My first RE investment before the first rent check

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My first post while riding the ripple of closing on my first investment property


Why?

I followed the path I was taught since grammar school: go to school, get a job, live below your means, save your money, retire. While also following my family method of arrive early, work hard, be dedicated, go the extra mile, get married, buy a house, have kids, do your best to be happy.

I have followed these regimes since I was 10, starting with cutting, splitting, and stacking wood, pet sitting, yard work, and many other forms of physical labor. Followed in highschool by skilled labor working with drywall, cement, auto mechanic, dirt related construction, and still other forms of physical labor. Moving on to college with skilled labor, machinist, dirt construction, and retail sales. Until I made it to the much talked about white collar desk job, at least one ruptured disk, and house payments.

More than 30 years later and 10 years of desk job… which turns out to be another form of skilled labor. I still have a mortgage, I am still concerned about having enough money for retirement, medical issues still cost more than insurance covers and steals time as well as having prevented children.

I want time to spend with family, time to be there for foster children, time to travel, reduced concerns about how to pay for living.

In this post I will have to gloss over how I arrived at the stage of wanting to invest in real estate. Short form: I had flirted with the idea of RE/investing while still in construction but became distracted by desk job and medical costs.

Where does the money come from?

Being a fan of education and fairly skilled at the art of Google I turned to the internet to educate myself. Flipping, rehabbing, and wholesaling were active forms of income not something I would have time for, but buy and hold resonated.

Through living below my means my whole life and maxing out my IRA for the last 20 years I had managed to accumulate a reasonable sum. However I am not 59 ½ and distributions needed to be approached cautiously. Fortunately when I opened my IRA account I did not want to believe I would make less money when I retired than I did currently so I made it a ROTH IRA with the anticipation that I would be in a much higher tax bracket at retirement (why do people buy into the concept of a lower tax bracket at retirement anyway?).

Some research indicated, because I had a ROTH IRA, I had already paid tax on the contributions. My ROTH IRA was over 5 years old which allows me to take up to all of my original contributions out without penalty or additional taxes (remember, with a ROTH I paid the taxes before investing).

https://www.law.cornell.edu/cfr/text/26/1.408A-6

Q-1. How are distributions from Roth IRAs taxed?

A-1. (a) The taxability of a distribution from a Roth IRA generally depends on whether or not the distribution is a qualified distribution. This A-1 provides rules for qualified distributions and certain other nontaxable distributions. A-4 of this section provides rules for the taxability of distributions that are not qualified distributions.

(b) A distribution from a Roth IRA is not includible in the owner's gross income if it is a qualified distribution or to the extent that it is a return of the owner's contributions to the Roth IRA (determined in accordance with A-8 of this section). A qualified distribution is one that is both—

(1) Made after a 5-taxable-year period (defined in A-2 of this section); and

Q-8. How is it determined whether an amount distributed from a Roth IRA is allocated to regular contributions, conversion contributions, or earnings?

A-8. (a) Any amount distributed from an individual's Roth IRA is treated as made in the following order (determined as of the end of a taxable year and exhausting each category before moving to the following category)—

(1) From regular contributions;

(2) From conversion contributions, on a first-in-first-out basis; and

(3) From earnings.

(b) To the extent a distribution is treated as made from a particular conversion contribution, it is treated as made first from the portion, if any, that was includible in gross income as a result of the conversion.

It helped a great deal, for the math, that I had made full contributions each year up to this point. While the maximum contribution amount changed each year it is easy to look up the historic contribution limits.

While researching where I could get money from, I had come across another concept using whole life insurance. While I generally agree with Neal Frankle’s perspective in the BP podcast 5 about the utility of term life insurance vs whole life insurance I am also willing to look a little further at whole life as a tax free ~5% interest bearing bank account. This concept deserves a much more in depth write up and can be looked up under names such as the 770 account, Income For life, Infinite Banking, etc (no I do not sell insurance, nor have I received or anticipate receiving any reimbursement for these statements). The point being to not view whole life insurance as insurance so much as a tax free ~5% interest bearing accumulation account with a bonus of life insurance - for an up front fee (in my case the fee is anticipated to be completely recovered after 6 years of accumulating interest – I hope all my investment properties do this well). I am sure there are many insurance agents salivating to sell you whole life insurance – do your due diligence and make sure they know what the heck they are doing before going down this road (like I hear about property investing, it is great when done right and miserable/expensive when done wrong).

