Using Commercial Real Estate as a Supplemental Retirement Plan

Friends, Redskins, countrymen, lend me your ear.  I come to praise Rex Grossman, not bury him.  Which is odd, since I have blamed him for everything from the increase in DC suicides to congressional gridlock.  The NSA has a secret surveillance program to figure out where he's throwing half the time.  Rex is the best third string quarterback in the NFL.  He is Bret Favre, without the talent, Peyton Manning, without the brains, Tom Brady, without the smokin' hot supermodel wife.   But, he is better than Pat White.

Pat White is the rule to which RGIII is the exception.  White is the rule that running quarterbacks can't throw.  Have you seen him throw to the right side of the field?  Not and complete a pass to someone wearing burgundy and gold.  So, I raise my glass in a toast to Rex Grossman.  May he forever stay on the Redskins sideline holding a clipboard.

Here's what I'm not talking about when I advise using commercial real estate as a supplemental retirement plan.  I am not talking about Rich Dad, Poor Dad nonsense.  I am not talking about buying real estate for no money down and flipping it in six months, thus becoming fabulously wealthy.  That won't happen.  You'll just go broke.  You're not that smart.  I'm not either.

I am also not talking about buying commercial real estate with your IRA money.  You have to be pretty stupid to do that.  It gives up the main tax advantage in owning real estate, the lower capital gains rate when you sell it.  If you put property into a qualified retirement plan, you don't pay taxes when you sell the property, but you pay ordinary income taxes when you take the money out of the plan.  Stupid - really stupid.

I am talking about buying space from which you will operate your business.  If your business doesn't require office or warehouse space, please go back to your porn site.  This post isn't for you.  There are three great reasons to buy commercial real estate for your business operations.

First, you are paying rent already to somebody.  You might as well pay it to yourself. This is the primary reason we bought our office space.  At the end of a five year lease, our monthly rent doubled, just because we needed to lease office space in a tight market.  When we bought our office space, we forever ended rent increases.  For the first few years, making the mortgage payment was difficult.  However, the payment was never going to increase again.  Our rent, in the form of the mortgage payment, was never going to increase, let alone double, again.

Second,  over a period of ten or twenty years, your commercial real estate investment will increase in value, and you get capital gains treatment when you sell it.  If you intend to be in business for less than ten years, again go back to your porn site.  Commercial real estate, in the short term, is a wild ride best avoided.  Prices can move down or up twenty percent in a year.  However, if time allows you to sit out the price swings, commercial real estate is a great investment.  The eventual appreciation is a great tax advantaged supplement to other pension plans.

The third reason to own commercial real estate for your business is that the rent is an excellent way to get money out of your S or C corporation without suffering the tax disadvantages of dividends or salaries.  You also have wide latitude in determining a fair rent to pay yourself.

How can you afford to buy office or warehouse space?  The SBA loves making real estate loans.  They love hard assets.  You'll have to operate your business there, though.  The SBA doesn't loan for investment properties.  Pretty much nobody does anymore unless you have forty percent down.  For your purchase, you'll likely need ten percent down.  The place to look for an SBA loan is a local bank specializing in small business lending.  Look for a bank that makes a lot of these loans.  You don't need an amateur banker, who is more comfortable with home mortgages.  Commercial real estate loans are a whole different animal.

Here's a hint on owning the real estate.  Create a limited liability company (LLC) to own the office or warehouse space.  Then make the LLC the landlord for your business.  This separates the building from your business for liability purposes.  If your main business goes bankrupt, you may get to keep the building since it is in a separate entity.  No guarantees there.  Check with your lawyer.  You can also easily sell the business, or real estate, separately from the other.

Commercial real estate can be a valuable part of a comprehensive retirement plan.  I drank the Kool Aid myself.  But have realistic expectations.  It is a part of the plan, not the whole plan.

Thanks for reading.  For real tax and accounting advice, please visit the main S&K web site at www.skcpas.com.  Also, please like the "How to Screw Up Your Small Business" Facebook page.  I post snarky tips there three or four times daily.

Until next time, let's do it to them before they do it to us.

