For investors, one truly under-appreciated aspect of real estate as an asset class is its favorable tax treatment.
Investors who focus solely on an investment’s underlying returns and not on how one’s gains are taxed miss the very real benefits of investing in real estate.
For a better understanding of how the government taxes one’s profits in real estate, compare the returns of an investment with no tax shields, such as debt, vs. the return on an investment in real estate.
A debt deal that earns 13 percent could be taxed at any rate up to the highest current federal tax rate depending upon an investor’s individual tax bracket. At present, the top marginal income tax rate is 39.6 percent.
Assuming an investor is fortunate enough to be in that bracket, which affects taxpayers with taxable income of about $415,000 or more for single filers and about $467,000 or more for married filers, a 13 percent gain on a $1 million investment would be $130,000. For someone in the highest marginal income tax bracket, the investor would only keep $78,520 of that $130,000 profit after taxes.
What about for someone who does very well but is a notch below the super-rich? An investor who is a single filer earning between $190,000 and $413,000, or who as a married filer reports income between $231,000 and $413,000, would find himself in the 33 percent tax bracket. Under the above scenario, that investor would keep $87,100 of that $130,000 profit after taxes. Although certainly better than the person in the highest bracket, this investor is still handing $1 out of every $3 in profits to the government.
By contrast, real estate returns on investment, assuming a reasonable holding period and not a short-term gain, are taxed as gains, where tax rates are far lower. For those in the highest marginal tax bracket, capital gains are taxed at 20 percent, while capital gains for those in every other marginal tax bracket are taxed at just 15 percent.
To lift a line from onetime Illinois Sen. Everett Dirksen, pretty soon you’re talking about real money here. In a real estate investment deal that earns 13 percent on a $1 million, an investor in the highest income tax bracket would keep fully $104,000 of that $130,000 profit, while all other investors would keep $110,500.
And real estate investments offer other favorable tax-related benefits beyond simply how gains are taxed. For example, investors also have the ability to deduct depreciation and interest expenses on their tax returns.
For a tax-sensitive investor, the favorable benefits of investing in real estate are paramount.