I bring the 770 account up because it allowed me to lock in a base at 4% compounding annual-variable-rate on the funds I sourced from my IRA account and it allows me to make unquestioned loans on the cash balance (I had a significant lump sum which required a policy rider to keep the amount of insurance purchased at a minimum while making as much cash value available to me to borrow against. Note: at year 3 all the cash I put into the account will be immediately available to me as a policy loan).

Now I have identified the source of my funds, I have leveraged them for a hedge against disaster. It is time to shop for some income producing assets.

Where do I invest?

BiggerPockets is a fantastic and informative community. I was convinced low-time-invested deals in my local area would be few and far between… until the next housing crash. For example a quick search indicates a typical price in my neighborhood would be around 400k while it would rent for around 1900/month. The investment to make buying such a place cashflow-positive would be a poor return.

The term “turnkey real estate” sounded too good to be true. Someone else finds a deal, rehabs the deal, property manages the deal, and sells the house to me at a cashflow positive price? Why would anyone do that?

I did some homework on the turnkey operations identified through online research. I found several that seem on the up-and-up and chose the one I did because I was able to interview a current client of theirs who agrees, for the last 3 years they have delivered as advertised.

What kind of property do I invest in?

If I understand my market criteria this would be a B neighborhood. Prices are going up slowly, schools suck, and a great deal of blue collar industry to support.

How the deal went down

I signed up for their turnkey process to become an investor (December). I identified one of the available properties I was interested in and committed to buying it (February). I visited the place to see that they were actually doing the work, meet the team, and get a tour of completed units (March). The rehab of the place took a month longer (April) then anticipated due to the unusually cold weather delaying all exterior rehab components. I signed on to use the property management umbrella insurance policy, the recommended broker, and the ASHI certified inspector.

While nobody from the turnkey said so, it seemed like my inspector and the appraiser were a bit premature (March) due to the delays. As a result the fixit list included items easily addressed (missing lightbulbs) and major components that had not had the rehab replacement installed yet (Air conditioning unit). Also the area has a 90 day 3 mile comp requirement for appraisal and nothing similar had sold during the cold spell. So the appraisal came in 12+% lower than the initially agreed upon price (original numbers were cashflow positive ~250/month – assuming my newbie investing numbers are accurate and no typos in the BP calculator).

I am anticipating years/decades of working with this company and do not want any part of the turnkey operation harboring negative thoughts. The numbers show cashflow positive at the original price so anything less would be that much better. Being a first time investor I was not sure what would happen next.

It was easy for me to agree to splitting the appraisal difference 50/50.

Goodwill

The turnkey owner also offered seller financing at 0% and for me to name an end time for payoff… since the sum above the appraisal price would not be financed. While this would be easy to agree to from a financial aspect, this is where I had a little room to earn some positive thoughts back. I already had the downpayment/closing-costs cash ready for the original price. Additionally the closing costs should have gone down by the reduced interest on the reduced principal amount allowing for more room. The lack of comps in the area would not be helped by a lower closing price.

I chose a number as high as I could go (with the existing cash) for the new sale price and opted to divert the cashflow from the rent payments to cover the remaining difference.

The end result is what I believe to be a fair deal, the turnkey owner did not get the asking price and 0% financed some of the price, and the comps for the area will be slightly higher for the next 90 days. While my cashflow will not start for a while on this property, my cashflow will be a bit higher from this property when it does finally flow and my DTI will be slightly lower than it would have been (while it still matters).

The renter moves in tomorrow (from the day I am writing this). May the renter have a long, happy, prosperous, and quiet tenancy.

great story except you didn't mention the market or the company you are working with. 

Hi Curt,

Thank you for the response.

The area is Memphis. I have family in the Midsouth which makes Memphis a nice writeoff location to review my property status and swing by to visit the family :-)

I did not mention the name of the company because I was not sure how aggressive the advertising clause in our posts would be policed. 

Cheers

Gary

I have gone and done it again. Now I have two rental properties in the Memphis area.

I was not able to travel to and personally walk around and inspect this purchase but I do anticipate being able to do a drive by in a few months and with everything going to plan also inspect my third investment property.

Going with turnkey investing at this point has allowed me to put some time into learning more about taxes, legal, and probate avoidance.

