Real Estate Investing – Part II

Last week I shared information about investing in real estate, specifically purchasing a single-family home for use as a rental. This week, I’ll share why duplexes and four-plexes can be even better investments, if you have the funds.

I’ll use a four-plex as my example. In Ukiah, you can purchase one for about $450,000 and expect rental income of $3,800 – $4,200 per month. That’s a higher rent-to-income ratio than you can typically find with a single-family home. And duplexes and four-plexes are still easy to finance because they qualify for the same preferred financing as single-family homes, so you can get a 30-year fixed rate loan (not true for most other types of real estate investments).

Because of the lower monthly rent, it is often easier to find tenants for duplexes and four-plexes, but the turnover can be higher. Obviously, you’ll want to fill vacancies as soon as possible, but be aware, having a vacancy is sometimes better than having a bad tenant. Screening tenants thoroughly is essential to your emotional and financial happiness, and your neighbor’s niece and her boyfriend should not be exempt from the same scrutiny all prospective tenants should face. I am biased as the owner of a property management company, but I’d say the work required to find and keep good tenants can be reason enough to consider hiring a property manager.

More living quarters means more people and more maintenance. Four-plexes are ideally suited to small families, adults looking to share expenses, or individuals who want a little extra space. Having all these people living in such close quarters (sharing walls or ceilings/floors) can sometimes lead to disputes, and unless you hire a property manager, it will fall to you, as landlord, to address them.

A four-plex will not require four times as much maintenance as a single-family home, but it will require more. As with a single-family home, you only have one roof to patch, four exterior walls to paint, and one driveway to seal. However, with a four-plex, you have four toilets to unplug, four heating/cooling units to maintain, and four sets of appliances to fix when they break.

As a smart investor you must include these maintenance costs into your planning. Anticipate expenses of about 3-4 percent of the purchase price per year, or $13,500 – $18,000. This includes taxes, insurance, and maintenance costs. While you won’t spend this much every year, you will over time. And when you need the money, you don’t want to dip into junior’s college fund to get it. Create a reserve savings account and pay into it each month.

Happily, you’ll benefit from your property’s depreciation, which helps offset your cash expenses. Depreciation is a bookkeeping expense that allows you to deduct the value of improvements over time. Depreciation is only a taxable expense, not a cash expense. This means, you have the ability to save on your income taxes and this savings should offset the cash expenses noted above.

So, now you own a $450,000 rental property with a break-even cash flow. You invested $95,000 (a 20 percent down payment plus $5,000 in closing costs), and your benefit is the potential appreciation in the value of this property. If values rise at three percent a year, you’d make $13,500 on a $95,000 investment or almost 15 percent. Not too shabby.

In addition, rents will likely increase over time. And while expenses go up with inflation, your mortgage payment won’t. The bottom line is, if you can afford to buy a $450,000 rental today, in 10-15 years, you should have an asset capable of paying for junior’s college tuition (or more rental properties to earn more income).

If you have questions about real estate or property management, feel free to contact me at rselzer@selzerrealty.com or visit our website at www.realtyworldselzer.com. If I use your suggestion in a column, I’ll send you’re a $5.00 gift card to Schat’s Bakery. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 35 years.

How are 1031 Exchanges like musical chairs?

If you’re interested in investing, 1031 Exchanges are a wonderful, legal way to defer tax liability almost indefinitely. Sound good? Read on.

As always, when I write about investing or tax implications of owning real estate, I am simply sharing my opinion. If you are thinking of investing or have questions about taxes with regard to real estate, speak with your financial advisor and/or tax accountant.

The basics of a 1031 Exchange are simply this: you trade the equity (amount you own free and clear) in your property for the equity in a new property. Basic enough? Although it sounds simple, it can get pretty complicated.

To defer taxes, you need to exchange your current property for a property of equal or greater value.  To the extent that you get cash out or reduce the amount you owe (called boot), you will have to pay capital gains taxes. Capital gains taxes are approximately 10-15 percent lower than income taxes, so that’s good, but if you want to defer all your tax liability, you need to trade properties with equal or greater equity and equal or greater debt.

So, what’s the benefit? Well, if you find someone who owns a property you’d prefer, and they prefer your property–and the properties have equal values and equal debt–you are allowed to trade without paying any taxes.

In recent years, a new chapter was added to the 1031 Exchange rulebook: the Starker Exchange. Prior to Starker, you had to either find someone who wanted your property or a number of individuals who all wanted to trade like properties. Think musical chairs except there are enough chairs for everyone: one, two, three, SWITCH.

In the post Starker world, you list a property for sale and sell it to an exchange accommodator, a middle man. The accommodator takes title to the property and sells it to a third party. The accommodator holds all the cash, kind of like an escrow account. You find a property you’d like to own and the accommodator buys it using your money. He or she then transfers the property to you to complete the exchange. You end up with a more desirable property and pay no taxes.

The clock is ticking on these transactions. After selling your property, you must identify the exchange property within 45 days and complete the purchase of the exchange property within 180 days or by the end of the tax year. However, the 1031 Exchange doesn’t have to be a one for one in terms of numbers of properties, just amount of equity and debt.

Let’s say you own an apartment complex. That’s a big investment, and therefore harder to sell than a single-family home. You could use a 1031 Exchange to trade your apartment complex for several single-family homes. Then, if you only need to liquidate (sell for cash) one of the homes, you only pay capital gains taxes on a single-family home, rather than on the value of the whole apartment complex.

The downside of 1031 Exchanges are these: 1. Accommodators charge a fee for their service. It’s a reasonable fee, but it’s a fee. 2. The income tax basis of your original property is carried to the new property. This means lower depreciation for the future, and when the property is ultimately liquidated, the capital gains will be increased by the amount deferred in the first transaction.

Income tax basis is the amount paid for the property plus capital improvements minus depreciation. The real benefit of a 1031 Exchange is that you basically get an interest-free loan from the Internal Revenue Service and State of California — you have more equity to invest in your next property because you’re not paying taxes on each transaction. As long as you have a long-term view of investing, 1031 Exchanges can be a great way to go.

This is a very simplistic summary of a very complex topic. You must have good real estate advice as well as a tax professional to work with you.

Next time I’ll write about disclosures – where there really is no such thing as TMI (too much information). If there’s something you would like me to write about or if you have questions about real estate or property management, feel free to contact me at rselzer@selzerrealty.com or visit our website at www.realtyworldselzer.com. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 35 years.

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