Why Real Estate Became a Popular Vehicle for Breaking Out of the Middle Class
People in the middle class are struggling to increase their income because of the many obstacles they’re facing. High inflation, limited financial reserves, debt and lack of generational wealth are all some of the obstacles those in the middle class are trying to overcome.
When you have debt, investing in stocks isn’t always the best option to increase income because it’s heavily reliant on external factors. Real estate investing remains to be a solid investment for those working toward breaking out of the middle class.
You can expand your knowledge about business and real estate to understand investment prospects even further by investing in business education. Relative areas of knowledge such as finance and marketing will also be helpful in your real estate investing journey.
This article covers foundational information about real estate investing such as, property appreciation, the use of investments, upsizing opportunities, tax benefits, the amount of money needed to invest and the ability to control your investment.
Appreciation of Property
When you’re researching real estate property investments, it is best to choose a property that will appreciate. Appreciation of property is when it increases in value over a period of time. For example, if you purchased a home for $200,000 and in 5 years the property appreciated to be worth $250,000 market value, this property is a good investment.
Follow these best practices for choosing and managing property that will appreciate:
- Make sure the location of the property is good: good school district, low-crime, up-and-coming neighborhood.
- Purchase a fixer-upper: renovations and repairs will usually appreciate the property.
- Pay attention to property size: Don’t purchase too big of a property. If your home is 2,000 square feet and your neighbors are 1,200 square feet, both will likely appreciate the same. Bigger isn’t always better.
- Take note of the neighborhood: even if your property is immaculate, if your neighbors’ yards and homes look run down this could affect appreciation.
Usability of Investment
There’s great value in choosing a real estate investment you can actually use while it appreciates. An example of this would be purchasing a duplex with plans of living on one side and simultaneously renting out the other side. You could rent one side of the duplex for long-term renting to a tenant, or list the property on a vacation rental site like AirBnB or Vrbo.
This is beneficial to you either way, because if the mortgage for the duplex is $2,000 per month and you rent the one side for $1,500 per month, then you only need to pay $500 per month out-of-pocket for the mortgage payment. This leaves more money for you in your budget to spend on other investments or things.
Opportunities Through Upsizing
Many people who are looking to upgrade their original property to something bigger or better think to sell their original property. However, there’s opportunities to be had if you keep the original property when you move to a different home.
For starters, the original home will continue to appreciate if you rent it out to tenants. Secondly, those tenants will be paying you the amount of the mortgage payment every month or sometimes more. As long as you aren’t pricing the rent lower than the mortgage payment, then this opportunity is good for you as a real estate investor.
If you’re going to rent out the original property here are things to keep in mind:
- Be sure the neighborhood and price point is desirable by renters
- Make sure a lender will approve a second mortgage for your upgrade home
- Make sure you’re able to take on being a landlord to tenants/other rental sites
- You want to secure a tax expert who can help you file taxes, including tax benefits
Real estate investing offers several tax benefits. Here are some common benefits to keep in mind:
Lower rates for long-term capital gains
A capital gain occurs when you sell an asset for more than what you originally paid for it. Since real estate typically appreciates over time, it’s common for investors to sell a property for more than they paid for it. As long as you own the property for more than a year, you can benefit from tax rates for long-term capital gains when you sell the property.
You can claim depreciation
Claiming depreciation allows real estate investors to depreciate a residential property over a period of time (27.5 year) in order to reduce your tax bill. For example, if you purchase a rental home for 250,000, you can deduct $9090 of depreciation per year.
$250,000/27.5 = $9090
When you purchase new appliances for residential property, you can also claim depreciation. Appliances depreciate over a period of 5 years. For example, if you purchased a new fridge for $1,000, you can deduct $200 of depreciation per year for five years.
$1,000/5 = $200
Rental income is not earned income
Rental income isn’t subject to Social Security and Medicare taxes (FICA) unlike wages from a job or self-employment income. This can result in significant savings compared to normal earned income.
For example, if a person owns a business and receives 10,000 in earned annual income the FICA tax would be 15.3% or $1,530. If the same income was earned from a rental property, no FICA tax would be due.
Operating expenses are deductible
As the IRS explains, operating expenses for managing and maintaining a rental property are tax deductible. Expenses may include property management fees, repairs and maintenance, landscaping, pest control, advertising costs and more.
Paying taxes on real estate investment returns can be complicated. When it’s time to file taxes, it’s best to work with a tax professional who can explain which tax benefits might apply to you.
Relatively Little Cash Needed to Invest
For your first real estate investment, many people think you need to have at least 20% for a downpayment plus closing cost fees. But that’s simply not true.
For a conventional mortgage you need as little as 3% of the home’s purchase price plus closing costs. This means you often need relatively little cash upfront to invest in a house or a duplex.
Different factors affect whether or not you should put down less or more than the 3%.
These factors include:
- The mortgage rate
- How long you plan on living in the property
- How much you have leftover in your savings
- Whether or not you plan to rent the property out after upgrading
- How quickly the property will appreciate, according to the housing market
Be aware of the downside to paying less than 20% for the down payment. Your lender will require private mortgage insurance (PMI) which is an added insurance policy that protects the lender if you can’t pay your mortgage. PMI costs range from .22%-2.25% of your mortgage, depending on your credit score and total loan amount.
Control of Your Investment
Real estate offers a flexible investment compared to investments that are more reliant on external factors. Once you own a property, you can decide what you want to do with it in order to increase its already appreciating value.
External factors that influence other types of investments are interest rates, economic growth, technological developments, inflation, and government policy. Because of these outside influences you have less control over stocks and other types of investments compared to real estate.
Ways that you can actively influence the value of your real estate investment include making repairs, renovating the interior/exterior, replacing the roof or siding, renting it out, etc.
You also have more control over which types of real estate investments you want to pursue. Different strategies for real estate investment include:
- Live-in and flip
- Flipping houses
- Managing rentals
- Buying and holding properties
With so many investment strategies available, there’s a real estate investment strategy bound to suit your cash reserves, risk tolerance, time and how involved in your investment you want to be.
In the end, property usually holds practical value even if it isn’t used as an investment. If you own a property, then you’ll have stable monthly mortgage payments (instead of landlords raising rent), an investment growing in value over time and future options if you want to make it an investment property in the future.
Keep in mind, there are certain characteristics that most likely indicate that a property will be a particularly secure investment. These characteristics are:
- You can put little money down up front
- Many physical and social amenities are available
- There’s schools with good ratings in the neighborhood
- The property is in a an up-and-coming neighborhood
- The property doesn’t need major repairs, like excessive water damage
Real Estate Remains a Strong Investment
Investing in real estate in order to break out of the middle class is still a viable option for many. Hopefully, this article helped you learn more about real estate investing and encouraged you to realize real estate investing isn’t that far from reach.
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