How would you invest $1M?

[Kusha Karvandi]

I’m interested in getting more into rental real estate investing (and potentially investing in notes). My main goal is to make sure I generate enough cash flow to cover my family’s needs which are around $80k per year in expenses. What would be the best way to invest $1M to generate that type of income? I’m newer to rental real estate investing so I’m not sure what type of cash on cash return is considered too conservative vs too aggressive. 8% seems more on the conservative side especially since I would be very active in this and not a passive investor. But I’d love to get some input from the bigger pockets community.

[Ian Ippolito]

@Kusha Karvandi

I invest in both directly owned real estate and passive syndications, so I see a lot of deals in both areas.

You said you are looking to generate $80,000 to cover your family expenses with $1 million and looking for ways to generate an 8%+ return.

The first thing here is that most likely your math is wrong and you're going to need a lot higher return than 8% to hit that goal because of federal, state and local taxes. And since this is to cover expenses, investments in tax-advantaged accounts like a self-directed IRA/solo 401(k) would be out of the question, so you can't take advantage of that.

Here's an example. I am not an accountant or attorney so always consult with your own accountant and tax professionals before making any decisions.

Hard money loan funds generally do not offer any tax shielding because they cannot take advantage of depreciation. These currently range from 6% to low double-digit returns, depending on how little or much risk you're willing to take. You can assume that they are fully taxable. So that 12% return may yield you a lot less than 8%, by the time you are done paying federal and whatever state and local taxes you may or may not have been your area. You'll need to figure that out yourself, because it depends on your tax bracket and location and varies from person to person.

On the other hand, investing in real estate equity usually does have tax shielding from depreciation. Again, returns can range from 4% to as high as double digits, depending on how little or much risk you're willing to take.

There is also a range of tax shielding of income. For example if you invest in value-added multifamily and do cost segregation analysis, you might be able to shield 100% of the distributions from taxes. Other types of investments might shield 40% or 20% or something different. It all depends and again this is something you will have to look at on a deal by deal basis.

However, even here you are not completely off the tax hook. The tax shielding of depreciation is generally not permanent, which is something many beginners do not understand. If you sell the property, you are almost always going to have to pay that depreciation tax benefit back. So it is really a deferral or delaying a payment and not avoiding it. So since you're looking to cover expenses, this is something to think about, and again I think your target would have to be higher than 8%.

Also, depreciation doesn't last forever, and after a certain number of years it will run out completely. So if you buy-and-hold, eventually you are going to be in the situation of paying full taxes. So again you woul dneed more than 8%.

The other alternative is to sell the property as soon as the depreciation runs out and then do a 1031 exchange. You can keep doing this over and over again to avoid paying back the depreciation tax benefit. And then when you die it's passed on to your heirs and they do not have to pay either. So in that case it would actually be a permanent situation. But that involves quite a long-term commitment, and anything less than that involves paying taxes.

So having said that, if you are looking at having a goal of getting a return of say 11%-15%+ you are not going to be able to invest in virtually any of the conservative options. You're going to have to be more aggressive.

To avoid sending your risk into completely off the chart, crazy territory, you're going to have to put in sweat equity yourself with direct investment, versus passive so that you can work for that extra return. It's very possible that the investments you will end up having to choose may put you very susceptible to loss of money in a severe recession. And since you are complete beginner, to get that kind of return you may have to expose yourself to the risk that you might be making some expensive mistakes which may also cause you to lose principal.

In the end, only you can say what's right for you and your family. I am a very conservative investor, so if my family were depending on that money for expenses, I would set a much lower, more conservative target and look to save up more money instead. But if you are more aggressive, you might be fine with a different solution.