Should you sell long-term stocks for a real estate investment?
I walk through one listener’s question and explain what you need to consider before making such a decision.
Aside from the obvious–is it a good financial investment–you also need to consider if it's a good emotional decision.
Learn:
➡ The tax implications: how are capital gains taxed differently?
➡ How to compare the dividends of a bond to those of a property investment
➡ What important factors and questions need to be carefully accounted for
Questions Answered:
When does it make sense to sell long-term stocks for real estate investments?
How can you determine the “dividends” of a real estate investment?
Timestamps:
0:00 - Trade stock for real estate?
2:55 - Calculate yield
6:39 - Consider net operating income
9:15 - Other considerations
12:36 - Calculate taxes
18:57 - Quick summary
Create Your Custom Strategy ⬇️
Should you sell long-term stocks for a real estate investment?
I walk through one listener’s question and explain what you need to consider before making such a decision.
Aside from the obvious–is it a good financial investment–you also need to consider if it's a good emotional decision.
Learn:
➡ The tax implications: how are capital gains taxed differently?
➡ How to compare the dividends of a bond to those of a property investment
➡ What important factors and questions need to be carefully accounted for
Questions Answered:
When does it make sense to sell long-term stocks for real estate investments?
How can you determine the “dividends” of a real estate investment?
Timestamps:
0:00 - Trade stock for real estate?
2:55 - Calculate yield
6:39 - Consider net operating income
9:15 - Other considerations
12:36 - Calculate taxes
18:57 - Quick summary
Create Your Custom Strategy ⬇️
Welcome back to the Ready for Retirement podcast. Today's question comes from a listener who's wondering if they should sell $450,000 worth of stock to purchase a vacation rental with potential $60,000 of annual income. It's a big decision with potentially serious financial and lifestyle implications. So before they trade their stock for real estate, we need to dive into the necessary analysis to see what benefits them most in long run. So I'll come up next on today's episode of Ready for Retirement. Today's question comes from a listener named Jim. Jim says would it be wise to cash in my long term stocks to buy a vacation rental home? It would cost approximately $450,000 with a potential yearly income of $60,000. Our current combined income is less than $60,000 and we are both retired receiving social security and small pensions. Also, what are the tax implications of selling the stocks? Thank you for any advice, jim. Thank you for your question. I do want to be clear anything I ever provide on this podcast should never be construed as advice. It is just for illustrative purposes only. But what we can do is take your question, provide some generalities and provide a framework of how to potentially think about this so that you can make the right decision for you.
Speaker 1:There's always two things that I like to look at when it comes to purchasing real estate. Number one I want to ask is this a good financial investment? And number two I want to ask is this a good personal investment? Because sometimes when someone purchases a real estate, specifically if it's something like a second home or vacation home, they often want to know is this a good financial investment? And sometimes we'll run the numbers and we'll say, no, this is a horrible financial investment, but you should do it anyways. And I say you should do it anyways because it would be a wonderful personal investment. Maybe there's a new family tradition, you want to start there. Maybe you're moving closer to family and you want to have a second place back where you currently live because you love the area. Maybe you love spending time by the lake and you want to get a second home there. So these are just examples I'm coming up with where, if you run the numbers and it's truly just a second home, it's more of a liability than it is an asset in many cases. So it's a horrible investment but can still be a wonderful personal investment, provide many personal dividends or happiness dividends when you look at what it could do for you.
Speaker 1:I'm taking this from Jim's question, he says a vacation rental. So I'm assuming not a place for he and his wife to take vacations, more as a rental property that they would use as, like, a vacation destination for a lot of people. So that's the framework that we're going to look at it through today. But I do want to be clear there are cases where a piece of real estate or buying real estate can be a bad financial decision when you compare alternatives, but can still be the right thing to do if it aligns with your own personal financial goals. So let's go back to Jim's question. He said would it be wise to cash my long term stocks to buy a vacation rental home? Well, in this case Jim's case, as I mentioned it does appear to be more of a financial question. So more is this return on investment better in real estate versus what I could potentially get in stocks? So I'm going to look at it through that framework. Here's how I would start.
Speaker 1:Real estate investors if you're listening, you're going to probably cringe, because this is not how real estate investors value a project or an investment. They like to look at some target IRR, internal rate of return over some lifetime of an investment. But in retirement people want to know a very simple question what's the cash flow that I can expect from this? What's the income I can expect from this compared to the income I could maybe expect from stocks or bonds or a CD or some other investment like that? So they really just want to know is this going to create enough income to justify the investment, which is a pretty simple question. That's the framework that I'm going to look at it through.
