One of the many benefits of real estate investing is depreciation—the loss in the value of a building over time due to wear and tear, deterioration and age. Depreciation can only be applied to the building, not to the land. After all, land does not wear out over time. Luckily for real estate investors, building depreciation reduces one’s reportable net income and, thus, his taxes. Sounds pretty good, huh? Follow me as we explore depreciation in more depth. Real Estate Depreciation Methods Several different depreciation methods have existed through the years. However, the method one uses is dictated by the property’s type and date of being placed into service. Depreciation for residential income property placed into service after December 31, 1986, for example, is calculated using the “straight line” method over 27.5 years. Depreciation for commercial income property placed into service after December 31, 1986 but before May 13, 1993, on the other hand, is calculated using the “straight line “method over 31.5 years. For commercial income property placed into service on or after May 13, 1993, one uses the “straight line” method of depreciation over 39 years. Remember that depreciation only applies to the building improvements and not the underlying land. What about property acquired before 1986? Investors that own property placed into service prior to December 31, 1986 generally use the “Accelerated Cost Recovery System” (ACRS) for depreciation. This method allows an investor to take more depreciation in the early years of a property’s holding period. Depreciation Recapture Upon the disposition of an income property, one is required to recapture all depreciation taken over the holding period. Basically, since the IRS allows the taxpayer to deduct depreciation from an individual’s ordinary income, all depreciation taken is subject to recapture at a maximum rate of 25%. If for some reason you are not taking depreciation on your income property, start filing amended tax returns; depreciation recapture is required regardless of whether or not you claimed such depreciation in previous tax returns. The IRS assumes you have claimed such depreciation, so you might as well do it. Capital Gains vs. Depreciation Recapture The best way to illustrate this relationship is through an example. Let’s assume Joe Investor has purchased a 20-unit apartment building in June 2004 for $2 million with $50k in acquisition costs. Let’s also assume that the building improvement percentage is 60%. Thus, Joe Investor’s cost basis is $1.025 million. Since this building is classified as a residential income property placed in service after December 31, 1986, it uses the 27.5-year straight line depreciation method. Thus, after a 5-year holding period, the accumulated depreciation on the building is $218,182 (=60% building improvement x $2 million x 5 yrs / 27.5 yrs). Thus, Joe Investor’s new cost basis is $1,831,818 (=$2.05 million – $218,182). If Joe Investor sells this property in June 2005 for $3 million with a 5% cost of sale, Joe would have realized $2,850,000 (=$3 million – 5%) generating a recognized gain of $1,018,182 (=$2,850,000 – $1,831,818). Of this $1,018,182 gain, we know that $218,182 of it is the result of depreciation and is thus subject to a maximum 25% tax. The remaining $800,000 ($1,018,182 – $218,182) gain is subject to a 15% capital gains tax. Of course, you can perform a like-kind 1031 tax deferred exchange, which you can read about here, and avoid paying the capital gains tax. The above explanations are far from exhaustive, but hopefully it has given you a decent working knowledge of depreciation recapture. Use this information when consulting your CPA regarding your particular real estate investments. Happy investing! Photo: irisb477 Free eBook from BiggerPockets! Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks, and techniques delivered straight to your inbox twice weekly! Actionable Advice for Getting Started, Discover the 10 Most Lucrative Real Estate Niches, Learn how to get started with or without money, Explore Real-Life Strategies for Building Wealth, And a LOT more Sign up below to download the eBook for FREE today! Click Here to Download the eBook Now! We hate spam just as much as you

There are many savvy real estate investors out there that understand how commercial and residential income properties operate. They can spot value-add opportunities a mile away, and they have the team necessary to implement them. They are confident that at any given time, they can find a real estate investment worthy of pursuit. They faithfully perform due diligence, and they formulate investment analyses and plans that are more spot on than Nostradamus’s predictions ever were. Fantastic! The above-described investors will undoubtedly make money in real estate. The question remains: are they building their wealth as quickly as they can? After all, wouldn’t you rather make a million dollars in ten years instead of in twenty? One of the best ways to optimize your money’s growth in real estate investing is to optimize your properties’ holding periods. Let me explain. What is the Optimum Holding Period for Real Estate? I’ve encountered investors inquiring about the ideal holding period for their value-add investment. A typical inquiry goes something like this: “This investment I’m looking at has a two-year holding period and an average internal rate of return (IRR) of 30% over that time frame. If I hold it for one more year, however, I noticed that the average IRR drops to 25%. That is still a