Buying real estate is a popular way to invest, and—if you do it right—you can make some real money! You know why? Because property is valuable. As Mark Twain put it, “Buy land. They’re not making it anymore.”
Studies show that most Americans think real estate is a great long-term investment.1 So, what holds people back? Let’s be honest: Investing in real estate is a big commitment that requires a lot of time and money—it’s serious work! And it’s important to fully understand how to invest in real estate before you dive in.
All right—it’s time to talk strategy. What are the different types of real estate investing? And how can you make money in real estate?
Types of Real Estate Investing
First, real estate investing comes in different shapes and sizes. It’s important to understand your options so you can make the best decision for your situation. Here are the most common ways people invest in real estate.
We need a mindset shift in our culture. Lots of people have the ambition to buy a home, but it’s time to reach higher. The goal is to own the place.
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Homeownership (emphasis on the own part) is the first step in real estate investing, and it’s a huge part of achieving financial peace. As long as you keep paying taxes and insurance on your property, you don’t have to worry about ever losing your house. You can stay calm regardless of the ups and downs of the real estate market, and it also frees up your budget to start saving for other types of investments.
The fact is, paying off your home is one of the best long-term investments you can make. It won’t increase your income, but it will be a huge boost to your net worth by giving you ownership of a valuable asset. Pay off your own house first before investing in any other type of real estate.
Now that that’s out of the way, owning rental properties is a great way to create additional revenue—it could easily add thousands of dollars to your yearly income. Then if you decide to sell, you could earn a nice profit. It all depends on what type of property you buy and how you manage it.
Listen: While rental properties are a great investment option, being a landlord has its challenges. You’ll face seasons when someone doesn’t pay rent or you’re in between renters. You also have to consider the additional expenses of maintenance, repairs and insurance. And then there’s the time cost: When the toilet busts at 2 a.m., guess who has to come to the rescue? That’s right—you!
Flipping a house means you purchase it, make updates and improvements, and then sell it—all within a fairly quick amount of time. House flipping is appealing because it’s a quicker process than renting out a property for years. In a matter of months, you could get the house back on the market and (hopefully) turn a nice profit. But just like other investments, there’s a risk you won’t make money on it—in fact, you could even lose money.
When flipping a house, remember that the key is to buy low. In most cases, you can’t expect to make a decent profit unless you’re really getting a great deal on the front end. And before you jump into house flipping, be sure and talk to a real estate agent about the potential in your local market.
Now, a word of warning—flipping houses isn’t always as glamorous as the HGTV shows make it seem. If you absolutely love hands-on work, then have at it! But make sure to budget plenty of time and money for the process. Updates and renovations almost always cost more than you think they will.
How to Make Money Investing in Real Estate
You can make money from real estate properties two different ways: appreciated value of the property over time (which adds to your net worth) and cash flow from rental income. We'll break all that down in a minute.
But before we jump in, let’s make something crystal clear: You should pay for investment properties with 100% cash. Don’t even think about getting into debt for a rental property! A 100% down payment takes debt out of the equation, lowers your risk, and sets you up to make more money a lot sooner.
Despite the ups and downs of the real estate market, most properties increase in value over the long term. In fact, home values have been going up pretty much nonstop every year for nearly a decade.2 The fancy investing word for an increase in value is called appreciation.
The key to buying real estate that appreciates is location, location, location! You want to buy in a part of town that’s on an upward climb in terms of value. Also, buy at a low price and ride out any downturns in the market until your property has appreciated.
Generating income from rentals is probably the more immediate and exciting reason investors decide to purchase a property. Once you’ve secured renters, owning and renting out property is a great way to make additional income without a lot of effort.
Other than needing cash on hand to cover any repairs or maintenance, your part is pretty hands off. There’s even less for you to do if you hire a property management company—but that will cut into your profits. Keep in mind, though, that dealing with renters can be frustrating and time-consuming. Do your homework before you allow someone to rent your property. You want to make sure they’ll keep it in great condition. And always have a written lease.
