Real Estate 009: 5 Tax Benefits for real estate investors

Many real estate investors and those seeking financial freedom know that the biggest "enemy" to creating long term wealth is taxes. One of the huge benefits of being a real estate investor, is that the IRS tax code is written to support business owners including those with rental real estate. As such, I want to discuss some of the tax advantages that rental real estate could bring to your portfolio. Please note that I am not a CPA nor attorney, so please talk to a professional that can assist you in your specific situation.

Top 5 Tax Benefits for real estate investors

1. Depreciation
According to the IRS, the building (not the land) portion of your real estate investment is depreciated over 27.5 years for residential buildings and 39 years for commercial buildings (as of this writing). That means on a $100K midwest single family home where the building is valued at $80K, land at $20K, you are able to off set $2,909 worth of taxable income with a depreciation loss of the same amount. As this is a "paper" loss, even though your property may be in great condition physically, you are able to take this depreciation each year starting from the year of acquisition.

Note: There is a downside to depreciation called "depreciation recapture". If you ever decide to sell your real estate property, you will have to pay taxes on any gains made on the sale. Lets look at two scenarios:

A - You (taxpayer) buys the property for $100K, and the taxpayer has taken $40K worth of depreciation over time, bringing the cost basis of the rental property to $60K at the time of sale. If the taxpayer sells the home for $70K, they realize a gain of $10K. As they have taken depreciation over the years, they are required to pay $10K worth of ordinary income taxes.

B - Same situation above, except the market is hot and taxpayer sells the home for $130K, resulting in a $70K gain on the cost basis of $60K. In this situation, $40K of the total $70K will be taxed as ordinary income (equal to the amount of depreciation taken over the years) and the remaining $30K is taxed at a lower capital gains tax rate.

One way a savvy real estate investor can avoid the depreciation recapture is to defer tax liability with a 1031 exchange.

2. 1031 Exchange
The 1031 Exchange is named after section 1031 of the IRS tax code which allows investors to defer their tax liability when selling their property for a gain. In the example B above, the investor sold the property for a $70K gain, but if they use a 1031 exchange to buy a "like-kind" asset such as a single family, multifamily, land, etc. they can roll their gains onto the newly purchased property. There are strict rules when it comes to the execution of a 1031 exchange, so please do your due diligence in researching this option.

3. Tax Breaks for Pass-through entities
If you have a pass-through entity (Sole Proprietorship, Partnerships, LLC, S-Corp), the new Tax reform (TCJA 2017) provides a 199A pass-through deduction. In a nutshell, this allows landlords of residential real estate operating in a pass through entity, to deduct 20% of net income off the top. This means, if your 10 rental properties in an LLC makes $100K net income a year, only $80K will be deemed taxable. There are exceptions, however, where the 20% deduction is capped by the greater of 50% of the taxpayer's wages, or 25% of wages + 2.5% of the unadjusted basis of qualified property held by the business. A qualified property is a rental property that is subject to depreciation and the unadjusted basis is the property's original cost without any depreciation.

4. Deductions
There is a laundry list of items that relate to your real estate business that can be deductible:
   - property taxes
   - insurance premiums
   - utilities
   - repairs and maintenance
   - commissions, property management fees, legal and professional fees
   - travel costs to visit out of state rental properties
   - mileage to visit local rental properties
   - meals
  
The key is to keep a detailed log of your expenses to ensure that it was ordinary and necessary for your real estate business. Note that this list does not factor in the perks of being a qualified real estate professional and the additional deductions they can take. However, please note that the IRS is very strict on who qualifies to be a real estate professional, so again, please do your homework.

5. Long-term Capital Gains
If you decide to sell your real estate property, you will have to pay capital gains tax on the profits of the sale. There are two types of gains: short-term and long-term. If the investment was acquired and sold within 1 year, it is deemed a short-term hold and taxed as ordinary income. If the investment was held for longer than 1 year, it is considered a long-term hold and has a more favorable tax rate.

To put this in perspective, if you have purchased a property for $100K and sold it for a $50K profit in less than a year, at a tax bracket of 28%, you would be paying close to $14K in taxes. Conversely, if you held the property for more than 1 year and made the same profit, you would pay long-term capital gains of 15% in taxes resulting in only $7.5K, a whopping $6.5K in savings. Something to keep in mind when you are considering disposing of your assets.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision. 

Good Luck!

Real Estate 008: BRRRR method of investing

In my previous posts, I have discussed different strategies to meet your real estate investing goals. I have recently come across a method that has been popularized by Brandon Turner at BiggerPockets.com but has existed and been used by savvy real estate investors who want to start investing using little to no money down. So what is it? The BRRRR method - stands for Buy, Rehab, Rent, Refinance, and Repeat. Lets take a closer look at each step below:

1. Buy

They say you make money in real estate in three ways: 1) buy 2) sell 3) cash flow. Knowing your numbers used in your BRRRR strategy is just as important as wholesaling, flipping, or buy and hold rentals. The main focus of the BRRRR strategy is to pull out all your money (in some cases, you may be able to pull out more than what you've put in) and end up with a cash flowing property with some equity. A general rule of thumb is to look for a purchase price that is 75% of the after repair value of the property.

