What do you wish you had known before your first purchase?

Question

Hello, everyone,

I'm new here so I'll briefly introduce myself.   I just turned 25 last month, and my goal is to make a highly successful career out of real estate.  I am currently in the military and I'll be moving to the states next month.  (due to complications, I still have no idea where I'm going).

I think the title says it all.  I'd like to gain information from people who have "been there", and this seems like the perfect place to get it.  What do you wish you knew before your first purchase?  What would you have done differently?  What questions do you think I should be asking, but may not be experienced enough to know I should ask them?

That being said, I am considering making my first purchase a fourplex in whatever state I end up in.  I was reading up on FHA and 203K loans, and I'd love to purchase a fourplex, rehab it, and live in one of the units while I rent the others out.  Does this seem like a good first purchase?  What would you do differently if you had the chance to do it all over again?

Right now, I'm reading "Loopholes of Real Estate" from the "Rich Dad Poor Dad" series, and there seems to be a huge opportunity to get major tax breaks if this is all done correcly.  If you have any insight on this, I'd love to hear about it.

Again, if there are any questions I should be asking, please let me know.

Thanks for your time!,

-E. Mace

Mike Watkinson · Answer

Ethan Mace

1. Talk to your accountant about a 1031 exchange. It simply allows you to deffer taxes on any gain you would have by allowing you to transfer your basis from the old house to the new house. Your responsibility to pay back the bank for your old mortgage and tax treatment on the sale of the house are separate considerations. Lets say of the $100K, $80K is the banks and $20K is your down payment. Under the assumption you had an interest only loan and there are no closing costs for simplicity, $70K is now yours and the $80K is owed to the bank. Skipping all the steps around who can and can't hold this money, you now need to buy a house in a set period of time. The basis in your old house, $100K (less one year depreciation) will now be the basis in your new house, plus any amount above $150K which you paid for the house. Any amount paid under the $150K for the replacement house is taxable, as your will be forced to recognize the tax gain to the extent that your receive consideration (cash or debt reduction). Any gain is taxed at your normal tax rate to recapture depreciation you have taken as a deduction on the house, and as a capital gain thereafter.

Basically, a 1031 exchange is just a tax strategy which allows for deferred taxes. You can't take money out of a house with it, but rather trade up without paying any taxes on the gains you have made until you sell the replacement house. Think of it like using a equity line of credit to remodel your investment property, but instead buying a bigger one.

2. With respect to the loan type, the IRS doesn't care how you finance a house. They do care if it is owner occupied through, which I believe is a requirement for the FHA loan. You may be able to use it on the investment portion of a multi family though, i.e., half of your duplex is treated as investment and half is not.

3. How to ensure capital gains rather than losses? Invest in treasury stock instead of real estate. Your gain is derived from the risk premium. Do your homework and you have a better shot of doing well. To tie it in to #1, the purpose of a 1031 exchange is to defer yours gains (ordinary and capital).

4. Don't speculate on appreciation for your investment strategy. Your buying an income producing asset, so count on the income. If your not in it to hold, then make your money on the front end rather than hoping for some luck on the back end.

I hope that helps. I'm not an expert on tax law and have never used an FHA loan so take my understanding with a grain of salt.

Kim Giannola · Answer

Ethan Mace Your strategy sounds very doable.  Lots of people on BP have used it, including myself.  It's a great way to get started on your first deal with little money down.

My biggest mistake and thing I wish I knew ahead of time has to do with the 203k loan.  I didn't know any good contractors and the FHA limits the number of contractors you can hire yourself, forcing you to find a GC.  I ended up getting a HORRIBLE GC who not only charged way too much for the work but was a terrible project manager.  I remember getting calls from him asking "hey did the HVAC guys come today?" while at work.  And he was supposed to do carpentry work and waited till the work was stopped by the HVAC guys waiting for him to do his part.  He also lied about the timeline and function of my heating systems in December/January which meant I had to find another place to live for two months.

My biggest piece of advice is to network in your chosen area and get solid references well a head of time.  Let them know you plan to do a 203k and see if they have experience, or find a GC who has done it before.  This will be huge.  Also make sure they know all the terms ahead of time as far as draws an inspections.  Mine was begging for cash advances constantly because he didn't read how the draws went.

Best of luck to you!!

Matthew Elmer · Answer

Bottom line the value of a property is never 100% known.  The only facts you can get is those based on previous sales, or what we in the industry call comps.

Basically, you want to think, in the condition this property will be in when I go to sell, what can I absolutely be sure it will sell for, based on what others have sold for.  There is an art to it in some situations where there aren't a lot of comps, but if you are starting out, start with properties you can comp out easily.  A good agent should be able to help with this.

If you are ever traveling through Dallas, I go through this in my 3 day training in detail.  Bottomline, can you find a similar property or properties that have sold in the immediate area of your subject property that are the same condition and the same size.

If you can't logic it out, you don't have a good comp.  However if you can say, oh this house which is only 100 square feet larger, in its condition, sold for $150,000 last month then you can pretty well figure your house can conservatively sell for $145,000 if you put it in the same condition.

Working with an agent they can explain reducing to price per square feet for more accuracy, but hopefully you get the jest of what I'm explaining.

Matthew Elmer

www.therealalliance.com

Ethan Mace · Answer

@Matthew Elmer

@Kim Giannola

Thanks for your replies!  I'll have to keep an eye out for properties below or equal to their actual value, and make sure I have a trustworthy contractor to handle the repairs.  I have a few more questions if you might share your insight.

I was researching last night, and stumbled upon 1031 exchanges.  I understand how they work, but I do have a few questions about the finer details.

1.  If I purchase a property for $100k, and after a year, it's worth $150k.  I do the 1031 exchange and now I have $50k as a down payment for a bigger property/properties.  What happens to the other $100k?  Do I use it to pay off that mortgage?  Is it taxed?

2.  Can I do this with an FHA/203K loan?

3.  Is there a strategy to ensuring capital gains (or at least managing risk), rather than losses?

4.  Do you have any other advice for this type of strategy, or suggestions for a better one?

Thanks again for your time, I really appreciate it!

-E. Mace

Bill Exeter · Answer

When structuring a 1031 Exchange the replacement property that you end up acquiring must have a total purchase price that is at least equal to, or exceeds, the sale price of the property that you sold.  In your case, you sold for $150 so you would need to acquire a replacement property that is worth at least $150 in order to defer all of your taxes.  The debt on the relinquished property would be paid off, but you would need to get replacement debt on the acquisition of the replacement property (or put in more out of pocket cash to replace the old debt).

William Powers · Answer

How little you should pay for property, how easy it really is to do what I do now, and the formula.....for every $10,000 invested in a property, you must see $200 in rental income per month. Simple but effective.

What do you wish you had known before your first purchase?

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