fantastic return. Should I hold the investment for an extra year, or should I get out after the two year holding period?” To understand my answer is to understand the IRR metric and the time value of money. Let’s look at an example illustrating why it would be most advisable to hold onto the investment for only two years instead of three. Two investors, Larry and Sean, would both like to invest $100,000 each over a six-year period with a primary goal of increasing their net worth. They are each considering investments with a 30% IRR over two years ad 25% over 3 years. Larry intuitively believes that the longer term 3-year year holding period is best and opts to invest in the 25% IRR twice over the six-year period. Sean, on the other hand, opts to invest in the 30% IRR investment three times in a row over the six-year period. Let’s compare their results: Larry Longterm: Initial Investment – $100,000 Investment Proceeds- $381,470 Net Gain – $281,470 Sean Shortterm: Initial Investment – $100,000 Investment Proceeds- $482,681 Net Gain- $382,681 As you can deduce from above numbers, Sean Shortter gained $101,211 more than Larry Longterm. Sean’s net gain was 36% higher than Larry’s! How can that be? While some might expect that Sean would earn 20% more than Larry (since 30% IRR is 20 percent higher than 25% IRR), he did not. Larry Longterm overlooked the opportunity cost of reinvesting his money at a higher return and the value of compounding. Remember, the optimal holding period for an investment is the period that yields the highest average IRR. Of course, all investors have different objectives and, thus, all employ different strategies. If your goal is to drastically increase your net worth, consider utilizing the above advice. Happy investing! Photo Credit: ollesvensson Free eBook from BiggerPockets! Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks, and techniques delivered straight to your inbox twice weekly! Actionable Advice for Getting Started, Discover the 10 Most Lucrative Real Estate Niches, Learn how to get started with or without money, Explore Real-Life Strategies for Building Wealth, And a LOT more Sign up below to download the eBook for FREE today! Click Here to Download the eBook Now! We hate spam just as much as you

In my last article, I discussed how lender recourse, prepayment penalties, a loan’s assumability, and fees and costs affect a real estate investor’s strategy. In this continuation, I will explore several other loan characteristics such that you can more successfully plan your next investment project. Fixed Periods Many commercial loan products offer fixed interest rates for some period of time before switching to an adjustable rate. The length of this time frame can vary based on several different factors. As a rule of thumb, the longer the fixed period, the lower the investor’s risk. Keep in mind, however, that a loan product with a long fixed period may be of little value when used to finance short-term projects. This can prove to be a determining factor when shopping around for the best loan product for your application; don’t pay a premium for a super long fixed period if you won’t need it. Loan-to-Value Ratio (LTV) The Loan-to-Value Ratio (LTV) is determined by dividing the loan amount by the sales price or appraised value, typically expressed as a percentage. Thus, a building purchased for $2,000,000 with a $1,600,000 loan has a LTV of 80%. Loan products may offer a maximum LTV from anywhere within the range of 70-85%. This ratio is extremely important to investors because the higher a loan product’s LTV, the less an investor’s capital outlay. Thus, the investor increases his leverage and his potential returns as the maximum LTV increases. Of course, when considering LTV, a limiting factor is often the… Debt Service Coverage Ratio (DSCR) Debt service coverage ratio (DSCR) is the ratio of Net Income to Annual Debt Service. Typically, the DSCR ranges between 1.15 and 1.25. The minimum DSCR is a loan-sizing factor just like LTV. For an investor looking to maximize his leverage, either DSCR or LTV will be his limiting factor. Investors are best served looking for a loan product with a low DSCR. This is significant because it allows investors to acquire properties with less of their own equity capital and increase leverage and potential return. Amortization Period A loan’s amortization period is the length of time required to repay an entire mortgage. This period is typically between 15 and 30 years; however, loan products exist with amortization periods as long as 40 years. For a given loan amount, as the amortization period increases, the lower the required periodic payment. Thus, yearly debt service decreases and cash flow shoots up. Similarly, for a given DSCR, as the amortization period increases, an investor qualifies for more loan dollars. More loan dollars means more leverage and, potentially, greater returns! Consider long amortization periods as you search for the perfect loan. Interest Rate Finally, let’s explore interest rates. Surely, this is the most obvious loan characteristic that investors consider. What isn’t so obvious is how the interest rate ties all of the aforementioned variables together. For example, a lender may offer longer amortization periods, but it will surely cost you in terms of interest rate. In another example, a lender may offer a non-recourse loan, but that lender will almost certainly charge a slightly higher interest rate than for a similar, recourse loan. See where I’m going with this? As a rule of thumb, tipping a loan characteristic in the favor of the borrower will have some negative impact on interest rate. With so many different loan variables, it can be difficult to determine which loan product is best suited for an investor’s project. While the search is tedious, it is certainly worth it. Happy investing! Free eBook from BiggerPockets! Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks, and techniques delivered straight to your inbox twice weekly! Actionable Advice for Getting Started, Discover the 10 Most Lucrative Real Estate Niches, Learn how to get started with or without money, Explore Real-Life Strategies for Building Wealth, And a LOT more Sign up below to download the eBook for FREE today! Click Here to Download the eBook Now! We hate spam just as much as you

