Advice on buying rentals, flips or loaning out cash?
Charlotte, NC · Member since 2016 · 56 posts · 8 votes
Advice on buying rentals, flips or loaning out cash?
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Investor/Syndicator · Cincinnati, OH · Member since 2014 · 470 posts · 599 votes
10y@Alec Sithong When it comes to real estate investment the two most powerful things are debt (leverage) and taxes. Typically you receive neither of those benefits when doing hard money lending that you mentioned. Flips are sort of a middle ground between the two. Flips are a ton of work, and far from a passive investment like you mentioned you wanted.
I have wrote this out for another example so I used $100k rather than $125k but the example should still illustrate the principles.
Here is an example of two investment channels you mentioned:
Hardmoney lending:
$100k lent out for 1 year at 12% interest w/ 2 points will give you a gain of $14k or a pre tax COC of 14%. Lets assume you are in a 35% tax bracket. You will cut a check to the IRS for $4,900, leaving you with $9,100 or a after tax cash on cash of 9.1%. Also keep in mind HML your money turns over quickly you have to be active to be sure you have another qualified borrow lined up needing your money at your terms or else your money just sits dormant between loans, and dormant money is decreasing money.
Apartment building investment:
$100k down payment on a $500k building. At an 8% capitalization rate (very achievable) you are left with $40k net operating income. lets assume when you borrowed the $400k from the bank they lent it to you at 4% interest over a 25 year term. This means your year one mortgage payment is $25,332 ($15,827 interest, $9,505 Principle) leaving you with $14,668 in cash flow or a pre tax cash on cash return of 14.6%. This beats your total pre tax return of 9.1% from the HML above BUT we haven't even started on all the other benefits of investing in real estate.
So you cash flowed $14,668 do you pay tax on $14,668?? NO! Another beauty of real estate and leverage is the depreciation tax benefit. Even though you only put 20% of the $500k in to the property you get ALL of the depreciation. Apartment buildings/houses are depreciated over 27.5 years, which means you get to depreciate the building value. The buildings value does not equal the property value because the building sits on land and that land also has value. The IRS does not allow you to depreciate the land. A typical percentage of a property value to allocate to land value is 20%, or in this example it would be $100k. This leaves you with 400k of building value to be depreciated $400k/27.5=$14,545. What does this mean? It means you barely pay any tax on that $14,668 cash flow you made on the building. You actually only have a taxable gain of $9,628 ($14,668 + $9,505 - $14,545) we add back the principle amount of your mortgage payment because it is not deductible and subtract out the deprecation we listed above. Again assuming a 35% tax bracket the gain of $9,628 would result in cutting a check for $3,370 to the IRS. This means your after tax return is 11.3%. A 2.2% increase on after tax return when compared to hard money lending
That's all great and will make you a lot of money, but HML has no tenants, no phone calls, no toilets. That piece of mind in its self is worth not receiving the additional 2.2% return owning real estate provides right? I don't think so because there is one more major piece to this puzzle.
Another huge difference between HML and owning investment real estate is the power of debt and with debt comes amortization. Wealth is built in the amortization of the debt you put on the property. Back to our example the $400k in debt you put on the building will have an army of tenants paying down your mortgage month after month. In our example after 10 years you will only owe $285K on the building IF the property never appreciated one cent and it was still worth $500k in 10 years you would have $215K in equity. You could then sell it or refinance it (again tax free).
Now lets wrap the amortization into our example. Using the loan terms I mentioned the first years of the loan will result in a $9,505 reduction in principle or if the value stays the same that would be seen as a $9,505 increase in equity. If we add that $9,505 to the cash flow and tax benefits we are left with an all inclusive after tax return of 20.8%.
This is just the basics. You can accelerate depreciation benefits through cost segregation, Structure loans for quicker amortization depending on your goals, force appreciation through several types of improvements, and many other tricks.
Everyone has their own specific investment tastes and beliefs. I post this here to hopefully help you make your choice. Good luck on your new venture!