For example: A home that has an after repair value of $150,000 * 75% (cash out refinance) - $25,000 est. rehab costs = $87,500 maximum purchase price.

If you are able to purchase below $87,500 or perform a quality rehab for under $25,000, then you will end up with more equity/less cash out of pocket. Note that the above calculation is a simple illustration and there are usually refinancing costs involved with the lender.

2. Rehab

The rehab budget is always an area of discussion among investors for many reasons. Here are my thoughts on the dollar amount on spent rehab and value add upgrades:

• There is a key distinction between primary residence (Owner Occupied) and rental properties (Leased). Simply put, renters may not need, nor would they pay the extra $25-50/month in rent to have all the bells and whistles that you would want for yourself. Granted, if there are two homes in a neighborhood with all things being equal and 1 has granite countertops/backsplash and the other has none, it may be more appealing and rent out faster. However, you have to decide for yourself, at what cost? For me, I am mostly focused on replacing key CapEx items with little useful life to reduce deferred maintenance as well as making the house livable and suitable for the market/neighborhood (an A class neighborhood will definitely have different upgrades than a C class neighborhood).

• You also have to decide what value add upgrades - new kitchen/new bath/new flooring will being the most return on investment. This is a great conversation with your property manager and rehab crew as they will have the most insight into the neighborhood and experience dealing with tenants.

3. Rent

The next key step is renting out the property after it has been properly rehabbed. Whether you decide to buy and hold or sell the property as "turn-key" alternative, renting the property will help you obtain refinancing with the lender. You can advertise and rent out the property by yourself, or I would personally recommend using a property manager who typically charge 8-12% of the rental income. Their marketing efforts, tenant screening, and maintenance handling should be well worth their fees. Make sure to received referrals from active investors in the market and interview multiple property managers. Remember, a good PM can make a good deal into a solid deal, whereas a bad PM can turn a solid deal into a horrible deal.

4. Refinance

You have crunched the numbers, bought/rehabbed/rented the property, so now you are ready to refinance and pull out your cash (downpayment + rehab costs). Depending on the lender, there will be different seasoning requirements. A traditional refinance may require a 12 month period for which you will have to maintain the property then request a refinance. However, there are many portfolio lenders who have 6 month seasoning requirements or some who can start the refinance process the day after closing (zero seasoning). The lender will order their own appraiser to go to the property and draft an appraisal. 

In the example mentioned earlier, lets look at two scenarios with the same expected ARV of $150,000.

Example 1: Purchase price of $50,000 (bought distressed/foreclosed/divorce/REO) and put in $25,000 amount of repairs for an all in cost of $75,000. The bank appraises it for $140,000. You request a cash out refinance and the bank gives you $105,000 (75% of the appraised value). Now you can fully pay off the $50,000 loan and $25,000 rehab costs (if you used private financing or hard money lender) and have $30,000 in excess cash + 25% in equity.

Example 2: Purchase price of $75,000 (normal sale) and put in $20,000 worth of repairs for an all in cost of $95,000. The bank appraises it for $135,000. The bank does not allow for refinances greater than your all in cost. In this case, you will get back $95,000 to pay off the $75,000 purchase and $20,000 in rehab, and the remaining amount will be left in equity ($135-95K = $40K/135K = 30%).

5. Repeat

The above examples are cases of success stories in which you were able to cash out your initial investment and maintain equity of 25% or greater in the home. Now you will rinse and repeat the process and scale your rental portfolio!

Few thoughts on BRRRR vs. TurnKey/buying off MLS

Although I have bought my first rental property from a turnkey company, I eventually want to try the BRRRR method for a couple reasons: 

• Ability to cash out refinance and retain equity in the home

• Control over the type/quality/amount of rehab

• Ability to retain your "seed" capital for other investments (typical buy will lock up 20-25% cash each time you by, thereby significantly lowering your buying power)

• Allows for faster scaling of your rental portfolio

• Higher return on investment (more of other people's money = higher ROI)

However, there are also a couple reasons why I do not want to jump on the BRRRR bandwagon just yet:

• More risk is placed on the project owner overall (you are buying/rehabbing/renting/refinancing)

• Risk of appraisal coming in lower than expected (not being able to break even)

• Risk of rehab delays (A turnkey is already rehabbed and tenanted)

• Longer process than buying turnkey/MLS

• Risk of being unable to cash out refinance

  • Seasoning requirements

The BRRRR method has been a very popular method for investors to increase their return on investment as well as overall net worth due to the fact that they are leveraging other people's money and if done correctly, able to repeat the process over and over. However, if it was so easy, why doesn't everyone do it? As mentioned in the reasons above, the BRRRR takes careful planning, finding the right deals, using the right team, and comes with its own set of headaches as things can go wrong during the process. What is your strategy? I would love to hear your thoughts on BRRRR vs buying turnkey/MLS.

