Real estate investing can be an excellent way to generate passive income and create a robust and diversified portfolio. Here are some of the most common ways investors accumulate wealth through real estate:
This term gets its name from Section 1031 of the U.S. Internal Revenue Code. 1031 exchanges occur when an investment property is sold and reinvested into a similar property of equal or greater value. This allows investors to defer taxes on capital gains.
Given the significant cost of capital gain taxes, a 1031 exchange allows property owners to divert the hefty costs that come with real estate investing. As a result, investors will have access to money they can use to buy more expensive properties.
Another way investors can benefit from a 1031 exchange is trading properties that need extensive upkeep for properties that have fewer responsibilities. This cuts costs and makes the investment easier to manage.
1031 Exchange Rules
45-day rule: Investors are granted 45 days to find three similar properties they could potentially exchange. Given that properties with low interest rates tend to be overpriced, this can sometimes be difficult.
200% rule: In some situations, property owners can find four potential properties, instead of three, as long as their value combined does not exceed 200% of the value of the property sold. This exception is called the 200% rule.
180-day rule: The property replacing the previous investment must be received no later than 180 days prior to the sale of the exchanged property. Or, if it occurs earlier, the property exchange must take place when income tax returns for the current tax year are due.
Business property only rule: The 1031 exchange only applies to business property, not personal property. You cannot exchange personal residence using this method.
Designated as economically distressed areas, opportunity zones were created to help spur development in underserved areas. Investors can contribute to this program by investing in an opportunity zone fund, an investment vehicle that can only be utilized in designated federally designated opportunity zones. By doing so, investors can delay and reduce taxes on capital gains or eliminate them entirely if held for at least 10 years.
Opportunity Zone Investment Rules
Spirit of the Law: The opportunity zone fund must actively improve the lives of residents living in the area in order to obtain the tax advantages. This can be done either by expanding job opportunities for the zone’s residents, or by improving the housing options located in the area. Some businesses are excluded from these tax breaks because they offer little to no value to distressed areas. They include the following: golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, racetracks or other facilities used for gambling, and liquor stores.
Holding periods: When it comes to opportunity zones, the taxes deferred depend on the length of the holding period. In order to receive a 10% exclusion of deferred gains, the investment must be held for more than five years. If the investment is held for longer than seven years, the investor may receive a 15% exclusion. If the investor wants to completely defer federal income taxes on the fund’s appreciation by sale, the investment must be held for 10 years.
Single Fund or Multi-asset Fund Options:
Commercial real estate describes property that is used for commercial purposes and generates regular income. Examples of commercial developments include office buildings, parking facilities, hotels, malls, and hospitals, among other things. Because commercial property is intended for income-generating businesses, buildings must be located on this property to be considered commercial.
On average, commercial real estate provides a higher potential income with a 6-12% return on investment. And, since commercial leases typically last longer than residential real estate leases, investors will receive a relatively stable stream of income.
Another perk of managing long leases is that there is less tenant turnover, providing stability and reducing the amount of work it takes to find new tenants.
Residential real estate typically includes single-family houses and multi-unit apartment buildings that are bought by an investor and leased out to tenants. By contrast to commercial, residential real estate is specifically zoned for living while commercial real estate is zoned for profit generation.
Residential real estate can be a lot less intimidating for both investors and tenants because most people are familiar with the rental process from personal experience. This makes residential more attractive in comparison to traditional investments like stocks and bonds, which can be confusing for beginners.
In addition, these investments also offer steady income,; long-term appreciation as properties increase in value; and certain tax advantages.
While restaurant investing is universally known to be challenging, active investors might find it rewarding when done right. Investing in a new restaurant concept can be extremely risky and expensive, so it’s imperative to learn the ins and outs of the business and create a lasting brand.
New investors also have the option to franchise already-established restaurants. This is typically a better investment because it gives franchisees access to the brands, products and expertise they need to thrive.
Another benefit of investing in a restaurant is that it’s short-term, meaning that investors don’t have to wait for the investment to mature before receiving cash.
Multi-family properties are classified as properties with more than one unit. They can range anywhere from duplexes to four-plexes. Compared to condos, multifamily units typically offer more privacy and space. These developments are great for new investors as they are often financed by banks, similar to single-family homes.
In recent years, horizontal developments have emerged in popularity as another type of multi-family property. Rather than building apartments that are multiple stories high, horizontal apartments are single-story. These developments are perfect for people who cannot afford a house yet but still want to live in a community with outdoor space and privacy.
One benefit of investing in a multifamily property is that it can generate steady monthly income. And, if you prefer passive income, it’s easy enough to hire a property manager to take on daily responsibilities. Another option would be to invest in a fund that manages multi-family properties, so that investment and property management are completely covered by experienced professionals.
Multi-family investing is also known as a safe investment when compared to other types of real estate property. People will always need a place to stay, even when the economy is suffering. Retail properties, on the other hand, could decrease in demand during a recession.
Core Plus Investing:
Core plus real estate investing is a process where the investor acquires mature assets and makes light improvements with plans to sell in the future. This investment strategy is considered low- to moderate-risk and is often compared to bonds.
Buying core plus properties is considered to be one of the safest real estate strategies because it provides stable and consistent cash flow. Investors who acquire these developments are often looking for higher-end properties in prime locations.
With so many different ways to invest in real estate, it’s best to extensively research and discover what is right for you. It’s also important to be cautious of the risks and problems that may arise during any investment process. Understand that not all investments are the same, even if they are very similar in nature, and that good investments rely on multiple factors.
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