For Part 1 of this post, start here if you would like to get caught up.
There are a lot of reasons why I like investing in securities. For one, you can invest as much as you need or can, in whatever increments you choose, and whatever frequency you choose. With a house, you need to save up enough for a down payment before you even get started. Then once you have a mortgage, you’re beholden to your bank’s mortgage payment schedule. If you happen to hit a rough patch and cash flow is tight, you still need to make those mortgage payments, or risk losing your property (and running into serious credit trouble). If you hold stocks, bonds or mutual funds, you can put a hold on investing if you find yourself short on cash for a while.
Do I think that real estate can be a good investment? Absolutely. But under the right conditions. If you have enough for a decent down payment and the rent you’re collecting is enough to cover your costs and be a source of monthly income for you, then that’s great. But consider this: in the meantime, while you’re saving for that down payment, why not put those savings into some securities and earn a little interest income on them so you can save your down payment faster? To me that’s win-win.
There’s one other issue that I must address here though, and that is tax. With a head nod to the Dividend Diplomats who did a good job here of pointing out the tax benefits of dividend investing, this is another thing to consider. For any non-Canadian readers out there, these specific considerations I’m going to mention might not apply to you, but rest assured that your own local tax jurisdiction will have its own points to consider for the tax treatment of certain types of income. If you’re in the US, that Dividend Diplomats link will be useful to you.
Let’s talk about tax
I live in Canada, so for me, any income I earn from rental properties is taxed as regular income, just like I would earn from a 9-5 job. So the additional income earned from rentals is subject to your marginal tax rate. I don’t want to get too technical here, but that basically means that whatever tax bracket you find yourself in will dictate the tax you pay on any additional dollars of income. Unless of course that income puts you in an even higher tax bracket, meaning the income you earn from that rental will be subject to even more tax than your regular pay. So while you thought your rental was making you an extra $1000 a month, it’s actually only earning you an extra $700 (assuming a 30% marginal tax rate). Still $700 more than you had right? Not bad.
Maybe now you’re thinking “but wait, can’t you deduct expenses from this income so your taxable income on that rental is lower?” Very good! This is true. In Canada, you can deduct the interest (but not any principal) from your mortgage payments on a rental, plus any maintenance costs, expenses like utilities if you pay them as the landlord, taxes, advertising expenses, etc. But you’ll still get taxed on whatever is left over at your marginal tax rate.
“But can’t you make it look on paper like the rental is losing money, so your taxable income goes down for the year?” Well look at you! You are a savvy one aren’t you? First of all, don’t commit tax fraud. You will likely get caught, and it makes you a bad citizen. Secondly, if you’re maxing out any and all legitimate expenses and deductions on your property and it shows that you’re operating at a loss as far as the taxman is concerned, then I’m afraid that means you’re not holding an investment that is earning you much money either. You can only fudge your taxes so much. Those expenses you deducted are real expenses! Your taxable income on your rental property will end up being pretty close to your actual income on your property once you have taken care of your expenses.
Now assume instead you held investments like stocks, bonds or funds. First of all, you could arrange to hold these investments in a tax deferred account like a RRSP (for my American friends, I think this is the equivalent to your 401(k)). This means that anything you put into this account will actually reduce your taxable income for that year. So all else equal, you’ll get a tax refund come tax time. Alternatively, you could hold your investments in a Tax Free Savings Account (TFSA), and in that case you will never have to pay any tax on any of the income earned from those investments, ever. Those are both pretty good options! But let’s forget them for now, because there’s even more good news.
Let’s assume for now that you hold investments in a normal, non-registered account and you have to treat everything normally from a taxation perspective. Say you own stocks. The only time you will have to pay income tax from holding those stocks is when you sell them. So if you’re buying and holding your assets and watching your savings grow over time, you don’t really need to worry about your net worth being taxed away as it grows. When the time comes for you to sell them and use the money, that income is treated as capital gains, not normal income. And while you will have to pay your marginal tax rate on those capital gains, you only have to pay it on 50% of those gains. So you’ve already cut your tax bill in half. Good for you!
Here’s an example: You buy some fund and later that year it has appreciated and you sell it for a profit of $1000. Your capital gains are therefore $1000, just like our previous example where we had $1000 of rental income. Of your $1000 capital gains, you only have to pay tax on 50%, or $500. If you’re the same person in our rental example who has a 30% marginal tax rate, then the government will take $150 (that’s 30% * $500), leaving you with $850 from your $1000 capital gains. You’re already ahead of the rental income guy by $150.
“But what about dividends?” Good question! If your stocks pay dividends then you will have to pay tax on that income in the year it is paid. But the dividend tax rate is 15%. So if your marginal tax rate is 30% for example, your dividend income is still worth more on an after tax basis. $1000 in dividend income will cost you $150 in tax, leaving you with $850. (The tax numbers are slightly more complicated than this, but I don’t want to get too deep into the taxation weeds and lose too many of you. Suffice to say that the actual numbers are close, and dividend income is going to be treated better by the tax man than any income earned on labour). In this example, taxes on dividends is the same as taxes on capital gains, but if your marginal tax rate is higher than 30%, dividends become more attractive, because dividend income is always taxed at about 15%. And again, remember that if your investment account is a registered TFSA, you will pay no tax on any of the profits.
I’m not trying to tell you that taxes are bad and that you shouldn’t pay your taxes. But let’s be honest while we’re at it and admit that nobody wants to pay any more tax than they have to. And taking advantage of these tax benefits is something that all taxpayers are entitled to. Nobody is pulling a fast one here. We’re just all trying to make the most with what we have and keep as much as we can while still playing by the rules.
“But you said your parents lost a bunch of money by buying stocks!” Yes I did, and that’s true. But the simple truth is they were doing it wrong. What my parents was doing was essentially gambling. They weren’t diversifying a portfolio or sticking with low risk funds. They bought a few stocks based on friendly advice, got unlucky, panicked and cut their losses. In other words, they did all the things you’re not supposed to do. Unfortunately they didn’t know any better. I have the benefit of learning from their mistakes. There are better ways to go about it. For example, you can buy mutual funds or ETFs and your risk will go way down. You won’t get rich overnight, but you should get a nice steady rate of return over the long term.
Finally, I do want to address that I realize for a lot of people, the idea of investing is completely foreign to them. They might like the idea in theory, but have no idea how or where to start. Real estate is just so much easier for a lot of people because they understand houses and rent. I get that, I really do. I will take some time in future blog posts to help explain things to my friends who don’t know the first thing about investing. If you have any questions about a topic you would like to know more about, please let me know and I will happily do my best to write a post about it.
For now, I’ll just say two things on the subject. First, it’s not as scary as you think, or at least it doesn’t have to be. Secondly, the sooner you start the better. There is a Chinese proverb about the best time to plant trees that often gets paraphrased for investing (thanks to My Own Advisor for helping me find the original source and quote): the best time to start was yesterday; the second best time to start is today.