10 Tips for Real Estate Investors

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1 10 Tips for Real Estate Investors FINANCIAL ADVISORS TRUSTWORTHY BY DESIGN SM

2 When you buy a home, people often remind you it could be the biggest investment you will ever make. But should you use that investment to help fund your retirement? What about rental properties? How can you maximize their potential for your retirement? If you re wondering how to integrate your real estate investments into your retirement or are interested in real estate investing in general, these tips are for you. 1 Things to Consider Before Investing in Real Estate Real estate is like a business: It s not like the late-night ads that make it sound really easy. The reality is: you will need to find tenants, find properties, collect rent, evict tenants and fix toilets among other things. Be realistic about what your skill set is. Do you have the skills and time needed to do the necessary repairs? Before buying a fixer-upper, take a step back and you might find yourself thinking, Well, if I want to be invested in real estate and I m honest with myself about my abilities, I m going to take a more conservative approach. Don t get stuck in an unrealistic budget and unrealistic timeframe. If you do, you could be stuck with a cash black hole that s just eating up money every month and getting worse and worse. A lot of people don t realize just how competitive it is to find a really great crew who will actually do what you want, on time and on budget. Pure Financial Advisors, Inc. 1

3 2 Understand the Make sure you understand the finances of real estate because ultimately you are here to make money in real estate. The first thing you should calculate is the cash-on-cash percentage. Cash-on-cash is your net profits divided by your equity. Finances of Real Estate (Cash-on-Cash) For example, assume you have a $100,000 of equity in your property. Your profits, after all expenses (even the mortgage payment) is $3,000. Take $3,000 divided by $100,000, and that equals a 3% cash-on-cash percentage. Realize, different areas of the country have different ratios. Texas might be around 10% cash-on-cash. In California, you d be lucky to be break even out the gate. Pure Financial Advisors, Inc. 2

4 3 Buy a Rental Property for the Cash Flow Not the Flair The most conservative way to invest in real estate is to buy something for cash, and to collect cash flow. If you introduce leverage acquiring a mortgage, (more on acquiring a mortgage later!), or if you are counting on appreciation and speculation to be your return, you re taking on more risk. In a booming market, you can make more money that way, but in a down market, you can also lose a lot of money. It really comes down to this: for every dollar invested in that property, how many dollars are going to come out (in terms of income) after all the expenses have been taken care of? As you go up the ladder in terms of price point, you don t necessarily see a commensurate increase in the rental rate. Now there can be certain nuances to that, depending on which market you re in and where there s demand. If you live in a place where there s an obvious tourist attraction, or if it s right on the water where you always have a high demand for short-term high-dollar vacation rentals, that can be a bit of an exception. But if you re just looking for a tenant who s will be there for a few years and be a steady source of cash flow, you typically do better with the more modestly priced homes. Keep in mind that the million-dollar home isn t necessarily going to have 10 times the rent of the $100,000 home. Pure Financial Advisors, Inc. 3

5 4 Minimize Taxes Through Real Estate Investing (As a Real Estate Professional) Real estate can be a great investment and a great write off, but only if your income is below $150,000 or you (or your spouse) qualify as a real estate professional. If your income is $100,000 or less that year, you can deduct up to $25,000 in excess rental losses. If you make between $100,000 and $150,000 then you can only use part of your losses to offset your other income. There are no real estate losses allowed when your income is above $150,000. These losses are referred to as passive losses and any unused losses will be suspended or carried forward until either you have income on your property, or you sell your property. A real estate professional means you have to work at least 750 hours a year doing your real estate investments management, buying properties, etc. You also need to have spent more than half of your total professional time that year in real property trades or businesses. And you need to materially participate in the management of the property. If all of these requirements are true, then you will be able to write off your passive income losses against other income. Pure Financial Advisors, Inc. 4

6 5 Using Vacation Rentals to Generate Income: Risks and Reward If you re looking to build up a portfolio and receive passive income for the rest of your life, you may be looking to use real estate to try and boost that passive income. You might try and expand that portfolio by doing a little bit more AirBnB, VRBO, versus just having standard rentals. Although a vacation rental requires more work on your part, the income potential is generally greater. Ask yourself if your property would be a good candidate for a vacation rental. Would others want to visit your town and community? Another factor is in areas where tourism is part of the base, there is always the chance for new regulations. In fact, one of the gotchas that has emerged in recent years is that homeowner s association and county boards across the country are not too thrilled with the coming and going with the vacation rentals. So, many people might be on borrowed time with the ability to rent out for 1, 2, & 3-night stays. Soon we might be penned into weeklong stays, which could potentially cut into profits. New laws and regulation regarding rental properties are a big risk and are becoming more and more commonplace. BONUS TIP! If you plan to purchase rental properties out of town, make sure you have local contacts to help you. Rental properties can be rewarding and profitable, but it takes work, and there will be surprises. How do you manage everything with property managers, repair people, and things that need to be done to the unit when you live away from the property? Pure Financial Advisors, Inc. 5

7 6 Leverage Plan Strategically If you want to get started in real estate, use other people s money to increase your returns when buying rental real estate. Consider this, if you use all cash, then if the property goes up 5% in value, you made 5%. However, if you put 10% down and it goes up 5%, now it s as if you made 50% because you have less invested and are now the equity owner. The problem is, if the property goes down 10%, now you ve lost 100% of your investment. That s where you have to be a little careful on leverage. For example, when you buy properties with high leverage, that means a high loan. With a $100,000 property, you put 10% down ($10,000) and you borrow $90,000. If the property goes down 10% and is now worth $90,000, you ve lost 100% of your original investment. Here is another consideration, in markets where real estate prices are falling, rental rates tend to fall as well. High leverage can be risky because reduced valves and rental rates could mean you can t sell because there is no equity and you can cover your rental expenses because your rental income is lower. Moral of the story: leverage can definitely work for you, but it can work against you in poor markets. Pure Financial Advisors, Inc. 6

