Posted on May 22, 2008 @ 10:06 pm - Written by BawldGuy
I was due for the conversation that transpired recently. A friend of a currently inactive client was a few days from entering into a tax deferred exchange. My client called me to ask if I’d talk with their friend about what they were doing and why. Not a problem.
After the conversation with her investor buddy, it occurred to me she had an immediate problem which was easily remedied, but a much larger problem that was systemic. Her tax pro was allowing her to enter into a classic delayed exchange when there was another obviously superior option.
In a nutshell, the investor had unused depreciation in an amount sufficient to offset a pretty impressive hunk of the capital gain she was deferring. In plain English? She’d be able to take out over 1/3 of her net proceeds in cash — without ever paying capital gains taxes. She’d accumulated massive unused depreciation as a result of being barred from using any of it against her ordinary income. (read: job income) Hence, the unused accumulated tax shelter.
By executing a tax deferred exchange (1031) sans the huge tax free cash exit, she’d have been penalizing herself. Read the rest of this entry »
Posted on May 8, 2008 @ 11:13 pm - Written by BawldGuy
Lately some have asked how many of these axioms there are. I don’t know. There’s a bunch though, and many have been taken from Dad and other mentors, some of whom were literally industry giants. I can claim originality on none of them, as they’re time tested over literally centuries — at least most of them. Come to think of it, I’ve been told my paraphrasing on many of them is original.
Here are a few.
BawldGuy Axiom: About the time the farmer trained the ol’ mare to work without eating — she died.
We can fool ourselves all we want when it comes to where, when, how, what, and why we invest in real estate. We can even appear to defy gravity for periods of time. Sooner or later though, Investment Physics win out. The core, or maybe better said, foundational principles of real estate investment are defined as such for a reason. As has gravity. Being a contrarian as I am much of the time, is one thing. But you’ll notice you’ve never seen me jump off a roof expecting to fall sideways. So sure, we can get a starving horse to work for us — until she dies. Then where are we?
BawldGuy Axiom: The words ‘Free & Clear’ have no magical powers. In fact they’re often the central figures in Grandpa Economics’ unintended consequences: Not a retirement supporting the Golden Years, but rather a mind numbingly financial life sentence. (See Grandpa Economics podcast.)
Grandpa retired with a retirement income quadruple his salary when he was 35 and a free and clear home. Read the rest of this entry »
Posted on March 31, 2008 @ 10:25 pm - Written by BawldGuy
Mondays are sometimes piled high and deep while other times devoid of any planned required attention. Today was one of those ‘tweener’ days. Taking care of day to day minutia, email, phone calls — you know the drill.
Then it happens, the call from the new person, the one with carrying my daily fix. This call was delayed due to emails falling into the black abyss of ‘what happened?’We finally hook up on the phone late today, and it’s the daily fix. I love talkin’ with new people who’re interested in the future, have done their own research, but found out what I keep saying is true — you can read the books until your eyes drip down your cheeks, and yer still not gonna feel that comfortable going out on our own. It simply doesn’t work that way.
So she and I are talking about her family’s situation, and quickly becoming apparent is a possible ‘have yer cake and eat it to’ scenario. Of course she laughingly admits it even before I say it. Love her already. 
We’re talking, and I’m learning the things I need to know, when it suddenly hits me — their tax returns are resulting in way too much of a refund. Duh. Not way too much, WAY to much.
What’s the big deal?
They decided she’d stop working a while back, and they’re living on her husband’s handsome paycheck. Since they live in a pretty ‘high cost of living’ area though, his check doesn’t go as far as many might think. Don’t jump to the conclusion they’re living over their heads, ‘cuz they’re not. Not even close. No car or plastic payments whatsoever. No payments on toys.
That huge tax refund? How ’bout a really simple and totally unoriginal idea? Why don’t we just have Hubby go to his employer and significantly increase his exemptions? After consulting with the resident expert, determining the number of exemptions resulting in these folks owing $1.80 next April should be relatively uncomplicated. If anything, they’ll probably undershoot it anyway, since they may indeed have more tax shelter this year than the last couple years have produced.
This one simple maneuver should result in an increase of his take home pay of $15-20,000 this year.
Think that might make a difference in their monthly family budget? Betcha it will.
File this under Purposeful Planning. Not everything we do at Brown and Brown is awe inspiring — mostly just effective — and yes, to stress the point, on Purpose.
How many of you out there are all excited about getting back a sizable income tax refund? Might you be more excited to have that money appear in your paycheck every couple weeks? How would it impact your family’s budget? Most folks could use the extra money in their take home pay. Or does your boat already have wings?
What if your refund is $6,000 — that’s $500 a month you loaned Uncle Sam interest free. Was it your intention to be that generous?
Doing things on Purpose isn’t just a catchy phrase. It’s what our entire modus operandi is based upon. (Almost sprained a couple fingers typing that phrase.) Often, it’s the little things that make bigger things become reality — or even possible.
