Author Topic: Real Estate Returns vs. Stock Returns: The Maths  (Read 55439 times)

boarder42

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #200 on: April 23, 2018, 12:47:39 PM »
only you can do that math yourself since the tax deferment is based on your income level now vs post FIRE

ARS the OP of this was a teacher as was his wife so the tax benefits of those accounts were not as good to him as the RE investing was.  He also hit the market at an excellent time for this right around the financial crisis. 

in general if you're lower income RE leveraging is probably an excellent use of your free time to learn and start doing - if you're higher income the more hours you spend to increase your income in your line of work are probably more valuable. 

Lan Mandragoran

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #201 on: April 23, 2018, 03:00:42 PM »
Yeah to get a truly accurate number, but ars was using a case study with a fairly generic setup if I remember the first post well.

Why do you say the tax benefits were useful due to him being a teacher? Are taxes better for lower income peeps in real estate?

maizefolk

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #202 on: April 23, 2018, 03:29:20 PM »
The assuming a low marginal tax rate in retirement (probably a safe assumption for most MMMers), the benefit of saving in save deferred vehicles like 401k, 403b and 457 plans are greatest if you're in an extremely high marginal tax bracket, and much lower if you're in a low one (which is generally where teachers are going to end up).

Lan Mandragoran

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #203 on: April 25, 2018, 09:32:33 AM »
Ahh gotcha =]

afox

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #204 on: April 25, 2018, 09:46:29 AM »
A simple way to calculate your tax savings for tax deferred retirement accounts (403b, 401k, T-ira) is to take the amount you contribute and multipley it by your effective tax rate (your final tax rate not including FICA taxes).  Average effective tax rate for americans is 13%, using that number:
401k/403b annual tax savigns on $18,500 contribution: $2,405
Tradional IRA annual tax savings on $5,500 contribution: $715

For an HSA the amount saved is the above plus about 8% savings for no FICA taxes.

Of course the "income earned" on the investment in the form of an increase in their value is also tax free but that is harder to quantify.  For RE we pay tax on the income earned minus our expense to run the business (depreciation, qualified expenses, etc)

Of course, any employer contributions are free money and not counted in the above.

In my case after running the numbers on RE investment options vs. pre tax retirement accounts it is very hard to find a RE investment that out-performs the tax advantaged retirement accounts.  I do invest in RE but only after maxing out all of these accounts.

sol

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #205 on: April 25, 2018, 08:43:16 PM »
A simple way to calculate your tax savings for tax deferred retirement accounts (403b, 401k, T-ira) is to take the amount you contribute and multipley it by your effective tax rate

We normally use the marginal rate, not the effective rate, because it's the marginal dollar that is either going into the tax sheltered account or not going in to the tax sheltered account.  You have to calculate the savings difference between those two scenarios in particular, since that's what you're deciding on.

Example:  An average American worker earning $50k/year in 2018 is firmly in the 24% 22% tax bracket, but is likely to pay more like 10% or less effective tax, after deductions and such.  If he puts $10k into his 401k he has $40k of income, and if he doesn't put in anything he has $50k of income, the last ten thousand dollars of which will be taxed at 24% 22%.  His tax bill is $2400$2200 different between these two scenarios, so he "saves" $2400 $2200 by contributing to his 401k.

I prefer to think of tax sheltered accounts as mandatory.  Any time you fail to max one out, you are voluntarily paying extra money to the government for the sole pleasure of spending less money in your lifetime (but slightly more money in the immediate short term).  From that perspective, tax sheltered accounts are like inverse lottery tickets, a tax on people who are bad at math.  If you're bad at math you buy lottery tickets and don't max your tax sheltered accounts.  If you're good at math you max the accounts and skip the lotto.  In both cases there is a mathematically optimal decision to be made, but millions of Americans choose otherwise.

edited for misreading the 2018 tax bracket table.
« Last Edit: April 25, 2018, 11:34:35 PM by sol »

afox

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #206 on: April 25, 2018, 11:17:57 PM »
Sol, that last paragraph is spot on.  Amazingly these points appear to have been completely missed in the first 4 pages of this thread.  Anyone that is earning income and not maxing out their pre-tax retirement accounts must compare RE returns vs. stock returns in pre-tax account to the extent which they can do so. 

