Health-care jobs are among the highest-paying occupations in the U.S., with median salaries of $200,000 per year or more. While it’s nice to work in an industry where salaries are high, one of the problems doctors face is that W-2 income is subject to withholding tax.
Investing in real estate provides the opportunity to create additional income streams and build an investment portfolio while potentially paying much less in tax.
Keep reading to learn more about the pros and cons of real estate investing for doctors.
- Investing in real estate can generate recurring rental income, create profits from long-term appreciation in property value, and offer tax benefits unique to real estate investing.
- In most cases, net income collected from rental property is not subject to withholding tax, such as Federal Insurance Contributions Act (FICA), Federal Unemployment Tax Act (FUTA), and State Unemployment Tax Act (SUTA).
- Some of the ways physicians invest in real estate include directly owning single-family rental (SFR) property, purchasing shares of a real estate investment trust (REIT), or contributing capital to real estate crowdfunds.
How doctors invest in real estate
There are a variety of ways that doctors invest in real estate, some of which you may already be doing. For example, you could purchase a primary residence to build equity, invest in a vacation home, purchase a home for a dependent, or invest in a rental property.
Of these options, arguably the best way to generate recurring income and build equity over the long term is by owning rental property.
Real estate investing strategies
Strategies for investing in real estate are typically divided into 2 types:
- Passive real estate investing includes purchasing shares of publicly-traded REITs, putting money into a real estate crowdfund or contributing capital to a real estate investing group (REIG) in exchange for a share of any recurring net income and any profits made when the project is sold.
- Active real estate investing includes buying and holding SFR homes, purchasing short-term vacation rentals, fixing and flipping in the hope of generating a quick profit, or repositioning an older building, such as converting a hotel into rental apartments.
At this point, it’s worth mentioning that neither strategy works quite the way the labels suggest.
For example, the passive strategy still requires an investor to put in a certain amount of time and effort, such as researching investments that make up a crowdfund or REIG, investigating the sponsor's credentials, and periodically monitoring the project's progress.
By the same token, active real estate investing doesn’t necessarily mean an investor has to be hands-on and work full time on the real estate business. You could purchase a portfolio of SFR homes to buy and hold for several years and hire a property manager to handle day-to-day responsibilities, such as leasing, dealing with tenants, and keeping the properties well maintained.
Benefits of real estate investing for doctors
Both a passive investment strategy and an active one have their pros and cons, and so does real estate investing in general. Here are some of the benefits to doctors who invest in real estate and some drawbacks to consider.
Generate passive income: The Internal Revenue Service (IRS) distinguishes between passive income from real estate and earned W-2 income.
Earned income is subject to withholdings for federal and state income tax, FICA, FUTA, and SUTA. However, passive income earned from real estate generally isn’t subject to withholding and is taxed based on a taxpayer’s bracket.
Interestingly, even if a doctor actively invests in real estate by visiting a rental property once or twice a year and meeting with the property manager, the income is still considered passive income.
Profit from appreciation: Over the past 20 years, the median sales price of houses sold in the U.S. has increased by nearly 239%, according to the Federal Reserve. By buying and holding SFR property over the long term, a doctor could profit from equity appreciation, assuming that the home is well maintained and that the 40-year history of rising home prices continues.
Deduct ownership costs: The costs of owning and operating a rental property can be deducted from rental income received. In most cases, the monthly rent collected from a tenant will cover operating expenses and the mortgage payment and leave money at the end of each period.
Common deductible rental property operating expenses include property management and leasing fees, repairs and maintenance, pest control and landscaping, homeowner association (HOA) fees and landlord insurance, mortgage interest, and property taxes.
Deduct business expenses: Generally speaking, you can deduct business and travel expenses connected to a rental property. For example, continuing education, reasonable travel and lodging expenses incurred when visiting a rental property once or twice a year, and legal and financial planning fees may all be deductible business expenses.
Use depreciation to reduce taxable net income: Depreciation is a noncash deduction used to reduce taxable net income. Residential investment real estate is depreciated over a period of 27.5 years. So, if an SFR home has a cost basis of $250,000 (home purchase price plus capitalized closing costs, less the land value), an depreciation expense of $9,091 could be deducted from pretax net income each year.
