top of page

5 Mistakes in Real Estate Investing

Real estate is often seen as the golden ticket to wealth - it has been for many, and that trend is likely to continue for those who are willing to educate themselves and put in some extra work.


However, for those starting out (and even those who have been at it a while), there can be some notable unknowns.


Make sure you’re not getting in your own way as you build and maintain your real estate portfolio.


Mistake #1: Foregoing Liquidity

If you’re going to be investing in real estate, you need to have money available for repairs, improvements, and investment opportunities. Having a line of credit with your bank is a great way to make sure that you have access to cash, but it can also get expensive to use debt for everything.


Instead, consider using high yield savings accounts or conservative investments to make sure that you always have access to funds if they’re needed. The added benefit here is diversification of your investments. 


Having funds set aside in investments that also have a positive expected return can supplement your real estate portfolio and make sure that you always have access to funds. This is especially beneficial when interest rates are high because it may allow you to avoid paying high interest on your line of credit, and you’ll be able to get a higher return from your non-real estate investments.


Mistake #2: Becoming a “Flipper”

Flipping houses can be a great way to make a quick buck in real estate, but it certainly comes with its drawbacks.


First, it’s expensive. Not only do you need to buy the property, you’re also going to be putting substantial money into it - and all the while, you’ll have cash outflows because you’re not renting it out.


Second, it’s risky. If the market cools off mid-flip, it could take longer than expected to sell the property. Every day you hold a property for sale represents the opportunity cost of not being able to use those dollars elsewhere.


Lastly, taxes suck on flips. Generally, if you hold a property for longer than 1 year, you pay a lower tax rate (capped at 20% federal). Under 1 year of holding period means a higher tax rate (capped at 37% federal). Even worse, if the IRS deems your house flipping to be a business, they’re going to make you pay 15.3% of self-employment taxes on your gains. That means that you could potentially owe over twice as much in taxes by flipping houses instead of making them long-term investments. An additional downside is that if you flip houses, you can’t do 1031 exchanges (explained in Mistake #4).


Mistake #3: Taking Deductions Prematurely

Cost Segregation is a bit of a buzzword in real estate these days. Most real estate investors know that they can take a deduction for depreciation (over 27.5 years for residential property and 39 years for commercial property).


What a cost segregation study allows you to do is split your purchase into the purchase of:


1. The property itself; and 

2. All of the things inside of the property. That may be appliances, furniture, or even improvements to the property.


Why does this matter?


Well, it takes a long time to fully depreciate real estate, but if you can prove through a cost segregation study that you didn’t just buy real estate, but you actually bought some real estate, and then a bunch of other items, you can depreciate those other items more quickly (commonly 5-7 years, but bonus depreciation can help you take those deductions even more quickly). This lowers your taxable income in the short-term, which means you pay less taxes today.


So what’s the downside?


Cost segregations don’t result in free money - they just bring deductions from the future forward. That means that you’re effectively increasing your future taxable income. If you think your income/taxes will be higher in the future, you may be better off foregoing this strategy. 


Not only that, but if you plan to sell the property (without doing a 1031 exchange), you’ll pay taxes on the depreciation you took on the non-real estate items at ordinary income rates (up to 37%). Depreciation recapture on real estate is capped at a 25% tax rate. 


Either way, you should be having conversations with your accountant and financial planner about this strategy.


Mistake #4: Paying Tax on Gains

Many real estate investors are familiar with 1031 (like-kind) exchanges - if you’re not, man do I have a gift for you!


1031 exchanges allow real estate investors to sell their investment properties and reinvest the proceeds in a new property without paying tax on the gains. There are all sorts of rules with 1031 exchanges, so it’s important to engage a professional well before you sell a property to determine if it’s a good fit.


One thing that’s nice about 1031 exchanges is that you don’t necessarily have to reinvest the proceeds yourself. If you want to be done with direct ownership of your real estate, you can use a Delaware Statutory Trust (DST) to defer your gains. 


DSTs are basically real estate partnerships that you can exchange your proceeds into to defer the gain on your sale while maintaining exposure to real estate. They’re completely hands-off, but there are expenses associated with them, so it’s important to work with a professional who knows your situation to determine whether a DST is a good fit.


Mistake #5: Misusing Partnerships

It always seems like a great idea, right? Instead of ponying up all the cash to purchase a property, you partner with your buddy and own it together. Partnerships can work very well, but there are some caveats that are important to understand.


Taxes get more complicated. It’s not as simple as pro-rating the income to each of the partners - you have to file a partnership return by March 15th (or September 15th if you extend). If you forget to do this or miss the deadline, the IRS assesses the partnership with a penalty of $220 PER PARTNER PER MONTH until the return is filed.


Once you’re in a partnership, it’s tough to get out. Remember how great 1031 exchanges are? Well, with partnerships, you may lose that benefit altogether. The entity that sells a property MUST be the same as the entity that invests in the new property through an exchange. That means that you can’t take just your own proceeds from a partnership sale and use them for a 1031 exchange. If you want to do a 1031 exchange from a partnership, the partnership itself must do it, which means the partners must agree to it.


Bonus: Concentration

You didn’t really think I’d stop at 5, did you?


Last mistake I want to mention - lots of real estate investors like a certain type of real estate and a certain geographical area. This often results in someone owning a bunch of similar property types, of similar quality, all in the same area. 


Sound like you? You might have a concentration issue.


You may want to consider branching out with your next property purchase or using one of the properties you currently own to do a 1031 exchange into a different kind of property (or DST). Diversification is key in investing - it lowers the amount of risk you’re taking for the amount of return you get.


Conclusion

Real estate can be a great investment. Make it even better by being prudent about your strategy and doing tax planning. If you feel like you could level up the financial and tax side of your real estate investment journey, schedule a meeting with me, using this link.

 

As always, keep in mind that you don't have to go it alone. I’m Austin Preece, a financial planner in Eau Claire, Wisconsin, and I work virtually with people across the US. Check out my website to see what it's like to work with me and reach out if you have any questions.


If you found this post helpful, help spread the word! Share with friends and family that you think may benefit as well. But remember, this is solely for educational purposes - it's not advice.

26 views0 comments

Recent Posts

See All

Traditional or Roth - Which is Better?

Here's the REALLY short answer: It depends. Less short answer: If you expect your tax rate to be higher when you use the funds, you should probably contribute to a Roth. But if you expect your tax rat

The Peril of Social Security

There’s been more and more talk about Social Security and its feasibility recently, as we get closer and closer to the mid-2030s when the trust fund is scheduled to run out. I’ve been vocal on this po

How Do I Pay My Advisor

One of the problems in the financial advice industry is a lack of transparency around pricing and how advisors get paid. It can be complicated, but I’m going to try to make it simple. There are three

Comments


bottom of page