Speaker 1:Here's how I would look at that, this investment. I'm going to assume Jim's numbers are accurate. So assuming $450,000 is the purchase price and assuming $60,000 per year is the income that could be generated. What I do right off the bat is I divide $60,000 by $450,000. What that gives you is a cash yield. Think of it almost like the dividend that a stock would pay you If you own a stock. That stock could increase in value. It could also or it often does pay you a dividend. So a cash dividend because you're an owner of the company. Same thing with a bond. If you own a bond, you own the asset value. You also receive interest payments. So I like to know what's the interest this bond is paying? What's the dividend the stock is paying. In the same way, I want to know, in a way, what's the dividend this piece of real estate is paying. So it's the yield on this. Well, $60,000 per year divided by a $450,000 investment, that's a yield of 13.3%. So, assuming Jim could consistently get that, it would be like the equivalent of owning a stock that paid you 13.3% per year as a dividend.
Speaker 1:Assuming the property value stays stable, it's a pretty nice return For perspective. Historically, the S&P 500 has grown by about 10% per year. No guarantee it's going to do that going forward, but that's historically what it's returned. Small company stocks in the United States have grown by about 12% per year. Again, no guarantee that's what's going to happen going forward, but that's what they've done historically.
Speaker 1:So as you start to look at that, it's not a perfect apples to apples comparison, but it gives you a framework. The reason I say it gives a framework is because if you were going to purchase a piece of real estate and the total return, for example, is maybe going to be 7%, I would look at that and say why would I own something that's going to be less diversified, require more of my time and energy, have more risk in certain ways and accept a lower long-term rate of return when I could just go own the entire US stock market and, historically speaking, it's delivered a superior return. So when you use that as a starting point of a true passive investment like the US stock market not saying it's a perfect apples to apples comparison, but it's what I like to look at as a starting point to say, is this investment even worth considering, yes or no? In Jim's case I would probably say yes, 13.3%, just cash return, assuming his numbers are giving me turnout. To be true, that's very much worth considering Because then, let's assume, the property value also increases over time. Well, I have no idea what part of the country Jim is looking at buying this in, but let's just assume it's 4% per year average increase in that property value. Well, now what I would do is I would look at the 13.3% cash return plus 4% per year of appreciation. Now you're looking at a 17.3% return on this investment. Now that looks pretty good on paper, but, jim, here's what I would do next.
Speaker 1:Sometimes people stop there. So, my gosh, 60,000 per year on a $450,000 asset. That's a wonderful return and it is a really strong return. But what they haven't done yet is they haven't backed out the costs. It's kind of like a company that says hey, we're generating $1,000,000 a year revenue. Great, that sounds good.
Speaker 1:What are your expenses? Oh, they're $990,000. Now, not so great. There's only a little bit that's actually left over as net income. But we want to do the same thing with our rental income. What are some of the expenses?
Speaker 1:You might look at property taxes. I have no idea what part of the country Jim is considering buying this in, but let's just assume property taxes on a $450,000 property are $5,000 a year. Let's assume there's insurances or HOAs in that area. Let's assume that's $1,000 a year, which is a pretty low estimate. If there is an HOA, let's assume he hires a property manager. Again, this may or may not be the case. Maybe Jim and his wife are self-managing this. Maybe they're hiring a property manager. Typically, property management is about 6% to 8% per year. Let's assume that's a $4,000 cost for Jim to do that. Then let's assume there's about $4,000 per year of maintenance.
Speaker 1:By the way, I'm just making these numbers up. These numbers maybe are within the ballpark of what you could expect, but this is in no way supposed to be a hey Jim actually plying on these numbers. I'm just using these for the sake of running through an analysis here. What we would do is we would add that up. Add up property taxes, insurances, hoa, property management, maintenance, any other costs that you would be looking at within this to get what's called the net operating income. If operating income, or the gross operating income, is the $60,000, the net in this case would be $46,000. That's because all those expenses I mentioned add up to $14,000 per year. So, yes, $60,000 comes in.
Speaker 1:But I'm more concerned about, jim, what are you actually keeping, which, in this example, is $46,000. Well now, if we divide $46,000 by the property value of $450,000, the 13.3% cash return we were looking at previously, that now drops to about 10.2%. So again, the net operating income divided by the asset value. And, to be clear, that's still a very strong return if Jim gets that. But it is less than what we started looking at before. Now, add on potential home appreciation or asset appreciation, again assuming 4%, and Jim's back up at about 14.2% return on this investment. So, jim, to your first question what makes more sense?