Most real estate investors acquire income properties by obtaining a loan. As you are probably aware, maximizing loan funds (or OPM—Other People’s Money) maximizes leverage and, thus, maximizes returns. The right loan product can easily make or break a real estate investment deal. As such, exploring various loan characteristics is more than warranted. Lender Recourse Regarding lender recourse, loans fall under one of two broad categories: “recourse” or “non-recourse.” The former refers to loan products that require the borrower to accept personal liability for the repayment of a loan. The latter, however, is a loan for which the borrower is not personally liable; if the borrower defaults, the lender’s only “recourse” is to seize the collateral—the property in the case of real estate. This is important because not every investor will qualify for a recourse loan. Likewise, an investor might only qualify for a limited amount of loan dollars that may prevent him from obtaining the money necessary for a particular property. This investor may be able to secure a non-recourse loan and the coveted property in the process. Keep in mind, however, that non-recourse loans are not only much rarer than recourse loans, they also take much longer to secure since the lender thoroughly inspects (read: qualifies) the subject property. Prepayment Penalty A pre-payment penalty is a fee that must be paid to the lender if the borrower prepays a loan within a certain time frame. Lenders do this to guarantee some specific yield on the loan they are making. Prepayment penalties can be “soft” or “hard”. A lender offering a “soft” prepayment penalty allows the loan to be paid off without penalty if the property changes ownership, but applies the penalty if the loan is refinanced. A “hard” prepayment penalty will kick in regardless of the source of repayment. It is crucial for the real estate investor to understand the specific terms of the prepayment penalty because it directly affects the investor’s exit strategy and return. Be sure to take the prepayment penalty into account when performing your analysis. Loan Assumability If a loan agreement includes a “due on sale” clause, the associated loan is referred to as a “non-assumable” loan. An “assumable” loan, on the other hand, does not carry a “due on sale” clause. Once again, the assumabilty of a loan affects the investor’s exit strategy. After all, a low-interest, assumable loan is much more attractive to potential buyers than a property with existing financing that must be paid off upon the property’s sale. Fees and Costs This one is fairly obvious, but don’t forget to take it into account since it directly impacts your initial investment. These also vary greatly from lender to lender and loan product to loan product. As a rule of thumb: the more unique the loan, the higher it’s associated fees and costs. Stay tuned because next week we’ll explore some other loan characteristics. Until then, happy investing! Updated 11/9/09: PART 2 – Other Loan Characteristics is now live on the site. Free eBook from BiggerPockets! Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks, and techniques delivered straight to your inbox twice weekly! Actionable Advice for Getting Started, Discover the 10 Most Lucrative Real Estate Niches, Learn how to get started with or without money, Explore Real-Life Strategies for Building Wealth, And a LOT more Sign up below to download the eBook for FREE today! Click Here to Download the eBook Now! We hate spam just as much as you

Owners of income property understandably cringe when they hear the words “vacancy and credit losses.” After all, anything that negatively affects net income is cause for distaste. Yet, vacancy and credit losses remain a necessary and unavoidable cost of doing business. Being able to understand and differentiate between vacancy and credit losses is vital to the success of real estate investors. I’ll explain how later in this article. First, let’s talk about vacancies! A vacancy occurs when a unit in an income property goes unleased (brings in zero income). A vacancy can be unwanted (“why can’t I get this unit leased!?”) or necessary (“After I finally renovate this dated apartment, I’ll get to increase rents by at least $200 a month!”). Regardless of the reason for it, vacancy is a curable problem. It is probably in your best interest to cure that vacancy sooner rather than later because un-rented units greatly reduce net operating income and have an exponential negative effect on the overall value of the property. What are credit losses? Credit losses are quite different from vacancy in that they result when the tenant in the property is not paying the full rental amount, or not paying rent at all. That’s not all; credit losses can be encompassing