Think about doing two things after you’re finished reading. Listen to both of the Purposeful Planning podcasts, located a few inches down from the top on the right of this page.
Make the decision to Contact BawldGuy.
I need another fix.
Posted on March 26, 2008 @ 11:42 pm - Written by BawldGuy
I recently posted on the subject of the ‘Professional Investor’ which garnered many questions. One commenter, Lee, asked a couple great questions which inspired me to expand on a subject she introduced with her questions. Thanks Lee.
Most real estate investors aren’t aware of the benefits of that designation on your tax return, or the unintended consequences of being declared a dealer. Ah, there’s the rub — most investors don’t know what a dealer in real estate is.
The IRS will, at their discretion, determine if a taxpayer is a dealer. Once they make that call the taxpayer will then be paying ordinary income tax rates instead of the much lower long term capital gains rates.
But what the heck is a dealer?!
Dealers buy and sell properties, generally for a profit. They do so as quickly as possible. They’re considered by the IRS as making their living this way. The key factor though is what they’re not — they’re not investors. 
You see, investors are long term while dealers are more the get in, get out ASAP variety. The IRS doesn’t want dealers to benefit from the much lower long term capital gains tax rate. In many cases it’s less than half the taxes of what a dealer would pay.
It gets better. The Internal Revenue Code doesn’t make it easy by providing a clear definition delineating the difference between the two. Nnooooo, they prefer the courts to decide, case by case, inch by inch what defines a dealer.
Internal Revenue Code § 1221 says a capital asset is, (in part) “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”
What that means to you is simple — if the property you buy is meant for your ‘trade or business’ and not for investment, you’re gonna be designated as a dealer — at least as far as that particular property is concerned. Your tax rate is then automatically derived from ordinary income tax rates which will almost always be double (usually more than double) the long term capital gains rate.
Paying 30-40% of your profits in taxes isn’t in most investors’ Purposeful Plans.
Also, if you’re a dealer, there will be no tax deferred exchanges for you. Not allowed. That tasty dish just ain’t on your menu. Also, the installment sale treatment is denied the dealer. That means if they carry a note for a part of the sales price it will be treated as if the note was cash. It will be taxed at ordinary rates too.
The investor opting for an installment sale is allowed to pay taxes as they receive the money over time, payable each tax year. There’s a specific formula, different for every property. Each dollar received can be looked at as one, two, or three different ways. Interest, return on capital, and/or return of capital.
Anyone wanna be a dealer?
Rehabbers are dealers — by definition. They buy property, as part of their trade or business, for the expressed purpose of adding value and selling as quickly as possible for a profit. If they could do it every month they would. They buy obvious fixers and proceed to make them pretty.
The IRS says investors buy and hold for appreciation, dividends, (cash flow) and interest. Dealers buy property to sell it for a quick profit.
How long you hold the property and how many properties you’ve been selling lately is what they want to know. The longer you hold the better you look. Don’t think their so called rules are anything but suggestions either, ‘cuz they’re not. If you’ve been buying and selling properties like a dealer, then sell one 14 months after buying it, you’re not in any way, shape, or form guaranteed investor status. In fact I’d bet good money they’re gonna call you a dealer. At that point you’re treated as guilty until you or your CPA or tax attorney prove you innocent. It’s not the hoped for end game — know what I mean, Verne?
The courts don’t make it any clearer either. They add their own brands of mud. Each court decision is yet another layer — and that doesn’t count the courts of appeal. I’ve been asked many, many times about specific cases, and have referred them to tax pros with intensive real estate training in what the Internal Tax Code and court rulings have said — lately. Geez.
Another factor is what the taxpayer does with the property. Did they rezone it? Make massive improvements meant to significantly improve value? Or God forbid, subdivide it? DEALER. Made a bunch of sales lately? Yer probably a dealer then too. (Not the case however, if they were held for say, 3 years or so.)
Purposeful Planning proactively avoids the road leading to Dealerville by preemptive strikes. There’s a river running through Dealerville. It’s the natural border separating the taxpayer from Investor City.
(Yeah, I know — way corny, but it works.) Crossing that river without a bridge isn’t recommended. The investor can be a dealer too, but by choice. They might be buying property to rehab and flip. If they held title to that property via an entity which clearly shows the IRS how to differentiate a dealer property from their bona fide investments — everyone’s happy. This is easily accomplished by employing your real estate attorney during the acquisition process, which we do as a matter of course.
This isn’t everything you need to know about being a dealer and/or an investor. But I’ll bet there’s all kinds of folks out there who just realized something chilling. This is another question they didn’t know to ask. That’s not a good thing.
It’s the answers to the questions we don’t know to ask that usually end up biting us where we sit.
And for the record? Real estate investors nearly always do far better over the long haul, (and usually the short haul too) than dealers.
Posted on March 20, 2008 @ 8:24 pm - Written by BawldGuy
Ever been to the gym for a workout and some guy with good intent tries to help you out? Has it occurred to you he doesn’t know any more about body building than your Aunt Fannie? We’ve all had that experience, if not at the gym, somewhere else with another subject. 
