Posted on October 1, 2007 @ 10:59 pm - Written by BawldGuy
Today, allow a small list of some questions often asked of me by real estate investors new to the game — and by some not so new. I’ll throw some of my own questions into the mix too, just for fun — and because I can.
How many of them can you answer with confidence? These are questions you’ll want answers to — if you’re a real estate investor — or want to be.
Here we go.
What the heck is a cap (capitalization) rate?
When an agent says an income property is priced at ‘X’ times gross — gross what?
Why should I care about the Starker family, and what could they possibly have to do with me?
Is it possible for your investment properties to appreciate at a lesser rate than your pain-in-the-patute brother-in-law, yet still have superior capital growth?
What is cost segregation? (Hey, I thought this was a real estate investment test!)
Just how did your office buddy sell for such a nice profit, paying no taxes, while not executing a tax deferred (1031) exchange?
Which is more important — your property’s appreciation rate — or your capital’s growth rate?
Pulling $250,000 in cash out, via refinancing, from an investment property which you’ve held for 10 months, won’t be taxed at a special rate. True? or False?
If all your investment properties combined, produce depreciation (tax shelter) of $110,000 annually, and your combined tax rate (state & fed) is 35%. What are your tax savings? Do you save actually any taxes?
How do I know when it’s time to make the next move?
Take a break. What grade would you give yourself so far? Acing the test? Maybe coming up with your own questions?
Is it better in the long run to keep all my properties, refi them, and buy more? OR Should I exchange them when the time is right?
Are the real estate taxes on my investment properties deductible from my ordinary (job) income?
I took some money out of an exchange last month. I was told it’ll be taxed. Is that true?
Why are you advising me to use different financing in Dallas than we used in Boise?
There are two investment options from which to choose — a five year old fourplex — and a couple duplexes, each 20 years old. The cost for each option is identical, as is the financing. Which option do you choose?
What’s a better recipe for capital growth — 10% down in a growth region, (8% annual appreciation) using a neg-am loan — OR — 10% down in a region with a relatively pedestrian appreciation rate (4% appreciation) with an interest only loan?
Is it true that Gillette makes the best blades for head shaving? (Extra credit 
)
Will the Chargers win the race for the #1 pick in the 2008 NFL draft?
I’ll answer the last two for you.
In my opinion, Gillette is far and away the best blade on the market, if, like me, you need to shave your face and your head daily. I cut myself about once a year. A straight razor couldn’t get better results.
The Chargers will fail miserably in their chase for next year’s first pick. Teams finishing with 7-9 records never end up with the first pick.
What’s the point of all these questions?
It doesn’t matter much if you got them all wrong.
Since you know the questions, you can find the answers.
Then what’s the problem, you ask?
Here’s where the head on train wrecks are created.
It’s not the answers you don’t have that will come back to haunt you.
You an get answers.
It’s the questions you don’t know to ask that will wreak havoc — which can result in tragic consequences for your retirement.
Why don’t you sit down for a minute or two. Make a list.
Write down all the questions you don’t know to ask about investing in real estate for your retirement.
Posted on May 9, 2007 @ 11:18 am - Written by BawldGuy
So I’m talking with this cost segregation guy today, very experienced, and absolutely a southern boy through and through. He’s talking about how so many investors using his company’s service will be saving so much money in taxes not paid. Of course, that’s what CS does for you. It ramps up the annual tax shelter provided by depreciation. CS is kinda nuclear vs conventional.
Anyway, it dawns on me. So many investors are going to be really irked at their accountants on the first day of the sixth year of their depreciation schedule. Why? Because though they thought they were planning, their approach wasn’t really purposeful - if you follow.
Their purpose was to cover all the property’s income so as to avoid paying taxes on it. Simple enough. But now it’s been five years of bragging to whoever will listen about all the shelter you were so clever to acquire, and the gravy train is over. Most of the time the sixth year is when the party begins to peter out, so to speak. The tax shelter doesn’t go away, it just shrinks — in many cases alarmingly so.
