At this point everyone and their mother is trying to find a way out of the corporate lifestyle that was a staple for our parents’ generation.
95% of all workers want a work from home option, with 52% wanting to work entirely remotely and 63% willing to take a pay cut for the benefit of working from home.
The FIRE movement is entirely built around people working as hard as possible early on in their careers to get out of corporate America as quickly as possible.
As more and more people are looking for a way out, real estate investing is often touted as a means to achieve this end. The idea at its core is simple: build a large enough real estate portfolio and you are essentially making rental income (on top of the yearly price appreciation of the property). The passive rental income essentially replaces your W2 income with hopefully significantly less work and then abracadabra you get to leave the corporate rat race for greener pastures.
The attractiveness of this approach is made more alluring through hindsight.
Here in California many of us know someone from our parents’ generation who started investing in real estate in the 70s or 80s and is a multimillionaire many times over.
There are a myriad of tax benefits that can be attractive as well; depreciation deductions can offset rental income, capital gains on appreciated properties can be deferred through 1031 exchanges.
These are often looked at as a holy grail of sorts, but the truth of the matter is that while there are some permanent tax savings here, the bulk of the value here is tax-deferral—NOT permanent tax savings.
I see this problem a lot with people who are super into tax-aware or direct indexing strategies without realizing that doing so in large part just passes the tax-bill forward making a currently difficult problem even a larger problem down the road. Not that these don’t still provide value, but that it might not always be the perfect solution they were looking for.
That’s an article for another day that I may tackle.
But for now let’s stick with real estate.
Let’s take a look at a couple examples.
Let’s say a plastic surgeon and her husband in California have a household income of $1 million.
Their marginal federal and state tax rate is 52.1% for rental income and 35% for capital gains.
They purchase a rental property for $5M generating $200k in rental income. In the absence of depreciation, the $200k in rental income flows down to ordinary income and they lose 52.1% of that or $104,200 to taxes.
Table 1: Tax Consequences of Rental Income with No Depreciation
Now let’s say they are able to use a standard depreciation schedule to offset $90,000 of that income.
Now that $200k in rental income is reduced to $110k in taxable income. So instead of owing $104,200 in taxes they only owe $57,310 in taxes.
Table 2: The Upfront Benefits of Depreciation
Now on the surface this looks like a permanent $46,890 tax savings ($142,690 – $95,800).
But in reality, depreciation is only an upfront tax savings that you have to pay back later when you sell the property through depreciation recapture.
So at best, depreciation is merely a tax-deferral strategy.
Let’s look at the same example. And let’s assume that after that first year they decide to sell the property for the same $5 million that they purchased it at.
This in itself is not a tax inducing event since they purchased it for $5 million and sold it for $5 million—so a $0 taxable gain.
However, on sale the government assess a “depreciation recapture” to recapture the depreciation deductions you took in the past (It’s important to note that the government assesses this recapture automatically on sale regardless of whether you actually took the depreciation deduction or not.
So if you own investment property it’s important that you are ensuring that you are actually utilizing it prior to sale otherwise you’ll end up paying extra tax on sale that you shouldn’t.
So in this case the client took $90,000 worth of depreciation. Which means they’ll owe depreciation recapture on this $90,000. Luckily the depreciation recapture rates are lower than the tax rate the client is subject to for ordinary income (in this case it’s 40.1% for depreciation recapture (25% federal +11.3% state+3.8% Net Investment Income Tax) instead of the 52.1% for rental income).
Table 3: The Backend Drawbacks of Depreciation Recapture
So while the client saved $46,890 on the front-end in taxes, they’ll owe $36,090 in taxes on the back-end. It’s still a savings of $10,800, but not the full $46,890 it’s made out to be.
So when we do our analysis of the benefits of utilizing depreciation, we also need to account for the downsides that come with depreciation recapture.
And when we do that, we see that we’re not really saving a whole lot on the effective tax-rate.
At best we’re only saving a couple percentage points here.
Table 4: Net Value of Depreciation After Recapture
In the example above, the tax-rate is 52.1% without depreciation and 46.7% when we account for both depreciation and depreciation recapture.
So while there is benefit in the tax-deferral abilities of depreciation the net tax savings here is small. Obviously, if we defer the taxation for more than the 1 year in this example, we get more of the benefit of tax-deferred growth.
But at the core of it, a 46.7% tax-rate is still ridiculously high whether I pay that in 1 year or 20 years. Plus the longer I defer, the more I risk tax-rates going up in the future relative to where they are today.
So what was the real benefit of replacing their W2 income that was taxed at 52% benefit and taking on the headaches of business ownership just to reduce their tax-rate to the mid 40s?
The marginal benefit relative to the cost and labor involved reduces the value of even the tax-deferral.