24 Replies
- Investor/Syndicator · Cincinnati, OH · Member since 2014 · 470 posts · 599 votes10y
@Alec Sithong When it comes to real estate investment the two most powerful things are debt (leverage) and taxes. Typically you receive neither of those benefits when doing hard money lending that you mentioned. Flips are sort of a middle ground between the two. Flips are a ton of work, and far from a passive investment like you mentioned you wanted.
I have wrote this out for another example so I used $100k rather than $125k but the example should still illustrate the principles.
Here is an example of two investment channels you mentioned:
Hardmoney lending:
$100k lent out for 1 year at 12% interest w/ 2 points will give you a gain of $14k or a pre tax COC of 14%. Lets assume you are in a 35% tax bracket. You will cut a check to the IRS for $4,900, leaving you with $9,100 or a after tax cash on cash of 9.1%. Also keep in mind HML your money turns over quickly you have to be active to be sure you have another qualified borrow lined up needing your money at your terms or else your money just sits dormant between loans, and dormant money is decreasing money.
Apartment building investment:
$100k down payment on a $500k building. At an 8% capitalization rate (very achievable) you are left with $40k net operating income. lets assume when you borrowed the $400k from the bank they lent it to you at 4% interest over a 25 year term. This means your year one mortgage payment is $25,332 ($15,827 interest, $9,505 Principle) leaving you with $14,668 in cash flow or a pre tax cash on cash return of 14.6%. This beats your total pre tax return of 9.1% from the HML above BUT we haven't even started on all the other benefits of investing in real estate.
So you cash flowed $14,668 do you pay tax on $14,668?? NO! Another beauty of real estate and leverage is the depreciation tax benefit. Even though you only put 20% of the $500k in to the property you get ALL of the depreciation. Apartment buildings/houses are depreciated over 27.5 years, which means you get to depreciate the building value. The buildings value does not equal the property value because the building sits on land and that land also has value. The IRS does not allow you to depreciate the land. A typical percentage of a property value to allocate to land value is 20%, or in this example it would be $100k. This leaves you with 400k of building value to be depreciated $400k/27.5=$14,545. What does this mean? It means you barely pay any tax on that $14,668 cash flow you made on the building. You actually only have a taxable gain of $9,628 ($14,668 + $9,505 - $14,545) we add back the principle amount of your mortgage payment because it is not deductible and subtract out the deprecation we listed above. Again assuming a 35% tax bracket the gain of $9,628 would result in cutting a check for $3,370 to the IRS. This means your after tax return is 11.3%. A 2.2% increase on after tax return when compared to hard money lending
That's all great and will make you a lot of money, but HML has no tenants, no phone calls, no toilets. That piece of mind in its self is worth not receiving the additional 2.2% return owning real estate provides right? I don't think so because there is one more major piece to this puzzle.
Another huge difference between HML and owning investment real estate is the power of debt and with debt comes amortization. Wealth is built in the amortization of the debt you put on the property. Back to our example the $400k in debt you put on the building will have an army of tenants paying down your mortgage month after month. In our example after 10 years you will only owe $285K on the building IF the property never appreciated one cent and it was still worth $500k in 10 years you would have $215K in equity. You could then sell it or refinance it (again tax free).
Now lets wrap the amortization into our example. Using the loan terms I mentioned the first years of the loan will result in a $9,505 reduction in principle or if the value stays the same that would be seen as a $9,505 increase in equity. If we add that $9,505 to the cash flow and tax benefits we are left with an all inclusive after tax return of 20.8%.
This is just the basics. You can accelerate depreciation benefits through cost segregation, Structure loans for quicker amortization depending on your goals, force appreciation through several types of improvements, and many other tricks.
Everyone has their own specific investment tastes and beliefs. I post this here to hopefully help you make your choice. Good luck on your new venture!
- Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes10y
I wouldn't lend outside a ROTH for the myriad of tax burdens @Jered Sturm mentions. Careful with the 'quick buck' mindset. Keep your risk/reward meter in the sane zone.
Flips - after you take all the risk and do all the work, your silent partner in the IRS will be waiting for theirs again. You get to split your measly leftovers with realtors.