Rent Out Your House

Who says Commies don't get capitalism?  This week Russian punk rock group, Pussy Riot, was back in the news.  They may not be good at music, but they are great at branding.  If they were named Ruptured Spleen Riot, would we have heard about them?

So you want to move to a bigger house but can't, because your current house is so far underwater the zip code was changed to Atlantis.  How will you ever manage to fit four wives, ten children, and fifteen cats into your three bedroom townhouse?  You're in luck, because I have the answer.  It might not be a good answer, but you aren't paying anything for this advice.  So you'll get what you pay for.

There are three things to know about taxes on rentals before you advertise your house on Craigslist: 1. How your rental will affect your tax situation, 2. What you can deduct, and 3. How you report the income and expense on your tax returns.  Let's start out with #1.

You might reasonably think renting out your house puts you in the rental business, not really from an IRS perspective.  Unless you are a real estate professional, meaning a real estate agent or involved in a real estate trade, your rental is considered a passive activity.  With a normal trade or business, if you make a profit, you pay taxes on the profit.  If you incur a loss, you can deduct the loss against other income such as wages.  This isn't true with rental real estate.

With rental real estate, you pay taxes on any profit you earn, but you do not get to deduct any losses you suffer unless your adjusted gross income is less than $100K.  If your income is less than $100K, you can deduct up to $25K in rental losses.  If your income is between $100K and $150K, you get a prorated portion of the $25K.  If your income exceeds $150K, you get no immediate deduction at all.

You don't lose any rental losses that you can't immediately deduct.  You carry the losses forward to future years until you either have a rental profit, which you can then offset dollar for dollar, or until you sell the house.  Then you can deduct any remaining losses that you have not been able to deduct.

If you make more than $150K and a buddy tells you to invest in rental real estate for the tax break, he is full of......full of something foul and smelly.  Rental real estate can be a good investment, but not for an immediate tax break.  It can be good for price appreciation potential, which can be taxed at the lower capital gains tax breaks.  Real estate can be a great part of a retirement plan, just don't put it in an IRA.  You'll lose the capital gains tax rate that way.

If you aren't planning on holding a property for five years or more, your investment will likely be a bad deal.  Yes, I know about flippers, not the amphibian kind, the stupid kind, who believe they can outguess the real estate market.  I prepare their tax returns.  Here's how they go:  small gain on the first deal, small gain on the second deal, then total loss on the third.  Losers don't brag, liars do, however.  You've been warned.

You might also ask, "Frank, how do I become a real estate professional?  That way I can deduct my losses regardless of my income."

There are two requirements to be considered a real estate professional.  First, you must have at least 750 hours in real estate activities.  That seems simple enough to meet.  However, the second requirement is that more than half of your work hours must be spent in a real estate related profession or trade.  That's the tough one.  If you have W-2 income from a non-real estate job, you probably can't qualify.

"But Frank, how will the IRS know whether I spend more than half my time in real estate?"

Here's how to find out. Try deducting a rental loss when you have substantial W-2 wage income.  You will likely get a personal invitation to your local IRS office.  You'll need a log of your hours to prove more than half your time was in real estate.  No log, no deduction.

Think broadly about the potential expenses you may be able to deduct against your rental income.  Let's start with this partial list:
a. Mortgage interest
b. Real estate taxes
c. Utilities
d.  HOA dues
e. Repairs
f. Depreciation
g.  Travel to the rental
h. Professional fees
i.  Landscaping and maintenance
j. Management fees and rental commissions
h.  Cleaning supplies

For depreciation, you depreciate the building, not the land, using the straight line method over 27.5 years.  Why 27.5 years?  Why not?  Tax law doesn't have to make sense.  How do you separate the building value from the land value?  Look at your tax appraisal.  That will give you the proportion of the total property value that is building.  You then apply that percentage to either your original cost of the property or the market value when you make the property available for rental.  You use the lower of the two values.  You do include settlement costs in the original purchase price.

