The Difference Between Investment and Ownership
The first thing you need to know about real estate investment is that it has nothing to do with home ownership. Your residence may represent a healthy portion of your personal wealth thanks to the real estate run-up of the last ten years, but it is not an investment. It is a home, a place of emotional and physical attachment.
How 1031s got started. Named for their place in the U.S. tax code, 1031 exchanges were created in the 1920s for businesses and big-league investors who owned many assets and wanted a way to defer taxes over the long term. Until a few years ago, those groups were still the main customers for 1031 transactions- but sky rocketing real estate values and the rising number of Baby Boomers headed for retirement have made 1031 exchanges popular for smaller investors too. However, these are complex transactions and almost always require assistance from tax advisers and intermediaries required to facilitate each deal.
How 1031 exchanges work. The 1031 exchanges have strict time frames for buying and selling real estate if the exchange is not simultaneous, so it’s important to find a broker and tax adviser who understand exactly how these complex transactions work. The simplest form of a “forward” 1031 exchange works like this: a person with available property identifies a property of “like-kind” value for an exchange. Because of the IRS’s broad definition of “like-kind;’ the property doesn’t have to be identical or for the exact same purpose-in other words, a six-unit apartment property could be exchanged for a warehouse, strip mall, or even undeveloped land. Under the basic rules of 1031 exchanges, investors have 45 days to identify up to three properties of equal or greater value that they plan to exchange for the old one and a total of 180 days to close the deal.
The 1031 exchange transactions require the involvement of a third-party intermediary-often a tax or real estate professional-to hold the money while the exchange is done so the tax advantage doesn’t evaporate. What’s a reverse exchange? It allows the replacement property to be purchased and closed on before the relinquished property is sold. Usually the intermediary takes title to the replacement property and holds title until the taxpayer can find a buyer for his relinquished property and close on the sale under an exchange agreement with the intermediary. Subsequent to the closing of the relinquished property (or simultaneous with this closing), the intermediary conveys title to the replacement property to the taxpayer.
Are there other restrictions? A person may be disqualified if they don’t handle their 1031 strategy properly. An investor who buys and sells frequently may be declared a “dealer” of real estate and be subject to ordinary income taxes instead of capital gains. Consult an adviser.
Is there an easier way to buy? Qualified commercial real estate agents are often good at continually spotting properties that would qualify for a 1031 exchange. But keep in mind alternatives that may save money in brokerage costs. Major retailers that do a good job of scouting locations may also have an outreach function for attracting individual investors for syndicates formed to own their real estate. This type of ownership can also be done as a 1031 strategy, but again, with the right advice. Even the most established real estate opportunities have risks.
Keep abreast of the tax code. Even if an investor doesn’t have as much expertise in tax issues as the average CPA or real estate attorney, it’s important to have a basic understanding of the tax issues that affect real estate transactions. The IRS Web site (www.IRS.gov) is a good bookmark to help investors start that education.
Investments are meant to be bought and sold when market conditions warrant. The level of commitment you have to a real estate investment should be dependent only on the profit you can extract from it.
Ways to Invest in Real Estate
Direct ownership of individual property. Many people already own real estate-their home. In fact, it often is the single most valuable financial asset they own. But homes typically aren’t counted as part of their investment portfolios because people usually don’t use their home as an investment. It is a place they Jive in for personal reasons, and while they hope to sell it for a profit when they move, it commonly is with the intent to move into another, and presumably more expensive, home. (Some retirees sell and move into a smaller home or apartment, and use the profits to help fund their retirement.)
A more likely way to invest directly in real estate is to buy individual properties, such as rental homes, apartment buildings, or office buildings. You then can generate income through depreciation-sheltered rent and sale for profit. This type of investing requires knowing the market well and being a landlord-not something the average investor may want to pursue. But it can be highly lucrative if done well.
Public and private limited partnerships. These involve a limited number of partners investing in property managed by a general partner or sponsor (such as a brokerage firm). They arc illiquid long-term investments, as there is a limited resale market. Limited partnerships were especially popular in the 1970s and 1980s until tax law changes, mismanagement, poor real estate values, and high fees killed the market. However, they are showing signs of life again.
REITs. In existence since 1960, real estate investment trusts have become very popular in the last decade. These companies pool investor money, much like a mutual fund company does, to invest in real estate. Equity REITs buy income-producing property such as apartment buildings, office buildings, and shopping centers. REITs often specialize in certain regions or types of proper-ties,such as self-storage buildings or health-care facilities. Income generally comes from rents, though there may be profits from the sale of the properties. Mortgage REITs buy mortgages and construction loans on commercial properties. Hybrid REITs buy property and mortgages. Buying a REIT is like buying and selling stock, and REIT prices fluctuate like stock prices. RE1Ts pay out 95 percent of their net taxable income. Unlike limited partnerships, the over 200 REITs are easily traded on stock exchanges and over the counter.