What I am getting out of the research... having not yet spoken any professionals except CPAs... is that:

  • California is a crappy place to try and start a business.
  • Using legal entities is a personal choice but if you are going to do it there are tax efficient ways.
  • While one LLC per property may be an ideal scenario from a liability protection consideration, it may not be cost effective and grouping/clustering houses in some way (such as by location or by value) may both mitigate your risk and provide some financial relief ($800 per LLC in California).

I have more interviews to do but I am leaning towards:

  1. 1. Implementing a Living Trust
  2. 2. Getting a Nevada based s-corp LLC (with address and landline phone in Nevada)
  3. 3. Putting the s-corp into the Living Trust
  4. 4. Getting a single entity LLC to cluster my soon to be 3 Memphis properties within and having the s-corp be the single entity owner of the LLC (anticipate to rinse and repeat this for more clusters of investment properties and 1:1 LLC to property for apartment houses)
  5. 5. Registering the Nevada s-corp to do business in California (ouch, another $800 after the Nevada fees.... annually!). This last step is the one I am most fuzzy about, I am not sure (hopeful) that only the s-corp will have to register to do business in California. 

I have skipped over a great deal of detail in the plan that is formulating in the interesting of writing anything at all. I look forward to adding more detail in future posts.

@Gary P.

Have you considered a NV Series LLC, where you could choose to have the master taxed as an S Corp (I believe you can do that) and then create as many Series as you want to hold individual properties, at no additional cost, and each Serie being owned by the master?

There may however be an issue whereby CA may want you to register each Serie in CA in which case they will ask for $800 per Serie. I don't know if you can get away with not registering the series in CA because they don't do business in CA, and just register the Master (or nothing at all, since the Master doesn't do business in CA either?). Maybe someone else familiar with CA's rule can chime in?

Jean

Forgot to add: your idea to put the holding entity into a living trust is good. We just did that.

If your individual properties have conventional financing on them, whereby the lender could trigger the due on sale clause if you moved them to an LLC, then you could consider putting each property into a grantor trust (Nevada's version of a land trust) and assign the beneficial interest over to the LLC, which should prevent from triggering the due on sale clause.

@Jean G.

Yes, California is clear on the series LLC, each entity within the series would be treated individually and each one would have to register to do business on their own at $800 each annually.

The grantor trust sounds interesting, thank you for the tip.

@Gary P.

I'm not a lawyer so I could be saying something very stupid here: but what gives California nexus over your business, so that you need to register it in CA? Do you need to register the company in CA simply because you live in CA as an owner? If the business is operated in Memphis, wouldn't it have to be registered in TN rather (and maybe use a TN entity in order to avoid paying fees in 2 states) and you would just have to pay CA personal state income taxes on the dividends/distributions that you receive as a CA resident, but not necessarily register it?

Jean

@Jean G.

Thanks for nudging me to continue the thread on the topic of California and foreign entities.

I spoke with a legal adviser yesterday to get a better idea how these entities work. What I took away from the discussion is that I can use Tennessee based LLC entity/ies in a flow through setup which would just be a line on my 1040 and as long as I did not tell California it would not know and thus would not require me to license the foreign entity to do business in California. This seemed to be the recommended approach when starting out.

The anticipation of growing bigger and having multiple LLC entities lends itself to another recommendation to use a Nevada holding LLC as the single member of the Tennessee LLCs so all taxes and income will flow through the single Nevada entity (one federal tax return this way rather than a federal tax return for each entity) as well as the legal charging order benefits of the Nevada LLC. At this point I can still roll the dice of what California does not know wont be taxed or register the single Nevada entity as a foreign entity doing business in California and pay the $800/yr California tax.

As I understand it, California tax law comes into play because I live in California so California deems any gross income coming to me is fair game to tax.

Another scenario and ultimately what I will likely go to (no matter where I live), once I achieve a level of income that will sustain it, is a Nevada S-corp holding company.

The S-Corp would be the holder of the flow through LLC entities and allow for many more write-offs. The S-corp would allow for me to manage my W-2 income as an employee of the S-Corp while allowing for dividend income from the S-Corp, thus regulating how much income is taxable.

I still need to better understand trusts. Apparently there are different types of trusts (who knew?). Living trusts to help assets avoid probate, land trusts to help reduce legal claims on RE assets as well as a legal vehicle for moving land into an LLC without invoking the due-on-sale clause. And, I have not even looked into the grantor trust yet.

@Gary P.