Speaker 1:One way I'd look at it is what's going to return more to you. Thank you, the stocks that you have. I have no idea what stocks you have. I have no idea if you even just own stocks. Maybe it's a mix of stocks and bonds and cash. So I couldn't tell you what type of return you should expect from that because I don't know the composition of what you're holding. But historically the US stock market's averaged about 10% per year. So maybe use that somewhat of a baseline as to what you're projecting going forward, at least for this analysis, and then compare that to what's the return I could expect on real estate. Well, as we walk through that example there, just looking at your cash income and any potential price appreciation, you're probably looking at someone in the mid-teens.
Speaker 1:Based upon the analysis, which, admittedly, I made up a lot of those numbers they're not necessarily numbers from GEM, but that's pretty strong the closer you are to stock market returns or even underperforming stock market returns for me just doesn't make a lot of sense. Why would I accept a lower return for what's going to inevitably be more hassle, less liquidity, less flexibility by owning real estate than I would have in the stock market? Maybe that's just a personal bias, but that's the way I look at it. As you start looking at returns from real estate that say, okay, this is higher than the long-term average of the US stock market. This is higher than the long-term average of small company stocks in the stock market. Now you start to build a pretty compelling case to say, okay, real estate may be a strong investment that I want to use or want to access and invest in, as opposed to stocks I did mention. It's not a perfect comparison. There's pros and cons to both of these.
Speaker 1:One with real estate one of the main ways people build wealth in real estate is using leverage, whether intentionally or not. When you're buying a home, you're typically putting some money down, and so what you're getting is, if that home is appreciating and it's appreciating in a greater clip than you're paying on the cost to borrow, which is the interest rate. That's just enhancing returns. On the flip side, if you're owning real estate, it's going to probably be more time consuming more of your energy, more of your effort.
Speaker 1:A lot of clients on real estate Some of them is the best thing in the world. They love it. It's how they've built their wealth. It's how they intend to pass down their wealth. It's how they intend to live in retirement. Others can't wait to get out of it. Others have had horrible experience with tenants, horrible experience with just repairs, with things that need to happen from a maintenance perspective, and they're just looking for the right opportunity to get out of it. So that's something that's not universal. Some people love it, some people don't.
Speaker 1:So make sure it's not just the financial comparison that you're doing, but also understand do you want to be a landlord? Do you want to have a property manager? What's the contingency plan? If somehow you need liquidity from that part of your portfolio, well, if it's in stocks, you can sell it because maybe there's a health event or a big expense. If it's in real estate, you can sell it. But you may have to take a haircut if you have to sell it really quickly. So just understand the different pros and cons as you're making the decision. But the first thing I would look at, jim, in your case, is okay, what's the target rate of return? It's absolutely at a point where, to me, it makes sense to pursue that analysis even deeper, because it does have some pretty compelling numbers that might turn out to be quite worth it for you when you're looking at this big picture.
Speaker 1:The second part of this analysis is the tax side. So Jim mentioned, he said, my wife and I. We have social security, some small pensions. Our potential income is less than $60,000 per year. They're combined current income. So the way I'm taking it is pension and social security are providing that almost $60,000 per year, and then they have stocks on the side. I can't tell you that's exactly the case because I don't have a full picture of Jim's situation, but let's make that assumption. Let's also make the assumption that social security and pension are sufficient for Jim and his wife to live on, meaning they're not constantly selling stocks to free up more income.
Speaker 1:Here's what I would look at. Let's assume, jim, that your adjusted gross income is exactly $55,200. Show you in a second why he chose that specific number. But he said hey, it's almost $60,000. Now social security not all of its taxed under these income amounts. I would guess actually very little is taxed because of the way social security is. But I'm just going to assume, to keep things super simple, that Jim and his wife have an adjusted gross income of $55,200.
Speaker 1:For 2024, the standard deduction for people under 65 is $29,200. So what that means is, if you look at Jim and his wife, they have 55,200 of a just-a-gross income, back out 29,200 for standard deduction I'm assuming they don't itemize here. That leaves them with $26,000 of taxable income. Okay, why do I go through that? Well, I go through that because in 2024, if your income, if your taxable income, is less than $94,050, you don't pay any federal capital gains taxes on any long-term capital gains. That you realize, for a lot of people this is news.
Speaker 1:So I want to be very clear about three things here. Number one this is only on your federal return. Depending on what state you live in, they might treat it very differently, for example, in California. California doesn't have a separate tax bracket for ordinary income versus capital gains. They tax it all the same. So I'm only looking at federal here. Number two this only applies to long-term capital gains. So if you have a short-term gain, when you invested in an asset and it's gone up in value and you sell it within a year, that's a short-term gain, that's taxed at normal ordinary income rates, whereas long-term capital gains these are what we're talking about here those are on the capital gain or the long-term capital gain tax thresholds. And then finally, number three any taxable gains or any taxable long-term gains above $94,050, you are starting to pay federal taxes and you're paying federal taxes at a 15% federal rate. It's just the gains up until that threshold that would be hit with a 0% tax bill.