Hopefully it’ll never comes to this, but you may even have to hire a lawyer if you need to evict a tenant who’s causing trouble or missing rent. The expenses pile up quickly, so make sure you have your own emergency fund fully stocked.
What Are the Tax Implications of Real Estate Investing?
Now we’re getting to the fun part. (Yes, math is fun.) But even if you live to crunch numbers, taxes for real estate properties are complicated. So our first piece of advice is this: Get a tax pro on your team. They’ll be able to help you understand the impact of your investing decisions and keep you up to date on tax code changes.
In the meantime, here are the most common taxes you’ll run into when it comes to investing in real estate.
Capital Gains Tax
When you sell an investment property, you’ll pay capital gains tax on the profit. In plain English: capital refers to assets (in this case, cash) and gains are the profits you make on a sale. Basically, if you bought a piece of property and sold it for a profit, you’ve made capital gains. Makes sense, right?
Now, there are two types of capital gains tax: short-term and long-term. We'll cover them one at a time.
Long-Term Capital Gains Tax
You’ll pay long-term capital gains tax if you sell a property you’ve owned for more than a year. This type of tax uses your taxable income to determine how much you owe on just the profit you made from the sale of your investment property.3
Here’s an example: Let’s say you buy a property for $100,000. Years later, you sell the property for $160,000. That’s a gross profit of $60,000. Of course, you also paid a real estate commission fee when you sold that property. Good news: You can deduct that from your capital gains. Let’s say the fee was $9,600 (6% of the property’s price)—that brings your capital gains down to $50,400.
How is that $50,400 taxed? Remember, for long-term capital gains tax, it depends on your filing status and your taxable income for the year. Most taxpayers will end up paying a capital gains rate of 15%, but some higher-income folks will pay a 20% rate—while lower-income earners won’t pay any capital gains taxes at all.
Short-Term Capital Gains Tax
Short-term capital gains tax is even simpler than long-term. When you’ve owned the property for less than a year (think: house flip), your profits are taxed according to short-term capital gains. But if you sell at any point beyond one year, those profits will be taxed at the long-term rate.
Unlike a long-term investment, the profit you make from a short-term investment is counted as part of your overall annual income and will be taxed according to your personal income tax bracket.4
Let’s say you’re single, your annual income is $50,000, and you made a $20,000 profit on a house flip this year. Uncle Sam sees that profit as taxable income—putting you at $70,000 total and landing you in the 22% tax bracket.
How to Postpone Capital Gains Tax
Say you want to sell a property but plan on investing in more real estate after that. It sure would stink to pay capital gains tax on that sale instead of getting to use it toward another purchase, wouldn’t it?
Well, here's some good news! By taking advantage of a fancy tax-deferred rule known as a 1031 exchange, you can sell a property and reinvest the profit into what the IRS calls a “like-kind” investment.
In other words, you can postpone paying capital gains tax if you use the profits from the sale of one investment property to purchase another similar property. But hurry up! You only have a short window of time to reinvest the money in order to defer the tax.5
Taxation on Rental Income
Any money you make from rental income must be listed as income on your tax return. But when you own property, you can also claim deductible expenses like repairs and maintenance—but keep in mind that improvements won’t count.6
So maybe you made $10,000 this year from rental income, but you also completed $1,500 worth of repairs on the property. You can deduct the $1,500, making your taxable rental income $8,500.
Do yourself a favor and save time by working with a tax professional. Meet with them regularly to discuss your investments and how they impact your taxes—you don’t want to get slapped with a penalty!
How to Start Investing in Real Estate in Six Steps
All right: It’s game on! When you’re ready to start buying investment property, here are the guidelines to follow.
Step 1: Pay in cash. This flies in the face of most real estate investing advice. But the truth is, there’s no such thing as “good debt.” No ifs, ands or buts! Taking on debt always equals taking on risk, so avoid it no matter what.
