By Dr. James M. Dahle, WCI Founder
As regular readers may or may not know, my main college savings tool has been Utah's excellent 529 plan, with funds in the plan invested very aggressively (50% international and 50% small value.) There are other, inferior ways to save for college, each of which has their own issues, including taxable accounts (high taxes), UGMAs (loss of control,) Coverdell ESAs (low contribution limits and no state tax break,) and even cash value life insurance (low returns.)
However, one method that I think is worthy of consideration—either on its own or combined with a good 529 plan—is real estate investing. There are a number of ways to do this, obviously, but this post will discuss some ways in which I think real estate investing could have real merit as a college savings tool. I'll talk about the downsides at the end, but first, let's list it out. And at the end of all this, if you decide you want to learn more about real estate investing, check out WCI's No Hype Real Estate Investing course.
8 Reasons to Consider Real Estate as a College Savings Tool
#1 The Time Frame Is Right
Real estate isn't a great short-term investment. But it can be a great investment in the 10- to 20-year range, about the period of time over which you ought to be saving for college. That's enough time to spread the transaction costs out over many years, get some reasonable appreciation, and pass through at least one bull and bear market.
#2 Returns Are High
I'm a fan of investing aggressively for college. Although the time frame is lower than retirement, the consequences of a shortfall are so much less significant that one can afford to be aggressive.
Real estate investing, like stock investing, has a long record of solid returns—which depending on leverage, can easily be in the 8%-15% per year range. Even a paid-off Cap Rate 6 property, not that hard to find, that gets 3% appreciation per year should get a 9% total return.
#3 Real Estate Becomes Less Risky as Time Goes On
Leveraged real estate investing automatically becomes less risky the closer you get to your goal, simply as a result of amortization of the loan. You don't necessarily need to add bonds, like many automatic 529 options, to lower risk. If you use a 15-year mortgage on the property, it may even be completely paid off by the time the kid enters college.
#4 Significant Tax Advantages
While I don't think the tax advantages of real estate investing are as good as using a 529 (you're not going to get a state tax deduction or credit for contributing, nor are rents and capital gains going to be completely tax-free forever if used for education), there are some tax advantages inherent in real estate investing.
You can depreciate the property, and that depreciation in the early years can make much of your cash flow somewhat tax-deferred. The only way to make the depreciation tax-free is to die before selling, but you can continue to defer the depreciation recapture by exchanging the equity into a more valuable property, a la the Monopoly game. All of your investing expenses (mortgage interest, taxes, maintenance costs, travel to visit the property), of course, are also deductible.
#5 Three Ways to Access the Money
There are three ways to get the money out so you can spend it on college.
Sell It
The first is simply to sell it. That causes two issues—first, you have to pay capital gains taxes and transaction costs. Second, you then have to figure out something else to invest the money in since all of your college savings aren't needed at any given time.
Borrow from It
The second way to access your money is to borrow it, a la whole life. You can get a home equity loan, or you can refinance. Aside from the obvious downsides of having to pay interest to use your own money; paying loan-associated fees; and increasing the leverage and, thus, the risk of the investment, this does have a certain appeal (no tax consequences).
Use the Income Stream
The third way to access your money is simply as an income stream. If you bought a $100,000 property with a cap rate of 6% and paid it off in time for college, it might then be worth $200,000.
That paid-off property ought to kick out sufficient rent, after expenses, to pay $12,000 a year worth of college expenses. Obviously, you've paid much more into this investment than $12,000 * 4 years = $48,000, especially considering the time value of money. But you also still have an asset, probably worth even more, at the end of the college years.
That asset can then be used for retirement, exchanged into a recreation property, used to pay for the next kid's college, gifted to the child as a graduation present (gift taxes would apply on such a large gift unless you used a trust to spread the gift over many years), or sold and used to buy something else you want.
#6 Insulation from Stock Market Returns
Although there is some correlation between the general economy, real estate returns, and stock market returns, real estate income streams tend to have quite low correlation with the overall stock market. Combining a 529 plan invested in stocks with a real estate investment can provide some real diversification. Obviously, putting a big wad of money into a single property could be considered the antithesis of diversification, especially with regard to any possible appreciation.