of a variety of losses. For example, an on-site manager, maintenance employee, or owner may be residing in a unit. For accounting purposes, the property can charge rent for that unit and then credit the charge, resulting in an increase in credit loss. Another example is when a rent credit is issued to a resident that has been excessively inconvenienced due to a lengthy maintenance or renovation. In the attempt to monetarily compensate a displeased tenant, the landlord incurs a credit loss. How does this apply to real estate investing? Perhaps the most important aspect of real estate investing is the property analysis. During one’s due diligence, he will examine a property’s vacancy and credit loss numbers. As a result, it is imperative that he understands exactly what is captured in the vacancy and credit loss account—is it vacancies, poor tenants, on-site management, combination of all of the above? An oversight in this department may result in missing real revenue or double counting a negative. If one doesn’t truly understand a property’s vacancy and credit loss account, it makes it difficult to get line of sight as to how and if the amount can be reduced. There are already so many uncontrollable variables in real estate investing—you owe it to yourself to understand and take charge of the ones you can control. Free eBook from BiggerPockets! Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks, and techniques delivered straight to your inbox twice weekly! Actionable Advice for Getting Started, Discover the 10 Most Lucrative Real Estate Niches, Learn how to get started with or without money, Explore Real-Life Strategies for Building Wealth, And a LOT more Sign up below to download the eBook for FREE today! Click Here to Download the eBook Now! We hate spam just as much as you

Many investors have a favorite strategy for weeding through the numerous income properties on the market in their search of a solid investment. Some use the “price-per-door” as a benchmark. Others consider the “gross rent multiplier (GRM)”. Yet others are convinced that capitalization (cap) rates are the way to go. Which evaluation tool is best? Investors have asked me the above question numerous times. A more profound question would be, “Is there really a BEST way? Let alone a right or wrong way?” Let’s explore some of the common comparison strategies. Price-per-square foot This technique is extremely easy to apply. Simply take the building price and divide by the number of total square footage of improvements. Thus, a 12,000 square-foot property with a list price of $1 million has a price-per-square foot of $83.33/sq. ft. This can be a useful tool when comparing different properties in a demographic area. It is not, however, without its limitations. For example, this method does not take income or expenses into account. Evaluating a property exclusively with this method and you could find yourself money pit and you wouldn’t even know it. Gross Rent Multiplier (GRM) The gross rent multiplier is another simple comparison tool, one that is slightly more useful than the price-per-square foot method. To calculate the GRM of a property, simply divide its sale price by its gross rental income. For example, a property listed at $2 million that brings in a gross rental income of $200,000, then it would have a GRM of 10. The property’s GRM is useless unless you have a good idea of typical GRMs of similar properties. Armed with this information, the GRM is a great way to filter obviously overpriced properties. Be careful, however, because the GRM method, like the price-per-square foot technique, fails to figure in expenses. Price-per-door This is a popular method. Simply divide the property’s list price by its number of dwelling units. While I look for low price-per-doors during my property search, I use caution because, like the price-per-square foot method, it fails to account for income or expenses. The following illustrates my point. One Main Street Price-per-door: $90,000 Gross Potential Annual Income $110,000 Five State Street Price-per-door: $140,000 Gross Potential Annual Income: $210,000 While One Main Street has a much lower price-per-door than Five Main Street, it also generates $100,000 in annual income. Capitalization (cap) rate This method is the most comprehensive method of them all. Take a property’s Net Operating Income and divide by its sales price to come up with its cap rate. Since the net operating income already accounts for expenses and income, it is undoubtedly the most complete evaluation method. Of course, without scouring the rent rolls and income statements, it is difficult to tell whether a listing’s numbers are accurate. The best thing to do during your search is employ a variety of the above. Know that none in inclusive and always proceed with caution. There is no shortcut for due diligence. Until next time, happy investing! Free eBook from BiggerPockets! Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks, and techniques delivered straight to your inbox twice weekly! Actionable Advice for Getting Started, Discover the 10 Most Lucrative Real Estate Niches, Learn how to get started with or without money, Explore Real-Life Strategies for Building Wealth, And a LOT more Sign up below to download the eBook for FREE today! Click Here to Download the eBook Now! We hate spam just as much as you

