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September 21, 2012

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I agree with your point about only investing in properties that have solid cash flow from day 1.

However, I've seen one combination strategy that can do even better than this, but it does take more time and effort up front.

It starts with purchasing a property that someone else might consider a candidate for a flip (rehab and sell).

But as a cash flow investor, you buy the property to rehab and then lease out.

In my city, 2 bedroom condos are unbelievably cheap, but here is an example of a deal just completed.

Bought a condo (foreclosure) for $25,000. Total cost after closing costs and rehab was $38,000. Market value of the property after being rehabbed is close to $55,000.

If the property would have been turn key, I would have been willing to buy it for perhaps $42k - $45k and could have rented at a nice cap rate (around 10%).

However, due to taking on the additional task of rehabbing the property prior to renting it out, the cap rate on this investment has increased into the 12% to 15% range (depending upon assumptions in the model I use).

I'd probably be willing to eventually take on a property as a true flip project (rehab and sell), but all of my numbers would have to prove that I could rent the property for solid cash flow after fixing it up, just as a backup plan if I could not sell the property quickly (holding costs will kill a flip deal quickly).

I agree with your assessment if being able to safely use leverage to execute this strategy. But you MUST have a good handle on the cash flow generation potential of the property, and put good equity into the deal to provide a cushion.

Lots of people would say that pumping all of your money into a local real estate market is not a good idea and lacks diversification.

Someone once said (not sure who):

"Put all of your eggs in one basket and watch that basket very closely."

I tend to agree with that assessment.

Bogey

Apex-

I really enjoyed reading this post immensely. All the pros of real estate investing is exactly why I am in it. I do want to focus on 2 negatives a bit and get a clearer picture and your take on it.

First, when you are bringing in side money as a landlord, the salary you make on your primary job has an affect on your income taxes where you are limited to claiming your losses for the year. I understand that you can offset this limitation by shelving the losses and offsetting real estate gains on future income tax returns. What is the salary limit and how much does this affect potential returns? Second, the tax deduction on depreciation of your property. I came to understand from Old Limey that all the realized gains from depreciation come back due when you sell the rental property. My understanding on the tax benefits of rental property depreciation is that you keep the dollar value of those deductions (money stays in your pocket longer) but they have to be recovered on the year that you sell the property. Is the idea of keeping money in your bank account for as long as you can the only realized gain from this tax benefit?

@Luis,

LIMITED TAX LOSSES

You can deduct any passive loss against passive income. So if you had multiple passive streams, real estate losses could be deducted against other passive gains. However most people do not have multiple passive income streams (again passive being the IRS tax definition of how the income was generated).

If your AGI is low enough you can deduct up to $25,000 of passive losses against active income. This begins to phase out at $100,000 of AGI and is fully phased out once AGI reaches $150,000. If your AGI is over $150,000 you could not deduct any passive losses from real estate against your active salary income.

There is another route which is to get yourself or your spouse classified as a real estate professional. This is a very high hurdle. You need to have a minimum of 750 hours per year of active involvement in real estate only activities (and you have to be able to document this) and real estate hours have to be at least 50% of your working hours. If you have a full time job it's a nearly impossible hurdle. If your spouse does not work full time, they would still need to put in serious hours in the real estate business doing active work and your spouse cannot count your hours. They have to be doing the work and they would be the one qualified as the real estate professional.

However as I stated in my section on tax deductions a properly purchased property should not be a in a tax loss situation in today's market. My first property needed considerable rehab so I had a lot of expenses and extra depreciation the first few years. I had a taxable loss that I was pushing forward for a couple years but it was quickly consumed by the profit of the unit. I now have enough high profit units that I is hard to imagine any scenario in which I could have a taxable loss regardless of what kind of property I buy in the near future.

SELLING DEPRECIATED PROPERTIES

You are correct that when you sell a property you will have to pay tax on the value of the property that you depreciated. Here is an example.

Purchase price: 100K
Depreciation: 80K
Sales price 30 years later: 200K

So in this example you have depreciated 80% of the value of the property. There are 100K of normal capital gains when you sell this property and 80K of recaptured depreciation capital gains. The 100K is taxed at normal capital gains rates. The 80K is taxed at recaptured capital gains rates (which are capped at 25% instead of the typical 15%).

