Why a 7% return on real estate beats a 10% return on stocks

The same reason a 401k or Roth IRA is such a good investment — up to a point, the capital gains are untaxed.

If you’re single you can exclude up to $250,000 from capital gains taxes — federal and state. If you’re married, it’s $500,000.

Even better, you can add improvements to the purchase price (initial investment). This new figure is known as the “cost basis”. And you can deduct closing costs (6–7 percent) from the selling price.

Here’s a simple model:

You buy a house for $900k in cash and spend $100k on improvements the first year. Then no addition capital is necessary until the sale of the home, other than closing costs of $130k. If you sell at $1,630,000 you pay $0 in capital gains.

Now let’s get to stocks versus real estate.

Imagine you buy a stock for $100/share, $1,000,000 total. You hold for 7 years and sell at $170/share. Capital gains tax (Federal + California) is about 33.3 percent. So your “ROI” is 10 percent per year ($700,000), but after taxes it’s really only 6.7 percent ($469,000).

You can see where this is going. Imagine instead you buy a house for $900k in cash and make $100k in improvements — a $1,000,000 initial investment. After 7 years, you sell for $1,630,000 and after closing costs of about $130,000 you walk away with $500,000 cash — untaxed — an ROI of 7.1 percent.

And that’s why a 7% return on real estate beats a 10% return on stocks.

Caveats and disclaimers:

1. Full financial models are complicated. You need to take into account expenses like debt service, transaction fees, etc., as well as savings/earnings like rental income, the mortgage interest deduction, and a number of other factors before you can accurately evaluate the full financial implications of investing in real estate.
2. Because of transaction costs, generally real estate becomes a better investment than stocks after 4–5 years. For a full financial model, contact samcooper@remax.net, MLS #02023359.
3. To qualify for the capital gains exclusion, you must live in the house for at least 2 of the last 5 years before you sell.
4. Real estate agents — myself included — are not tax professionals. Consult an accountant before initiating a transaction.

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