5 Reasons Real Estate Is the Perfect Early Retirement Tool
Are you interested in retiring early? And by retiring, I don’t necessarily mean sitting around doing nothing or sipping piña coladas on the beach (although that’s cool for a while).
By retiring early, I mean removing the need for a nine-to-five job. I mean working on projects and on schedules you love, whether they pay enough or not. And ultimately, I mean spending only a few hours per month on real estate and the rest on whatever matters most to you.
This idea of early retirement has been my goal for a long time.
And a couple of years ago, at 36 years old, I finally hit it using real estate. To take advantage of that freedom, my wife, my two young kids, and I just spent 17 months living in Cuenca, Ecuador.
For us, language learning, cultural immersion, and lots of quality time together was the big motivation (i.e. the why) for early retirement. For you, it could be something else. As long as your why motivates you, that’s awesome!
But whatever your reason for early retirement, it turns out that real estate is the perfect tool to get you there. I’ll show you five reasons why in the rest of this article.
Deal analysis is one of the best ways to learn real estate investing and it comes down to fundamental comfort in estimating expenses, rents, and cash flow. This guide will give you the knowledge you need to begin analyzing properties with confidence.
1. Beautiful, Dependable, Monthly Income
Income is the core benefit of real estate investing. Even the worst rentals I own produce more income than equivalent amounts of money in other assets like stocks or bonds.
But in the right markets, I often see unleveraged (no debt) income returns of 5 percent to 10 percent with rental properties — even after paying all expenses (including a property manager). And with safe, long-term leverage (if you choose to do that) you can sometimes see those income returns double to 10 percent, to 20 percent, or more.
For early retirees who want to live off investment income, these differences in income matter A LOT!
For example, here’s a chart comparing actual yearly income (pretax) for an S&P 500 index fund, 10-year US Treasury bonds, and an unleveraged rental property with a 7 percent income yield. It assumes you invest $500,000 in each asset type.
|Asset Type||Income Yield||Income/Year for $500,000|
|S&P 500 Index Fund||1.83%||$9,150|
|10-Year Treasury Bond||2.86%||$14,300|
|Unleveraged Rental Property||7%||$35,000|
That’s a huge difference! Which would you prefer to live on: $35,000 or $9,000?
And yes, I understand stock equity investors can sell appreciated shares and live off the principal. But which is safer in a volatile, bubbly investing environment like 2018? Eating into your principal or never touching it?
I’ve made my choice. You’re here reading on BiggerPockets, so I bet you have too.
Related: Free Mortgage Quote
2. Control — You Make a Difference in Your Success
Now that I’ve beat up on stocks and bonds, let me also say that they can make great investments as well. In particular, owning a low-cost index fund of the entire stock market is likely to do very well over the long run.
But when you’re first building your wealth to retire early, real estate has a clear advantage over more passive investments.
Real Estate Gives You More Control
I have a theory that we real estate investors are all secretly (or not so secretly) control freaks. We need to be involved. We like jumping in, getting our hands dirty, and influencing the success of our investments.
Luckily, getting personally involved is what real estate is all about.
Your best deals will happen when you use your skills and hustle to find deals below value. You’ll increase your wealth dramatically when you improve properties to increase rents. And when you manage properties well on the back-end, you control your income stream for years.
So, it’s not only possible to influence your real estate investments, it’s imperative!
What about an index fund? You only control when you buy, reinvest your dividends, and sell. The managers and employees of the companies you own control your success.
Neither choice is wrong. Some people like 100 percent passive index investments. I actually like them, too, as a diversification tool.
But early retirees get another aspect of control from real estate: timing.
3. Timing — Waiting on Passive Stock Markets Isn’t Necessary
Real estate gives you more control over the timing of your wealth building. As an aspiring early retiree, you probably have a target date for your financial independence (FI). And I’m willing to bet the date is sooner rather than later!
So, how do you reach your target date on time? By ensuring that your investments grow at the right pace.
With non-real estate investing like stock indexes, the core growth of your portfolio depends on appreciation of prices. This growth of stocks has been steady over the long run, but it tends to be extremely volatile (i.e. goes up and down) over the short run.
A sudden short-term drop in stock prices can delay or destroy your target FI date as an early retiree.
Real estate investing, on the other hand, gives you two very predictable core growth levers:
- Positive rental income
- Debt amortization (paydown)
While nothing is guaranteed in the investment world, rental income on quality properties is typically stable. As the charts below show, even during the 2008 – 2010 U.S. housing crisis, rents held steady, or only slightly decreased, in most U.S. markets. And this happened while housing prices themselves plummeted.
These past trends do not guarantee the same result with rental rates in the future. And the national trend doesn’t mean rental rates won’t go down in your specific location. Rents are very closely tied to local rates of income and other supply-and-demand factors, so those will ultimately determine your rates.
But the main point is that real estate rental income doesn’t always correlate with the prices of assets. And that’s helpful when you’re quickly building an early retirement portfolio.
The second real estate growth lever, debt amortization, is both built into your mortgage payment and something you can accelerate. The Rental Debt Snowball Plan, which I discuss in detail in the book Retire Early With Real Estate, is a powerful example of this.
