All Forum Posts by: J Scott Hamilton

Even here in the middle of the Pittsburgh metroplex, we have buildings like that which can't stay filled with tenants.  In Homestead nearby a large shopping center, a vacant bank building had a barbershop in the basement. It would not surprise me if the barbershop's rent could have covered the carrying cost of the building, even with the main floors being vacant.  But after walking by that barbershop for two years (I ride the bus), it moved out.  Now it is again a completely vacant building.

In these Rust Belt towns there are many buildings vacant because the population declined so much that there weren't enough people and businesses to fill all the buildings. Many of them decayed and fell apart, and now are plowed under.  Unless you think there is a tenant compelled to rent your prospective location, you just have an appreciable/depreciable investment with no cash flow to cover its expense burden.

The provisions of Internal Revenue Code 1031 has changed over the years and may change in the future.  But it was built on the fundamental principle that exchanging two items of like kind between two (or more) parties should not be taxed.  Some items, like investment securities, were exempted from the beginning, but for the most part it would be very difficult for Congress to exclude all forms of tax free like kind exchanges without having structural consequences to the tax code.

It may be possible that the NAR article was saying that real estate professionals may not want to bother with these deals. If such were the case I can't see why attorneys might not want to take over the burden, assuming that real estate was still eligible for 1031.

For individuals you file Form 1116. Your credit will generally be the lesser of how much you paid to the taxing authority or the amount you would pay to the US. And unfortunately, if you are subject to the Alternative Minimum Tax you may have to fill out the form twice.

Scott

A couple of things to consider with tax deductions:

1) The expense you avoid is worth far more than the tax deduction on that expense.  Don't accumulate needless expenses just for the deduction.

2) The income you earn will still net out to money in your pocket even after paying the tax. Don't leave income on the table just because you will be taxed on it.

3) Most real estate expenses are deductible in the year you pay them, especially if the benefit is immediate (like a utility payment or property tax).

4) Some expenses are prorated through the life of the improvement, such as depreciable buildings and roof repairs. This is also known as a capital expenditure (although land is not expensed). Even though you will be out of pocket up front for the expense, it will take years to get all of the tax deduction.

5) Choosing your tax strategies with legal entities and exchanges will change the timing of your tax bill and the tax rate at which you pay. Most have tradeoffs in terms of benefits and complexity.

So these are five rules that I used to advise my clients when I was in practice a long time ago. If you keep track of every expense, a tax professional can go over what is usable or not, and how to best put them to use.

Scott

If you try to take cash out of a property around the time that it is being traded in a 1031 (Like Kind) exchange, the IRS will try to apply the “step transaction doctrine” to characterize the cash taken out as 'boot'. Boot is normally cash or non-like kind property that is taken as part of the exchange, and there is usually a taxable amount of the exchange equal to the value of the boot. So for these exchanges the rule of thumb is to trade up in value, not down, to avoid getting taxed on boot.

Now having said that, the IRS has lost some court cases where a refinance was unrelated to the exchange itself. You might find some people have used creative ways to leverage these court rulings, but they likely add additional expense and complexity to the transaction. Even plain 1031 exchanges have enough rules to follow that circumstances of the exchange, such as not closing on the new property fast enough, can cause you to lose the tax benefit.

If your big picture is to sell one property and buy multiple, or even to sell an SFR and buy a multi-unit, that can already be done under 1031 if you identify replacement properties equal or greater to the value of the property being sold. The IRS does not use a narrow definition of "like kind" when it comes to passive income properties. But if you are just trying to cash out and still roll forward the gains, you're going to be fighting the spirit of the 1031 exchange.

Which is more important to you, reducing your carrying costs, increasing your borrowing capacity, or increasing your liquidity?

You'll have more total free cash flow/earnings if you pay down (and retire) the higher interest rate. An ARM HELOC that has no capacity to borrow against is just a ticking time bomb if interest rates start to rise (which could happen if the US dollar decides to devalue). Let's say the ARM's rate was indexed to an interest rate dependent on US Treasury debt, and the auctions start going haywire, you could see interest rates approaching 9%. That's about the point where your second property cash flows down to zero.

If you want more borrowing capacity then get another HELOC on more favorable terms, at least on the first property. The second property is already underwater.

If you want more liquidity, then put the cash aside instead of paying extra principle on the mortgages and HELOCs. 

If I did the math right your combined debt to equity ratio is about 97% on the two properties. It looks like from your post these are not your only two properties though. Given that we are at the historical bottom for interest rates, any amount of ARM with this leverage scares me.

