The Business of Real Estate

0
305

Taxes are our greatest expense. Today the average person is paying more than 50 percent on income taxes and hidden taxes. One of the beauties of real estate investing, when compared with investing in stocks and mutual funds, is the ability to pay nothing in taxes, legally. As far as I know, this real estate loophole is the biggest and best legal tax loophole remaining, and that is why Gary Gorman is my friend and advisor.

Gary has both saved and made Kim and me a lot of money. While this tax loophole has saved a lot of people money, it has also caused people to lose a lot of money. Many people lose money because they sell a piece of property, deferring their tax bill, but fail to plan their next real estate purchase. This failure to carefully plan their sell and their next buy cause them to either pay the capital gains tax anyway or purchase a bad piece of property just to avoid the tax. Often, rushing to buy a bad piece of real estate is worse than paying the capital gains tax. Today before I sell or buy a property, I call Gary Gorman’s company for strategic advice. I call Gary before I call a real estate broker.

One of the last great tax shelters left in the United States deals with the ownership of the real estate, and more importantly, with how it’s taxed when you sell it. There are essentially four different classes of real estate: property you own for development, the property you own for a short time (less than one year), your personal residence, and investment property you own for an extended period of time (at least a year). Each is taxed a little differently. Here’s a quick overview.

First, the property you own for development is subject to ordinary income taxes, as well as self-employment tax (the self-employed equivalent of FICA). Short term the property, by contrast, is subject to short-term capital gains tax, which is typically taxed at the same rate as your salary and other ordinary income. There’s no self-employment tax. Your personal residence is treated differently, too. It qualifies for a gain exclusion of different amounts, depending upon whether you’re single or married. That leaves us with an investment property that you’ve owned for at least one year, and this is where real tax shelter advantages kick in.

Four Property Types and How They Are Taxed
  1. Property owned for development—is taxed as ordinary income.
  2. Short-term property—is taxed as short-term capital gains.
  3. Personal residence—qualifies for a gain exclusion based on marital status.
  4. Investment property—is the place where real tax shelter advantages kick in!

The government actually wants you to invest in long-term, investment-type real estate. So to encourage you to make this type of investment, it offers you a couple of tax benefits: The first is that you are allowed to write off the cost of the property, over a predetermined period of time, through annual depreciation deductions. The benefit of this depreciation deduction could be used to offset other income that you’ve earned.

For those of you who want to sell your property, you’ll pay long-term capital gains tax, which is at a much lower rate than ordinary tax rates. Another author in this book, Tom Wheelwright, does a great job of discussing these benefits in Chapter 21 of this book. My chapter, however, is about my favorite tax benefit, which is available only with a long-term investment property, and that is your ability to roll the gain from your old investment property over to your new property. This is called a 1031 Exchange because Section 1031 is the Internal

Revenue Code section that allows you this benefit. The 1031 Exchange is a beautiful thing. All sophisticated investors include 1031 Exchanges as a critical technique in their bag of investment tools, and if you’re not using this tool, you need to learn how powerful it can be to the creation of your personal real estate wealth. Start by understanding how an exchange works: When you sell your old investment property and buy a new investment property, you can roll the gain from the old property to the new one without paying the tax until some time way in the future. Investors who are experienced with this tax code section often can actually pick the amount of tax they want to pay, and when in the future they want to pay it.

The obvious benefit of doing this is that you don’t have to write a check to the government every time you sell a property. An even bigger benefit is that it allows you to buy a bigger property, which will result in more cash for you somewhere down the road. To illustrate this, let’s say Fred and Sue are selling their rental property, and the tax on their gain would be $100,000. Fred and Sue decide to do an exchange instead so that they’ll be able to plow this money back into their new property.

Because they are getting a 75 percent loan on their new property (which means that their lender will loan them three dollars for everyone that they put into the deal, or $300,000 to their $100,000), Fred and Sue are able to buy $400,000 more property than they would have if they had paid the tax and not done an exchange.

Hold for Investment

Section 1031 applies only to property held for investment, but if you meet this

you could also buy an office building, an apartment building, a warehouse, or bare land. We have clients who sell bare land, which is not income-producing, and then buy rental properties, such as apartment buildings, which do produce income. In other words, they use an exchange to create cash flow. We also have clients who sell one income-producing property and buy another in order to increase their cash flow, and we have some who sell income-producing properties, generally apartment buildings, and buy bare land in order to get out of the hassles of managing their property; they use an exchange to simplify their lives. the rule you can sell any type of investment property and buy any other type of investment property. In other words, you can sell a rental house and buy a duplex.

Exchanges are a great tool to help you accomplish your investment strategy.

A common misconception that people have about 1031 exchanges is that if
you sell a purple duplex, you have to buy a purple duplex, and this is not the case; simply put, both your old property and your new property have to be held for investment.