Claim a pass-through deduction: Doctors who earn qualified business income (QBI) from a pass-through business—such as an S-corp, limited liability company (LLC), or sole proprietorship for real estate—may be able to deduct up to 20% of their net business income from their income taxes. The pass-through deduction took effect when the Tax Cuts and Jobs Act (TCJA) was passed in 2018 and is scheduled to expire at the end of 2025, unless Congress extends the deduction.
Drawbacks to consider
Real estate has potential disadvantages and benefits, as with the stock market or any other investment. Some of the drawbacks to consider before investing in real estate:
Real estate investing is capital intensive: The down payment on an investment property loan is typically 20% or more of the property purchase price. In addition to a sizable down payment, there are closing costs to consider, along with future capital expenses, such as replacing a roof and holding up to 6 months of operating expenses and mortgage payments in a reserve account.
Even passive real estate investing requires time and knowledge: Owning and operating a rental property requires being knowledgeable about things like fair market rents, landlord-tenant laws, making repairs to keep a home safe and habitable for a tenant, and conducting periodic inspections. These are some reasons why many busy professionals hire a local professional property manager.
Real estate is not liquid: Real estate is an illiquid investment that cannot be quickly and easily sold, which is why many investors buy and hold rental property for the long term. Even in a strong seller’s market with more buyers than sellers, it could still take 30 days or more to close escrow after an offer is accepted.
Liability risks: As in the medical profession, where a patient might sue a doctor, landlords risk being sued by a tenant, guest, or contractor who gets injured on the property. A real estate investor can mitigate potential liability by holding real estate in an LLC, purchasing a landlord insurance policy, and requiring tenants to obtain renters insurance if allowed by landlord-tenant laws.
Metrics for measuring financial returns
There are several different ways to measure financial returns from investment real estate, and it can make sense to use more than one metric. Some of the most common are:
- Cash-on-cash return is calculated by dividing pretax annual cash flow (after all operating expenses and mortgage payments have been made) by the amount of cash put into a property.
- Net operating income (NOI) is determined by subtracting operating expenses from rental payments received, excluding any mortgage payment.
- Capitalization rate is the annual rate of return calculated by dividing NOI by the property value or purchase price.
- Gross yield is the total annual gross income divided by the property value or purchase price, without deducting any operating expenses or mortgage payments.
- Total return is determined by subtracting any outstanding mortgage balance or other liabilities at the time the property is sold from the property sales price, including the cumulative amount of net operating cash flows collected over the holding period.
Where doctors can find investment real estate
Doctors can invest in real estate indirectly, through direct ownership, or a combination of both.
A REIT is a company that owns and operates real estate, such as SFRs, mobile home parks, or commercial properties. A REIT can be publicly traded just like regular stock or a private REIT like Roofstock One.
Investing in a REIT can be a good way to earn recurring income through distributions, provided a REIT is profitable. However, an investor will miss out on some benefits of directly owning real estate, such as tax deductions and depreciation.
Real estate crowdfund
Real estate crowdfunds are companies that raise money from a large pool of investors to develop, own, and operate different types of real estate like build-to-rent subdivisions, apartment buildings, or industrial properties.
Contributing capital to a crowdfund can be a good way to diversify an investment portfolio, but unlike owning a publicly traded REIT, shares of a crowdfund are typically tied up for several years before they can be sold, provided there is a market for the shares.
Directly investing in a rental property can be a good option for a doctor looking for recurring rental income, equity appreciation over the long term, and all of the tax benefits of owning residential investment property.
While traditional listing sources like the local multiple listing service (MLS) and Zillow may be good ways to find a primary residence, Roofstock is a better place to look for SFR homes. Rental property listed for sale has already had much of the due diligence done. Many of the homes are already rented to tenants, so you can begin collecting rental income the day that escrow closes.
Many doctors invest in real estate to generate recurring income that isn’t subject to withholding tax, profit from future appreciation in property value, and harvest tax benefits unique to investment real estate. While real estate investing does require some time and education, it can be worth the time and effort in the long run.