For many investors, real estate is coveted, highly attractive — and uncomfortably unfamiliar.
Although it’s widely accepted that a strong real estate investment has the potential to generate considerable wealth, until recently relatively few investors had the chance to acquire first-hand experience with the asset class. And despite its many advantages, real estate can be a complex investment. With today’s wide availability of opportunities, it’s as important as ever to know how to approach all types of real estate investment methods — both active and passive, from rental properties to public REITs to Fundrise.
Shrewd investing starts with knowing how to ask the right questions. That’s where this article can help. No matter which method you plan to use to put your first dollar toward real estate, these are questions you should consider beforehand. By studying the points and potential pitfalls outlined here, you can learn some of the crucial ways to assess an investment before committing your hard-earned cash.
Let’s start with questions that every prospective real estate investor should think about, no matter what kind of investment model they’re considering.
There are major differences between active and passive real estate investing, and most investors will have a clear inclination for one over the other. However, if you’ve just started to think about real estate generally, you might not have figured out exactly where your preference lies. Once you do, you’ll likely identify which option best suits your situation — or you might recognize that one model is simply not feasible or economical for you. For example, love the idea of being a landlord? Look at active options. Alternatively, simply don’t have the time to deal with properties and tenants first-hand? Consider passive investments. Those decisions can have an immediate impact on the specific investment you pursue, and how much it costs for you to get started.
Defining a timeline, or investment horizon, is crucial for any investment, though some kinds are particularly illiquid (which isn’t necessarily a bad thing!). That makes identifying a comfortable timeline even more important when it comes to real estate investing. Make sure you know if and when you’ll need liquidity and, if so, whether the investment can support your particular needs.
Read More: The Benefits of Illiquidity
Both active and passive real estate investments can offer tax advantages, but the exact tax benefits available to investors depend on the investment.
For example, on the passive investing side, thanks to the Tax Cuts and Jobs Act, income earned from pass-through structures, such as REITs, can qualify for a 20% tax deduction.
The Tax Cuts and Jobs Act also established the Opportunity Zone Program, which allows both active and passive real estate investors to invest in Opportunity Zones through Qualified Opportunity Funds. Opportunity Funds offer many capital gains tax incentives to investors, including a way to defer and reduce capital gains taxes for funds invested into Opportunity Funds – and they provide a way to eliminate taxes for any capital gains earned from Opportunity Fund investments.
On the active investing side, a 1031 Exchange offers investors a way to defer capital gains taxes on their initial investment indefinitely. While a 1031 Exchange doesn’t let an investor reduce their capital gains tax liability, it can offer a step-up in basis upon inheritance. This feature has made it a useful tool for estate planning for some active real estate investors.
Each set of tax advantages can help an investor achieve a different goal. That’s why it’s important to determine which tax advantages best help you meet your investment goals.
One of real estate’s most renowned benefits is its capability to diversify a portfolio. But not all diversification is equal. Make sure you understand exactly how the addition of a new investment will impact the overall risk and earning potential of your investment situation. For example, whether an investment is in the public or private market can play a huge role in its power to diversify.
“Money!” might seem like the obvious answer, but responses can differ as much as people themselves. For some, an adrenaline-pumping fix-and-flip is their first choice real estate scenario, while others want to stay as far away from hands-on work as possible. Knowing what matters most to you in an investment will help you determine a clear view of what success in this investment can look like. It will most likely involve a return goal, but will it include any other aspects, benefits. or responsibilities?
Read More: How do you define wealth?