Im trying to understand the math you used to calculate the tax savings in your example of the 50k earner with a 10k pre-tax contribution.  I understand that only the portion of income in the highest bracket is taxed at the highest bracket but the effective tax rate seems to take this into account.  The last 10k of income for the 50k earner is taxed at the 24% marginal tax rate but marginal rates are meaningless if we want to know the amount of tax saved vs. scenario 1 and scenario 2 since the marginal rate is not the actual rate charged to the taxpayer. For a sanity check this calculator says that the 50k earner who contributes 10k to the pre-tax account will save only $1200 on their taxes, that is only half of what you said, so is it possible that there is an error in how you are calculating the tax savings or am I missing something? 
https://ffcalcs.com/pretax_savings

sol

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #207 on: April 25, 2018, 11:32:43 PM »
this calculator says that the 50k earner who contributes 10k to the pre-tax account will save only $1200 on their taxes, that is only half of what you said, so is it possible that there is an error in how you are calculating the tax savings or am I missing something? 
https://ffcalcs.com/pretax_savings

That calculator is using a 12% marginal rate, exactly half of the 24% marginal rate you would pay if you had a 24% marginal rate.

For the 2018 tax year the brackets will all change.  For a single filer, the 12% rate goes up to $38,700 of taxable income, not $50k, but it's taking off the $12k standard deduction first to get your taxable income down under $38,700.  The effective rate would drop from 8.74 to 7.92%, in that case.  My example above only applies to taxable income after the deduction, so you can replace $50k with $62k to add the deduction back in if that makes it clearer.  I should have been more precise about separating income from taxable income.

Note that you are still realizing a tax savings equal to your marginal rate, whatever that is, not your effective rate.
« Last Edit: April 25, 2018, 11:38:42 PM by sol »

afox

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #208 on: April 26, 2018, 10:11:38 AM »
Okay Sol, you are really helping me out here, appreciate it!

I understand what you are saying now.  It was tough to compare numbers since I was using 2017, you were using 2018 and you were using AGI and I was using gross income.  Nevertheless I have been missing the point all along that the tax savings for the pre-tax contribution are in fact computed using the highest marginal rate (or several rates if the contributions span several AGI brackets).  So, I have been underestimating the tax savings of the pre-tax contributions.  This means that it will be even harder to find a RE investment that outperforms 401k,T-IRA,403b.  I think this is important because for the vast majority of folks the choice is not a RE investment vs. post tax stock investment.  In practice the choice is nearly always between a RE investment vs. tax deferred stock investment.

I found this article which explains this better than either of us can: https://www.kitces.com/blog/understanding-marginal-tax-rate-vs-effective-tax-rate-and-when-to-use-each/





SwordGuy

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #209 on: April 26, 2018, 11:51:34 AM »
I think this is important because for the vast majority of folks the choice is not a RE investment vs. post tax stock investment.  In practice the choice is nearly always between a RE investment vs. tax deferred stock investment.

Do you mean the majority of people generally or the majority of people in this forum? In the general population I agree with you. In the forum, lots of folks with savings rates up in the 40-60% range (or even higher) have already run out of tax deferred savings space, so they would be comparing taxable stock investments to real estate investments.

But if you are comparing these investments, shouldn't you be comparing it after adding the tax at your FIRE marginal rate back in?   You're still paying the tax, it's just deferred.   

afox

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #210 on: April 26, 2018, 01:12:11 PM »
I think this is important because for the vast majority of folks the choice is not a RE investment vs. post tax stock investment.  In practice the choice is nearly always between a RE investment vs. tax deferred stock investment.

