Taxes and Other Implications of Real Estate Investing for Retirement

Two of the biggest concerns of those who are investing for retirement are not running out of money and maintaining regular cash flow. It can be difficult to switch from a bi-weekly paycheck to carefully timed withdrawals from a retirement account.  Market fluctuations cause balances to rise and fall, leaving an investor with less in their account than they’d planned. 

These are the reasons that some investors consider real estate investments for retirement. A multi-family property yields regular, monthly income similar to a paycheck. Home values typically don’t fluctuate wildly and over time show appreciation. But what are the deeper implications of real estate investing for retirement?

Pros of Real Estate Investing for Retirement

Five thousand dollars in rent, deposited into your bank account every month, can easily take a salary’s place. One of the biggest pluses to real estate investing for retirement is passive income. Tenants pay monthly rents and you can use that income to fund your retirement.

If you can’t afford to pay cash for your investments, you’ll have a monthly mortgage payment. But, depending on your down payment, it could be quite small.  Protecting your cash reserves is important in retirement, so if you’re not fully comfortable purchasing properties directly, look into real estate investment trusts, or REITs.

Before deciding to invest through a REIT or partnership, talk to a Registered Investment Advisor or RIA with deep knowledge of real estate investing. They can outline the risks and rewards of each type of indirect real estate investment available to you, and guide you to one that fits your needs.

With a real estate investment, you’ll have more control over its appreciation. Stock prices rise and fall for reasons entirely out of your control. If a CEO makes a poor investment or an acquisition falls through and your portfolio loses so much value that you have to touch principal that quarter. But with a property, you have more control.

Make improvements to the structure, or add some landscaping or a new roof, and your property’s value rises.  If you have creditworthy tenants who pay on time and schedule regular rent increases to keep pace with inflation, your property will continue to appreciate in value.

You can also decide on when to sell if home values rise sharply in your area and you want to cash in the equity. If you pick the tenants, you control the people living in your building. And you decide how much of your retirement funds you want to put into property and how much you invest elsewhere.

Diversifying your retirement portfolio protects you against stock market crashes or economic downturns. After you’ve put money away in a 401K, then what? Adding real estate to your retirement plans helps diversify your portfolio and hedge against risk.

Cons of Real Estate Investing for Retirement

Properties have to be managed. From collecting rents to managing tenants to snow removal, a real estate investment isn’t one that is maintenance-free.  In a way, building a retirement portfolio around real estate investments ensures that you’ll never actually retire.

A way around this is to hire a property management company. A property manager handles the administrative duties of properties. They collect the rent, they arrange for repairs, and they contract for lawn care and snow removal. But not all property managers offer the same level of service.

You will have to interview prospective management companies, and check references.  And since it’s not a great idea to be a completely hands-off landlord, you’ll have to monitor the property manager’s performance and periodically review their service. This means that, in the midst of your golden years, you could be firing and hiring a new company.

Property manager fees range from 2—5% of the monthly rents or they charge per-unit.  When putting together a retirement plan, build these fees into your costs. The problem is that price increases can be unpredictable, and if you switch managers your fees could jump. Many property managers also charge a mark-up on repairs, up to 50% of the repair’s total cost.

Which is another con of real estate investing for retirement – repairs. Homes and buildings must be maintained. Furnaces will need servicing or replacing, roofs could take storm damage and need to be replaced, or tenants kick holes in the wall or break windows.  Most experts advise setting aside 1-2% of your monthly rents for repairs.

Unlike retirement investment accounts, whose fees increase at predictable intervals and rarely for huge amounts, one bad year in a real estate portfolio could wipe out all your profits. And leave you with nothing to cover living expenses. If you do decide to fully or partially invest in real estate for retirement, evaluate the building’s condition and build major repairs into your long-term plans.

Vacancy rates can also become an issue. No property will remain rented 365 days a year. Plan on a rental vacancy rate of at least 10%, and keep an eye on trends in the area where you invest. It would be a bad idea to budget to use all of your rental income for your retirement living expenses. Save a little each month for both repairs and to cover the mortgage if the property becomes vacant.  

Property taxes are another negative to investing in real estate. The flip side of price appreciation is property tax increases which could cut into your profit margins. Special levies and city assessments could also cause your property taxes to increase, and you can’t always predict them. Some cities also charge different tax rates for non-owner-occupied properties.

When deciding whether or not to invest in real estate for retirement, carefully consider the pros and cons and crunch the numbers. Enlist a tax professional to help you structure your portfolio to keep the most money in your pocket.

Other Considerations when Thinking About Real Estate Investing for Retirement

Real estate investing isn’t easy, and investors considering this for retirement should think about how much time they have to put into their investment plan. Even if you hire experts to help you narrow down the best locations and properties for your investment, you should take the time to educate yourself about the local real estate market.

Most investors will want to visit the properties they’re thinking of acquiring, which could require travel. And there are other costs to acquire the properties in your portfolio. To even start real estate investing on your own you’ll have to pay home inspectors to examine your properties, real estate agent commission fees, mortgage fees, and points and closing costs. One of the downsides to real estate investing for retirement is the time and money it takes to ramp up a portfolio that’s broad enough to support your retirement goals.

The amount of money you have to invest could limit your real estate investing dreams. A 20% down payment on a rental property could be a good portion of your cash on hand. Don’t forget that commercial lenders charge higher interest rates and sometimes require larger down payments, too.

This is why it’s a good idea to start early before you need to live off the income generated by your investments.  You can roll the income you make in the first few years into acquiring other properties or paying down the mortgages on your existing rentals.

This is one of the reasons that many experts advise starting early and building your portfolio slowly. Don’t wait to start buying properties until one or two years pre-retirement.  Give yourself time to build a portfolio and learn the ropes of being a real estate investor.

Before you make any large investments for retirement sit down and talk to a financial professional and your accountant about your financial health and the tax implications.

Tax Implications of Real Estate Investing for Retirement

When calculating your profits and returns, don’t forget to deduct money for taxes. If you purchase property in an LLC or as an individual, the income will be taxable. It counts as ordinary income, and will for the entire time you own the property. Your age and retirement status has no impact on this, which is a downside to this form of investing for retirement.

Many retirement fund withdrawals are either fully or partially taxable, but in some cases only the gains are taxed.  Money withdrawn from a ROTH IRA is non-taxable as long as you meet withdrawal requirements related to age and the length of time you’ve had the account. High-net worth individuals should carefully balance their retirement portfolios to best manage their tax burden.

To avoid paying taxes on your rental income, talk to your tax advisor about investing through your IRA. Deducting depreciation and the above-mentioned costs associated with rental properties can also help reduce your tax burden.  

In conclusion, while real estate investment for retirement can bring in a steady income stream, it’s not without its drawbacks. Always talk to professionals before making a large change to your retirement investment strategy to make sure that you’re set up for success.