Step 2: Diversify. Have you ever heard the phrase “don’t keep all your eggs in one basket”? The same wisdom applies to your investments. Mutual funds through your 401(k), Roth IRA and other retirement savings accounts should be the foundation of your wealth-building strategy. After those are locked and loaded, you’ll be well set up to start investing in real estate.
Step 3: Stay local. Keep it simple—don’t buy a house in Arizona if you live in Illinois! When you’re far away from your properties, you’ll have to trust a management company to assess damage and make repairs. Now, it might still be a good idea to hire a management group, even if you’re local, to help keep things running smoothly. But you—and only you—are the owner. So stay close and keep tabs on your investments.
Step 4: Be prepared for risks. In most cases, renting out property is not as simple as getting renters and checking in once a year. Sometimes rentals can sit empty for months, which can be a tough blow if you’re not financially prepared. And even in the best renting situations, appliances will still break and gutters will still need to be replaced. The best way to prepare for risks is to have a fully funded emergency fund that can cover unexpected expenses.
Step 5: Start small. If you’re not sure if owning a rental property is for you, test it out. Maybe you have a space above your garage or an extra bedroom you could rent out—even if it’s just for a few nights at a time with Airbnb. That experience will give you a taste of what it’s like to own a rental. It’s also a good idea to talk to other real estate investors. Take someone in the industry out to lunch and ask them what they wish they’d known before getting started.
Step 6: Hire a real estate agent. Even if you’re still just weighing the pros and cons of real estate investing, you need to talk to a real estate agent in your local market. They’ll know what areas you should look into and what potential hurdles you may face as a real estate investor. And then when it comes time to purchase a property, you’ll need their expertise to make sure you’re getting a great deal.
When Should You Start Investing in Real Estate?
If you’re familiar with what we teach at Ramsey, you may be wondering where investing in real estate fits into the 7 Baby Steps or your overall wealth-building plan. We like the way you’re thinking!
You should invest in real estate only after you’ve already paid off your own home (Baby Step 6). That means you’re completely debt-free with an emergency fund of three to six months of expenses saved. You should also already be investing at least 15% of your income into retirement accounts, like a workplace 401(k) or Roth IRA.
And remember: If you can’t pay cash, don’t buy an investment property.
Why Pay Off Your Own Home First?
We get it—waiting until you’ve paid off your house probably sounds like a really long time, especially if you feel like the opportunity is knocking at your door right now. But trust us on this. It’s worth it to wait until you’re really ready.
Let’s take Greg as an example. He owes $150,000 on his own house and makes $5,000 per month. Greg’s kept his mortgage payment to 25% of his monthly take-home pay, paying $1,250 a month (that includes PMI, property taxes and homeowner’s insurance).
He thinks having rental income will help him make progress on his financial goals, so he decides to finance a rental property and take out a 15-year fixed-rate mortgage for $100,000 (uh-oh). That adds a second mortgage payment of $927 to his monthly budget, but he plans to rent out the house for $1,350 per month. Greg thinks it’s a great plan. (Spoiler alert: Greg is wrong.)
What Greg didn’t know is that it would take three months to find renters, which means he paid $2,781 in mortgage payments on his new rental while it sat empty. For those three months, paying the mortgage on his own place and his rental took up 44% of his income! He felt like he could barely breathe—but what would he do if the air-conditioning unit went out or the dishwasher started leaking? What if he lost his job?
Don’t be Greg. Don’t rush it. Real estate can be a fantastic investment—but not if you do it the wrong way. So be smart and wait for the right time.
Is Real Estate Investing for You?
Real estate investing has its pros and cons, and it isn’t for everyone. If you’re wondering whether or not real estate investing has a place in your wealth-building plan, sit down and have a conversation with your investment professional. And be sure you’re working with an experienced real estate agent to help guide you.
When considering a new investment, an investment pro can offer practical advice on how to diversify your investments so you’re prepared for the future. Need help finding quality pros? Try SmartVestor. It’s a free way to find qualified investing pros in your area.