Do you mean the majority of people generally or the majority of people in this forum? In the general population I agree with you. In the forum, lots of folks with savings rates up in the 40-60% range (or even higher) have already run out of tax deferred savings space, so they would be comparing taxable stock investments to real estate investments.


But if you are comparing these investments, shouldn't you be comparing it after adding the tax at your FIRE marginal rate back in?   You're still paying the tax, it's just deferred.

No, we are talking about the tax savings  which are not tax deferments, these are an actual discount that is never paid back to the IRS.  In essence this is "free money"  There is no equivalent for RE investments that I am aware of.  And, you dont pay income tax on the tax discounts, so as other scenarios you are better off saving $1 than making $1 extra because you only get $.80 of the $1 extra you made while you keep the whole $1 you saved.

I have no idea how many forum people are maxing out their tax deferred accounts.  None of the active RE investors I know in real life do.  Tax deferred is a bit of a misnomer since these are actually tax discount + tax deferred accounts.



SwordGuy

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #211 on: April 26, 2018, 05:38:06 PM »
I think this is important because for the vast majority of folks the choice is not a RE investment vs. post tax stock investment.  In practice the choice is nearly always between a RE investment vs. tax deferred stock investment.

Do you mean the majority of people generally or the majority of people in this forum? In the general population I agree with you. In the forum, lots of folks with savings rates up in the 40-60% range (or even higher) have already run out of tax deferred savings space, so they would be comparing taxable stock investments to real estate investments.


But if you are comparing these investments, shouldn't you be comparing it after adding the tax at your FIRE marginal rate back in?   You're still paying the tax, it's just deferred.

No, we are talking about the tax savings  which are not tax deferments, these are an actual discount that is never paid back to the IRS.  In essence this is "free money"  There is no equivalent for RE investments that I am aware of.  And, you dont pay income tax on the tax discounts, so as other scenarios you are better off saving $1 than making $1 extra because you only get $.80 of the $1 extra you made while you keep the whole $1 you saved.

I have no idea how many forum people are maxing out their tax deferred accounts.  None of the active RE investors I know in real life do.  Tax deferred is a bit of a misnomer since these are actually tax discount + tax deferred accounts.

Until next month, my wife and I have both been maxing our 401Ks and we are real estate investors.   So there are two of us.

(To be accurate, though, we both FIRE in May so that's going to be harder this year (and in years following).   We're looking into setting up a self-employed 401K for me.  We have to figure out if the tax savings from 401K employer/employee contributions (or as close to max as we can get it) is worth doing or not.   Lots of rules to look up, because I don't want to take rental property income and convert it to wages and thus cause it to to be subject to SS and Medicare taxes in addition to the income tax it's already subject to.   Trying to find out if I can minimize my "employee" contribution and maximize the "employer" contribution. 

sol

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #212 on: April 26, 2018, 08:47:50 PM »
No, we are talking about the tax savings  which are not tax deferments, these are an actual discount that is never paid back to the IRS. 

Well, it's a little bit of both.  Yes you are deferring taxes until later, and yes you are saving by paying less taxes, but it's not like the money you put into a 401k is automatically untaxed forever.  You do have to pay taxes on it when it comes back out.

But the advantage is that when you make the contribution you are avoiding paying taxes at your (usually high) marginal rate, off the top of your total income, and then when you withdraw you are paying taxes on it from the bottom of your income (including in the 0% tax bracket, aka the standard deduction).

tralfamadorian

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #213 on: April 27, 2018, 08:22:18 PM »
No, we are talking about the tax savings  which are not tax deferments, these are an actual discount that is never paid back to the IRS.  In essence this is "free money"  There is no equivalent for RE investments that I am aware of.  And, you dont pay income tax on the tax discounts, so as other scenarios you are better off saving $1 than making $1 extra because you only get $.80 of the $1 extra you made while you keep the whole $1 you saved.

I have no idea how many forum people are maxing out their tax deferred accounts.  None of the active RE investors I know in real life do.  Tax deferred is a bit of a misnomer since these are actually tax discount + tax deferred accounts.