As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision. 

Good Luck!

Real Estate 007: Rental Property Criteria

Now that you have identified a market, its important to start developing a criteria (again, a ship with no clear direction is sailing towards nowhere) and analyzing properties.

So how does an investor analyze properties? Below are some metrics that I use to evaluate rental properties. Remember to subscribe to my blog to receive updates as well as gain access to my free cash flow calculator and rental property criteria.

1. Cash on Cash (Used when financing a property)

To calculate the cash on cash return percentage, I take the net monthly income after all mortgage, insurance, property taxes, property management fees, vacancy and maintenance expenses are included, and annualize the amount. That amount is divided by your total cash invested into the property.

Below is a property analysis using real numbers of a sample investment in the midwest, USA.

Net Cash flow of $174.13 * 12 months = $2,089.56 divided by total out of pocket cash $13,600 down payment + $3,400 estimated costing cost 5% = $17,000.00

• Cash on Cash %: Net Annualized Cash Flow / Total Cash Invested

• 12.29% (rounded): $2,089.56/$17,000.00

2. Cap Rate (Used when paying all cash)

The Cap Rate is used to make comparisons between similar rental properties. By taking the Net Annualized Cash flow / Purchase Price, you arrive at the Cap Rate of a rental property. This method is more meaningful when an investor pays for a property all cash thereby calculating their annual return on their lump sum of money. Please refer to the picture above that illustrates the Cap Rate calculation on this property

• Cap Rate %: Net Annualized Cash Flow (no mortgage) / Purchase Price

• 8.30% (rounded): $5,643.96/$68,000.00

3. Rent to Value Ratio

Another quick measure of relative costs of buying and renting across different markets is the rent to value ratio. As mentioned in my previous post of cyclical and linear markets, I have generally observed that cyclical markets tend to have a lower rent to value ratio, meaning you will make less by renting out of property relative to its purchase price, compared to linear markets with a higher rent to value ratio meaning its a better market for investors looking to cash flow on their investment properties. The rent to value ratio is calculated simply by taking the gross rent divided by the purchase price of the property

• RTV %: Gross Monthly Rent / Purchase Price

• 1.21% (rounded): $825/$68,000

4. Debt Coverage Ratio

The debt coverage ratio is not often used by all investors, but I like to use it to gauge the cash flow that is generated to pay my mortgage on the property. It is calculated by taking the Net Annualized Cash Flow / Total Debt Service owed to the lender. A debt coverage ratio of less than 1% means that the buyer will not be able to pay the current mortgage without using their own funds (i.e. negative cash flow). A ratio greater than 1% means that the buyer can use cash flow from the investment property to pay the mortgage.

• Debt Coverage Ratio %: Net Annualized Cash Flow (no mortgage) / Annualized Mortgage Payment

• 1.59% (rounded): $470.33 * 12 months / $296.20 * 12 months

So what do I look for when analyzing rental properties?

Great question. As I mentioned previously, I am a buy and hold investor primarily focusing on single family homes in strong working class (blue collar) neighborhoods for positive cash flow. Note that this criteria is quite fluid and used as a basis to narrow down my search from a pool of 50+ properties at any given time. Note: these are my "rules of thumb" as of writing date, and can change any time.

• When Financing a property: Net monthly cash flow (after all expenses)> $200 per unit

  • Assumptions used: 5% closing costs, 8% vacancy reserves, 8% maintenance reserves

• Neighborhood Rating: B- or above (Note that each investor may rate neighborhood's differently). For example, some investors rate A/B/C based on ratio of owners/renters, crime stats, schools, other statistics and demographics.

• Property Type: Single Family 3 bedroom 1 bath (or more), ideally with a Garage in markets such as Kansas City, where there is heavy snow and hail. Note: Some markets (i.e. Memphis), it is common to have a carport instead of a garage. Further, 2 bedroom homes are more difficult to lease. 3 bedroom houses are most common, thereby increasing the tenant candidate pool.

• Size of home: Ideally 1,000 - 1650 sq ft. Not too large, nor too small. Note: I do this on purposes as the extra sq ft. of ~800 (ex: 2,400 sq ft. homes) do not necessarily correlate to the same ratio of increased rent. Also, replacing a roof/flooring on a 2,400 sq ft. home is significantly higher than a 1,200 sq. ft. home.

• Low Crime Areas

• No HOA fees. The HOA fees are unpredictable and can kill your projected cash flow.

• Cash on Cash: 12-15% or higher (Depends on market, type of property, location, etc.)

• Rehab including updates to CapEx items 5 years life or less (Water Heater, HVAC, etc.) 10 years life or less (roof). Note: The amount of rehab (after reviewing scope of work) may result in a lower or higher maintenance reserve from base of 8%.

• Rent to Value Ratio: At least 1% or higher, ideally 1.30% or higher

Please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision. 

Good Luck!