Jul 10 2014
There are three ways to build wealth:
- Investing in the markets
- Starting a business
- Owning real estate
For many of us, numbers 1 & 3 are the most likely ways for us to achieve our financial dreams of freedom. For military personnel, we can invest in TSP (which is a good, tax deferred way to save or post-tax way to save). Personally, I recommend any investment portfolio include the use of a financial professional to ensure proper diversification.
Owning real estate is a good option, especially to those who move frequently (as military do). Take this scenario, if a military member moves on average every 3 years (as was the case, when I was in and when my father was in), one could accumulate 5 houses in 15 years (assuming that for the first 5 years, the military member does not purchase a home). If the average home costs $150,000 (around $100,000 in the beginning and up to $300,000 in the end of a career), it is possible to control $750,000 of real estate after a 20 year career in the military.
Why is property ownership such a good thing? First of all, there is the tax advantage. There are ways to pay capital tax rates (0-15%), whereas TSP earnings are subject to ordinary income upon withdrawal from the TSP account (with a tax deferred account) or taxed at ordinary rates (10-39.6%) upon contribution to a Roth-style TSP account. The second advantage, regardless of the crashes which have taken place (2008 and late 1980s for example), the real estate market has grown over the long run. While there are many short term loss possibilities, over the long term, real estate tends to hold its value, in the aggregate. Third, real estate taxes are deductible, whereas only certain taxes are deductible on investments. Fourth, it is easier to obtain financing for real estate vice investments. Have you ever gone to the bank and said that you wanted to borrow money to buy stock on the open market. Give it a try and let me know how it goes!
Owning property is good, but what about renting property out? The first thing on your mind is likely “I don’t want to deal with the hassle!” Setting this aside for a moment, let’s look at the benefits of renting out real estate.
- When renting out property, you move the property from an investment property to a “production of income” property. What is “production of income?” It is like running a business, but is treated under the IRS codes differently. For the sake of simplicity, treat it as running a business (unless I state otherwise). In this case, you can take deductions against your rental income, which you receive, which are “ordinary and necessary.” Permitted expenses include:
* Real estate taxes
* Interest payments (on the home loan or equity loan)
* Management fees
* Other ordinary and necessary expenses (cleaning, repairs, advertisement, etc).
- Someone else is paying off your mortgage in your other home, while you still retain ownership! This is provided you can rent out the home for at or more than the interest and escrow costs of your home. Why interest and escrow costs? Principal is more about paying yourself (which acts like a savings account over time). This is why even if you are not able to rent out for more than your payment, you might still make out profitable because of the amount of principal and the tax advantage of owning the home.
- If you own a vacation home and use it for less than 14 days out of the year (or 10% of the days rented out if rented out for less than 140 days), it still counts as 100% rented out for the year. Imagine owning a nice home in North Carolina (or Oregon for those on the West Coast) near the beach and vacationing there for a week each year. If it is rented out for more than 140 days, you can treat it as 100% rented out for the year (but personal expenses directly attributable to the time you use it are not deductible, for example cleaning or food expenses)
- Home values (generally) go up over time. While the increase is not equal to that of the stock market, real estate is an investment, which tends to hold its value. When including the amount of rent received, minus the cost of maintenance and adding the tax advantage, if can be a good investment.
This is something to consider along with a balanced portfolio. In order to achieve the balanced portfolio, it is recommended you discuss your financial plans with a certified financial planner (CFP®), CPA or EA. In future blogs, I will discuss in further detail how this works with dealing with the IRS and state tax agencies.
 §1221 of the IRC
 IRS Schedule E