Usually by then the income has increased, and now the poor guy is standing out their in his BVD’s with his cash flow showing. So he gets the bright idea to get out of that property via a 1031 tax deferred exchange. Just a doggone minute there, cash flow breath. Since you’ve taken some pretty impressive depreciation against some very nice cash flow for the last five years, your adjusted cost basis is now hovering around two Snickers Bars and a half eaten rolled taco. Oops.
In plain English this means when you sell, your profits will be magnified. Instead of say, your actual purchase price of $1Mil, your capital gain will now be computed on an adjusted cost basis of about $700K! If you sold it for a net $1.5Mil — you’re on the hook for a taxable gain of around $800K. Now you guys who actually know what I’m talking about — don’t get your panties in an uproar. I know this is simplified to the nearly absurd. It also doesn’t take into account the concept of recapture which will cost you more in taxes in terms of tax rate than capital gains. Recapture is an expensive item — another post another day.
Of course, you’re now screaming that the guy said he was going to make use of a tax deferred exchange. Fair enough. Let’s take a ride down that road.
He’ll take his net sales proceeds and find another property to execute the exchange. No big deal, right. Maybe — maybe not. Since his adjusted basis has been so radically reduced by his five year use of magnified depreciation, his new basis will be the much lower than if he hadn’t used CS. He can only increase his adjusted basis only by the increase in debt. If he’s going for cash flow, he’s trying to limit debt, right? The bottom line here is that his depreciation for the new property, even with another CS study, could fall short of sheltering is new cash flow.
Now he’s possibly in a position where he’s living the punchline of a good news/bad news joke. What’s the good news? Dude, you gotta lot of cash flow. What’s the bad news? Dude, you gotta lot of cash flow. What’s the really bad news? Your new depreciation schedule, even with another cost-seg study may fall woefully short of sheltering the new cash flow — which over time will only increase, exacerbating the problem.
This could happen in the first exchange or not. It will happen though — and most likely sooner rather than later. There are solutions to this — but they need to be in place — you guessed it, before and not after you find yourself hanging out in your BVD’s.
Back to the main point. The investor didn’t have to end up this way. His plan needed more of a purpose. And merely sheltering cash flow to avoid taxes isn’t a stand-alone purpose. When was the last time you saw the government give something without eventually taking something away? Right — never.
So understand what you’re doing, and ensure all parts of your Purposeful Plan play nice with each other. The IRS very rarely calls you up to tell you what a great job you’re doing.
Finally, this isn’t to steer investors clear of making prudent use of Cost Segregation studies. Used within a comprehensive, well thought out Purposeful Plan CS can make a hugely positive difference. Just don’t find yourself looking at the immediate tax benefit then charging into battle. CS is like any tool in your chest — use it wisely or suffer the consequences.
Note: I’m closing in on the recapture dilemma solution. It’s ah, complicated. But the experts are one and all telling me it’s a very cool way to look at the problem. The firm with whom I’m talking is, in my opinion, one of the elite in the business. Makes me feel tingly all over.
Posted on March 22, 2007 @ 8:22 pm - Written by BawldGuy
“Oh yeah, we had to do a 1031 exchange — didn’t pay a dime in capital gains taxes.” I often wonder how many times that’s said, followed by a short pause, a very wise look at their listener, then another swig of their beer. Just the mention of the numbers 1031 seem to empower some investors to flights of fancy at the neighborhood BBQ. I can’t imagine what the conversation will be when some investor mouths the words ‘cost’ and ’segregation’ together while staring appreciatively into space. Can’t you just see the ever loyal wife’s eye’s rolling skyward?
Meanwhile they very possibly may have just executed an absolutely unnecessary exchange. Why? They don’t know. They might never know it could have been done another way. Or, that the other way might have allowed them to pocket a little TAX FREE cash in the process. Really? Honest — I never kid about tax free cash.
In the last few years my clients have, with careful planning, arranged to sell investment properties without paying capital gains taxes. And they DID have significant capital gains. And for the record, we’re not talking here about deferring or delaying taxes to a later date. We’re talking avoiding taxes period and forever on a sale. And most of the time they didn’t even resort to cost segregation.