Why the need for the all the money back in a year or two @Alec Sithong? I'd go with buy and holds for the reasons Jered mentions. Maybe I'm biased as a buy and holder lol, but it's worked for me!
Good luck and congrats on having that kind of capital do deploy!
- Charlotte, NC · Member since 2016 · 56 posts · 8 votes10y
@Jered Sturm thank you! Nice explanation on apartment building. As an architect I have no issues with remodeling or construction. I just don't want to work as hard anymore. I'd prefer to sit back and let my money grow with least headaches. Having multiple tenants, repairs, property manager, insurance, legal, and other moving parts that I'd have to be quickly learn would be a challenge. Is it worth it? I'm sure. Am I ready? Probably not until I get a couple of single family homes or duplexes under my belt. These have smaller pieces I can control at arms length. What you present is a great way for maximum return which I will certainly look into. I take it you're not big into flipping properties for good returns? Thanks again for a great explanation on apartment investment.
- Charlotte, NC · Member since 2016 · 56 posts · 8 votes10y
@Steve Vaughan with my business plan using the ROBS from 401k I am limited to active business income and not passive income at this point. Unfortunately I can't do the Buy and Hold although I wish I could (unless I sell it under a year and let the IRS know it's active income). I need to build as much capital as possible within the first year or two to buy passive income later. I could mix the passive income (rental property or hard lending) within the active income (flips) but I cannot do only passive income. Either methods, I'd like to find out which has the most return.
- Investor · Washington, DC · Member since 2016 · 175 posts · 73 votes10y
Why not combine the benefits of flipping (adding value/forced appreciation) and the tax benefits of holding for more than one year? Buy a property at a discount, rehab it, refinance for cash out if you want, rent it out and hold it for at least a year to qualify for long term capital gains, and then sell it with the 15% capital gains rate. Or when you sell, defer the capital gains using a 1031 exchange, buy a larger property and repeat.
My question would be if you can do a 1031 immediately after the rehab is complete, but haven't held it for a year, does that carry with it the same tax implications.
- Charlotte, NC · Member since 2016 · 56 posts · 8 votes10y
Yes I am also considering combining it as well. Although not sure $125K can get me to do both. Need to see if the numbers work. good point about the 1031 and deferring capital gains. I'll have to research that. Thanks!
- Las Vegas, NV · Member since 2014 · 732 posts · 137 votes10y
Hi Alex,
Well I have always been a fan of vacant land. In this market you are able to buy land in the path of growth for 20/30 cents on the dollar. Again depends where your head is at. You always make money on the buy side. With that kinda cash you could buy land way undervalued, sell off enough to get your money back hold the rest for future date and sell on time with high interest rate and collect cash every month, so no leaky toilets to deal with.
- Charlotte, NC · Member since 2016 · 56 posts · 8 votes10y
@Steve Haight nice idea! Loving the fact of no headaches to deal with. I've always loved land itself and thinking of developing multi homes on it. But the thought of just selling it piece by piece is an excellent idea. I'll check out your website.
- Investor/Syndicator · Cincinnati, OH · Member since 2014 · 470 posts · 599 votes10y
Happy to help!
You said "I take it you're not big into flipping properties for good returns?" The answer to that is a big no. I love flipping but man is it hard! In the past 12 months we did 16 houses for just under 3 million dollar in flipped house sales. I have a contracting background so I love working with my hands and seeing a project come to life. But like I said its hard and a lot of work.
Rentals are far more passive and are true wealth builders. You mentioned wanting that passivity. You should look into entering into a syndication partnership as a limited partner. This would allow you to receive all the benefits I mentioned in my first post but be responsible for zero of the day to day issues you're looking to avoid. From how you have briefly described your goals and motivations I feel it would be a great fit for you.