So yes you will pay that tax savings back when you sell.

However, having the money while you are growing your business means you do not have to borrow it and pay interest on it so it saves you considerable money every year that you did not pay it in taxes even if you have to give it back some day.

It's very similar to the deferred tax benefits of an IRA or 401k. You don't pay the tax on that money now so that it can be used in your funds to grow and compound your money quicker. Then you do finally pay the tax when you withdraw the money in retirement but you have benefited in the mean time. This works the same way.

But unlike the IRA which will eventually force you to withdraw funds and pay tax, you do not ever have to sell a property and pay the tax. You can even do a 1031 exchange to transfer the gains in one real estate property to another. You can even use this process to transfer to something like a tenant in common investment which would move you into a nearly full passive investment.

You can hold the property or a transferred property until your death at which point the heirs of your estate will inherit it. Currently inherited assets get what is known as a stepped up basis. That means that their cost basis for tax purposes is the current market value. In that case they could sell it for its full value and owe no tax on it. If you estate was large enough there would still be inheritance tax but that would be true whether you held property or had sold it and held cash.

I certainly like the tax deduction benefit and consider it helpful. But I don't get as excited about it as some people do. As you can see from my article, I think cash flow and leverage are the things to get excited about, not tax benefits. But I also don't see any reason to be concerned about the idea that you have to pay it back. Think about it this way: if someone gave you 50K to use with no interest charges but said you had to give the original 50K back 30 years, would that concern you?

No concern at all. Thanks!

I used to have many discussions with an engineer friend in my hiking group that owned 10+ rentals. Financially they worked out well for him and appreciated greatly over the years. However he had always done all of his own repairs and maintenance. On a few occasions when we talked he was really infuriated, and cussing and moaning over what he found when tenants moved out. One in particular moved out without telling him and without making the last rent payment. When he checked out the unit he found so much water damage that even some of the main beams supporting the bathroom floor had rotted out. The damage was caused by water leaks that the tenants never reported. It literally took him weeks, a lot of backbreaking work, and a lot of money, to get it all repaired to where he was able to rent it again. He was semi-retired and after this episode he started selling his units one by one. The good thing was that the units had appreciated nicely and he was using the proceeds to build up his investment portfolio in the market.

@Luis
I own a condo that I bought decades ago. It is now fully depreciated as well as having gained in value by over 400%. My understanding of what I would realize from selling it is that most of the proceeds would be owed in state and federal income taxes. Thus, in our will it is being left to our son. He will inherit it with a brand new basis of its value on the day he becomes the owner. Of course our estate will also be paying quite a bit in inheritance taxes - but it won't be my problem - it will just mean less money for the children.

@Old Limey,

You would certainly owe taxes on that property but it would not be possible that "most of the proceeds would be owed in state and federal income taxes"

The 400% increase in value would be taxed at normal capital gains rates. Currently 15% federal plus whatever that CA tax rate is which is probably around 10%. So you would lose 1/4 of the value of the gain to state and federal income taxes, not most of it.

The original purchase price would not be taxed at all unless it was used as an investment and you depreciated it. In that case the depreciated gains would be taxed at 25% recapture gains plus state so 35% meaning you would lose 1/3 of that gain.

Clearly you do not need this money so there is no reason for you to have to sell it if you don't want to. But you would retain the vast majority of the gain if you did sell it.

@Apex @Old Limey

Apex, correct me if I'm wrong, but if the property stays in the family, won't the property taxes remain the same and not be applied to the current value?

@Noah,

In this particular case I believe you are close to correct due to prop 13 in California assuming that is where the condo is.

Prop 13 doesn't actually keep the property taxes the same, it limits them to increases of no more than 2% annually regardless of the true market value of the property as long as it stays with the same owner or family.

Interestingly enough, this is a great advantage for a long time owner but as a person trying to get into real estate investing I would view this as a negative. As a new buyer I would be paying property taxes that might be 5 times what my competing investors would be paying if they have properties they have owned for 20+ years. That would tend to hold down rental rates to a point that made it nearly impossible to purchase property and rent at a profit in that environment.

That describes a lot of the California market from what I understand. I don't know how much prop 13 is responsible for that but it would seem to be a contributing factor.

