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Backdoor Real Estate

Steve Abramowitz

“I’VE GOT SOME REAL estate here in my bag,” croons Paul Simon, as he consoles his lover in the iconic 1968 song America.

The real estate industry’s marketing arm couldn’t have put it better. The industry’s message: If you want to feel secure and be prosperous, get yourself some real estate.

Problem is, many people can’t come up with the down payment for a home or rental property. The good news: There’s an alternative to direct ownership. Often referred to simply as REITs, real estate investment trusts are part stock and part real estate. Each REIT is a company that owns and operates perhaps 25 or more rental and commercial properties across the country.

In their early days, REITs were confined to an arcane corner of the stock market. But they’ve achieved a certain pedigree by virtue of their designation as a separate entity of the S&P 500. If I were starting over, I would undoubtedly supplement my privately owned real estate with REITs.

REITs don’t require a down payment or even a minimum initial investment. Subsequent purchases can be made in any amount and on your own schedule, which can be a boon to investors who fund their retirement accounts through dollar-cost averaging. Nor do REITs have to be bought and sold in one swoop. Say you need some quick cash. Instead of suffering through open houses and contract negotiations, you could simply sell a few REIT shares.

Here’s where REITs become not just an acquaintance but a staunch ally in your quest for financial independence: When you buy or sell by pressing a few buttons on your online brokerage account, you incur no commission. That’s right, zero commission and fees regardless of the size of the transaction, though you will lose a little to the bid-ask spread. This staggering advantage to REIT ownership has lured many investors, including those who could otherwise afford the down payment needed for a direct real estate purchase, to instead plunk for REITs as a hassle-free alternative.

Imagine this scenario: You want to sell your small duplex for $500,000 and an eager buyer snaps it up. Pretty awesome, right? But don’t forget to deduct the standard 6% sales commission, equal to $30,000, and closing costs of maybe 2%, or $10,000. So you walk off with $460,000, right? Not quite.

Remember that roof repair and all the primping necessary to get the duplex in shape to sell? There goes another $10,000, reducing your take to $450,000. Still quite an accomplishment. But if instead you’d sold $500,000 of REIT shares, you would have no commission, no closing costs and no annoying pre-sale expenses. You would keep all of the $500,000, the whole enchilada.

Another consideration: Do you have boundless energy and outrageous free time? Are you steeped in the legalese of local rental regulations? Will you have a meltdown when it’s raining and your prospective renter is a no-show? Investor, know thyself. If you just cringed, take refuge in real estate investment trusts.

Okay, so what’s the catch? How risky are these REITs? All investments carry risk and REITs are no exception. But large REITs are only about as risky as the broad stock market and both have averaged about 11% annual returns over the past 10 years. But beware the year-to-year swings. You should be prepared for at least one 30% up and one 30% down year during the next decade.

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To neutralize the possibility that one bad apple could be your undoing, consider an exchange-traded fund that focuses on real estate companies. Since each REIT already owns a large number of properties, investing through a fund provides exceptional diversification across many different property types and locations.

The taxman looks kindly on both REITs and direct property ownership, though the tax breaks bestowed on in-person investors are usually thought to be superior. But these benefits are sometimes exaggerated. Take the vaunted depreciation deduction. Sure, private property owners get to take it on their tax return, but it’s ephemeral and must be paid back when they sell. I know, I know, it’s still a no-interest loan and it will receive capital gains treatment, but depreciation is not the boondoggle it’s often made out to be. And besides, do you really think all those buildings held by REITs are not being depreciated?

Every so often, the price of a single privately owned property takes off, but things can also go the other way. The fact is, the returns from direct investments are less predictable than those from REITs. They’re dependent on the landlord’s real estate aptitude, unforeseen developments and just plain luck.

Should inexperienced mom-and-pop investors dig deeply into their life savings to buy one rough-and-tumble piece of local real estate, or instead reap profits from hundreds of properties reaching from coast to coast and managed by industry experts with their own skin in the game? Should you hedge your bets across the two strategies? These are knotty questions that call for professional consultation.

Investing in real estate through REITs does not confer bragging rights. You won’t have a grand Victorian to show off. But as a longtime landlord who currently owns a dozen properties, let me remind you of the upside of hands-off real estate investing: You’ll be able to enjoy a life unfettered by late-night phone calls, deadbeat renters and legal nightmares.

Steve Abramowitz is a psychologist in Sacramento, California. Earlier in his career, Steve was a university professor, including serving as research director for the psychiatry department at the University of California, Davis. He also ran his own investment advisory firm. Check out Steve’s earlier articles.

