Owning investment property is a tremendous wealth building strategy. Thousands upon thousands of individuals have amassed great wealth by investing in rental properties.
Unfortunately, few investment property owners learn how to leverage equity in a way that maximizes tax deductions while creating and locking in equity gains. Instead, they leave themselves open to price fluctuations in the residential property market. These fluctuations can wipe out or severely reduce equity positions in property.
Housing Boom To End?
There is little doubt we are coming to the end of a huge boom market in residential properties. For the last four years, properties have appreciated at unheard of rates. The question, of course, is what happens when the market cools off? Will we simply see a price plateau or an actual drop in prices? While nobody is sure, the clear consensus is property owners should move to preserve equity while they can.
Protecting Equity Gains
Protecting equity gains in your investment property requires careful planning. This leveraging strategy is fairly simple, but can sound complex. Please keep in mind this is just an introduction to the investment property tax strategy. You will need to contact us to learn more.
The investment property tax strategy protects your equity gains by separating and leveraging them. The leveraging process is best explained with an example.
Scenario 1: Without Tax Strategy
Assume you purchased a rental property in 1999 for $250,000 with nothing down. As of July 2005, the combination of loan payments and appreciation has resulted in a gain of $250,000. You have amassed wealth, but all of it is at risk. If prices drop twenty percent over the next year, you will lose $100,000 of your equity in the rental property.
Scenario 2: With Tax Strategy
We are going to use the same exact scenario. It is July 2005, you have $250,000 in rental property equity, but all of it is risk. You decide to implement the investment property tax strategy and the following occurs.
Our goal is to protect the $250,000 in gain on the rental property while also maximizing tax reductions. The first step is to refinance the property with, typically, an interest only loan. A percentage of the equity gain is taken out of the property and placed into an equity index insurance product. The equity percentage is arrived at by determining the payment amount you can afford on the loan. Typically, it is tailored to match your current loan payment amount.
Going back to our scenario, what happens if property prices pull back 20% over the next year? You do not suffer the loss of $100,000 because the gain is sitting in your equity index insurance product. Essentially, it is a wash and you have protected the capital gains while capturing a stock market-based rate of return.
Ah, but it gets better.
Equity Index Insurance
The investment grade insurance product isn’t just any policy. Instead, the policy we use is tied to a stock market index. What if the stock market suffers a loss? Not to worry, this policy carries a guarantee that you will never lose a dollar, even if the market crashes. If the stock market did crash, the policy would simply credit you with nominal growth for the year in question. In all other years, the policy would grow with the stock market. On top of all of this, the money in the insurance product grows tax-free.
So, what has been accomplished? First, you have protected your rental property equity gains from home price fluctuations. Second, you have leveraged your equity into two growth channels, the stock market and appreciating house prices. Third, you have converted taxable growth [property appreciation] into tax-free growth [insurance].
With housing markets ready to cool down, this strategy effectively locks in your profits. Preserving equity gains should be a primary goal of any investment property owner.