There’s so much out there in the real estate investing world perceived to be universally understood as ‘known’. Just a few examples might be . . . .
- “Buy ‘n hold, and never sell.”
- “Only fools pay taxes when a tax deferred exchange is an option.”
- “Leverage is all about down payment. The lower the down, the better the return.”
- “Flipping is investing.”
Buy, Hold, and Never, as in Never Ever, Sell.
The good news/bad news joke that’s never funny about this school of thought. First, the good news is that the investor following this Grampa Economics school of thought will most likely end up with a few small income properties free ‘n clear. That will, undeniably, generate the most income possible — for each property — a fact which nobody attempts to argue is bad news.
The bad news? They end up with relatively older properties, usually at least 30 years old, and many times over 50 years old. Why is that bad news? Oh Lord, let me count the ways.
Older properties as a rule end up being at least somewhat functionally obsolescent. Kitchens without garbage disposals and/or dishwashers, wall heaters and the like. Yeah, every woman wants to live there, right?
Tenants prefer more modern units. Duh. Combine older units with subpar amenities, crummy off street parking, and in a badly aging part of town. What would you speculate the percentage of the tenant pie that owner will ‘enjoy’?
The older the property, the higher the operating expenses, especially maintenance, repairs, and outright replacement. Vacancy rates also tend to be higher.
However, the worst news by far and away, is the amount of capital growth and ultimate retirement income (cash flow) that wasn’t generated. Why? Simple: By never making no-brainer moves that would’ve significantly improved their position — WHEN the market invited them to do so, they purposefully and severely retarded their end game retirement cash flow. This isn’t arguable, as the physics of investing principles are like gravity. Gravity can be our friend or our worst enemy — our choice.
Never Ever Pay Taxes if They can be Avoided — Period!
Whether it’s long term capital gain taxes on your real estate, or deciding whether or not to ‘gut’ your 401k/IRA in order to generate a better retirement, there are times when paying the taxes, even if they’re relatively high, is the more rewarding choice. The key is found in the phrase, ‘long term’. This is especially true in the two examples given — tax deferred exchanges and qualified retirement plans.
1031 exchanges can and do save investors tons of money, but not anywhere near always. The idea is to compare paying the tax bill vs doin’ the exchange. The downside to tax deferred exchanges is that you’re forced to carry a backpack loaded with the ‘rocks’ of the previous property. That pack can become unbearably heavy over time. This is especially true when there are two or more exchanges stemming from an original property. In retirement your options are often reduced to refinance, or pay horrendously high taxes on a sale. Hitting retirement with an adjusted cost basis of a Happy Meal isn’t recommended.
If you’re one of the VERY small minority of Americans who will end up with a two comma 401k/IRA balance as retirement becomes reality, good for you. But let me pose one of those pesky questions first.
Wall Street advisors tell us we should be way more risk averse in retirement, which also means the yield on our capital at that point in life will likely be in the range of 3-5% or so. Now you tell me, did you manage all that self-discipline and sacrifice for 25-40 years so you could amass a seven figure balance in your qualified plan that would generate $30-50,000 a year? Before taxes? Yeah, I didn’t think so.
Imagine you have more than a few short years ’til retirement. Imagine you pay a very painful tax bill, PLUS a 10% penalty as a result of withdrawing your plan’s balance over a one or two year period. Ouch and a half! If all you ever did was buy discounted first position notes secured by real estate, you’d surpass the after tax income from that significantly lower amount by double, at least in most cases. In real life my experience is that $500,000 in a Roth ‘envelope’ will produce as much or more TAX FREE income as your 401k/IRA will do with twice as much in BEFORE TAX income. Hhmmmm
See what I mean? Pay the tax now. Today is likely to be the day when the tax liability generated will be the lowest it’ll ever be. You can pay now, or pay later. You’re likely to be unhappy with the results if you remain in your current non-Roth, non self-directed plan. Once folks see the numbers on paper, they grin and bear it while paying the tax guy.
The last Two are Much Easier. The Concept of Leverage and what Flipping Really is, are Short Topics for discussion.
Once and for all, leverage is never primarily the size of the down payment as it relates to the price paid for the property acquired. The investor can put 0% down and have disastrous leverage, that can drive them to bankruptcy. I’ve seen it play out too many times to count.
The actual definition of leverage is this:
Positive leverage: When the cost of borrowed money to acquire the asset is lower than the overall yield generated by that asset. Example: The money is borrowed at 5% while the property has an overall yield/return of 9%. The down payment can be 1% or 99%, but if the yield is more the the cost of money, it’s ‘positive’ leverage.
Negative leverage: Reverse the two numbers.
And Finally, Can We all take Step Back and a Big Breath While we Agree that Flipping isn’t Investing?
The IRS treats it no differently than if you were buying used cars and sellin’ them for a short term profit. Short term is defined by our favorite uncle as less than a year. But that’s not even the primary point.
The most important point to make about flipping is that while it can be incredibly profitable, often creating huge ‘ordinary incomes’ for flippers, it allows for zip, zero, nada, nothin’ for retirement. Flippers find themselves with a rapidly improved lifestyle for their family, but nothin’ whatsoever for their ultimate retirement. Then they learn that they can’t really quit cuz that new lifestyle is a lot more costly than their pre-flipping days. It’s long term investing that spawns retirement income. Until the flipper makes the conscious effort to begin diverting portions of their profits for the expressed purpose of creating said retirement income, they’ll eventually become a prisoner of their own often times phenomenal success.
Those are just four misconceptions I’ve found to be almost universally believed while simply not being accurate.
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