Apex,

I've never thought about the effect Prop 13 might have on keeping rental rates low here in California but you're right - it certainly must have an effect.

Great article! As a real estate investor I know all of these things but you articulate them very well. I'm really enjoying this series.

If your property has appreciated 400% then the effective tax rate is ~17% for federal assuming you depreciated the entire base value.

For example : You buy a rental for $100k and then depreciate it fully over 30 years. Its then worth $500k. You sell the unit. You owe capital gains taxes on teh $400 appreciation currently 15% for $60k bill. You have to pay 25% depreciation recapture on the original $100k cost you depreciated or $25k. Thats a total of $85k or 17%. Not bad at all. (plus whatever state taxes are and in CA I believe its 9.3%)

The benefit of prop 13 is that if you bought that $100k house back in 1980 and its now worth $500k you are being taxed at $180k rather than $500k. 2% annual increase for 30 years would put your assessed value at $180k yet your actual market value is now $500k.

@Apex

Yes, you are right about the 2%. It's such a small amount that I didn't add it to my post. I'm in the boat with other new home buyers and the CA market is still quite expensive unfortunately.

Having an investment property these days involves a lot of risk. If you can't rent it, you 'd have to make payments out of your own pocket. Sometimes, renters just don't pay their rent for 6 months - it can be a real pain. It depends if you are ready to deal with all that!

@Elena

If you are willing to file an eviction 3-5 days after the rent is late you probably shouldn't be in the rental business. I'd be curious to know how often Apex has had to evict someone and whether he collects rent in person or has a manager handle that.

*aren't willing to file

Yes sometimes tenants won't pay their rent. But thats really only a small portion of the time. You should build that assumption into your finances. Over the long run you could assume you'll get ~95% of your money and write off the other ~5% from vacancies and deadbeats. Of course you want to make sure you do a good job screening your tenants or it will be worse. In short term period with 1 property you might get 0% of your rent. But over time with multiple properties over multiple years it will average out to a fairly low loss rate. The details may vary based on where you live and what your tenant profile is like.

I'm guessing Apex will touch on this stuff in future topics.

@Noah,

I collect all my rent in person. Well technically they mail it to me. If it's late then I start chasing it. I have late rent from time to time.

As to evictions, I have never had to evict a tenant yet. I have never had a single tenant not pay 1 dollar of rent. As I said, I chase late rent from time to time but thus far I have always gotten every penny. I know that won't always be the case, but if you have properties that attract good tenants and screen well, it should not be that common.

@Jim,

You are correct that I will touch on these in future columns. I am in the middle of writing my columns on tenants right now.

@ Apex,

Thank you so much for the time and effort you are putting into this series. I am a beneficiary of the wealth of knowledge which you are sharing, not only in the columns, but in the comments as well.

@CT,

Thanks for the kind words. I am enjoying writing the columns as well.

@Apex
Prop 13 (passed in 1978) does make a huge difference in the annual taxes, especially for close family members that inherit property. Our home purchased for $107K in 1977, now valued at $1.2M, has annual property taxes of $2,239 and when we leave it and its contents to our 52 year old daughter she will keep the same assessment. She is also our executor since she lives near us, obtained a divorce 4 years ago, is my hiking companion every Friday, is the best educated, already has a muni bond portfolio that I manage, worth over $2.7M, and has an appreciation of the art that we have collected in our travels. We worry that, given the opportunity, our other two, less affluent, children would likely sell some of our art treasures, in a heartbeat, at a garage sale for a fraction of their worth.

The beach condo was purchased for $125,600 in 1979, now valued at $550,000 with property taxes of $3,061, and when my 48 year old son, just initiating a divorce, inherits it he will keep the same assessment.

Both properties have unique locations that would be very hard to duplicate today. The home is on a large lot at the end of a very quiet court in the heart of Silicon Valley, close to some of its most famous corporations such as Apple and HP. The condo is at clifftop level and within a very short walk of a little used sandy beach whose access and parking is very inconvenient for the general public.

My son was recently promoted to Western regional sales manager for a large international company and thinks he has found a way of saving taxes. He is investigating the purchase of a small vacation property at Lake Bridgeport in Texas and making that state his domicile since it has no state tax. He travels there on business frequently so he may be right. I don't know.