You also get depreciation deductions for improvements and major replacements.  Improvements attached to the structure of the building are depreciated over 27.5 years.  Replacement appliances are depreciated over five years.  IRS publication 527 covers expenses related to residential rental real estate.  You can get it at www.irs.gov.  It's great bathroom reading, guaranteed to cure constipation.

There are three primary schedules you'll use to report your rental activity on your personal tax returns, schedule E, form 4562, and form 8582.  Schedule E is the main form where you list the rental income and expenses.  Form 4562 is the form where you calculate depreciation.  Form 8582 is where you determine how much of your rental loss is deductible and how much carries forward to future years.  You can also get these forms at www.irs.gov.  This site's porn for tax preparers.  Sad, but true.  At least it's free.

Good luck in renting out your house.  You'll need it.  The tax complications are the least of your worries.  You'll face idiot tenants.  You'll get to pay moron contractors to repair your property.  All of this is pure joy.  Trust that I know this from experience.  We just received a contract to sell our rental property.  If I had to make a choice between that sales contract and sex with Jennifer Aniston.....well it's a close call.

Thanks fro reading!  As always for real tax and accounting advice, visit the main S&K web site at www.skcpas.com.  Also, please like the "How to Screw Up Your Small Business" Facebook page.  I post snarky and helpful business advice several times each day.

Until next time, let's do it to them before they do it to us.

Are Your Real Estate Flips Flops? Part II

The real referees are back. No more referees rejected from college training programs. This week, Ed “Big Guns” Hochuli will be back torturing the Redskins. Hochuli makes Arnold Schwarzenegger feel inadequate physically. He's built like a Redskin hating Greek god. Of course, there was that officiating gaffe that cost the Chargers a playoff spot a couple years ago as well. Yet, I am a forgiving person, especially given the danger to RGIII from the fake referees.

In my previous post, I explained how you calculate return on investment for real estate investments or for that matter for any investment. The basic calculation was profit divided by investment. I encourage you to read that post first before this one. In this post, I assume you understand the basic ROI concept. I will also use a more complex example. Let's plunge into an example with some realistic numbers in place of the very simple ones from the last post.

Our objective in this exercise is to calculate how much we have to sell an investment property for in order to obtain a desired rate of return over a particular period of time. In simpler terminology, we are fixing up and flipping a house. To accomplish this, I have to give you some numbers. Here they are:

Purchase price of the house $350,000

Settlement costs on the purchase $10,000

Fix up costs $50,000

Loan amount at 80% of the purchase price at an annual interest rate of 8%

We intend to sell the house after six months with a 50% annual rate of return.

Settlement costs on the sale $20,000

Our objective is to determine the selling price of the house to get our 50% annual rate of return in a six month period. Let's start out with how much money we need to invest in the house. We need this information to know the dollar amount of the return we desire. To get the total amount invested in the house, we add the purchase price, the purchase settlement costs, and the fix up costs, which gives us $410,000. We can borrow 80% of the purchase price or $280,000. The bank typically won't finance the settlement and fix up costs. If we then subtract the loan amount from the total amount we have in the house, we get our investment of $120,000. That's our money in the deal.

Next, let's determine the profit we need to achieve our annual rate of return of 50%. Since we are holding the house for 6 months, our actual nominal rate of return is 50% divided by 2 or 25%. So we take the 25% times out investment of $120,000 to get $30,000, which is our desired profit.

Finally, we determine the selling price we must get. Add the original cost of the house including the purchase price, fix up costs,and purchase settlement costs. That gives us $410,000. To that we add 6 months interest on the loan, which is $11,200. The bank isn't loaning you the money for free. Then we add the settlement costs on the sale, which are $20,000. Finally, we add in our desired return on investment of $30,000. That gives us a desired selling price of $461,200.

Put simply, to achieve a 50% annual return on our invested funds, we need to sell the house for $461,200 in six months. If you don't follow the math exactly or would like to run your own scenarios, I have an Excel spreadsheet I will send you if you shoot me a message requesting it at fstitely2@gmail.com. I have no agenda in this. I ain't looking to sell you nothin'.

