A lot of investors are asking me why they should invest in real estate right now when they can take advantage of higher returns on Treasury bills (10-year is around 4.12% at the time of writing) and other fixed-income investments. This is a great question. I often get into discussions about risk and what is the ‘safest’ investment. But one item still leans heavily to real estate: the tax benefit.
With the help of the Wall Street Journal article, ‘Investors Are Finally Making Money on Bonds and CDs. Be Prepared to Pay Taxes,’ I would like to call out the tax burden on the bonds and fixed-income assets we typically discuss during these conversations. Here are the tax details on various fixed-income investments.
Investors flocked into inflation-adjusted U.S. savings bonds last year when they were earning a 9.62% annual rate, and they’re still buying them even though the rate is now 4.3% for new purchases. There are no state or local taxes on the interest earned, which benefits investors in high-tax states. Generally, I bonds aren’t taxed at the federal level until you cash them in. At maturity, the interest accumulated over the years is taxed as interest income at regular tax rates, not long-term capital gains.
Certificates of Deposit
Interest earned on CDs is taxed as ordinary income at the federal and state level, typically in the year you earn the interest. On a five-year CD, for example, you’d owe taxes on the interest earned and paid out each year.
Money-market funds can be subject to federal and state income taxes. There are taxable money-market funds and tax-free money-market funds, depending on the underlying investments in the fund.
Treasury bills are generally exempt from state and local taxes. You’ll owe federal taxes as interest payments roll in each year when you file your federal tax return.
Income from bonds issued by state, city and local governments is generally free from federal income taxes and from state income taxes in the state where the bond was issued. For example, if you live in Arkansas and have an Arkansas bond, it would be tax-free, but if you live in Arkansas and have a Missouri bond, you’d owe Arkansas income tax on it.
However, municipal bonds and their tax status vary from state to state, and a conversation with your tax advisor should be considered before investing.
Now, let’s look at real estate. We all know that real estate allows us to take advantage of depreciation to lower our tax liability. This is further enhanced by cost segregation and bonus depreciation, which we are still in the 80% window for 2023. This depreciation is on top of the other tax deductions that owning and operating real estate provide—costs associated with property taxes, repairs, maintenance, travel, and legal and management services. Further, I don’t remember ever reading that the IRS allows you to ‘1031’ from one T-bond to the next to help reduce your tax burden. The point is, real estate is more advantageous in the first few years of distributions because of accelerated and bonus depreciation and at the time of disposition because of the 1031 exchange.
The important thing is to make sure you understand the tax burden before you make any investment. Don’t get me wrong, there are multiple other reasons to invest in these assets. In fact, I just invested more money into the PassiveInvesting.com Real Estate Debt Fund because of the consistent eight percent monthly return, diversification, compound interest, and liquidity options. But I do this with complete knowledge of the tax burden. If you are considering getting into these types of assets, make sure you speak with a tax professional to understand how these assets will impact you.