can be private REITs, publicly-traded REITs, and public non-traded REITs.
- Syndication: Several investors partner to form a real estate syndication. They bring in their skills, resources and capital to purchase and manage a property which they otherwise cannot afford. There are usually two roles in a syndication namely that of a syndicator( or sponsor) and the other is that of an investor. As an investor, the role is to provide money for which they receive a monthly or a quarterly return. They are usually shareholders in the partnership/LLC and get issued a K-1 towards the end of the tax year. Those members expect to play a passive role in which they invest their cash. Typical rates of return can be anything as high as up to 10%.
The above mentioned strategies for investment into real estate happen to be some of the common ones though there are other ways to invest as well but they were beyond the scope of our discussion.
GavTax Advisory Services accepts clients from all 50 States including the State of New York, California, Texas, Illinois, Florida, Pennsylvania, Ohio, New Jersey, Virginia, North Carolina, and all U.S territories as well.