Question: What do real estate and fishing have in common?
Picture this: It's a spectacular spring day. As you drive to your next listing appointment, you pass a beautiful lake. Glancing across the blue water, you notice something odd. There are dozens of fishing boats bunched close together on one area of the lake. But on the other side of the lake there are just a few boats spaced far apart.
What does this scene have to do with real estate? Well, the lake is a good analogy for the real estate business. The bunched-up boats represent the majority of real estate salespeople, striving in a crowded marketplace, competing for the same goal: residential sales.
Meanwhile, on the other side of the lake, the smaller number of boats have open space and fewer competitors. They represent real estate salespeople who confidently work with investors. The National Association of REALTORS® reports approximately 20% of sales are to investors. So, if you're not comfortable dealing with investors, you're missing one of every five buyers! But, with a bit of dedicated effort you too can capture your share of this rewarding market.
Here's a key point: our focus is on real estate investors, not real estate speculators. There's a huge difference. Wise investors know they're buying a business when they acquire a rental property. It has to be analyzed prior to purchase and must make financial sense. A speculator often buys a property without analyzing the numbers (or even knowing how to analyze the numbers) and hopes it'll increase in value in the future. That's asking for trouble.
You might be thinking, "Geez, I'm not good with numbers. In fact, I hate numbers!" But don't worry – analyzing a property does not necessarily mean memorizing a bunch of complicated formulas. Most of the math is simple: add, subtract, multiply and divide – you learned it in grade school!
It's useful to think of a rental property as a three-legged "money machine." Each leg must be strong or the money machine doesn't work properly. The three legs are income, expenses and financing.
The three legs work in harmony to create the four financial benefits of owning investment real estate. If you understand these benefits and can communicate them, they'll enable you to work effectively with investment buyers and investment sellers.
Helping Buyers: The Four Financial Benefits
In order to "talk the talk" and be equipped to help buyers, put yourself in the buyer's shoes. Think like an investment property buyer. How does this "money machine" work? It can produce four financial benefits:
1. CASH FLOW BEFORE TAX: Once you collect the rent then pay your operating expenses and mortgage, there ought to be some income left over. All investment real estate has income – unfortunately it's not always positive income! So, be careful and always run the numbers before you buy. You don't want to invest in a money machine that loses money.
2. PRINCIPAL REDUCTION: The loan is paid down with rent collected from tenants. The tenants are essentially buying the property for the owner. I'll bet you know someone who has rented the same property for many years. For one reason or another, they don't want to buy. Well, surprise, surprise! They are buying the property . . . for the owner!
3. INCOME TAX SAVINGS: Let's say you buy a rental property that generates $1,000 in cash flow this year. Is that taxable? Yes, the money came from your tenants. The property also produces $500 of principal reduction this year. Is this taxable? Yes, this money also came from your tenants. So your first two benefits total $1,500.
Now here's the good news: for tax purposes, these benefits can be sheltered by depreciation. Depreciation is a "non-cash" deduction (it's also known as cost recovery). The tax rules allow the owner of rental property to depreciate their cost over a number of years. The specific number of years depends on how the cost is allocated. It's important to allocate the cost of the property into categories that include: land, building, personal property and land improvements. Many people lose money by only dividing their cost into land and building.
Each category is depreciated over a different number of years:
|Building|| 27.5 years for a residential rental building|
39 years for a non-residential rental building
(appliances, carpet, furniture, etc.)
| 5 years in a residential rental property|
(parking lot, landscaping, fence, etc.)
Returning to the example, let's assume your total depreciation for the year is $5,000. Every dollar of depreciation shelters a dollar of income, starting with income from the property. So, the depreciation first shelters the $1,000 cash flow plus the $500 principal reduction. They're completely tax sheltered. And you've still got $3,500 of unused depreciation left over.
This leftover depreciation is reported as a "loss" for income tax purposes. For most people this loss can be used to shelter income from their job or other sources, resulting in tax savings. That's the third benefit. The tax savings are in addition to the tax-sheltered cash flow and principal reduction. Not bad!
Why did I say most people can use the leftover depreciation to shelter their income? Well, as you know, tax law is never simple and there are rules called "passive loss rules" which govern when a real estate tax loss can be applied. These rules are beyond the scope of this article so be sure to ask your good tax manager how your unique situation is affected. Be extra sure to ask about the special "exception for real estate professionals." You'll love it!
4. APPRECIATION: The fourth financial benefit of owning investment real estate is appreciation (or increase in value). We all know someone who owns a property that's worth a lot more than they paid for it years ago. It didn't happen overnight, but over the years.
The combination of these four benefits can be a powerful, powerful wealth-building tool!