8 7 Weigh the Pros & Cons Before Buying Real Estate in an IRA You have the option to buy real estate in your IRA, but you have to set up a self-directed IRA. You cannot go to a custodian such as Schwab or T.D. Ameritrade; you have to go to a special custodian that will hold real estate. While you can buy real estate in an IRA, it is important to know both the pros and cons. PROS The best advantage of using IRA funds to purchase real estate for most investors is the availability of the funds. If you want to be a real estate investor, your IRA may be your only source of investment capital. CONS Owning real estate in an IRA often lacks some of the advantages that direct ownership in an individual s, trust or entity name may provide. Some cons include: You generally must pay all cash for a property (no financing allowed) Annual income is taxed at ordinary income rates when withdrawn from your IRA rather than potentially tax free (with depreciation) Profits on sale are taxed at ordinary income rates when withdrawn from your IRA rather than at capital gain rates There is no step-up in basis upon passing of taxpayer Required minimum distributions are still required each year at 70 1/2 Repairs must be paid out of IRA cash balance You are not allowed to repair the property yourself No personal use is allowed for you or your family members Pure Financial Advisors, Inc. 7

9 8 Ready to Sell? Consider a 1031 Exchange If you sold a rental property for $150,000 and purchased a new property for $300,000, how could you defer capital gains tax? Consider a 1031 exchange. A 1031 exchange is when you sell an investment property (a rental property) and buy another rental property within the following timeframes and parameters. When you sell the property, your money must go to a qualified third-party intermediary or exchange accommodator After the escrow closes, you have 45 days to identify up to 3 properties that you might want to buy Then you have six months from the close of escrow to actually buy one of those 3 properties you listed So as long as you do all of those things, and the rental property that you purchase is the same price or more expensive than the property that you sell, then you defer the gain but you don t eliminate the gain. Note that if the new rental property purchase price is lower there is boot. This just means there s a tax event on the difference. So, if you walk away from a transaction with cash in your pocket or less debt, either of those things are considered boot and it s taxable. But, it s not pro-rata. This means that if you have gain of $100,000 and you get boot (cash of $80,000) the entire $80,000 is gain. You still have another deferred gain of $20,000 that goes into the new property. When you sell the new property, you ll pay the tax on that $20,000 gain in the future. Pure Financial Advisors, Inc. 8

10 9 Other Ways to Sell Your Real Estate Outright Sale When you sell a property at a gain, you have to pay all kinds of capital gains taxes, and it gets worse than that. You have to pay depreciation recapture, because when you buy a residential property, the IRS lets you depreciate or deduct it over 27 ½ years. If you have owned that property for 10 years, you have taken a lot of depreciation. You received some tax benefits, but now you need to pay those tax benefits back. Plus, you hopefully sold it for more than you bought it for, so you will need to pay taxes there as well. Installment Sale An installment sale means you sell the property, but instead of receiving all the cash now you will receive it in installments over time. You become the bank as you are making a loan to the buyer. So, whoever you sell it to, the buyer, makes monthly payments to you. As they make principal payments, you pay a percentage of the gain. However, this process has all kinds of issues. For example, if the buyer stops making payments, then you have to foreclose on the property to get the property back, and a lot of people don t necessarily want to do that. Pure Financial Advisors, Inc. 9

11 10 Other Ways to Sell Your Real Estate We already mentioned 1031 Exchanges as a tax favorable option when selling rental property, but there is also another option: a Tax-Exempt Trust (also known as a charitable remainder trust). Maybe you don't want to exchange the property at all. You have decided you are done with real estate and just want to sell it to have more liquidity and income. This is where a tax-exempt trust comes into play. You have to set up a tax-exempt trust and contribute the property over to the trust, so that the trust now owns it. When the trust sells it, there is no tax to pay because it is a tax-exempt trust. You can have the entire proceeds to invest without taxation. What you get is a lifetime earnings stream. Year after year, you get payouts from this trust and the payouts are part income, and part capital gains of the trust. These pay outs are taxable in the year received. At the end of your life, charities of your choice receive the remaining balance of the trust. That is the reason there is no up-front taxation on the sale. Pure Financial Advisors, Inc. 10

12 ! Understand Why You re Investing in Real Estate in the First Place BONUS Real estate can be a great investment to build net worth or to create cash flow. Very often, it s not the same in different areas of the country. Let s go back to Texas. Historically, Texas has not appreciated very much, but the cash flow on rental properties has been fairly good. In Texas, you make your money in cash flow. In California, the cash flow has been abysmal, but the properties have gone up in value. In California, you make money in appreciation. Keep in mind, if you have California style properties, when you retire you may be selling those properties. Selling the properties may be the best way to access that equity without borrowing against it. When you sell properties, you have options. You can do an outright sale, an installment sale, a 1031 exchange into a property that has a better cash flow, or you can do a tax-exempt trust (or Charitable Remainder Trust). Consider all of your options and make the best choice for your situation. This material was written and prepared by Pure Financial Advisors, Inc., an SEC Registered Investment Advisor. SEC registration does not constitute an endorsement of the firm by the commission nor does it indicate that the advisor has attained a particular level of skill or ability. Intended for educational purposes. This guide does not take into account your personal situation nor disclose all risks and details of real estate investing. Past results do not guarantee future performance. Investment in real estate involves the risk of loss. You are encouraged to seek advice from an independent professional advisor based on your individual circumstances. Pure Financial Advisors, Inc. 12