#7 Opportunity to Teach the Child
One of the things I really like about using real estate as a college savings investment is the opportunity to teach the child financial principles. I use my 529s to teach my kids about taxes, stocks, bonds, dividends, appreciation, and compound interest. But I think a real estate investment would be even more useful.
I could teach the kids about
- rents
- inspections
- appraisals
- mortgages
- interest rates
- appreciation
- depreciation
- amortization
- property management
My eldest rappeling in her first technical canyon
and perhaps most importantly, I could teach them about work.
If you manage the property yourself, you can drag the kid down to the property with you to deal with the tenants, collect the rent, fix the toilet, paint the fence, etc. “This is your college fund, kid. Better take care of it.” If you buy the property in the college town, the kid could become the property manager in college, providing them the ability to work for their income and to learn valuable skills. They could even live in the property, using the rents from their roommates to pay their own college expenses, building valuable life and business experience.
#8 Estate Planning
If you give the child the property (especially in the beginning, when it isn't worth much), this has the added bonus of getting money out of your estate. Obviously, this is not much of an issue for most docs in many states given the high federal estate tax exemption amount ($12.92 million in 2023), but it is a potential opportunity to reduce estate taxes. You would obviously lose control over the asset (like an UGMA account), but you could reduce that loss through the creation of a trust.
Downsides
There are also a number of downsides to doing this, especially compared to using a 529 account.
- The loss of the tax benefits of a 529. It's tough to beat an upfront state tax break plus tax-free growth.
- Loss of liquidity when compared to a good 529 invested in stocks. It's relatively easy to pull a few thousand out of a 529 every month, semester, or year. It's much harder to match your cash flows from real estate to your college cash needs.
- Both home equity loans and selling the house have significant costs that a 529 does not.
- Real estate investing also requires expertise and skill that buying and holding index funds in a 529 simply doesn't. It's an inefficient market, and just as there are plenty of people who use their skill, expertise, hard work, and luck to boost their returns, there are plenty of people who do not get good returns due to lack of skill, luck, and hard work.
- Of course, there is also the issue of real estate investing being part investment and part second job. While a second job gives you the opportunity to teach your child to work, it also means you're going to be doing some additional work you wouldn't otherwise be doing. You may simply wish to use your time for something else.
- Even if you're not a do-it-yourselfer, it's far easier to hire an advisor to manage a 529 than to find one to acquire and manage real estate properties without significant input from you.
- Finally, as mentioned, buying a single investment property instead of thousands of stocks is the classic “Put all your eggs into one basket and watch it very closely” vs. “don't put all your eggs in one basket” conundrum. If that property does poorly or requires significant unforeseen expenses, it may not work nearly as well as a more diversified approach.
These downsides are the same whether you're buying properties directly or whether you're involved in syndicated real estate.
In the end, the most important thing about college savings is starting early, saving enough, and choosing investments with the potential for your money to grow significantly faster than inflation over the relatively short time period you have. Stock index funds in a good 529 are a fantastic option. Selected real estate investing may also work well for the right person/family, either on its own or in combination with the 529.
And if you're interested in pursuing real estate investing and working with WCI-vetted partners who could help you build wealth, here are some of the best companies in the business.
Featured Real Estate Partners
Do you think real estate would work well for paying for your child's college? Why or why not? Comment below!
[This updated post was originally published in 2014.]
Great article considering real estate as a college savings tool. In a way it is thinking outside of the box.
WCI (and fellow readers), what are your thoughts on the best ways to save for college if you live in a state that does not have state taxes? Would you still prioritize a good low cost 529 as your first choice, or would something such as real estate or another investment vehicle be preferred?
Remember the biggest tax break associated with a 529 is a Federal tax break- the earnings aren’t taxed. The state tax deduction or credit is just icing on the cake. So I don’t think you should abandon a 529 for something just because your state doesn’t have income taxes, although it is one factor to put into the equation.
Consider your own strengths and opportunities and play to them. Also, think about what you enjoy doing and managing.
My husband and I both became accidental landlords before we even met. We both bought property whose equity went upside down and we both held it and rented it out, rather than sell at a loss when our jobs and lives moved on.