Helping Sellers: Return on Equity
Once you're comfortable with how the four benefits affect investor buyers you can also use these same concepts to work with investor sellers. One approach is to show a property owner their "return on equity." Consider the following.
Assume an investor named Ben bought a rental house sixteen years ago. Ben invested $10,000 and borrowed the rest. He was smart and did the pre-purchase analysis. The cash flow, principal reduction and tax savings added up to net benefits of $1,400 that first year. By dividing the net benefits by the $10,000 investment Ben's rate of return was 14% ($1,400 divided by $10,000). Not bad – plus, the property was appreciating. He's an investment genius!
But… fast forward sixteen years. Today, Ben's cash flow and principal reduction are still positive. However, much of the depreciation has been used up over the years. There's no longer enough depreciation to completely shelter the cash flow and principal reduction (let alone shelter income from other sources). Instead of having a loss that saves tax, Ben now has to pay tax.
In order to calculate his net benefits, Ben adds his cash flow plus principal reduction, then subtracts the tax he has to pay. If he divides these current net benefits by his original $10,000 investment, the rate of return might still look good. But here's the key point: Ben's investment is not the amount he originally invested sixteen years ago. Instead, his investment is the amount he could get out of the property if he disposed of it today.
For the sake of this example, assume Ben's loan has been paid down significantly over the years and the property has increased in value. Let's say he could sell the rental property today and walk out of the closing with net proceeds of $80,000. If that's the case, Ben doesn't have $10,000 invested, he has $80,000 invested.
If he divides his current net benefits by $80,000 his return on equity is probably very low. As equity grows, return on equity usually falls.
Ben should ask himself, "Could my $80,000 equity do better if it was invested in a different property?" If the answer is "yes," he should move his equity. The best way to move equity is by doing a 1031 exchange. Exchanging allows investors to move their net equity from one property to another without paying tax.
Therefore, if Ben wants to retain his membership in the "investment genius" club, he'll exchange the equity into a different property – or properties – and re-boot his rate of return.
A successful investor's goal is to maintain the highest possible rate of return throughout their investing lifetime. This is accomplished by wisely moving equity from property to property.
A REALTOR® who had attended one of my seminars called me recently. He was proud to report that after the seminar he had explained return on equity to an investor who owned seven properties free and clear. After the REALTOR® demonstrated that the return on equity was only 4.2%, the investor listed all seven properties and exchanged them into two larger ones that produced a much higher return.
That REALTOR® definitely captured his share!
Other Important Issues
Before concluding, let's touch on a few issues that are important but beyond the scope of this article.
1. Analyzing a property is only as good as the accuracy of the numbers. Be sure to be specific and verify the accuracy of income, expenses, etc. One way to do this is by making the transaction contingent on seeing the seller's Schedule E (the tax form reported to the IRS). You should be diligent and require accurate numbers. Otherwise the analysis is a classic case of "garbage in, garbage out."
2. All dollars are not equal. There are significant differences in how dollars are taxed. If you earn a dollar from your job you have to pay federal and state income tax plus Social Security tax (or self-employment tax) on that dollar. However, if the dollar comes from rental property cash flow, it can be sheltered from income tax and is exempt from Social Security tax (or self-employment tax). Therefore, a dollar of cash flow is better than a dollar from your job.
3. Depreciation is great while you own the property but what happens when you sell? When you buy a rental property the IRS says, "Climb on the depreciation bus and ride it as long as you own the property." But when you sell, you jump off the depreciation bus. Then, the bus turns around and runs over you. The depreciation deductions you enjoyed during your ownership are taxed back when you sell. This is referred to as "recapture" (that's an accounting term, not a zoological term). But the good news is there are several methods and strategies to reduce or eliminate recapture.
4. And finally, you should utilize the services of a good tax manager. By tax "manager" I mean someone who'll help you understand the tax implications of real estate investing; not merely prepare your tax return. Most people don't have a tax manager...they have a tax preparer they see once a year on April 14th. And the tax preparer tells them how much tax they owe! That's not what I'm talking about. I'm talking about seeing your good tax manager throughout the year to plan ahead and manage your unique tax situation proactively.
Ok, that's it. You've got a good start on the basics – but there's plenty more to learn. Investors are searching for good REALTORS® who can be part of their team. If you commit to learning and improving, I'll bet you'll capture your share of the investment market and be fishing the entire lake in no time. I hope you catch a WHOPPER!
This material is designed to provide information in regard to the subject matter covered. It is understood that Tom Lundstedt, is not engaged in rendering legal, accounting or other professional services. Everyone's situation is unique, so – before you, or your clients take any real world action – be sure to check with the proper professionals.