One of the ongoing debates is whether vacation homes (or second homes) qualify for 1031 Exchanges; many of you own these types of properties. The debate is whether or not vacation homes are investment properties (which do qualify for exchanges) or personal-use properties (which don’t qualify for exchanges), and since vacation homes by their nature fall somewhere in-between, the debate has raged for years.

We do a lot of counseling with our vacation home clients to make sure that they are doing everything they can to protect their rights to exchange their property, and if this is the kind of property you have, I suggest that you work with a good intermediary (which I’ll define in a moment) to make sure that you follow current law.

Current law, by the way, allows you to exchange vacation homes if you follow very strict guidelines. One of the things that Section 1031 does not allow is the exchanging of property held for resale. The IRS, however, does not define the terms held for investment and held for resale. Guidelines for these terms have arisen from a series of court cases that give us a pretty good understanding of what an investment property is versus a property held for resale.

I expect that as time goes on, the court will continue to refine these definitions, but for now, the property is held for investment if you hold it as such for at least one year and one day before you try to sell it. Property that you try to sell within the year after you bought it is generally considered to be held for resale. While a defined holding period is

not mentioned in the code section, most exchange professionals are comfortable with a holding period of more than one year because one year is the required holding period to get long-term capital gain treatment if you sold the property and did not do an exchange. A classic example that defines the term “properties held for resale” is the “fix-and-flip.” A fix-and-flip is where you buy a “fixer-upper,” clean it up and then put it back on the market.

Because your intention is to sell the property right away, the property does not qualify for an exchange, even if you have trouble finding a buyer. Does this mean that you can’t buy a property with the intent to fix it up? No, you just have to hold the property for investment. How do you do that? The best way is to hold the property for at least one year and one day before you put it back on the market.

Lessons Learned

What One Property Can Teach You

What can I say? I got lucky. Kim is beautiful on the outside, and even more beautiful on the inside. On top of that, she has the courage and is very smart. She learns quickly. And I know she did not marry me for my money because when we met, I did not have any money. What we had was our love and a dream of becoming a rich couple together. In 1987, the stock market crashed. The savings and loan industry went bust, and the real estate market crashed.

This is when I said to Kim, “Now is the time to invest.” She often states that, back in the 1980s, she had no idea what investing was, especially investing in real estate. On top of that, most people around us were crying the blues and complaining about the bad economy. Fear and pessimism were everywhere. In spite of that, she trusted me, and we began looking at distressed properties. Our plan was simple.

We would buy two houses a year for ten years, which meant we would have twenty homes to provide us income. She studied, did her research, and looked at house after house. Finally, she bought her first property. That investment changed her life. Within eighteen months, she had achieved her ten-year goal of twenty properties. She has never looked back. She took to investing like a duck takes to water.

Today Kim is an investment partner in more than fourteen hundred rental units. Even as the economy crashed in 2007, her properties delivered positive cash flows while many other real estate investors were losing everything. In fact, her investment income went up as more people became renters. She is, as the title of her book states, a rich woman. But more than money rich, she is financially smart. She is a financially independent woman who does not need a man, or me, to take care of her. That is why I am so proud of her and love her with all my heart.
—Robert Kiyosaki

It is amazing the number of life lessons as well as the amount of hands-on knowledge you can learn from one single investment property. I’m not just talking about your first two or three investment properties as you’re starting out; those almost always seem to deliver a steep learning curve. I’m talking about the lessons I continue to learn after years of real estate investing. Every property teaches me something new that I didn’t know before. Here is the story of one property that to this day remains one of my greatest teachers.

Miami, Florida

In 2003 my husband, Robert, and I were in Miami, Florida, attending an investment conference. At one of the breaks during the first day, a young real estate broker, Matt, introduced himself to us, and we spent a few minutes chatting. Being the good salesman that he was, he couldn’t help but tell us about a real estate property that he had some inside knowledge of. The property was not on the market, but the two owners were entertaining offers if the buyers were serious. My first response was understandably skeptical. I didn’t know this guy, and I didn’t know if this was just a hyped-up sales pitch.

In any event, it was a good pitch, and we had a couple of hours free that afternoon, so we drove with Matt to take a look at this property. Of course, according to Matt, it was the best deal he’d seen in years! About twenty minutes later, we pulled into an attractive strip mall with a few shops and restaurants. The mall was less than two years old, and some buildings were still under construction. At one end of the mall was a large health and fitness club. The building was about thirty-eight-thousand square feet with parking spaces allocated for the club. The property for sale was the building occupied by the one tenant (known as a single-tenant property): the fitness

club. This particular piece of property was a triple-net lease investment. This means that the tenant—the fitness club—pays the property taxes, insurance, and all repairs and maintenance. There is very little management on the owner’s end. It is a very appealing type of investment, given the right terms. We wanted to know more.