Let's have some more fun with these numbers. Let's start out with the selling price we need to break even. That's an easy number to get. We take our desired selling price of $461,200 and subtract the profit of $30,000. Our breakeven price is $431,200. If the price is above that, we make money. If the price is below, we lose money. In other words, we have to sell the house, that we bought for $350,000 and spent $50,000 fixing up, for $431,200. Or we lose money. If we are selling within six months, the house, that we paid $410,000 for after fix-up costs but before settlement costs, has to go up in price to $431,200 or we lose money. The breakeven number is an incredibly important piece of information to have before you plunge into this investment. If you haven't calculated that number, real estate investing isn't for you.

Now that you know how to set your objective and calculate breakeven, let's discuss the circumstances under which you can accomplish your profit objective by flipping a house. Let's start out with a sanity check. Why would somebody pay you $461,200 for a house you bought and fixed-up for $410,000. Why wouldn't someone just go out and buy another house for $350,000 and spend $50,000? What makes your house worth the $461,200 after six months or even the breakeven of $431,200? Few amateur house flippers ever ask themselves this question.

There are three circumstances under which you might achieve the return you desire. The first is that you are in the construction business. That means you are doing a lot of the work yourself or through your employees. You are paying wholesale for materials and labor. You aren't paying for the improvements what the average Rich Dad Poor Dad reader pays. You are paying $50,000 for improvements worth $90,000, assuming no other increase in the price of the underlying house. Are you in the construction business with access to great pricing? Most of you aren't.

The second circumstance is that you have identified a house that is significantly under-priced. Under-priced to the tune of $40,000. In other words, you paid $350,000 for a house that was really worth $390,000. How did you happen to have this magnificent foresight? You might have this foresight if you have been in the real estate business for a long time. You might be able to identify houses in neighborhoods about to become desirable. I have known a few people, who have done this, but damn few. Look in the mirror and be honest. Do you really have this sort of insight?

The final circumstance under which you might achieve our annual return of 50% is that the real estate market has gone truly crazy and there is a buying frenzy. The early 2000's are a perfect example of a real estate market gone crazy. You could buy a house from a builder that had not been built yet. Then you could sell it two weeks later for a good profit still before the house had been built.

Of course, you had better not get in on the end of the cycle. My business partner Paul and I have a saying. “The party is over when the fools arrive.” Fast forward from 2000 to 2006. When the music stopped, a lot of people had borrowed a lot of money on houses that were worth 60% of what they had paid a year earlier. They weren't underwater. They were completely under the riverbed. I had clients whose real estate investments went as follows: profit, profit, bankruptcy. Some of these people were real estate agents. So much for superior market knowledge.

Your ability to make money in a crazy market depends on your ability to recognize the beginning of the price run-up and then get out before the crash. Do you have that level of expertise? I don't. Pretty much no one does.

My intent isn't to tell you that real estate shouldn't be part of your investment portfolio. It should be. However, flipping houses isn't investment. It's speculation. If you're not real estate savvy, you are just gambling – with borrowed money in most cases. If you aren't doing the ROI calculations above and making realistic judgments, you aren't real estate savvy. Your real estate flips will be flops.

Our house is in mourning over the death of the baby panda at the National Zoo. The Zoo has had incredibly bad luck raising baby pandas. There are two possible explanations for this. The first is that the pandas are just another defective Chinese export product.

The second explanation is the lack of sex appeal of the female pandas at the National Zoo. Despite importing male panda studs, the zoo has resorted to artificial insemination. We can only imagine the conversations between the male pandas. “Dude, she's a double bagger. I'm not doing that.”

Maybe panda love works the same way as human love. They should spike the bamboo shooters the males drink. Get them liquored up. Then announce last call for alcohol. The females will probably look a lot more attractive then.

Thanks for reading. Next time, I plan a post on falling behind the times in marketing. As always, for real tax and accounting advice, please visit the main S&K web site at www.skcpas.com. Until next time, let's do it to them before they do it to us.

Are Your Real Estate Flips Flops?

The FBI arrested two NFL replacement referees today. They were charged with felony embezzlement for stealing the Monday night game from the Green Bay Packers. These two officials conspired to make one of the worst calls in the history of the NFL, granting a game ending touchdown catch to the Seattle Seahawks, who were charged by the FBI with receiving stolen property.

