This article was published in the May 2025 issue of the Traverse City Business News and can be read in its entirety below. Black Walnut Wealth Management contributes articles and is featured in various media outlets.
Investing in real estate has long been a reliable way to build wealth and can effectively diversify your overall investment portfolio. Based on our experience, buying or selling real estate necessitates a thorough analysis of various financial aspects, including financing options, cash flow analysis, tax considerations, and how these decisions align with your overall financial planning goals.
Many of our clients with real estate investments typically fall into one of two categories:
- Planning to Buy. They own a primary residence and are planning to purchase an additional property in a warmer climate, such as Florida or Arizona.
- Planning to Simplify. They own multiple residences or investment properties and have decided to simplify their lives by downsizing, reducing the burden of managing several properties.
Considerations When Buying
When thinking about acquiring a second home for retirement or as a rental investment property, it is essential to assess how this second home will affect your annual lifestyle budget and the overall costs associated with investment real estate. Some aspects to consider:
- Financing: Options include refinancing the primary mortgage, opening a Home Equity Line of Credit (HELOC), outright purchase, or a conventional mortgage. Consider the cash flows involved and how self-funding or loan payments might affect the overall financial situation.
- Interest rates: Interest rates and the terms of financing are critical factors in analyzing the viability of the purchase. Even half a point on the interest rate may be the difference as to whether a property is affordable or if the rental will be “cash-flow positive.”
- HOA, insurance, taxes, and other expenses: Many second and retirement homes are purchased in exclusive communities where the burden of property maintenance is outsourced. These conveniences come at a cost and fees tend to rise each year. Insurance in warmer climates and coastlines is expensive and property tax assessments have risen substantially. Between 2019-2023, insurance coverage in Florida has risen 60% and some insurers have canceled coverage altogether. There may also be travel costs or property management expenses.
- Legal titling: Consider alternative titling for the additional property, such as a revocable trust to avoid dual-state probate issues or holding rental property in an LLC to avoid personal liability risks. These are important legal questions best answered by a qualified attorney.
Considerations When Selling
For those looking to downsize or simplify their lives, it is essential to carefully analyze the tax implications involved. Strategies to minimize taxes, as well as considerations for special tax issues and other selling costs, should be discussed well in advance of the sales process.
Depending on future objectives and in collaboration with your financial and tax advisor, it may be possible to defer or even eliminate taxes entirely.
Strategies may include:
- Strategic use of the residency exclusion: If you’ve declared the property as your residence for any two of the previous five years, you (and your spouse) may exclude up to $250,000 each in capital gains from taxation. The rules are specific, but with careful documentation and planning, the tax savings could be substantial.
- Depreciation and other deductions: With rental real estate, annual depreciation deductions taken are brought back in the final tax calculations for the sale of the property. Figuring these into the sales analysis is critical to avoid surprises. Past improvements to the property may raise the cost basis (and lower capital gains), so keep records of these expenses.
- Utilizing a Section 1031 Exchange Election: Simultaneously selling and buying similar-type investment property may defer capital gains taxes on the sold property using this tax strategy. 1031 rules are strict, so it’s critical to work with your advisor, tax professional, and a “1031 specialist” to coordinate the sale and purchase and to maintain compliance with the criteria.
Additional Considerations
While the financial and legal aspects of real estate should be a priority, it’s also important to consider other factors that can impact your potential investment. These factors include location attributes, property type, and your overall game plan and exit strategy. These are crucial criteria to keep in mind when making your decision.
Seek Professional Help
Navigating the complexities of real estate investing, especially when trying to align it with your overall financial strategy, can be overwhelming. A wise first step is to seek professional guidance from a fee-only CERTIFIED FINANCIAL PLANNER® and a tax advisor. They can help you determine which strategies will be most beneficial for your individual situation and goals.