In my last article, I described an investment tool—syndication—and how one could benefit from its utilization. Perhaps syndicating sounds appealing and you would like to know more. If that’s the case, read on and dig deeper into the little-known world of syndication. In case you missed last week’s article, a syndication is simply a group of like-minded investors that pool their resources together in order to participate in investments larger than they otherwise would have been able to alone. In real estate applications, members within a syndication take ownership of an income property proportional to their capital contribution. Thus, if a $100,000 cash outlay is required purchase a property and syndication member Bob contributes $20,000 to the cause, he will hold a 20% interest in the property. How to take ownership in real estate syndications The theory of syndication is easy enough to understand. Where things start to get tricky is during the formation of the legal entity. I will discuss some of the commonly used ones in syndications. Tenants in Common Perhaps the most common ownership entity used in syndication applications is tenants in common (TIC). In a TIC, title is held by each investor as tenants in common with each other. To the individual investor, the benefits of ownership are just as if he had sole ownership of the property—except he only owns a portion of it. Expenses, depreciation, and revenue are reported on the Schedule E of the investor’s tax return just as if he had sole ownership—except his reported expenses, depreciation, and revenue are limited to the proportion of his ownership. Since syndication member Bob holds a 20% interest in the property, he collects 20% of the revenue and may deduct 20% of the expenses and depreciation. Additionally, members of a TIC are eligible for IRS code 1031 like kind exchanges. The tenants in common entity is relatively simple to form and offers many benefits. The caveat, however, is that financing can be difficult to obtain. A lender may have to qualify every member of the TIC. This can be especially problematic for large TICs. Some lenders even limit the number of people/entities that may take ownership in a property. Limited Liability Company Another entity commonly used in syndications is the Limited Liability Company (LLC). LLCs are popular because no member of an LLC is exposed to unlimited liability. Additionally, lenders typically only qualify the managing member of an LLC for loan approval. Unfortunately, ownership interests in an LLC are considered to be personal property and, accordingly, do not qualify for 1031 exchanges. However, the LLC itself may perform a 1031 exchange. Hybrid-entity Some syndications are formed with both TICs and LLCs. For example, an individual performing a 1031 exchange may purchase a property via a syndication where he is tenants in common with an LLC. Let’s say Bob is performing a 1031 exchange and he finds a great replacement property—but he can’t afford it all himself. So he syndicates with “Fond Returns, LLC” and takes title to the new property as tenants in common. Keep these points in mind as you continue to develop your personal real estate strategy. Happy Investing! Free eBook from BiggerPockets! Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks, and techniques delivered straight to your inbox twice weekly! Actionable Advice for Getting Started, Discover the 10 Most Lucrative Real Estate Niches, Learn how to get started with or without money, Explore Real-Life Strategies for Building Wealth, And a LOT more Sign up below to download the eBook for FREE today! Click Here to Download the eBook Now! We hate spam just as much as you

In today’s society, the possibility of becoming wealthy exists but remains a lofty aspiration for most. While many have come to understand that real estate is one of the most effective mechanisms by which one can attain wealth, many would-be real estate investors are held back for one reason or another. If only there was a way such an investor could more easily cross the bridge into the wonderful world of real estate… One viable option is to participate in a real estate syndication. What is a Real Estate Syndication? A real estate syndication is simply a group of like minded investors that pool their resources together in order to participate in investments larger than they otherwise would have been able to alone. These resources may include liquid capital, expertise, project management, and a variety of other valuable things. Similarly, syndications come in a variety of flavors. Let’s look at reasons one might want to participate in a syndication before discussing the various types of syndications and common pitfalls to avoid. There are many would-be real estate investors—doctors, lawyers, engineers—that would love to jump in the real estate game but lack the time or inclination to do so. Inversely, there are many experienced investors that know a good investment when they see one, but they may lack the capital necessary to pursue it alone (such as a larger 75-unit property). Both types of investors are ideal syndication candidates. The passive investor—with money, but no time or expertise—can join a real estate syndication and reap the various benefits of real estate investing without any of the hassle. The experienced, but capital deficient, investor can purchase the investment of a lifetime while helping out others. It sounds like one of those fabled “win-win” situations I keep hearing about. Sounds intriguing, but what kind of syndications are out there? Syndications are basically formed as follows: some managing member, or expert, pools all the necessary resources, including capital, and basically does all of the dirty work. Naturally, the