3/3 Mustachian real estate investors who fill their tax deferred accounts before adding to the down payment kitty. 

Well, real estate does have tax advantages. Paper losses via depreciation that you get to take against your rental income, which the majority of the time brings the taxable rental income to ~=<0. Like tax deferred accounts, those will come back as income in the future if you decide to sell but hopefully that would be at a point when your marginally tax bracket is lower. If your investments are profitable enough that you do have positive income, then 20% of that is deductible.

FiveSigmas

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #214 on: April 27, 2018, 10:39:17 PM »
(including in the 0% tax bracket, aka the standard deduction).
To be pedantic, the 0% tax bracket isn't the same as the standard deduction (nor is it the same as the personal exemption [may it RIP *]).

https://taxfoundation.org/2018-tax-brackets/

* Until it (possibly) returns.

sol

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #215 on: April 28, 2018, 09:16:33 AM »
(including in the 0% tax bracket, aka the standard deduction).
To be pedantic, the 0% tax bracket isn't the same as the standard deduction (nor is it the same as the personal exemption [may it RIP *]).

https://taxfoundation.org/2018-tax-brackets/

* Until it (possibly) returns.

You may notice that in the table you linked, there is no 0% tax bracket. 
« Last Edit: April 28, 2018, 09:30:49 AM by sol »

FiveSigmas

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #216 on: April 28, 2018, 11:19:59 AM »
You may notice that in the table you linked, there is no 0% tax bracket.

Sigh. How embarrassing. Please ignore my previous post.

sol

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #217 on: April 28, 2018, 12:37:19 PM »
Sigh. How embarrassing. Please ignore my previous post.

No problem, this stuff is super confusing.

There used to be large options for declaring tax-free income, through the standard deduction, the personal exemptions, the dependent exemptions, deductible accounts like 401ks, and (in some cases) by offsetting income above the 0% tax rate with tax credits, for example the EITC, child tax credit, or the various savers credits.  Together, these made it pretty easy for a family with a couple of kids to have up to ~$60k of income and still pay zero taxes without even itemizing! 

Things are a little harder now, and this impacts mustachians who are planning on drawing relatively low incomes from their 401k accounts in retirement because it looks like we will face higher tax burdens under the new law than we did under the old one (but lower tax burdens while still working and earning money).  These are exactly the sorts of complications that make it so hard to compare real estate returns to stock returns.  The tax treatments are very different, not just in percentages but in what amounts count as income at what times.

For example, I make more money in property price appreciation than I do in rental cash flow.  If I pocket $10k in cash from excess rents this year, that amount is not taxed as income until after I deduct depreciation and expenses from my gross rents (making my net rents, the most important part, kind of an afterthought in the taxation process).  If the value of the home goes up by $20k in the same year, I pay zero taxes on that increase until I sell the house, at which point I pay either capital gains (which depends on my income level) or depreciation recapture or both.  But those taxes are only due in the future, and are potentially avoidable if I hold the property until death and pass it on as an inheritance.  The whole system is just loopholes on top of loopholes and exceptions to exceptions.

Income tax, by contrast, seems relatively straightforward despite the myriad of deductions and credits you can get.  At least there's a form to walk you through the process, unlike RE taxes which are just a black box to most people.

edit:  there IS a zero percent tax bracket for capital gains income, if your total income is in the 10 or 15% income tax bracket.  That makes total sense, right?
« Last Edit: April 28, 2018, 01:22:59 PM by sol »

moneetalks

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #218 on: May 01, 2018, 10:51:29 PM »
Forgive me if someone already pointed this out.  But to me, the biggest argument against real estate as an investment is not the maths....its that owning rental RE is not "passive" income like stock ownership is. 

Owning, maintaining, cleaning, repairing, managing real estate for 30-50 years vs enjoying life while your stocks grind away without you doing a thing???

Having said that,  I own just such a rental property.  It returns around 10% a year....but with a good deal of effort on my part. 