What I was suggesting is that whatever foreign entity you have (NV or TN), if it pays you dividends (for a Corporation) or distributions (for a LLC), you will show these on your CA tax return and pay CA income tax on this. I wasn't suggesting to hide anything.

However my understanding is that entities have to register in a state if they do business there of have some form of nexus. This would happen if you bought a house in CA in the entity for example, or maybe also if the entity had a CA W2 employee, but not necessarily if it does all of its business in TN. What do others think about this? Surely there are people out here that live in CA and hold all of their rentals in other states?

Jean

@Jean G.

Yes, I am interested in hearing from other California located investors with out of state properties and how this works for them.

@askbp

How to best handle , or at least real examples of how some are handling, income from out of state properties - especially when one lives in California?

I am looking forward to the responses :-).

Gary

What about a self directed IRA? Since it sounded like you were more worried about retiring than living today on the income you could have the IRA hold all the assets and avoid taxes all together until you take it out at retirement. Delayed taxes are better taxes.
Originally posted by @Ellie Hanson :
What about a self directed IRA? Since it sounded like you were more worried about retiring than living today on the income you could have the IRA hold all the assets and avoid taxes all together until you take it out at retirement. Delayed taxes are better taxes.

Good point Ellie, passing the income stream through an IRA would be one way to defer the taxes unless it is a ROTH IRA in which case it would be: skip taxes.

For future properties the IRA route would not be an option. For existing properties it would be an unauthorized transaction for me to transfer/sell the properties to my IRA.

Also, I am a good distance from tax advantaged account disbursement age, all the property investment income would be contained within the IRA not flowing through to my pocket to be used in a more discretionary manner such as repairs, vacation, personal home maintenance, or the most likely reinvesting.

My investment perspective with regard to housing and tax advantaged accounts: housing has so many tax advantages that when used right is a tax advantaged way of investing. Most tax advantaged accounts are not as tax advantaged as I would like them to be. I would prefer to retire with an income stream that is greater than my current income stream so deferring the taxes does not appeal to me. And, all this only matters if the US government does not choose to raid the liquid assets of our retirement accounts to bail out the promises our elected officials have made in order to buy votes.

However I do have a ROTH IRA account which means I pay the taxes up front. My ROTH IRA account has a mix of dividend paying stocks and momentum stocks. Primarily the account grows through the dividend stocks and dividend re-investments. But the position-sized and stop-loss monitored momentum stocks have the capability of very high short term returns which I want to keep in a tax free account ($1,000 that grows by 1000% would be a hefty tax bill).

@Jean G.

I talked with a couple of tax and legal structure advisers this past week. The adviser outside of California suggested not saying anything about the legal entities and what California Franchise Tax Board (CFTB) did not know about would not be taxed. Further to create a legal entity in the state of the properties for now (using land trusts to move the properties into the entity - LLC specifically). Alternatively to setup a Nevada LLC to be used as an umbrella corp to setup the Tennessee LLC so that even if the CFTB did find out about an entity I could register the Nevada entity to "do business in California" and just pay the $800 fee for the one entity.

The California based tax adviser pointed out the Federal IRS is sharing filing information with the states now. The aggressive CFTB is seeking out any k-1 filings with California addresses and sending the address a tax bill. Further the CFTB would require every legal entity that is ultimately owned by a resident of California is subject to the $800/yr "tax" fee.

An interesting caveat would be if I had a second home in the state of the legal entity (for example Nevada). The LLC in Nevada may not have to pay CFTB taxes... I need to track down more information. This leaves me with more questions: under what circumstances would this "may not have to" apply, would using this Nevada entity as umbrella corp short circuit the CFTB claim on all the other entities in other states?

In the meantime I have a third property under contract and hope the rehab will be complete and property closed in time for October rents.

@Ellie Hanson:

"For future properties the IRA route would not be an option" should have been

"For future properties the IRA route would be an option"

OK so it seems that we determined that the rule for the $800 franchise tax as far as CFTB is concerned is whether a company has a CA owner, not whether it actually does business or not in CA. I would think that CFTB would not have anything to say about subsidiaries of the one company that you own directly. Those companies are owned by the parent company (and have an address of the parent company, presumably outside NV).

As far as holding property in an IRA, if the property is leveraged it must be a non recourse loan, otherwise it becomes very complicated and you need to pay taxes on the leveraged portion.

Jean

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