managing member is compensated in some way. This is where problems can arise. Some managing members will perform all of the steps necessary for completing a successful real estate transaction, and all they will charge is a “reasonable” 10% interest in the property. Offhand, this doesn’t sound terribly unreasonable. But on a $10 million property, the managing member would have just netted a fractional ownership interest worth one million dollars. Not bad for a day’s work, huh? Stay away from these forms of syndications! Another form of syndication—a fair one—is where the managing member charges a fee that is some inverse percentage of the investors initial investment. In other words, the larger an investor’s share of ownership (not to exceed 50%, of course), the less his syndication fee. After all, that investor is less dependent on the syndication—the other investors—than they are on him. Add this information to your arsenal of investing knowledge, and continue making informed decisions along the path to achievable wealth. Happy investing! Free eBook from BiggerPockets! Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks, and techniques delivered straight to your inbox twice weekly! Actionable Advice for Getting Started, Discover the 10 Most Lucrative Real Estate Niches, Learn how to get started with or without money, Explore Real-Life Strategies for Building Wealth, And a LOT more Sign up below to download the eBook for FREE today! Click Here to Download the eBook Now! We hate spam just as much as you

Income properties are, to many, the ideal investment. Not only does one receive rental income on a monthly basis, but he also gets to enjoy capital appreciation—or at the very least, a solid hedge against inflation. With favorable tax treatment throughout and available 1031 tax deferred exchanges, one would be silly to not at least consider real estate investment. And so he does. Hypothetical investor Bob purchases his first income property: an 8-unit multi-family in sunny San Diego, California. He loves the fact that it’s in a great location, has a favorable unit mix, and there has only been one vacancy in the last two years—and that vacancy didn’t last very long. As far as Bob is concerned, he has made the perfect investment. How could he do any better? Raise the rents! Typically, investment properties in low-vacancy, heavily renter-occupied housing areas that incur vacancies about as often as the Chicago Cubs win World Series have one problem: their rents are too low. If the rents weren’t below market, they would incur significantly more turnover. That’s the key word: turnover Turnover is a good thing; vacancies, themselves, are not. What’s the difference? A vacancy occurs when a unit has been turned (i.e. “rent ready”) and it does not have a tenant, or a prospective tenant. Turnover occurs when someone moves out of a unit and another moves in. You may be saying to yourself, “that sounds like basically the same thing. Why not keep rents low to keep the same tenants longer?” Using Bob’s property above as an example, let’s explore why it behooves an investor to keep rents at market. As stated earlier, Bob owns an 8-unit property that has incurred zero vacancies over the last year. The rents are below market; each unit rents for $1400 per month. Thus, the property’s Gross Operating Income (GOI) is $134,400 (=$1400 x 8 units x 12 months). Let’s assume that the market rents are closer to $1600 per month and that Bob will incur the standard vacancy rate in the San Diego area: 4%. Apply these assumptions to Bob’s property and its GOI increases to $147,456 [($1600 x 8 units x 12 months)-4%]. That’s a difference of $13,056 (=$147,456 – $134,400) in GOI which should equate to a similar difference in net operating income, assuming expenses stay about the same. Let’s take it even further; let’s say Bob has some trouble with vacancies during the rent increase and incurs double the normal vacancy rate: 8%. The resulting GOI of $141,312 [($1600 x 8 units x 12 months) – 8%] would still result in an increase in revenue of $6912 over Bob’s initial figures! That’s not all! While the immediate improvement in cash flow is nice, the real perk is the increase in property value. If you recall, a building’s value is determined by its Net Operating Income divided by its market Cap rate. Thus, if the market is trading at a 6% Cap rate, then Bob’s building’s value would have increased by $217,600 [=$13,056(difference in GOI) / 6% Cap Rate]. Using the 8% vacancy rate example, the building’s value would have increased by $115,200 [=$6912(difference in GOI) / 6%]. To conclude, Bob could continue to keep rents below market and enjoy a fully occupied building. Or, he could maintain rents at market, allowing him to enjoy more cash flow and significantly more building value with normal vacancy. Which would you choose? Happy investing! Free eBook from BiggerPockets! Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks, and techniques delivered straight to your inbox twice weekly! Actionable Advice for Getting Started, Discover the 10 Most Lucrative Real Estate Niches, Learn how to get started with or without money, Explore Real-Life Strategies for Building Wealth, And a LOT more Sign up below to download the eBook for FREE today! Click Here to Download the eBook Now! We hate spam just as much as you