So while depreciation definitively offers real estate investors a benefit, the deeper question that needs to be looked at is:
“Why am I investing in something that is so heavily taxable to begin with and I’m merely trying to find ways to defer the tax bill until later?”
At it’s best, depreciation is only covering a part of the rental income—not all of it. The rest of it is flowing down to ordinary income.
And what is the end game here?
Eventually the rental property value and rental income are going to increase and the depreciation benefit disappears.
And then all the income just flows down to ordinary income taxed at the same rates as your W2 income was.
When Escaping One Rat Race Turns Into Another Instead of Passive Equity Ownership
Let’s say that same $5 million dollar property increases in value to $20 million over the next 30 years and rents increase accordingly.
Now instead of $200k in rental income they have $800k of rental income and the depreciation schedule has run out.
That $800k is now taxable at 52.1% meaning they’re losing $416k of that $800k to taxation.
That’s an extreme amount to lose to taxes in comparison to investing in the stock market.
Let’s take a deeper look at this stock market to real estate comparison.
Assume they have $20M in real estate and $20M in an S&P500 Fund. Both are earning 10% a year or $2M.
As with any return, that $2M is a mix of price appreciation (the yearly increase in the value of the asset) and the dividend that the asset kicks off. In the case of real estate, the dividend is just the yearly rental income.
However, the mix between price appreciation and dividend is not the same for real estate investing and the U.S. stock market. For the U.S. stock market the dividend rate has been a under 2% the last 10 years, whereas the net rental income rate here in California has been about 5%.
That means if I’m assuming a 10% total return for both assets, on the real estate side I’m assuming 5% of that return to be due to price appreciation and 5% to be due to net rental income.
But if I’m assuming a 10% return on the stock market side, that means 8% will be due to price appreciation and only 2% will be due to the dividend.
Table 5: Understanding the Difference Between Price Appreciation and Dividend Return
This might sound like an inconsequential delineation since the total return in both cases is 10%, but as I’ll show in a second it’s by no means trivial.
Price appreciation is the holy grail of investing. Namely because you’re not taxed on the yearly growth. The value of the asset can continue growing and I don’t pay taxes on this growth until I sell. If I’m super strategic about this, I can borrow against my gains here before I sell and not pay taxes on the amount I borrowed. Even better is that I get a tax-deduction for the interest.
So I’m getting the benefit of the growth and access to liquidity without ever having to pay taxes.
And If I’m super strategic about this, I’m holding the asset until I die to get step-up in basis so my kids inherit it tax-free—all while I continue to borrow against it so that I have liquidity while I’m living and then the loan will be paid off when I die.
Once you see all the economic and tax benefits of price appreciation, it’s hard not to get addicted to it.
To misappropriate a quote from Rick James here, “Price appreciation is one hell of a drug.”
Dividend return does not offer the same benefits. You cannot eliminate the tax here in the same way. Only depreciation with real estate allows you to defer it (no such benefit with equity dividends although equity dividends are taxed at much lower qualified dividend rates).
So if I have to choose here between the economic and tax value of equity price appreciation versus dividend return, I’m always going to choose price appreciation.
From a risk tolerance standpoint, some people prefer the stability of dividends since that doesn’t change too dramatically from year to year whereas equity values (moreso with stocks than with real estate) can be dramatically volatile.
It’s hard to know whether the stock market is going up or down in a given year and by how much. So the lower volatility of dividends can smooth this out and (even improve long-term returns due to reduced volatility drag).
But heavy taxation of dividends negates part of this benefit.
And that’s the problem with real estate investing.
The end game is ultimately the same large ordinary income problem that you had while you were working with ongoing management responsibilities—that you also had while you were working and the liabilities involved in running a business where someone can sue you.
This is in contrast to the pure equity investing you can do with a click of a button with the stock market.
You have large taxation due to the high dividends (i.e. rental income) that is being generated whereas with the stock market the dividend rate is significantly lower and taxed at significantly lower capital gains rates.
So if I go back to my example of having $20M in the real estate market and $20M in the stock market, with the stock market most of that return is price appreciation whereas with real estate I can’t avoid the large amount of the return that is dividend return.
So if I’m making 10% on both my real estate portfolio and on my stock market portfolio, then in both cases I’m making $2 million a year.
But with the stock market portfolio most of that is untaxed price appreciation whereas with my real estate portfolio I’m paying a heavy tax due to the large dividend return—and to make it worse, the real estate dividend returns are taxed at significantly higher ordinary income rates.
Table 6: Understanding Tax-Drag from Rental Dividend Income versus Stock Dividend Returns
In the table above that same $2M gain in both cases is taxed incredibly differently due to the difference in price appreciation vs dividend return resulting in $275,600 in extra taxes due on the real estate return every year ($416,800 vs $141,200).