BUT - I also get to enjoy that property by staying in it or having a great place for guests to stay.  Hard to apply "the maths" to that. 

See the MMM article on being a lazy landlord....


Hoosier Daddy

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #219 on: December 22, 2018, 09:01:59 AM »
Hey guys,

Sorry if I just missed it but I'm curious about the variability/risk comparison. Leverage should increase risk but it feels like real estate returns would vary less overtime than stocks right? I am not sure how to do this analysis since mass data isn't available like it is for stocks but if stocks and real estate earned relatively the same return BUT the variability in that return from year to year was greatly reduced that would still make real estate a worthwhile investment.

FYI-i currently have no real estate holdings, but have been considering this question recently. If risk and return is relatively similar, I'll take the passive route.

maizefolk

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #220 on: December 22, 2018, 09:28:01 AM »
If you look at real estate as a class, yes the volatility is lower than the stock market. However, to get the volatility and returns of the whole class of real estate you'd need to own a significant numbers of properties in a substantial number of markets without incurring substantial management costs. (REITs give you geographic diversification, but at the cost of significant management expenses and a lot more exposure to interest rate/credit risks than you'd have as an individual investor with 30 year fixed rate mortgages.)

As an individual investor with less than 10 units, individual events -- rather than market conditions -- are going to produce a lot of your volatility in personal rate of return. Maybe one year everything goes right and you match or beat the "real estate market" return. In another year, you find out you unexpectedly need to replace the roof on one unit, two others sit vacant for a while as it takes an extra month or two to secure new tenants when your old one leaves, and you're also forced to evict a tenant from a fourth unit when they lose their job and stop paying rent and you end up with well below the average returns for a real estate investor.

For single real estate investors, second biggest source of volatility after individual events might be regional ones in the city where you are buying the rental units. A major employer leaves town. Amazon opens a new headquarters ("head-eighth" now that it's split?) in your neighborhood. A new freeway cuts the neighborhood with your rentals off from the rest of the city and rents drop. A new Trader Joes/Whole Foods opens three blocks away and rents rise (apparently this actually makes a significant difference).

If I could invest in an index fund of real estate across the USA or world that utilized 30 year fixed rate mortgages and had a total expense ratio similar to what we might see from Vanguard/Fidelity I would do it in a heart beat. It's the non-passive involvement required and volatility of real estate returns for individual small sets of properties that have convinced me that real estate is not for me (even though it does great things for other people).

SwordGuy

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #221 on: December 22, 2018, 10:14:54 AM »
Forgive me if someone already pointed this out.  But to me, the biggest argument against real estate as an investment is not the maths....its that owning rental RE is not "passive" income like stock ownership is. 

Owning, maintaining, cleaning, repairing, managing real estate for 30-50 years vs enjoying life while your stocks grind away without you doing a thing???

Having said that,  I own just such a rental property.  It returns around 10% a year....but with a good deal of effort on my part. 

BUT - I also get to enjoy that property by staying in it or having a great place for guests to stay.  Hard to apply "the maths" to that. 

See the MMM article on being a lazy landlord....


I own 3 properties that are rented out.  I buy them for cash in distressed state, so getting them up to snuff using sweat equity is a non-trivial investment of my time.


BUT -- after I have them repaired I hand them over to a property management company and have little to do with them after that.  The property management company inspects them, rents them, deals with the tenants, dispatches repair staff and even goes to court on my behalf if need be.

If I had bought a rent-ready unit per the example in this study, I would not even have the big investment in time to renovate them.

So, it's a myth that owning rental homes REQUIRES a huge input of personal time.



Telecaster

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Re: Real Estate Returns vs. Stock Returns: The Maths
« Reply #222 on: December 23, 2018, 11:46:24 AM »
I am not sure how to do this analysis since mass data isn't available like it is for stocks but if stocks and real estate earned relatively the same return BUT the variability in that return from year to year was greatly reduced that would still make real estate a worthwhile investment.

There was no implication that real estate isn't worthwhile.   Just a comparison of returns over very long periods of time.