The First, of Many, Lessons

One of the first things that struck me on this visit was the potential risk. Since there is only one tenant, this means that all of our income on the property would be dependent on this one tenant. Therefore, the ultimate key to the success of a triple net, single-tenant investment property is, very simply, the quality of the tenant. Our income, our cash flow, and the value of our property would all depend upon the tenant’s ability to pay us every month until the end of the lease. You can see the implications here.

With any single-tenant building, you want to make sure that the tenant is financially strong and has a solid business foundation. In other words, Microsoft is a quality tenant, Martha’s typewriter repair shop probably is not. The reason why you want an A-list tenant is that if the tenant leaves, so does all your income, and then you’re left with an empty building that was designed for the tenant who is no longer there.

One way to protect yourself from your only tenant vacating your property is to set up a reserve account. This is an account that you add to every month from the cash flow of your property. To sleep well at night, I’d recommend at least one year of reserves that allows you to pay the mortgage and any expenses associated with the property, while you look for your next better-quality tenant.

The Good and the Bad

With any single-tenant property, there is the risk of the tenant moving out early and leaving the property vacant with no income. However, associated with that risk we discovered another risk that was unique to this property. The mall where the fitness club was located was adjacent to a gated neighborhood community. Ordinarily, that might be a good thing, but in this case, an agreement between the owners of the fitness club building and these neighbors was in force. The agreement stated that any changes to the building must get approval from the neighbors. What would this mean for us? It meant that if the fitness club tenant moved out, then the neighbors would control what we were allowed to do with the property. They would control who and what could move in there.

The neighbors, not the owner of the property, were in charge. This was a stumbling block. Of course, Matt, the broker, didn’t see this as much of a problem. Robert and I did, though. If we were to move forward, we would want this agreement closely reviewed. On the plus side, this property was in a prime location. It was just around the corner from a prestigious country club, and it was on a high-traffic main street. The property was newly built, and the financials, at first glance, made sense. Based on the numbers shown to us, we would receive a healthy cash flow of about 18 percent.

Lesson Learned: The financials given to you by most brokers are projected numbers, not actual numbers. Projected numbers are typically the best-case scenario, and they present a better picture than how the property is actually performing.

Matt drove us around so we could get a feel for the area. There was quite a bit of new construction going on, and the number of people moving into the area was on an upswing. All good signs. We gathered up all the information he had and flew home to Phoenix. On the plane trip home, Robert and I discussed the pros and the cons of the property, at least what we knew of it in the brief time we had. By the time the plane touched down in Phoenix, we had decided we would make an offer on the Miami property and pursue it further. The next day, I phoned Matt and put in our offer.

We went back and forth with the owners and fairly quickly came to an agreed-upon price. Now the work began, otherwise known as the due diligence period. This is when you perform a very thorough check of the property to make sure that what you think you’re getting is what you’re actually getting. And this is when my problems began.

From the Beginning

From the outset, this property had challenges. First of all, I live in Phoenix, Arizona. The property is located in Miami, Florida. Phoenix is nearly two thousand miles from Miami—quite a distance. There was no way I could just drive down the street to check on the property. If a problem arose, I’d have to get on a plane, spend all day flying, rent a car, stay overnight in a hotel, and then spend another day flying home—a lengthy and costly affair.

a day with a new wrinkle in the deal. Finally, after weeks and weeks of this, Robert and I decided we needed to get on a plane and go meet face-to-face with the owners to work out the final four or five issues that were still unresolved. We flew to Miami, rented a car, drove to the property, and sat down with the owners to discuss the final points. Within thirty minutes, all issues were resolved and agreed to. It was that fast when we met buyer-to-seller (another lesson learned).

The seller went back to his attorney to draw up the final contract. Robert and I flew home. I called my attorney and explained what we agreed to and that a new agreement was on the way.
The new agreement arrived, and every point we and the seller had agreed to in our conversation was different than we had discussed. Had the seller or the seller’s attorney revised the deal points? I didn’t know. The two attorneys went head-to-head once more. This whole process was not just frustrating, it was exhausting.

Real-Life Story: Why Waste a Priceless Mistake? During this last real estate bubble, a friend bought one property, flipped it, and made some money. That first easy success went to his head. He now thought he was Donald Trump’s long lost brother. As the property bubble continued to inflate, he went on a buying spree, buying properties in Las Vegas, Miami, San Francisco, Mexico, London, and Phoenix. Today he is bankrupt and blames real estate for his problems. His problem was he knew only one type of market, a market bubble. He now knows what a real estate bust looks like. Since he blames real estate rather than himself, he has not learned much. He has wasted priceless mistakes. He fails to learn that it is after the bubble bursts that the real, real estate investors come out, and the real killings are made. The killings are made from foolish investors who got killed.

Facebook Comments

LEAVE A REPLY

Please enter your comment!
Please enter your name here