When our kids were pre-school age, we had the chance to buy more property and we took it. At the time, we had already been through the tough learning curve of landlording. We understood the finances and we knew the work involved and we knew that we could do it. We did not (back then) understand 529s or much about investing. We still thought we were doing the right thing by having a financial advisor. Sigh!
So we took some of our own money and all of the money we had saved and been gifted for the kids, and we used it as down payments on two rentals.
In retrospect:
– We were right to do the real estate. Between the two of us we had the skills and availability to run the finances, do the small fixes and hire help for the big ones
– If we had understood finances as well back then as we do today, we would probably have done just as well pushing all the down payment money into the right allocations in the right 529. But we did not know then what we know now.
– We did way way better with the money we used on down payments than the equivalent sum left in an IRA under management by the financial advisor. But I think anyone who has made it as far as this blog would do better than that advisor!
amazing to see the kids do rappelling!
We setup 529 plans for the kids when they were young, and have made regular contributions. Any birthday money that they’ve received from friends or family, they’ve asked that it go to their college fund (although most of the time they spend it on entertainment). So, that’s one benefit of the 529 plan – being able to direct their own funds into it. They can’t point to a property and say ‘pay my birthday money towards the principal’. Another benefit is that i can tell my wife exactly how much we’ve saved for education. Along the way, I’ve invested in property but only because the opportunity presented itself.
Silly to use re for college planning
A diisservice to your readers
Quite surprised as it’s so inappropriste
I’m surprised you see it as so inappropriate that it is a disservice to even mention it. Do you see an issue with using it that I didn’t mention in the article as a downside?
What is the disservice? WCI has discussed the pros and cons, and it is up to the reader to determine if real estate is suitable for their needs. Personally, I’ll be using a combination of 529 and funds from real estate investments for my kids. I hope the income from real estate (mine is commercial) can be used for future generations. That would be something!
The tax free gains cannot be ignored as any other investment has a very poor chance of doing better than a 529 plan
Using re is very poor alternative and should be avoided
The fun thing about investing is if you view an investment as a poor alternative, you don’t have to use it!
The tax-free gains on a 529 might not be as impressive as you might think, especially if you don’t invest aggressively and/or start late. Imagine a doc who starts saving when his kid is 8 by putting $4K a year toward college. Since he only has a decade, he invests it in a moderate risk portfolio of 50% stocks and 50% bonds, and manages a 5% nominal return over 10 years. Then the money is withdrawn and spent on college. How much did he save in taxes? Well, the account grows to $52,827. $40,000 was principal and $12,827 was gain. If he had invested in a very tax-efficient investment in a taxable account instead, then the taxes due on that $12,827 may be as low as 15%. 15%*12,827=$1924. Yes, you shouldn’t ignore that, but it’s also less than many docs make in a day or two.
Personally used this strategy. Cash flow from my rental and one extra call per month to fund my kids private high school and majority of boarding expenses in college. RE is part of diversification . In today’s market it may be smarter to pay for college by selling RE rather than withdrawing from 529. Also selling RE and paying entire 4 yrs in advance with that will save extra few thousands dollars against rising tuition. WCI always bring new ways to help readers. Thank you Dr Dahle for your service.
We had always thought about buying a property in the college town with a few extra bedrooms for the kid to live in and rent out the other rooms. Anyone do this? We in the end did not.
Lots of people do this. In fact, my daughter just asked for a loan to do this for the last 3 years of her college so we may be doing it soon.
Buying college-town property seemed like a great plan to aspire to, but as we got closer to our actual kids going to actual college towns, we came to understand that for both of our kids this was financially viable but the wrong choice for their personalities, stress levels and emotional health.
Our kids have different personalities but for each of them it would have been too much of a burden to become the landlord or the landlord’s representative. Figuring out who was in and who was out as a roommate, and navigating the chores of shared living space was enough of a learning curve .
College is tough enough. If they had been different people, who viewed this as an opportunity, we could have made it happen. But it was not the right choice for our kids.