- Real Estate Attorney · Manhattan, NY · Member since 2014 · 129 posts · 106 votes10y
You can verify with any accommodating company for a 1031 exchange and they will unanimously tell you that you should hold the property for one year and a day to defer tax using a 1031 exchange strategy - The IRS clearly states that if your intention was to resell it then you are a dealer and will be taxed at a higher rate - the key thing if you want to flip fast is use the method of having a fund buy it from you on a seller carry back financing (you are the seller) on the same day you are closing for all cash (even if cash and loan it is considered an all cash sale) and since the fund would have bought it from you in the morning on a seller carry back and sold it in the afternoon for same price all cash, there is no tax to you (no realized gain as of yet) and no tax to the fund (same price sale). Buyer gets property with clear title, the fund gives you your original basis price to reduce the note and you carry the balance. Then the fund can use a special internal revenue code to be able to loan you the gains. You pay interest to them for the loan and they pay you interest since you carried the financing.
We have two clients that own and operate such funds and if you consider your dealer status will get you taxed at ordinary gain like 35% Federal and almost 10% in most states versus paying them just 8% then everyone wins -
I am simplifying this as best as I can but there are certain rules and steps that must be followed to be in compliance with the IRS but I assure you most brokers are unaware this is possible and the 1031 exchange companies will certainly not share that info because it can impact their business tremendously! They want you to keep deferring the tax forward and going from property to property - it makes realtors rich and bankers can keep giving out loans etc
- Charlotte, NC · Member since 2016 · 56 posts · 8 votes10y
thanks @Pat Marco! Nice info to have. I'll certainly investigate. Much appreciated!
- 10yBill ExeterBusiness Member1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
Originally posted by @Aaron Smith:
Why not combine the benefits of flipping (adding value/forced appreciation) and the tax benefits of holding for more than one year? Buy a property at a discount, rehab it, refinance for cash out if you want, rent it out and hold it for at least a year to qualify for long term capital gains, and then sell it with the 15% capital gains rate. Or when you sell, defer the capital gains using a 1031 exchange, buy a larger property and repeat.
My question would be if you can do a 1031 immediately after the rehab is complete, but haven't held it for a year, does that carry with it the same tax implications.
Hi Aaron,
Unfortunately, you can't buy, rehab and then sell using a 1031 Exchange. The Qualified Use requirement of buying and holding for rental, investment or business use will not have been met because the investor's intent would have been to buy and hold for sale (inventory), which does not qualify for 1031 Exchange treatment. The intent must be to buy and hold for rental or investment purposes in order to qualify.
Exeter 1031 Exchange Services, LLC and Exeter Trust Company4.726 Reviews - Charlotte, NC · Member since 2016 · 56 posts · 8 votes10y
@Bill Exeter thank you for following up.
- Real Estate Attorney · Manhattan, NY · Member since 2014 · 129 posts · 106 votes10y
Bill is correct that is why you need one of the funds that act as intermediary so you woul not need to worry about s 1031 exchange whether because you cannot do it or don't want to do it - there is an approved structure - private message me if you need these two companies that have done it successfully and I will put you in touch with their key people
- 10yDave FosterBusiness MemberQualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
@Alec Sithong, Your desire to kick start your war chest is great. I'm sure you know the power of compound interest so when you're looking at utilizing that war chest you want to gain the benefit of it's power but also the benefits of the benefits that come from the use of that capital. The power of a 1031 exchange is that you are deferring whatever the tax would have been and transferring the basis into the replacement property. the 1031 defers it allowing you to use those tax dollars for further investment for your own benefit.
However, from another perspective, the previous posters are correct - property held primarily for resale is inventory and not investment real estate qualifying for 1031 treatment. There is no statutory holding period. The test is your intent which can be evidenced by many things including actual holding period, stated intent, normal practice, and extenuating circumstances. The common mantra is that property held over a year is safe for 1031s but there are situations where a shorter hold period has upheld and where a much longer period has been disqualified.
The takeaway here is that by adjusting your model slightly you could create the opportunity to not just reduce your tax burden but actually defer and later eliminate it. Instead of using a buy flx flip model, change that to a buy fix rent, and evaluate model. This can place you in a more favorable tax bracket and perhaps offer you the opportunity to 1031 and defer all tax. It can also be a very powerful way to boost returns when a hot market starts to dry up the quick flip opportunities. shift to a longer horizon and evaluate yearly whether it is time to sell or not. While you're doing that you're enjoying appreciation and cash flow - partly from Uncle Sam's money that he's willing to leave with you for a while.
