Before you can build wealth through real estate, you'll want to understand the fundamentals. Wealth is generated by four primary factors, whether you're buying your first home or your hundredth. You'll want to understand how these four wealth generators work to build the greatest amount of wealth possible with your real estate investments:
The difference between how much money comes in and how much money goes out each month is called 'cash flow'. If the difference is positive, this is called 'positive cash flow'. If the difference is negative, this is called 'negative cash flow'. How do you build positive cash flow? There are two primary strategies: increasing the amount of rental income a property earns, and decreasing the expenses required to maintain a property. The more positive cash flow a property generates, the greater your return on investment. Cash flow through real estate is often labeled 'passive income', though most pros understand that real estate investing is never 100% passive. If you're looking to offset your W2 income and become financially free, working toward a monthly cashflow amount is a great place to start. However, if you're looking to build wealth, number two on our list is the primary operator...
When you invest in something with an intrinsic value that rises over time, you're building wealth through appreciation. Appreciation comes from investing in things like real estate, but the same rules apply in the stock market -- both of which have a historical track record of increasing in value on average over the long term. You can't predict whether or not an asset will go up or down, but in real estate, it's often the safest bet.
But unlike stock, real estate is a flexible asset, and you can very well force appreciation through renovation. A simple kitchen upgrade can add thousands of dollars to the value of your home.
The money that comes out of your pocket every month to pay your mortgage is called loan paydown. Let’s say you take out a 30-year, $300,000 mortgage at 5% interest (a common situation). If you make the monthly payment of $1,212.02 and never make any additional principal payments or pay down the loan in any other way, your loan will be completely paid off in 360 months—30 years. In that case, you would have made a total of $332,690 in interest payments before repaying the full amount borrowed. If you add a monthly principal payment of $100, however, you will have the entire loan paid off in only 240 months—20 years. The point is that paying down a long-term loan -- especially a mortgage -- is one of the most effective ways to build wealth. When you enlist others to pay down your mortgage for you, as is the case with rental properties, you can see how this could be a very powerful strategy.
These include deductible mortgage interest and property taxes, tax-deferred exchanges, and depreciation deductions. These benefits can add up fast for those who have several properties in their portfolio or are involved in multiple real estate transactions.
Here's a common example:
The 1031 exchange allows you to exchange the equity in one property for another without paying taxes on it. Each year, thousands of people defer hundreds of millions of dollars' worth of capital gains using this strategy. If you're selling your primary residence and have lived in the home for 2 out of the last 5 years, you can exclude up to $250k in capital gains from your taxes.
In an extremely effective tax strategy, you might use a certain portion of cash flow each year for tax-deductible home improvements. Then your house becomes more valuable and you get bigger depreciation deductions when you sell it down the line.
It's important to note that these benefits are subject to restrictions and limitations, so make sure you understand all the rules and speak with your tax advisor.
Let's say you buy your first rental property. Let's take a look at your financial journey, considering these four wealth generators:
Over the year, you've put $2400 in your pocket through monthly cash flow. You've built up your home's equity by paying down your loan to the tune of around $1500. And, you've also seen appreciation over the year of $6k, netting you a grand total just shy of 10k!
You've also seen some massive benefits through tax deductions. You can deduct interest on your monthly payments, and you can also deduct the interest on the portion of your mortgage that goes to paying down the principal. In other words, if you have an $80k loan at 4%, but you've managed to pay it down so only $40k is left at this point (a 50/50 mix), then you only pay interest on $40k. This means you can deduct half of the 4% or 2%.
The more rental properties you acquire, the more cash flow you make, the more equity you build up in your homes, and the greater tax benefits pile up too.
Now, if you do this for 10 years, you'll have $100k in equity in your home, you will have paid down more than $33k on your loan (a 60/40 split), and you will have saved almost $4200 through tax benefits.
Now, let's imagine you don't stop there. You have a little money on hand from the cash flow, enough to put 20% down on another property.
So you do it! You buy a second rental property for $100k and you pay it off over 30 years at 4%. At the end of 10 years, this one will be worth around $154k and your total portfolio value will be around $154k + 100k = $254k.
Now, your equity in home worth is just shy of 200k and you have almost double the amount on your loan as before at 33.3k. You also have saved over $7200 from tax benefits, giving you more wealth generators to invest with!
You can see where this is going, right?
The more rental properties you acquire, the more cash flow you make, the more equity you build up in your homes, and the greater tax benefits pile up too. The real magic of this is that these are all passive income streams (wealth generators) that continue to grow even while you sleep! Once you build momentum, the money will come faster than you have deals to spend it on.
With a handful of deals under your belt, you can be well on your way to your first 1 million and to financial freedom!
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