This is largely due to the fact that real estate investing is generating twice the dividend return that the stock portfolio is combined with the fact that the tax-rate on those dividends are significantly higher.
So even though both are generating the same $2M total return, the taxation on those returns are drastically different.
So leaving a W2 job in which I have a skillset that is valued in the market place to run a rental property empire that I’m not skilled at that comes with more liabilities, responsibilities, and headaches than my W2 job—and which I’m taxed just as much as my W2 job—doesn’t make sense.
I’m just signing up for another job with the same problems I faced at my last one.
Even worse, with interest rates as high as they are now, purchasing properties in areas like California are often cash flow negative because the rental income is currently significantly less than what’s needed to pay the mortgage and other expenses involved.
Which means I’m signing up for a job I am actively paying out of pocket for with the hopes of future price appreciation making it all worth it.
Imagine if on your next job they told you had to pay for it because it wasn’t cashflow positive and you had to just wait and hope for the future to earn your money back.
When people are talking about real estate empires, they are largely talking about the ability for the value of real estate to go up.
And that brings up a larger question of “What Am I Exactly Betting On?”
A Bet on Restricted Supply, Housing Unaffordability, and Heavy Use of Leverage
If I’m choosing to invest in real estate over easier index funds that take a press of a button to invest in without the headaches of real estate involved, I must believe there is some advantage in doing so.
Perhaps there is a new development in town where I think the growth in the surrounding infrastructure will lead to significant upside in the future.
Maybe I think the stock market is overvalued and real estate is a better store of short-term value than the stock market is.
These positions make sense to me.
But if I believe in general value of real estate as an investment, I think it’s fair to ask what is actually creating the value here.
And ultimately it’s restricted supply and the leverage involved which I touched on in my last post.
Imagine if I told you there was a new company IPO and you should invest in it.
If I told you that you only had to pay 20% of the price for the IPO and could borrow the rest, you would be intrigued.
If you ask what it does and I say it provides a product that all Americans need, you would get excited.
But if I were then to tell you that another company could easily build the same product and that doing so would dramatically reduce the value of the company’s own product and the value of its IPO, you would almost certainly see the writing on the wall and walk away.
But this is exactly what investing in housing is.
An increase in the supply of housing would instantaneously bring the value of housing across the board down.
Furthermore, when you can purchase properties with only 20% down (if not less), then the market value of the asset class is heavily influenced by interest rates.
When interest rates are low, people are willing to borrow more and that drives up the price of housing.
When interest rates are high, people are less inclined to borrow as much (and make the higher mortgage payments) and the value of housing declines.
And if people purchased properties when interest rates were low, but now interest rates are high, then they are less likely to sell and buyers are less likely to buy which results in stagnation of a market place that was supposed to allow for housing to be treated as an investment.
We criticize the use of leverage for overinflating returns and valuations and risk in every other industry except for real estate.
And all this for an industry in which the simple creation of more housing would reduce its existing value proposition.
But building more housing is often made politically infeasible because people who own housing inherently know that more housing will lower the value of their own.
So the answer for these investors of course is to restrict the construction of future housing in order to artificially inflate the value of their own investment.
But again what’s the end game here?
Does housing get so expensive and unaffordable to the masses that the wealthy have to purchase housing just to house their employees?
At which point, does the cost of housing becomes a corporate cost as opposed to a personal one and then the political forces against housing development stop so that the cost of housing becomes more affordable?
I don’t know.
But the truth of the matter is that a bet on housing appreciation/return in excess of other investment opportunities is in part a bet on increasing housing unaffordability.
This is not to say that stock market returns aren’t partly inflated due to a similar supply and demand element as the amount of household wealth in the stock market is near all time highs.
But even with sky high P/E ratios for stocks, at least at these stocks are bets on either the current value or the future value that these companies will provide to the world at large and not just a bet on restricted supply.
Maybe these bets are wrong.
More likely they may be wrong relative to the prices we’re being asked to buy in at.
But betting on excess housing profitability in relation to stock market returns for the long-term is a bet that the United States continues to restrict the supply of housing for its citizens in excess of the value being created by the actual products and services the country creates.
Investing is about owning passive equity in an enterprise that largely comes from the work of other people.
Investing in a personal real estate venture ultimately becomes a bet on the value of my own labor in extracting value from the limited supply and increasing unaffordability of the socioeconomic system we currently are a part of.
So what are we really investing in versus simply contorting our logic to our own biases to feel is a good investment?
That’s what Separating Value From Bias is about.
About the Author
Rajiv Rebello is the Principal and Chief Actuary of Colva Insurance Services and Guaranteed Annuity Experts. He helps HNW clients implement better after-tax, risk-adjusted wealth and estate solutions through the use of strategic planning and life insurance and annuity vehicles. He can be reached at rajiv.rebello@colvaservices.com.
You can also book a call directly with him here: