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How to Incorporate Income-Producing Real Estate into a Financial Plan

Dana Anspach, the president of Sensible Money, explains how financial advisers can incorporate income-producing real estate into a financial plan.

Real estate investors have trouble finding financial planners who can incorporate their real estate holdings into their plan.

And that's because most financial planners are using off-the-shelf software that supports traditional investment accounts such as IRAs, 401(k)s, and taxable accounts but not the unique aspects of real estate investments, according to Dana Anspach, president and founder of Sensible Money.

"Off-the-shelf software packages do an excellent job of handling the basic investment types," Anspach said in a video interview. "But when you get into real estate holdings, everything changes."

Like traditional investments, real estate investments do appreciate. But owners of income-producing real estate must also factor net cash flow after expenses, depreciation, amortization, and taxes into their investment. "Many rental real holdings are cash flow positive, but tax negative or neutral, said Anspach. "And that is not an easy thing to model using most financial planning software packages."

In her practice, Anspach worked with her client who owns income-producing property to create a spreadsheet that would consider the unique factors associated with real estate investments and merge that data into a financial plan.

In addition, Anspach considered other unique factors, including whether the owner of the rental property qualifies as a "real estate professional." If someone qualifies as a professional, they can offset losses against other types of income. "But there are a series of qualifications that must be met to achieve real estate professional status," she said.

Plus, she factored in the potential tax rate arbitrage from the depreciation that rental property owners can use. "When you sell the property, you recapture the depreciated amount and it's taxed at a 25% rate," she said. If you've been at a 40% plus tax rate along the way, paying tax on gains at 25% is relatively nice."

"That's a lot to incorporate," she said. "And since most of the tools available to planners don't include this functionality, it can be challenging."

There's also the risk management associated with owning rental property.

One way real estate investors manage the risk of natural disasters or unreliable and unpredictable cash flow is by creating an emergency fund for each property. Another is to only spend cash one year in arrears. And another is to build their portfolio until it delivers twice the cash flow they would need to live on. "That way they can weather a year where the cash flows are cut in half," Anspach said.

"Overall, the concepts we apply to financial planning and investing apply to real estate," she said. "There is no free lunch. Real estate offers returns that can exceed what you might achieve in a stock index fund over time, but the level of risk can be much higher."

Ultimately, Anspach said it is far more time-consuming to build financial plans that have real estate because there are so many more factors to incorporate. "But now we can see how all those factors interact, and how to blend them together to get to that baseline level of reliable, predictable income that is what most people want as they near their retirement years," she said.

For those who want to become owners of income-producing real estate, Anspach recommends The Book on Advanced Tax Strategies, Cracking the Code for Savvy Real Estate Investors, by Amanda Han and Matthew MacFarland.