Mutual funds. There are a number of mutual funds that focus on real estate. They invest primarily in RElTs or real estate-related industries such as homebuilders or building supply companies. Funds that invest primarily in REITs tend to be income-oriented. Some mutual funds invest in real estate overseas. The biggest advantage of mutual funds over other types of real estate investments is that they provide greater diversification and they are easier to select than the more specialized and complex REITs and limited partnerships.
The Flipping Phenomenon
There have always been “flippers” in real estate-people who buy distressed properties with cash and sell them to a waiting buyer. Yet the real estate frenzy of the last few years bears little resemblance to the cash-based process that provides the biggest opportunities for gains.
In the past few years, people have attempted to get into this field with debt, not cash, and those with the right skills did okay. Actually, some did more than okay in the right situations. But as real estate began slowing in late 2005 and interest rates began to accelerate, many flipper wannabes found out that the lure of easy profits blinded them to the potentially devastating financial risks of being in too much debt with property they couldn’t sell at the price that would secure them a profit. The bottom line is that real estate moguls aren’t made in a day, no matter how many infomercials you watch.
In fact, real estate investment is either a career you can devote yourself to full-time, or in small, careful increments with a minimal dependence on debt. In fact, many newbie investors have found that a less-than-thorough once-over on a property can reveal expensive repairs that need to be done before the property can be resold. Sometimes, ‘a buyer’s financing falls through, the market cools, and you, the investor, are left with holding costs that far outstrip your cash flow until the property can finally sell.
What It Really Means to Be an Investor
Successful investing is informed investing. It also means having the money and time to be patient and to rescue yourself when things go wrong-and in the beginning, many things can go wrong. Here are characteristics of successful real estate investors:
- They are students of finance, construction, and neighborhoods.
- They spend anywhere from three months to a year learning all they can, until they feel comfortable making the move. If they miss an opportunity, they miss it.
- They get to know bankers and other key property players personally.
- For those who plan to get into the foreclosure market, they get to know bankers and courthouse staffers personally so they understand how the process really works. Infomercials and Web sites don’t know what’s going on in your community. People do.
- They get their advisory team together first. CPAs, attorneys, financial planners-the decision to invest in real estate cannot be isolated from your personal financial circumstances. Your personal finances and business finances will be connected to the moves you make in real estate investment whether you are planning for it to happen or not. Don’t wait for the IRS to point that out.
- They often start as owner-occupiers. If you are handy, continue becoming a real estate investor as an owner-occupier. Learn to do the bulk of the renovation and fix-up work yourself, and be realistic about more dangerous or complicated jobs you know you cannot do. Owner-occupiers generally get more favorable loan and tax terms.
- They try to have some cash in the bank. Problems always crop up that lengthen time frames in renovation and selling. Real estate investors have to have a sizeable emergency fund for that purpose alone.
- They understand their investment limits. While real estate deals are far from uniform, there are some rules of thumb for setting a dollar investment. in a property or walking away entirely. For many, that means a target purchase price of at least 30-50 percent below the market value you’ll create after you’ve fixed them up. That way, after you subtract rehab expenses, commissions, financing, and miscellaneous costs, your target is a minimum 20 percent profit margin.
Tax Implications of real Estate Investment
If you start going crazy buying properties, don’t be surprised if Uncle Sam knocks on your door wondering why you’re not doing it as a formal business. Your advisers will point out that thin line between investor and business owner. It’s a fairly expensive one. If investors hold the property for a year or more before selling, sale proceeds are considered long-term capital gains and are taxed at a 15 percent rate. If the IRS renders your property transactions as a business or a trade instead of ordinary investment, that could mean a tax hit as high as 35 percent. Without planning, you’ll quickly be scratching your head wondering why you ever made the first step. So be careful.
1031 Exchanges and How They Work
If you plan to buy and sell real estate as a long-term asset or retirement strategy, it’s worth understanding the 1031 exchange. Also known as “like-kind” exchanges, 1031 exchanges allow an investor to defer capital gains taxes if he or she sells a big asset, such as a rental vacation home, and invest the proceeds immediately in a similar asset. Although 1031 exchanges can apply to many types of exchanges, they are most often used for real estate. The advantage? The investor can delay tax consequences when upgrading the investment property he or she owns.