With a debt snowball, you can apply extra savings to pay your mortgages off in seven to 10 years instead of 30. And with paid off mortgages, you reduce your risk and increase your income just in time for an early retirement.
4. The Tax Code Loves Real Estate Investors
Politics and changing winds of public opinion can alter tax policy in a heartbeat. For example, the 2017 GOP tax bill changed many tax rules (although many real estate benefits were mostly left in place). So, you can’t ever count on any particular tax benefit to last forever.
But, I see tax benefits as icing on an already good real-estate-investing cake. Here are eight sugary tax-frosting benefits that we get as real estate investors:
Unlike income from your job, rental income is not subject to social security or medicare taxes (a.k.a. FICA taxes). In 2018, for example, this could save you between 7.65 percent (employee salary) to 15.3 percent (self-employed earnings). On $100,000, that’s $7,650 to $15,300 per year!
The U.S. government requires real estate investors to spread out most of the cost of real estate purchases over 27.5 years (for residential buildings). This creates what’s called a depreciation expense, which can shelter or protect your rental income from taxes and reduce your tax bill.
Keep in mind, however, that what the IRS giveth, the IRS taketh away. When you sell a rental property, it’s very likely that you’ll have to recapture the depreciation and pay taxes on it. And the tax rate on this recaptured real estate depreciation is typically 25 percent (as of 2018).
This is why investors often say depreciation comes back to bite you. It’s also why many investors use a 1031 tax-free exchange, which I’ll discuss next.
1031 Tax Free Exchanges
Named after section 1031 of the U.S. tax code, this technique allows you to trade one property for another without paying taxes — if you follow the IRS rules. This tax-free sale allows you to grow and compound gains without the drag of taxes. Properly and strategically using a 1031 exchange can make you millions.
Gains on long-term investments (held over 12 months) are usually taxed at lower rates than comparable earnings from a job. For example, as of 2018, the long-term capital gains rates are between 0 percent and 20 percent, depending on your overall tax bracket.
So, if you plan well, you can strategically sell long-term properties to capture gains with lower effective tax rates. And for high earners, even the highest capital gains rates can be better than taxes on ordinary income from a job.
Living in a fixer-upper house (a live-in flip) can be a huge tax benefit if you move in immediately after the purchase and live in the house for two years or more. In this situation, tax law in the U.S. allows between $250,000 (individuals) to $500,000 (couples filing jointly) of tax-free profit when you resell.
I need to repeat that for emphasis. TAX-FREE PROFIT.
This rule is probably the best deal in the entire tax code. And BiggerPockets’ own Mindy Jensen and her husband have used live-in flips better than anyone I know. You can learn all about it in this podcast episode.
Borrowing is Tax-Free
You only pay a capital gains tax when you sell a property. So, if you decide to refinance and pull out some of your equity, you can use all of the money tax-free.
Of course, this increases your property expenses and you have to pay the money back. But this can be a helpful strategy to use the wealth in your properties as you need. I actually plan to do this with two rentals to help pay for my two kids’ college expenses.
Self-Directed Retirement Accounts
You probably know about the tax benefits of 401K and IRA plans, but you might not know that you can invest these in real estate and other alternative assets like private mortgage loans. This means any income or gains you make from the real estate are tax-deferred or tax free (depending on the retirement account type).
Of course, there are many very strict rules you must abide by. But learning how to invest in a self-directed retirement account is worth your time.
Die With Real Estate (Seriously!)
Death itself is not exactly a good strategy. But dying with real estate can be a big tax advantage for your heirs.
Instead of facing capital gains and recaptured depreciation taxes like you would, your heirs will get what’s called a “stepped-up basis.” This means their basis for taxes is reset when you die. So, if they immediately resell, they’ll pay no tax.
Keep in mind, however, that inherited assets are still subject to estate taxes. But there tends to be a large estate tax exemption (in 2018 there is an exemption for anything below a base of $10 million). The actual amount and limit of estate taxes seems to change with every new political administration. So certainly keep an eye on it.
5. Real Estate Is Simple and Understandable
I’m a big fan of Warren Buffett, and I like to study his lessons. And one of his primary investment tenets is to only buy assets that are simple and understandable.
For this reason, I choose to invest primarily in residential real estate. Compared to most other investments, residential properties are very intuitive and easy to understand.
Because ordinary people live in residential units. They want things like safety, convenience, comfort, affordability, style, and good school districts. When you shop for a residence, you probably look for the same things.
Real estate is also a “real” asset. It’s tangible. In the right locations, ever-rising construction costs and salaries buoy real estate values.
Housing also doesn’t easily go out of style or get replaced by the latest technology. People just remodel instead of abandoning the property.
People will still be living in homes long after you and I are gone. And that makes me very comfortable depending on real estate as a safe early retirement investment.
Is Real Estate Your Early Retirement Tool?
The great French Marshall Lyautey once asked his gardener to plant a tree. The gardener objected that the tree was slow growing and would not reach maturity for 100 years. The Marshall replied, ‘In that case, there is no time to lose; plant it this afternoon!’ – John F. Kennedy, 35th president of U.S. (1917 – 1963)