Two Silent (but Greedy) Partners!

As a real estate investor, whether you do it alone or with a team of two or more people, you still have to contend with two additional silent partners on every real estate transaction.One of these silent “partners” will require you pay them the majority of your cash flow and the other silent “partner” will take anywhere from 20% to 35% of whatever profit is left!

Silent partner number one is your bank or lender.Since nearly every real estate purchase is transacted with borrowed money, the lender will require repayment of both the principal and interest.Generally, for every dollar in principal and interest you pay back to the lender, you get to keep around twenty-five cents after expenses.Sometimes that figure is even less (or can even be negative) because the principal and interest are a fixed cost but your rental income and other expenses can fluctuate!

The second silent partner to contend with is the government.The county government where your property resides (and sometimes, there is a city government, too) will require you to pay annual property taxes.Even if your property has no debt, you are still required to pay them each and every year for as long as you own the property.If you don’t, they will take back your property and auction it off to pay the past due taxes.

This reminds me of my favorite quote from the movie “Crocodile Dundee” when he was asked if he “owned” a huge tract of land in the Outback to which he replied:“That is like two fleas arguing over who owns the dog.”In the end, the government gives us the right to “own” property and manage it for them to collect taxes.If we don’t hold up our end of the bargain, they will take it back and sell it to let someone else pay taxes to them.If you don’t believe me, stop paying your property taxes and wait a few years to see what happens.

Besides property taxes, the federal government will also tax your profits as well.If you sell a property after owning it for 12 months or less, the tax bill could be as high as 39% of the profit since it will be considered ordinary income.If you hold onto the property for more than 12 months, that rate can drop to approximately 20%.It is still a big chunk of the money, either way you slice it.

One of the sneakiest things to be aware of when you sell a property you have held for a long time is depreciation recapture.What this means is the government allows you to depreciate the rental property you purchased over a period of 27.5 years (don’t ask me why they threw half of a year into that equation) less the value of the land (since land does not depreciate).Let’s say you owned a property that you purchased for $120,000 and $20,000 of that total was for the land.The government allows you to take as a deduction against rental income each year a non-cash expense (depreciation) of $3,636.

Now if you sell the property ten years later, since they allowed you to depreciate the property and take a deduction to reduce your taxable income, you will owe taxes on all the depreciation you were allowed to deduct.After ten years, in this example, the total depreciation would equal $36,360 which is recaptured upon the sale of the property and taxed as long term capital gains.So the government is really a large beneficiary of all your hard work.You get to do all the work and take 100% of the risk when there are problems, and the government gets to collect a big chunk in taxes while you own it and after you sell it!It is a good thing to be in power and collect a big percentage of the cash flow and sales proceeds, is it not?

After the debt is paid off on a rental property, the cash flow you were sending to the bank is now cash flow you get to keep!Well almost all of it.Remember your second silent partner?They still want you to pay property taxes so those don’t go away just because you paid off the debt.But now that your property has no bank debt, that means it has no interest payments to deduct either.And when you get deep into the depreciation schedule you could even run out of depreciation to take as an expense.Cha-ching!Nice fat juicy profits are rolling in every month and life is good!

Each of these expenses (interest and depreciation) you used to get a tax deduction for can disappear which means your profit goes up tremendously and, you guessed it, the government takes more from you in the form of taxes on the bigger profit number each year.Sigh.

Thankfully, there are always strategies to implement to lessen the bite of the tax bill.One strategy is to use the equity in a paid-for property to either secure a line of credit or put another permanent loan on the property so you have interest to deduct on your taxes again.This money can be used to buy additional rental properties to add to your portfolio that will also have a brand-new depreciation schedule to start all over again.

The other strategy an investor can use is to lessen the bite of the taxman is to roll the equity in the paid for property into the purchase of a “like-kind” property of equal or greater value and borrow the difference.This is a 1031 exchange and it works pretty well, if you follow the rules and find a qualified third party intermediary to handle the transaction for you.

Let’s say your property you purchased ten years ago for $120,000 (in our former example) has increased in value to $240,000 today.If you sold this property and it had no debt, the tax bill would choke a horse.Your silent partner would show up to the closing and laugh all the way to the bank with the big pile of cash you worked hard to build over ten years and not even get a “thank you” card from them.

Instead, if you sold your property and found another property to purchase, you could roll all the $240,000 proceeds into another property that you purchase for $480,000 and get a bank loan for the difference at a 50% equity position.Then there would be zero taxes owed on the equity that is rolled over at this time, unlike a typical sale which would trigger the tax bill.

What if you wanted to get some of your cash out?You don’t want to leave your equity tied up in the property forever, do you?That is a simple transaction called a loan.You can borrow a lot of the equity out of the property and pay zero taxes since it is borrowed money and the tenant pays your loan back for you in the form of rent!Isn’t that nice?

In the previous example, if you rolled your $240,000 equity into a property so that it was 100% debt free, you could turn around and get a loan for 80% of the value which would be $192,000 which would not be taxed as income.How long would it take for you to make $192,000 after tax?Probably several years.In this case, you could cover a lot of living expenses for a long time with this money and just manage the rental properties that are still spinning out positive cash flow!

When I first started in real estate at the age of 45, my goal was to accumulate a lot of houses so that by the time I was 65 I would have 10 paid for rental houses that each would generate, after expenses, about $1,000 per month in cash flow to me for passive income.That is $120,000 per year in real estate income which is additional money on top of anything I might get from Social Security at age 67 or from retirement savings, which typically don’t throw off much income if you only withdraw about 4% per year.

This plan seemed so much smarter and I can tell you, from personal experience, it is a lot faster than the traditional way of trying to save increasingly larger percentages of salary each year and maybe, if you are lucky, accumulate $1 million or more in retirement savings which would only allow you to pull out around $40,000 per year adjusted for inflation.Why not do both?