Another great article. For someone with so few years in the business you have a great handle on the big issues. Remember that real eatate over the long term can only track inflation, since people need to pay for it out of income. To increase wealth one needs to borrow at after tax rates below long term inflation. Then by having your tennants pay off your loan you create actual wealth. Beyond that the cash flow can be reinvested to add to net worth, but appropriate use of tax advantaged leverage is the real wealth creator

In more than 10 years of real estate investing, I have only recently had a tenant who didnt pay rent. One unit, 1 tenant owing 3 months worth of rent. Its risky like any other business/ investment. But you have to love it.

I also outsource any repairs, management, etc. I hate running around, but that's where I started.

You cannot write of deadbeats and vacancies.You can't write off what you did not get.
As far as rent collection goes,I use a rental program and generate invoices on the 23rd of every month.Rent and amount of water bill.These get sent out with a SASE.I found that by doing that it eliminates excuses like no stamp,no envelope or that they forgot my address.I also use a PO box as my return address.
There is still a good amount of chasing I have to do every month.Urban properties in a job decimated area are tough today.
Over the years we've done 90% of maintenance ourselves.I will not do roofs though.We've also decided to stop using carpeting in the living rooms.Lower end tenants destroy it much too quickly.I've started using Allure Vinyl Planks from Home Depot.Looks and feels like hardwood and is water resistant.So far my tenants love it and so do I.

Apex - you should start a real estate blog. Great article.

Question - is there any benefit to depreciate if you have to pay it back when you sell? Doesn't that just create more paperwork headaches every tax filing?

G.E. -
Yes , huge benefits. Real estate investing heavily relies on the concept of the time value of money. Money in pocket today is worth more than money not available until the future. With depreciation, you get a lower tax bill every year until it's fully depreciated, which means cash in your pocket sooner. Besides, you may not sell the property for 40 years - or not at all - which is a long time off to worry about paying a few dollars more in taxes (which come out of the sale price anyway). Further, as some have mentioned above, you can avoid those taxes through a 1031 exchange. And finally, depreciation schedules are very easy to incorporate into your tax return.

In short, depreciation is a benefit all around.

@G.E.

In addition to what Jonathan said, you actually have no choice but to depreciate the property. When you sell the IRS will require you to recapture the depreciation that the property generated. But here is the kicker, the IRS assumes you took depreciation and makes no allowance for someone who didn't. You will pay taxes on the amount of the property that could have been depreciated whether you actually took the deduction or not. So if you don't take it, you lose on both ends. You have to take it!

Great article on Real Estate Investing! One topic that I did not see in your article is investing in real estate with your IRA. Very few people know about this as an investment strategy. I think it is a great alternative to putting your cash into today's stock market. What are your thoughts on using your IRA to purchase investment properties? Thank you!

@Steve Jolly,

I am not opposed to using the IRA per se, but it is a bit tricky to pull off. I have looked into it just a little bit but found it to be more of a headache than I wanted to continue with. Since I am not doing it I won't have much of anything to say about it in these articles.

A few reasons I don't currently do it.

1. You need to have your IRA with a firm that manages self directed IRAs for a fee which can be somewhat expensive.
2. There are very strict rules about using your money for this kind of thing so you have to be very careful not to violate them. The penalties for doing so can be severe.
3. You have to run the business 100% inside the IRA. All expenses must be paid from the IRA as well with no mingling of any funds from non-IRA properties.
4. Getting loans for anything inside the IRA can only be backed by IRA money and properties which would make loans very hard to get. That means you have to do most things in cash which means you need a lot of cash in your IRA.

I would really like to find a way to orrow the money from my IRA to my business as a loan but it seems that loans to your business are either prohibited or very hard to do with a self directed IRA.

If anyone has purchased properties with a self directed IRA and would like to post a comment on their experiences that would be very interesting.

Investing in distressed single family residences really makes sense in the current market condition. With prices low and rental rates very competitive, you can have higher than average returns. In fact, I think that investors are seeing returns higher than 10%.

Plus, when it comes time to sell, single family homes generally appreciate faster than multi-family and in many markets are easier to sell.

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