To amplify what @Wayne Brooks said, you have a choice of swapping out of your target out of state property by either selling it or like kind exchanging it via Section 1031. We're assuming here that you dispose of an out of state property and acquire another property closer to you to manage. Whether you cash out refinance or sell the old property and buy the new one, your new property's depreciation would be based on how much you paid for it, not based on how you paid for it.

If you do not have a lot of capital gains nor a lot of accumulated depreciation in the property being sold, then it probably would not be worth it do a 1031 exchange. The trade off with 1031 is you defer taxes on the gain, but you consequently have less basis (cost) in the new property available for depreciation. (I'm mentioning this more for people reading this thread other than the original poster.)

Since depreciation on real estate is more of a "benefit now but pay it back later" proposition, you want to treat its value as means of sheltering current income at the expense of paying a bigger tax bill when you finally sell the property.

Thanks guys. For now I have leading and catalytic landlord set up as alerts. My thinking is about the blog is perhaps to hold off until either I have more content posted in the forums (as I am doing with tax and direct foreign investment knowledge) and/or when I am closer to making my first investments in real estate.

During a currency (dollar) devaluation, there are two factors that come to mind that would drive real estate prices up. One has to do with dollars outside the United States coming back to the United States, and the other has to do with another currency that decides to go bargain shopping.

Let's say you are Japanese, and you have both dollars that you earned in a foreign investment, and yen available to also make an investment. You want the best rate of return on your currency, and you find that the local market doesn't provide you a good rate of return. Your dollars start to devalue, meaning that they will buy fewer yen. A weaker currency (dollar) is one you want to unload, and you can do so by either exchanging them for yen or buying something denominated in dollars. 

There is no doubt that if devaluation is an ongoing process you'll need to dump the dollars, as any investment whose face value in dollars, such as bonds, will continue to lose its value and offset any gains that might be had from the interest coupon. So an investment whose value is determined by ongoing auction, such as stocks or real estate, makes a good vehicle for your devaluing currency so long as there are market forces to drive the price up. For now think of investing dollars instead of exchanging dollars as a gamble -- the first factor.

The second factor is that when a nation's currency becomes worth less, the value of the goods and services of that nation start becoming a lot cheaper to a foreign buyer. This is why it is good for that nation's exports, because exported goods become less expensive relative to the same goods on the global economy denominated in a stronger currency. This is not only true of exported goods but also of any assets you as a foreigner are allowed to purchase inside that currency's country.  Real estate is an odd one in that many countries do not allow direct foreign investment, but the United States does allow it.

So with the first factor, those dollars held by a Japanese person are trying to find a home in real estate, so it begins the bidding up process.  And with real estate become cheaper from the perspective of the purchasing power of yen, it would make sense from the second factor perspective to exchange yen for dollars and then use those dollars to also buy real estate. So long as the real estate appreciates as fast or faster as the dollar devalues, the yen investor will break even on their yen investment. And as long as the rents increase in line with an underlying property appreciation caused by the effect of more dollars entering the real estate market, then increased cash flow will offset the loss in value of that cash flow being denominated in dollars.

Many foreign investors will just use the intrinsic value of the property rather than try to play the exchange rate game. So with the Japanese investor, assuming would want to live anywhere in the world, it might make more sense to have a penthouse apartment in Manhattan over one in Tokyo, or to have a vacation home on US lakefront property over a villa in Italy. 

So while the exchange rate differentials may cause an increase price pressure on real estate in general, not all markets may necessarily be affected. Just as US exported goods become cheaper, foreign goods become more expensive. So an American who is used to cheap Chinese imported goods with a strong dollar will find that their trip to Walmart becomes much more expensive. If their budget is strained by buying imported goods (and for now assume oil is also priced as an imported good) they will have less money to afford on housing. So real estate that is of interest to an American but not to a foreign investor may find its value decrease, not increase during devaluation. 

With as many dollars as the US has overseas, if the the real estate market were perfectly efficient, then perhaps all real estate prices would increase as those dollars try to find a home back in the US. But since it is not, you are likely to see the most desirable properties become the most inflated, and the least desirable properties breaking even on value or possibly even deflate.

Scott

Given that my goals may be a bit of an outlier, other than the fundamentals of investing in sub-30K real estate, is it worth the BP community's attention span for me to start a blog here?

Short and sweet. People have important things to do in helping each other and reviewing deals. But I'm motivated to help turn around the Rust Belt and still make a profit... audience?

Scott