One of my all time favorite cousins is a nationally known and highly respected commercial photographer. One day he was taking some shots for a job while I was visiting. He nearly wet his pants when I tried to sound like I had the first clue about the ins and outs of what a professional photographer does and why.
After my third comment he was wiping tears while begging me to stop. I still say it wasn’t that funny.
When real estate investors do it though, it can be miles from funny when they act on their sometimes misunderstanding of various concepts. Here is one of My Greatest Hits — which if misapplied or misunderstood can have some fairly sour unintended consequences.
Adjusted Basis — Doesn’t this beg the question a bit? Wouldn’t it help to understand what a Basis is before we get into adjusting it?
First, you head over to the Basis Store. (Sorry, long day. ) 
When you invest in a real estate property — through a purchase, not an exchange — you establish your basis. Simply put, it’s what you paid for the property. It can get more complex than that, but suffice to say, your purchase price is your basis.
When you take depreciation (a phantom loss) it lowers your basis. When you add a physical improvement, a new roof for instance, you increase your basis. Upon the sale of that property your sales costs add to your basis. I won’t bore you with all the rest of the various potential basis adjustments here. Just understand when you improve a property your basis will probably rise, and when you take depreciation you lower it.
Why is it important to understand Adjusted Basis? Simple. Your capital gain/loss is calculated upon this concept. Many investors think they’re taxed based upon what they paid vs for how much they sold the property. In my experience, this gross misconception has been the catalyst for some very nasty surprises which usually come sans gift wrapping around April 15th. Once that horse is outa da barn, there’s no going back — a sale is a sale is a sale — and so are the taxes owed.
Here’s an example of a recent oops!
First, a couple quick definitions.
1. Depreciation — It’s a loss in the value of an asset, in this case real estate. However, since real estate historically rises in value, this loss is really not ‘real’ — it’s a phantom loss. The investor, with some limitations and/or exceptions, is allowed to take this phantom ‘loss’ against the income of the property and if there’s any left over, against his job income — which is called ‘ordinary’ income.
2. Recapture — When an investment property is sold, and the taxpayer has taken the allowed deductions against their ordinary income over the years the investment property was held, the accumulated amount of depreciation used (deducted) by the taxpayer will be ‘recaptured’ and taxed as ordinary income. (ouch!) Note: This tax rate is much higher than that applied to a long term capital gain.
An investor paid $300,000 10 years ago for a fourplex. During the holding period he took a total of $120,000 in depreciation. He made no improvements to the property, i.e. rooofs, additions, etc. However, three years ago he refinanced the property for $700,000 — as he wanted to invest in more property and didn’t realize at the time a tax deferred exchange was the better way to go.
He sold the property towards the end of last year for $900,000 — (why, is anyone’s guess, since he wasn’t executing a tax deferred exchange) then called me at the behest of his son the Business Major. Fortunately the escrow had just been opened. That fact, along with his call, saved him many sleepless nights. (The sales price reflected the recent decline in values.)
I’m gonna oversimplify this massively to get the point across — so no kibitzing. Capital gain is taxed at a lower rate than depreciation recapture, as mentioned above.
When you subtract the $120,000 he took in depreciation then add his sales costs of $70,000 — his adjusted basis is about $250,000 or so. What’s the big deal you might ask?
He sold it for $900,000 which leaves him a (over simplified) capital gain of $650,000 or so. The total taxes he’ll owe on his next tax return could easily be $100,000 — give or take a few grand.
His net proceeds from the sale will be a little over $155,000 +/-. Ah, but wait a minute. He now owes the $100,000 in taxes — so his real world net is less than $60,000 from the sale of a property that sold for triple the price he paid for it.
Since he wasn’t my client, I didn’t pry into what he had done with the $400,000 in cash he received from his refi. If he didn’t invest it as was represented and this poorly thought out sale had proceeded to close, 10 years of solid investment would have been poured down the virtual drain. Not a happy prospect.
Allow me to pause here and shine a bright light on one huge factor missing here: Nowhere could I find even a thread of any kind of Purposeful Planning. This is what happens when an investor just decides to buy and sell without a Plan. It can become a little hairy at times.
Fortunately he called our office before his sale closed. We advised his agent, using his CPA as a conduit, to turn the sale into a tax deferred exchange — which was done immediately. He’ll now totally avoid — ah, read defer — those taxes. To be fair to his agent, the guy begged his investor client to get tax advice, but the guy wouldn’t listen. We’ll never know why.
I’ve seen several cases where the net proceeds of a sale weren’t even enough to pay the capital gains taxes owed. Imagine being a real estate investor receiving that sorta surprise.
The moral of today’s story is this: It’s so often true — Buying low and selling high has no relationship to basis and adjusted basis. The government will almost always say your profit is far higher than what reality (and the net proceeds check from escrow) tells you.
Knowing your adjusted basis is always part of any Purposeful Plan. A tax bill should never be a surprise.
The government’s plan for your capital gain is already in place.