The 1031 Investor5137 Reviews - Charlotte, NC · Member since 2016 · 56 posts · 8 votes10y
@Dave Foster great insight! All of you are a tremendous help. Thanks
- 10yClayton MobleyPro MemberBirmingham, AL · Member since 2014 · 875 posts · 947 votes
@Alec Sithong have you considered turnkey? Full disclosure, I am the CEO of Spartan Invest, a full service turnkey outfit in Birmingham, AL. I won't try to sell you, but you've mentioned a couple times that you don't want to work so hard, buying, refurbing, managing, tenant selection, etc, and yet mostly these posts focus on self-managing properties that you fix and then sell later, which is a lot of work. Better for flow and taxes than a straight flip, but arguably more work because of the management angle.
@Jered Sturm, in particular, has made some really excellent points about the merits of buy-and hold RE, but self-managing properties is a lot of work and if you don't want to be super hands-on, the stress can outweigh the marginal increase in ROI gained by doing it yourself vs working with a provider. If you are really looking to generate passive income, turnkey is a great place to start because it takes all the guesswork out.
You'll see quickly that BP can be pretty divided on the benefits of TK, largely because there really are some very shady outfits that will try to sell you hard on very misleading numbers. However, the TK model absolutely has the power to generate sustainable long-term passive income, with capital preservation or even appreciation, if you find an provider that you trust. I tend to harp on this point a lot, but if you can find a provider that you trust to show you all the numbers and exactly how they add up, walk you through the process and remain transparent and accountable to you every step of the way (we back up everything we do with a 100% money back guarantee, for example), then turnkey is one of the best ways to build a diversified investment portfolio that flows year after year. And since there's no rule that says you can only do things one way, you can use your experience and extra income to build a self-managed portfolio down the road if you decide a hands-on approach appeals to you, all the while knowing you have a solid income engine already running in the background.
Since I hadn't seen it mentioned, I thought I'd through my two TK cents in, for what it's worth. If you have any questions about TK in general or about what we do at Spartan, feel free to drop me a line any time.
All the best in your new adventure!
Clayton
- 10yBill ExeterBusiness Member1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
Originally posted by @Pat Marco:
You can verify with any accommodating company for a 1031 exchange and they will unanimously tell you that you should hold the property for one year and a day to defer tax using a 1031 exchange strategy
I am simplifying this as best as I can but there are certain rules and steps that must be followed to be in compliance with the IRS but I assure you most brokers are unaware this is possible and the 1031 exchange companies will certainly not share that info because it can impact their business tremendously! They want you to keep deferring the tax forward and going from property to property - it makes realtors rich and bankers can keep giving out loans etc
Hi Pat,
I thought I would jump in here. I completely disagree with your "unanimous" comment regarding Qualified Intermediaries. We never tell clients that they must hold their property for at least one year and a day. The amount of time they hold title to the property is not the critical issue here. The critical issue is that the investor must have the intent to hold the property for rental, investment or business use, and not for sale such as inventory in a real estate business. The amount of time can help demonstrate intent to hold for investment, but does not cure the problem when the true intent was held for sale as opposed to held for investment. Trusted advisors never make blanket statements as indicated in your post.
Exeter 1031 Exchange Services, LLC and Exeter Trust Company4.726 Reviews - Investor · Washington, DC · Member since 2016 · 175 posts · 73 votes10y
Thanks for that tip, I've never heard of that before and its a bit confusing to be honest. But I like the idea of 8% vs 25%+
Thanks for clearing that up. That's a huge difference in taxes, flipping vs long term capital gains rate. Especially with multifamily properties with nice cash flow, it seems to me it makes a lot of sense to hold after a rehab and wait until I can do a 1031 or take out the cash at long term capital gains rate.
Thanks for your input, I appreciate it.
- Real Estate Attorney · Manhattan, NY · Member since 2014 · 129 posts · 106 votes10y
Well a trusted advisor would certainly have to stress the time factor. If as you wrote "you never" mention that then I assure you, you will have issues as soon as one of the clients gets audited.
