Real Estate as an Investment - Why not stocks?

Historically, the S&P 500 has outperformed the US real estate market. In fact from 1978 - 2004, CNNMoney.com reports that the US housing market returned 8.6% compared to the S&P's 13.4%.

So why would investors continue to invest in real estate? The reasons are simple:

1. Leverage

2. Tax Advantages

Almost everyone understands the benefits of leverage, or OPM (other people's money), so let's discuss the tax advantages of real estate investment. There are distinct tax advantages both in terms of owning real estate and selling real estate that are generally unavailable to owners of stock.

Tax Benefits - Owning

There are three tax benefits available when an investor owns real estate:

1. Mortgage Interest Deduction

2. Expense Deductions

3. Depreciation

All three tax benefits mentioned above allow the real estate investor the ability to shelter income from taxes.

Tax Benefits - Selling

The tax breaks available when selling real estate depend on the type of real estate sold. The two tax breaks available are:

1. Section 121 - Homeowners can avoid paying taxes when selling a home they have lived in as their primary residence. Owners must have lived in the property as their primary residence for 2 of the past 5 years. Single owners can avoid taxes on the first $250K of gain and married owners avoid taxes on the first $500K of gain. The Section 121 benefit can be taken once every two years.

2. Section 1031 - Real estate investors can defer the capital gains tax liability on the sale of an investment or business property by conducting a 1031 Exchange. Investors should reinvest all the cash and purchase a property equal or greater in value, and the 1031 Exchange needs to be completed within 180 days. There is no limit to the number of exchanges an investor can do and many investors utilize the "swap till you drop" strategy of exchanging to avoid taxes altogether.

When looking at historical returns, the stock market will often appear to provide a better return than real estate. However, taking into account the numerous tax benefits available to real estate owners, many consider real estate a better option.