The other day, I was preparing to check my email when a headline on Yahoo!’s homepage caught my eye: Tough Times for Blockbuster. As a fan of Blockbuster’s, I felt compelled to learn why so many of its beloved stores (between 810 and 960!) were closing. As it turns out, several of its stores were becoming unprofitable money pits, no doubt due partly to the success of online rental goliath Netflix and newcomer Red Box—the rental box company taking the nation by storm. Needless to say, Blockbuster has had to implement several changes necessary to stay competitive in this ever-changing market. Like Netflix, Blockbuster has launched an online, mail-service component. Blockbuster has even started distributing rental box dispensers much like Red Box. The question remains: is this too little too late for the former movie rental giant? What does this have to do with real estate? The Blockbuster Saga illustrates how important it is for real estate professionals and investors alike to stay on top of current trends and innovations in the real estate realm. Real estate professionals run a business, and they must treat it as such or risk getting left behind in the dust. The internet and social media marketing provide access to an almost unlimited number of potential clients and investors—but everybody and his mom knows that. The trick is to find out who your target demographic is… and target your marketing efforts there. Of course, that is easier said than done. There certainly is a trial and error aspect to this process. That is why it is imperative that you document where and how you’re getting your leads. How else will you know where to utilize your time, money, and energy to most effectively target your clients? Too often, real estate professionals rely on gut feel rather than statistical evidence—don’t make the same mistake. Investors, like real estate professionals, have a wide variety of tools at their disposal to make informed decisions. They can check out a real estate company’s track record at the Better Business Bureaus’ website, or right here at BiggerPockets.com. They may look up a wide variety of statistical evidence at Reis.com, or scour investment properties on LoopNet. Keep in mind, however, that everyone else has access to the same resources, so be diligent! Don’t rely exclusively on the internet Checking out a property, or its neighborhood, online, is no substitute for physically checking out a property. A ten-minute drive through a property’s neighborhood will tell you more than several hours worth of research on the internet. Investing in a property without truly understanding its market—neighborhood, trends, economic situation, future developments—is like investing in a stock when all you know is its 5-year high/low prices and its most recent closing price. You might be making a good investment, but you don’t really have any substantial evidence to back it up. Without knowing the company’s business plan, looking at its financial statements, or understanding its recent acquisitions, how can you truly be confident in the stock you’re purchasing? The same principles apply to real estate investing. A properties operating numbers only tell a part of the story. You must dig deeper to truly understand what you’re getting yourself into. Free eBook from BiggerPockets! Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks, and techniques delivered straight to your inbox twice weekly! Actionable Advice for Getting Started, Discover the 10 Most Lucrative Real Estate Niches, Learn how to get started with or without money, Explore Real-Life Strategies for Building Wealth, And a LOT more Sign up below to download the eBook for FREE today! Click Here to Download the eBook Now! We hate spam just as much as you

In last week’s article, we explored the anatomy of a 1031 exchange and the government’s reasoning for creating such a powerful tax-saving tool. This week, we’ll look at a hypothetical example such that we may more clearly understand how a 1031 exchange works. We’ll close by addressing some common concerns. Let’s get to it! Ted’s First Investment Property Ted understands the advantages or real estate investing and does everything he can to acquire his first investment: a nice little income property located at 101 Main Street. After careful analysis, he purchases it for $400,000 and pays $8,000 in acquisition costs. Over the next year, he operates the property as a rental—this is crucial because simply acquiring property for the sole purpose of resale does not qualify for a 1031 exchange. During this time, Ted replaces the roof and makes some other capital improvements totaling $15,000. He also takes a depreciation tax deduction of $5,333. At the end of the year, Ted decides to sell his property for $475,000. So, what is his capital gain? First, we must calculate the adjusted basis. Add the original cost ($400,000), acquisition costs ($8,000), and capital improvements ($15,000) and subtract depreciation ($5,333) to come up with the adjusted basis of $417,667. To calculate his capital gains, subtract the selling costs ($28,500) and adjusted basis from the selling price to come up with $28,833 [=$475,000 (sales price)-$417,667 (adjusted basis)-$28,500(selling costs)]. How Ted Avoids Paying Taxes Ted doesn’t want to pay taxes on his gain of $28,833, and he doesn’t have to if he properly performs a 1031 exchange. He starts the process by identifying a replacement property at 505 Clark Street that he can purchase for $500,000 (he can choose up to three replacement properties; that way if one doesn’t pan out, he has two back-ups available). Before he sells his original property—101 Main Street— he sets up the exchange with a qualified intermediary. The intermediary holds the net proceeds from the