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Marla Mccune
Marla Mccune
2 months ago

I agree and now have a small amount of XLRE ETF in my ROTH account. I hope others do NOT make the expensive mistake I did though by falling for non-publicly traded REITS. I was misled about by a corrupt advisor and am now stuck with hundreds of thousands in non paying REITS which I can not liquidate since 2016.

Last edited 2 months ago by Marla Mccune
steve abramowitz
steve abramowitz
2 months ago
Reply to  Marla Mccune

Hi Maria

Thanks for reminding everyone about how fraught with sharks is the investment advisor industry. Most of us have likewise fallen prey at one time or another and can commiserate with you. You are not alone.

parkslope
parkslope
3 months ago

I don’t know that capital gains and recapture depreciation taxes should be considered ephemeral. As I assume you know, both are currently excluded from inheritance taxes and can be deferred in 1031 property exchanges. Biden did propose a $500,000 deferral limit ($1 million for couples) on 1031s that didn’t make it through Congress this year. A limit of that amount or higher may pass in the near future, but that will still be a nice break for those of us who are small rental property owners.

steve abramowitz
steve abramowitz
3 months ago
Reply to  parkslope

You make a good point, ephemeral was not a really fair word to characterize the deduction. I just feel that many small investors take it literally as a pure “deduction” rather than as a deferral and capital gains benefit and are then unprepared for the ultimate big capital gain at the sale. Yes, you’re right, it’s not insignificant but it is too often misunderstood. Not everyone is as aware of the nuance as you are!

James McGlynn CFA RICP®
James McGlynn CFA RICP®
3 months ago

Are you comparing REIT ownership to owning a home? If so the $250000 /$500000 cap gain exclusion for the home is more tax-friendly than the REIT income taxed at ordinary rates. Or are you specifically comparing investment properties?

steve abramowitz
steve abramowitz
3 months ago

very good point but, yes, I was comparing investment to investment.

T. V. NARAYANAN
T. V. NARAYANAN
3 months ago

I have invested in REIT index fund for many years. Looking back I feel that It might have been better to invest in index ETF. ETF costs are lower than index funds which may be an important factor over long periods.

Philip Stein
Philip Stein
2 months ago

Vanguard’s Real Estate Index Fund (VGSLX) and ETF (VNQ) have the same expense ratio, 0.12%. And since both funds are share classes in the same pool of assets, there doesn’t appear to be a significant advantage of one over the other.

steve abramowitz
steve abramowitz
3 months ago

You’re right about the cost advantage of the broad index ETF. The REIT ETF would give you a sector in a broadly diversified portfolio. Thanks for writing.

M Plate
M Plate
3 months ago

I figure the income they generate warranted a coveted spot in my Roth. Perhaps 25% Reits in my Roth.
The other 75% allocated to what I hope are growth stocks.

steve abramowitz
steve abramowitz
3 months ago
Reply to  M Plate

Also, REIT dividends do not get qualified status from IRS and are taxed as ordinary income. This disadvantage is completely bypassed in your tax-free Roth. Careful: I wouldn’t go beyond that 25% allocation, or your long-term portfolio becomes too heavy in one sector. Thanks for contributing.

wtfwjtd
wtfwjtd
3 months ago

I believe that REIT dividends are noted in the “Section 199a” box of Form 1099div, and they’re eligible for the 20% QBI deduction. But this is usually pretty modest for most investors, and really isn’t much to get excited about much of the time. And I definitely agree, 25% seems a pretty hefty allocation to REITs in one’s portfolio, especially given that their volatility often makes an S&P 500 ETF seem like a stable value fund. To each their own I guess.

M Plate
M Plate
3 months ago
Reply to  wtfwjtd

A little clarification. 25% of my Roth….only. 401k, IRA, and brokerage accounts do not have this same allocation.

steve abramowitz
steve abramowitz
3 months ago
Reply to  M Plate

M Plate, cool, wanted to make sure just in case.

steve abramowitz
steve abramowitz
3 months ago
Reply to  wtfwjtd

Good catch! But that’s really only a small part of the story. The majority of REIT dividends are taxed at the ordinary income rate up to 37%. Yes, 20% can be deducted as qualified business income through December. Still, for many people the overall rate would come to about 30% as compared with 20% for qualified dividends. Perhaps not a huge difference, but maybe enough for some folks to hold REITS in nontaxable accounts. Thanks for helping me clarify this for everyone.

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