Speaker 1:So let's look at this for Jim's situation. We know that up to $94,050, I'm just going to keep this simple and round that to $94,000, we know up to $94,000 of taxable income Jim and his wife can sell stocks or investments that have a long-term capital gain and pay 0% taxes at the federal level on those gains. We also know that their taxable income, which is their actual adjusted gross income minus deductions, is $26,000. What that means is, jim, in this situation, you could realize up to $68,000 of long-term capital gains and pay $0 on your federal tax bill. That would be subject to a 0% tax bracket. Now, obviously, jim talked to your financial advisor, talked to your CPA before doing this, because I don't know what other income sources you have. Even if you're saying, well, that's all we're living on is social security and pension, well, you probably still have dividends or interest or interest at your bank that you're receiving, so all that needs to be included. I'm making this a super simple example for the sake of the podcast, but what we can see in this super simple example is the first $68,000 that Jim realizes is completely tax-free, or at least is completely tax-free from the federal level.
Speaker 1:So let's go to his portfolio. He says he has $450,000 in stock. I have no idea if that stock that he purchased at $400,000. And now it's worth $450,000. I have no idea if he purchased it for $600,000. And now it's worth $450,000. So really, what we care about here isn't the amount of stock, it's which of that stock represents a gain that will be taxed potentially when he sells it.
Speaker 1:Let's make the assumption that of the stock Jim and his wife hold, $300,000 is the cost basis. So when I say cost basis, that's just the amount that they originally put into their investment account before any growth. So if Jim and his wife were to sell the entirety of this $450,000, $300,000 is going to come back tax-free. They already paid taxes on that. That's their cost basis. They get that back without paying taxes. $150,000 of that is a long-term capital gain, making the assumption that all these gains are long-term. When we look at that, of the $150,000 that are long-term capital gains, $68,000 of that is going to be subject to a 0% federal tax bracket because of the exercise we just went through, meaning it's only the remaining 82,000 of it that is subject to federal long-term gain tax brackets. That tax bracket would be 15% in 2024. So if you apply a 15% federal tax bracket to $82,000 of gains, so remember the first 68,000 are taxed at 0%. The next 82,000 are taxed at 15%. That means they would pay $12,300 in federal taxes on this $450,000 sale of stock.
Speaker 1:One more time, just to make sure I'm very, very clear. I just made up numbers here. I have no idea Jim and his wife's actual tax bracket. I have no idea the cost basis on this stock. I'm making up numbers so we can go through this exercise. But, jim, or any other listener, before you go out and sell stock, talk to your financial advisor or CPA to see what your actual tax implications would be here. Now, the last step in this gym would be based on whatever state you live in. See, are there any taxes for the state that you live in on top of this? But that's a starting point for this.
Speaker 1:So, as we start to bring this to a close, what you should be looking at is number one, even before digging into the financials. What makes more sense from a personal standpoint? Is this a property that we're going to use and we can have family traditions in and have a lot of memories in? Or is this purely just going to be an investment? Or we just want to know what's the rate of return on it? If it is just purely an investment, to what extent do you want to be involved? Do you want to be a landlord? Do you want to be responsible for repairs and tenants and the different things you're going to have to do? Or do you want a property manager From there, start to dial in what's the expected return on investment?
Speaker 1:Yes, you can target the IRR, so the internal rate of return over the lifetime of the investment. But really, as a retiree, you're just concerned about the simple cash return. Is this something that will create income that can supplement our pension, our social security or other investments to allow us to live the lifestyle we want to live? Once you've done that, then compare what that potential rate of return is to the rate of return you think you might be able to achieve in your stock portfolio over a longer period of time as well, because at the end of the day, a real estate can be wonderful in the right situations. It can backfire in the wrong situations, but if you understand your goals, if you understand the extent to which you want to be involved in the investment and if you understand how this investment's return compares to alternative returns and other types of investments, then you can make a well-informed decision of what makes most sense for you.
Speaker 1:So, jim, thank you very much for that question. I hope it was helpful. Thank you to all of you who are tuning in. Always appreciate you doing so. That is it for this week. I'll see you next time. I'm ready for retirement.
Speaker 1:Hey everyone, it's me again for the Disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Everything in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click Start here, where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who is familiar with your unique circumstances before making any financial decisions.