The next time I attend a Redskins game, I am tempted to get liquored up, get close to the field before the game, and shout at one of the replacements, “You should be mowing my grass, moron.” But I won't. Yes, I will get liquored up, but I won't berate the replacement officials, even assuming that I could put together a coherent sentence in that condition.

The replacement officials come from small college football. The NFL is to small college football what the space shuttle is to a single engine prop plane. These guys have never experienced the speed and violent contact of an NFL game. If they had a season to adjust, they might become competent. Nonetheless the integrity of the game, and mostly importantly RGIII's health, depend on quality officiating. Gimme back the damn regular refs. Of course, I'll complain about them when they're back.

Are you tempted to enter the wonderful world of real estate investing? If you are, this post is critically important to your success. I am going to show you how to calculate return on investment. If you decide you aren't interested in this topic, real estate investing isn't for you. If you want extra income, get a job at Burger King. At least you won't lose money flipping burgers instead of real estate.

Return on investment (ROI)is a simple concept to explain, but a sometimes difficult concept to apply in the real world. ROI is calculated by dividing your investment return by your investment, which yields a percentage. Let's take on a very simple example.

Let's assume you bought a house on January 1^st for $100K. Let's also assume you paid cash for it. Now let's assume you sold it on June 30^th for $125K after selling expenses. You have a profit of $25K. If you take the $25K profit and divide it by your original $100K investment, you have a 25% return on investment. That's true but it doesn't give you any useful information versus other investments you could have made, whose investment returns are usually expressed on an annual basis.

To make our ROI an annual return, since you held the house for half a year, simply double the 25%. Thus, your annual ROI was 50%. In fact, if we were being exact and using compound interest, your return would be a little greater than 50%. However, our approach is accurate enough for what we intend to do. Hopefully, this simple math isn't beyond you. If it is, find a fifth grader to explain it.

Let's now make our example a little more complex. Let's add the assumption that you didn't pay cash for the property. Let's assume you borrowed $50K from a bank. Now let's calculate your ROI. You sold the house for $125K after expenses, but you paid the bank $5K in interest. So your profit is $20K instead of $25K. Now your ROI is $20K divided by your investment of $50K or 40%. If we double that to annualize it, we get an annual return of 80%. Why are we using $50K as your investment? Because that is how much you invested of your money. Notice that borrowing increased your annual ROI from 50% to 80%. That is the magic of debt. It is called leverage. It also functions on the down side, however.

Let's change our example to assume that we sold the house for $75K after expenses instead of $125K. Without a loan, our ROI is ($25K) divided by $100K or a 25% loss, which annualizes to a 50% loss. If we assume that we borrowed the $50K, our ROI becomes ($25K) divided by our $50K investment or a 50% loss, which annualizes to a 100% loss, before considering the interest you paid to the bank. In other words if you did this deal twice in a year, you would lose your entire $50K investment.

We can conclude that debt not only magnifies your ROI when you make a profit, it magnifies the effect of your loss on the down side. Thus, debt increases your investment risk. Hopefully, this is relatively simple math. In my next post, I will explain when making money investing in real estate is possible – and when it isn't. An understanding of ROI is necessary for the analysis.

My marketing person for my eventual book has advised me to ramp up my activity on Twitter. If you are on Twitter, my handle is @fstitely. I tweet mainly about business and the Redskins as you might expect.

Today, I received a direct message from one of my followers. She, I hope she is a she, wrote to me that she has a vagina. Of course, this is really special information that sets her apart in my eyes since only approximately 50% of the world has that particular body part. I wonder what makes her specific female crotch organ special. I am guessing hers is set apart by the amount of drugs I would have to take if I got close to hers. Yes, Twitter has porn spam.

Thanks for reading. As always, send me your comments, gripes, and suggestions for posts. I take requests – at least ones that don't involve vagina’s. For real tax and accounting advice, please visit our main S&K web site at www.skcpas.com. Until next time, let's do it to them, before they do it to us.