Also with rent being about 15% to 20% of the overall cost of college for us, our kids made their biggest contribution to cost reduction by dual enrolling at online community college and picking up as many credits as they could at a huge discount. Both our kids had/have jobs and internships. They are good with hard work but they were not up for the emotional stress of being the landlord.
50% international / 50% small cap value didn’t turn out to be a great bet in 2014 – 2022. 50/50 VBR (vanguard small cap) / VXUS (vanguard total international) had 5.9% return compared to 10.5% for VTI (vanguard total market). I’m hoping the next decade will be different though as I’m making the same bet although not all in — 50% total market, 25% small cap value, 25% international in 529s.
Nope, but I bet it’ll be a lot better over the next 8 years and I’ve still got a 7 year old. Small value and international are both throttling VTI over the last year plus.
Sadly cash beat both of them this year, so hopefully this won’t be the only year of outperformance in the next decade.
Jim great article. Why did you choose 50% total international and not 25% total US, 25% total international in the 529 Asset Allocation?
It’s been a long time but my recollection was that I put 50% in US stocks (which happened to be small value stocks) and 50% in international stocks (which happened to be large stocks). That way I was diversified both on the US/international spectrum and the small-value/Total market spectrum. Wrong bet for the last decade but probably the right one for this next decade.
There are a couple additional benefits you forgot.
1. There is an addition 2-5% return added in for the mortgage pay down with the variation being lower return early in the mortgage since more goes towards interest.
2. The best part is your tenants are the ones paying for your kids education. Outside the down payment, the rest is paid by tenants.
1. Probably not that high, but yes, it certainly adds to the return.
2. Money is fungible. That’s like saying Wal-mart and Exxon customers are paying for your kids to go to school if you’re using a large cap mutual fund to pay the expenses. Fun to think that way, but not really intellectually honest.
1. 2-5% is being generous. In my first year (so lowest return), I’m getting 3.5% return just off my mortgage paydown alone.
2. That is not what gives stocks an increased return. Otherwise I would have expected to see similar growth in my Walmart stock that they had in sales, yet despite the 8.2% growth in grocery sales and 16% growth in eCommerce for Q3, my Walmart stock is down. Our returns on stock are based on so many more factors than people buying stuff in the stores. And yes, all those people paying me rent goes into my bank account which pays my mortgages and expenses so they are, in fact, paying the mortgage. I don’t think equating those two is intellectually honest. There is a MUCH more direct link to tenants paying my mortgage than my buying groceries at Walmart is helping the stock price.
1. This might make an interesting blog post. But let’s just run some numbers and get an idea of what this adds up to. Let’s say one puts down $100K on a $400K property. So a $300K, 30 year fixed mortgage at 7%. The annual payment on that is $24,176 of which $3,175 is principal. So yea, 3%. In later years that’ll be skewed a bit. Obviously more is going toward principal, but there is more equity too.
2. Nope, it’s exactly the same. They’re both businesses and people buy businesses for earnings. Is there a speculative component too? Sure. But that doesn’t change the underlying equation of what’s going on. People buy stuff at Wal-mart. Wal-mart pays its expenses. What’s left is earnings, which are either paid out to investors or reinvested at the company. When the company is sold, the current and future earnings are the primary driver of what it is worth. People pay rent at a property. The property pays its expenses. What’s left is earnings, which are either paid out to investors or reinvested at the property. When the property is sold, the current and future earnings are the primary driver of what it is worth. Same same. Any suggestion otherwise is simply a misunderstanding of what a stock fundamentally is.
My kid’s dad and I co-own a vacation home, and we plan to sell it to pay for college costs. So far it’s looking like a way more profitable investment than the measly 529 I’ve been able to accrue – we’re looking at potentially $150k of profit on the second home versus $12k in the 529 which has shrunk in this market downturn. The 15% capital gains tax though is daunting, and I thought we might be able to get around it by gifting the property to the kid at age 18 and having the kid sell it in their own name. Since kid otherwise has no income I believe their capital gains tax would then be zero. Is this correct? I hadn’t really heard of other people doing it so I’d be interested to hear other thoughts on it.
Yes, you could do that. You’d use up some of your estate tax exemption though. Don’t know if that’s an issue for you or not.