Let me explain why so you could give your clients better advice and possibly an alternative way to not have to worry about neither time not intent.
The key point you seem to want to stress here is the "intent" which is the hardest thing to argue with the IRS and that makes the "time frame" the client holds the property the primary factor.
The best way to make use the IRC 1031 exchange method is to hold the property for a year and a day, that is when the investor can easily argue "intent" - try to tell the IRS you held it for a month and sold it but you really were intending to keep it as an investment property and let's see what kind of tax you will pay.
If you still have doubt ask a qualified CPA or better yet, a tax attorney who had to dispute such an issue with the IRS.
One more point, using the funds that I mentioned to defer the tax is a much better way because you could flip a property after one day with the clear intent to resell it and still have no issues with the IRS - these are called structured settlements -
I wonder if you will truly disclose all that to your client going forward especially the alternative way to avoid the 1031 exchange all together or would that be a conflict of interest?
- 10yBill ExeterBusiness Member1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
Originally posted by @Pat Marco:
I wonder if you will truly disclose all that to your client going forward especially the alternative way to avoid the 1031 exchange all together or would that be a conflict of interest?
I suspect that I already know, but what specific "alternative way" are you referring to? I'm sure the other readers would be interested to know.
Exeter 1031 Exchange Services, LLC and Exeter Trust Company4.726 Reviews - Wholesaler · Pompano Beach, FL · Member since 2016 · 10 posts · 1 vote10y
I think a good thought process is to determine whether you need capital gains or if you need income (cashflow). Of course, we often need a "nest egg" that we can generate cashflow with. I don't know about you, but I would much prefer doing work once and then getting paid over and over again through income.... and that is my ultimate goal. If you have little money to work with, I would suggest doing some fix and flips until you have a bit of capital to work with. Otherwise, I would work with a group of investors to put together either a) a larger deal that will generate cashflow income or b) a larger deal that will generate capital gains so that I have capital to generate cashflow income with. I've known a lot of super intelligent people over the years who have made massive amounts of money only to loose it because they've always had the "broker mentality". I suppose that it is only human nature to be optimistic that the party will always continue, but the long term play is definitely to invest for income asap and then when the hard times come or the market turns you will be able to continue to keep paying your bills.
- Real Estate Attorney · Manhattan, NY · Member since 2014 · 129 posts · 106 votes10y
You suspect you already know of alternative ways to doing a 1031 exchange? Ok do you know about structured settlements? How about seller financing? Or CRT? Etc
- 10yBill ExeterBusiness Member1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
Originally posted by @Pat Marco:
You suspect you already know of alternative ways to doing a 1031 exchange? Ok do you know about structured settlements? How about seller financing? Or CRT? Etc
Hi Pat,
Yes, I'm very well aware of "structured settlements." They have been marketed over the years under various names, including Self-Directed Installment Notes, Deferred Sales Trusts, Structured Sales, Structured Settlements, and numerous other names, each with a slightly different twist as to how they are structured and how they work.
They are usually drafted or structured pursuant to Section 453 of the Internal Revenue Code, which covers installment sales. They all make claims that they are "compliant" with the IRS requirements (some even claim they have been approved by the IRS), but I have yet to see any Treasury ruling or court decision that covers these specific structures/strategies/techniques. They merely rely upon the fact that they have been draft under Section 453 of the Internal Revenue Code. They generally fail to mention to clients that there is no ruling directly on point.
We have used them in cases where a 1031 Exchange is not appropriate for the client and the client is a sophisticated investor that understands the risks of implementing such a strategy and is willing to assume the risks.
By the way, in addition to discussing Section 453 strategies (installment notes, seller carry back financing) whens speaking with clients or speaking at events, I also discuss 1033 Exchange, 1034 Exchange (repealed), 721 Exchange, 121 Exclusion and Charitable Trust (CRT) strategies so that the client has a brief overview of the most common tax strategies available so that they can make an informed investment decision. This is what a trusted advisor does.
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