Cost segregation? What the @%#$& is that? I’ve written posts recently, here and here. The very quick, down & and dirty definition is — a maximizing of depreciation (usually by a factor of 3-7 times what you’re used to) resulting in significantly increased after tax cash flow for real estate investors. A shameful over-simplification, but workable.
Though I’ve had clients make use of ‘CS’ for years, most smaller clients couldn’t afford to pay for a CS study simply because of the costs involved. For example, it’s almost universal these days that Cost Seg companies won’t even talk to you if your property isn’t worth at least $750K-1Mil. This isn’t arbitrary on their part at all - just the reality of their business costs. I’ve made it my Numero Uno goal this year to locate an experienced and geographically unlimited Cost Seg firm to handle all my clients’ CS needs.
This isn’t proving to be an easy assignment. Though I’ve spoken to at least a dozen very professionally competent project engineers, CPA’s, and everything in between, it gets quiet when we talk about smaller properties. However, this week I may have struck gold. I’m not going to jinx it by naming them, but our preliminary conversations have been very encouraging. They can do business anywhere in the country, and will definitely negotiate fair deals for less than huge investors with small clusters of less costly properties. That’s a long way of saying they’ll work with the regular-folk investor.
Applying the principle of ‘doing things on purpose’ to our own endeavors is an every day reality for us. This search could result in some exceptional results. We’re keeping our fingers crossed. If we can negotiate a win-win deal for all concerned, this CS firm could very well be added to the Brown and Brown team.
We’re jazzed at the prospect.
Posted on March 6, 2007 @ 2:37 pm - Written by BawldGuy
The first thing I was taught when I entered the real estate business was to say ‘I don’t know’ when I didn’t. I’ve followed that advice strictly from my first day in the office. I’ll say ‘I’m sorry’ in advance to all the CPA’s out there who say ‘ I don’t know’ when indeed they’re ignorant about some portion of tax law. God knows the average real estate agent wouldn’t admit ignorance to anything. How many of us blithely assume our accountant knows how to file a tax return for a restaurant as well as he does for a mining firm? Does that make any rational sense to you? Of course not. Yet, given the same question about your family doctor, you know in your heart he’d refer you to a specialist immediately if he thought you needed knee surgery.
CPA’s, in my experience, generally won’t say ‘I don’t know’ when it comes to real estate. Some do, but most seem to think all they need is the Internal Revenue Code (IRC) to correctly deal with any ignorance on their part. I found this out the hard way many moons ago.
Let me give you an example of someone I know who just last year discovered her CPA didn’t quite have her covered.
Somebody very close to me (a real estate broker) recently had her most recent corporate return audited by her best friend’s accountant. Her friend had commented on her tax bill. To make a long story short, she just cashed an IRS check for almost $15K. Overpaying your taxes $15K might concern you! This on gross revenues of $500K, not $10Mil. She was not happy her guy had left that much on the table.
I recently opened the phone book and randomly called ten CPA’s. They all said they do many tax returns for taxpayers owning one or more investment properties. They knew all about depreciation.
Four of them new what cost segregation was. Wow!
What about cost segregation? What is it exactly?
Cost Segregation, when boiled down, is a tax saving tool that allows companies and individuals who have built, purchased, added to, or remodeled real estate to increase their cash flow by accelerating depreciation deductions and decreasing their federal and state income taxes. It’s a strategic approach to maximizing your investment’s cash flow.
Engineers visit your property to conduct a Cost Segregation Study. This is to identify, set apart, and reclassify property or project related costs that are now shown as real property, to much shorter depreciable tax schedules (lives) for fed/state income tax purposes. You’re allowed to change accounting methods (with the IRS) in order to fully benefit from the increased amount of depreciation. As a matter of fact, you can go back as far as 1987 to take advantage of this. The cool part? You don’t have to amend tax returns.
Part II will show a real life example of what CS can mean to the average investor.