sale of 101 Main Street until Ted closes the sale on his replacement property, 505 Clark Street. Keep in mind, however, that the exchange must be completed within 180 days after the sale of the original property. Therefore, it’s a good idea to plan the exchange well in advance and to utilize the expertise of someone experienced in performing such exchanges. Ted completes the exchange and purchases 505 Clark Street for $500,000. What is the new basis? Assuming that the acquisition costs were $8,750 and knowing that the deferred gain is $28,833, the new adjusted basis is $462,417 [=$500,00 (purchase price) – $8,750 (acquisition costs) – $28,833 (deferred gain)]. What’s the Big Deal? While the above is simply a hypothetical example, realize that people have deferred much larger gains in real life. It San Diego, it is not uncommon to find a property owner who purchased an building ten years ago for $500,000 only to sell it today for $3,000,000. You can imagine how steep the taxes on those capital gains might be were it not for the 1031 exchange. Some of you may be shaking your heads thinking, “won’t Ted have to pay taxes on his gains eventually? He’s just delaying the inevitable. Why not just pay the taxes now?” To address the first question, Ted may never have to pay taxes. There are ways he could transfer the property to loved ones tax-free. To understand the answer to the second question is to understand the “Time Value of Money (TVM)” theory. The theory suggests that money today is worth more than money tomorrow because it can be invested and, thus, earn a return. The money Ted would have paid out in taxes will instead be reinvested. Understanding this, it becomes easy to see how blowing off Uncle Sam for as long as possible bears sweet financial fruits. Understand the 1031 exchange and use it to increase your net worth. Happy investing! Free eBook from BiggerPockets! Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks, and techniques delivered straight to your inbox twice weekly! Actionable Advice for Getting Started, Discover the 10 Most Lucrative Real Estate Niches, Learn how to get started with or without money, Explore Real-Life Strategies for Building Wealth, And a LOT more Sign up below to download the eBook for FREE today! Click Here to Download the eBook Now! We hate spam just as much as you

Most real estate investors understand the general concept of a 1031 exchange or, at the very least, have heard of it. Few, however, understand exactly what takes place within one of these exchanges and how powerful a tool it truly is. So let’s explore a subject that is close to everyone’s heart: not paying taxes on hard-earned money! What’s in it for Uncle Sam? So, why does the IRS Section 1031 like-kind tax-deferred exchange exist in the first place? After all, doesn’t the government relish every taxable opportunity? While the government is certainly not adverse to taxation, they also use the tax code as a tool, encouraging or discouraging certain acts they deem beneficial or detrimental to the economy. As it turns out, the private sector is pretty darn good at providing housing to society (a lot better than the government). As such, Uncle Sam provides various benefits to real property owners (mortgage interest deductions, real estate investment expense deductions, ability to depreciate, etc.). The Like-Kind Exchange: Apples for Apples? To go along with this philosophy, the IRS allows real estate investors to defer the capital gains resulting from the sale of their property as long as they identify and purchase “like-kind” property within specified time frames. So, what is “like-kind” property? Basically, it is any real property held for a specific use. Hence, vacant land held for investment purposes (the government doesn’t say it has to be a good investment) can be exchanged for a residential income property. In other words, trading investment property for other investment property is allowed. One wouldn’t be allowed to, however, exchange a residential rental property for a brand new single family home in which the investor plans to take residence. You can find the exact IRS verbiage on the IRS Website. Time is Ticking… Complicating matters, the IRS imposes rigid timelines for identifying and purchasing these replacement properties—45 days and 180 days respectively. These timelines are long enough to withstand long closing periods, but they are short enough to solicit immediate action. If you are in the process of selling a property and would like to perform a 1031 exchange but you have no replacement candidates, get help immediately! Please keep in mind that I am not an accountant and, as such, this information is provided for informational purposes. See your tax preparer and CPA for specific information regarding your tax situation. Next week, we will explore an example 1031 exchange (in detail) such that you get a (hopefully) crystal clear understanding of how this powerful tool works. I will also counter the standard (yet misguided) objections to such an exchange. Until next time… Happy Investing! Any Questions? Free eBook from BiggerPockets! Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks, and techniques delivered straight to your inbox twice weekly! Actionable Advice for Getting Started, Discover the 10 Most Lucrative Real Estate Niches, Learn how to get started with or without money, Explore Real-Life Strategies for Building Wealth, And a LOT more Sign up below to download the eBook for FREE today! Click Here to Download the eBook Now! We hate spam just as much as you