The real potential issue.

BawldGuy Axiom: In this age of uber-accessible information, finding answers to our questions is, generally speaking, not a major problem. What bites us where we sit are the answers to those questions we never knew to ask. Answers to unasked questions can be deadly.

One of the many ways you can look at your tax return is as a summary of the investment strategy(s) you’ve chosen to execute — purposefully or not. The question beggin’ to be asked is, 

“Is there a strategy that would’ve been far more beneficial for my circumstances?”

Over the years there’ve been countless times, when while perusing an investor’s tax return I’ve been able to pinpoint what appeared at first blush to be a less than optimal approach. Now understand, I don’t pretend to be a tax advisor or anything close, as a CPA is always close at hand when needed. But I do know quite a bit about the IRC as it relates to real estate investing. I’m like the birddog — smokin’ out weak links in an investor’s approach — if one exists. I tend to error on the side of, ‘We need to see what the tax guy has to say’.  There have been many, many times when I’ve literally stopped a tax related move by an investor, so as to prevent catastrophe. Most of the time those stories include botched or misunderstandings about tax deferred exchanges per section 1031 of the IRC.

It’s counterintuitive, but I’ve learned that half or more of the people who come my way either still do their income tax returns themselves, or use a tax preparer undertrained for the job. A surprise to many, I find that a large minority of investors who’ve hired CPAs, are unaware even the CPA isn’t fully cognizant of all the possible arrows available for their tax related quivers. This isn’t to say the CPA in question should know everything in the code. That’s an impossible dream if there ever was one. In fact, I’ll go a step further. I think CPAs as a group are unfairly charged, much like physicians and medicine, with knowing the entire tax code. Doctors don’t know everything about medicine, do they? Of course they don’t. Yet the same guy who wouldn’t dream of asking his buddy’s podiatrist about his shoulder problem, hires a CPA with strength in an area(s) other than real estate.

I have a friend who owns not only a couple retail operations but a nationwide wholesale firm. Wonder if a CPA expertly versed in the ins and outs of real estate tax law would be a solid choice for him? See what I mean?

Put another way, every year I personally witness, first hand, new clients who when introduced to a, you know, real estate savvy CPA, quickly learn they’re owed money from 1-3 past returns. Occasionally there are mistakes found that when rectified are pivotal in avoiding future unwanted IRS attention. Then there are the annual changes to what we think we already know about the tax code itself. Some years the changes are minor, other years they’re significant, and other years they’re literally worthy of front page headlines. Going into the last weeks before the Tax Reform Act of 1986 went into effect, the real estate investment world was almost literally operating a couple sandwiches short of a picnic. It was beyond chaos. More transactions closed in December of 1985 than pretty much any December I can remember.

With that picture in mind, think about all those real estate investors who realized how much better off they woulda been, had they done in 1985 what they’d planned for 1986. What a painful irony it musta been for those who had this epiphany while in their CPA’s office doing 1985′s tax return. I met more than a few of those folks in ’86, and it was indeed a sensitive subject.

I suspect Chuck Perkins might have a few thoughts on this topic. (That was me, not winning the battle to avoid dripping sarcasm.

So, thinkin’ we might put our heads together and improve your retirement plan? Sweet — gimme a call at 619 889-7100 and we’ll get started. I also like gettin’ emails, which is as easy as clicking on the Contact BawldGuy button at the top of the page. Have a good one.

Why? Remember, the “I” in IRA stands for Individual, and not anyone else. While you can certainly make other individuals the beneficiary of your IRA, it is still YOUR IRA.

So, with regard to a self-directed IRA, a typical question will be, “Is there any way my IRA and my wife’s IRA can be brought together for greater purchasing power for an investment in real estate (for example)?”

Yes, of course.

Both individual self-directed IRA accounts could purchase in proportional shares the assets of a jointly-owned and managed LLC. Ownership would be in direct proportion to the value of each person’s IRA. As an example, if Jim’s IRA was $60,000 and Susie’s (his wife) was 40,000, Jim’s IRA would have a 60% proportional share ownership of the joinly-owned and managed LLC, and Susie’s IRA would have a 40% proportional share of the LLC.

In the second half of this series, we will review how, if Jim or Susie were self-employed, they may want to rollover their IRAs into a self-administered 401K of which they are both co-trustees.

Section 1031 of the Internal Revenue Code is one of the few tax deferral strategies available for real estate investors.  It is basically an “avoid tax on the sale” provision for real estate.  It should go without saying that in order for this provision to apply, the sales proceeds are reinvested in similar or like kind property.  However, reinvestment in like kind property is just part of the qualification for an exchange.  For investors who utilize entities for their property, the knowledge of this has come at inopportune times.  The use of land trusts, limited liability companies, corporations, or other entities may nullify an exchange if you do not have a complete grasp of the requirements under 1031.

Basic Rules For a 1031 Exchange

1. The Property You Are Selling Must Be Held For Investment or Used In Your Trade Or Business.   Investment property is straightforward.  It includes any real estate, improved or unimproved, held for investment or income producing purposes e.g., residential or commercial property, raw land, fractional interests, leasehold interests, easements, water or mineral rights, oil and gas interests, even development rights.  Property used in your trade or business includes real estate and equipment used by your business.  In an exchange this is sometimes referred to as “incidentals” depending on the type of property e.g., dump truck or excavator received to assist with developing the property acquired in the exchange.

2. The Replacement Property Must Be Like Kind.  Like kind does not mean an exact replica of what is exchange, i.e., a 3-bedroom rental for another 3-bedroom rental.  This prong is an intent based requirement and not a physical requirement i.e., if the property you are selling was held for investment then the property you are buying must also be treated the same.For instance:
   

   • An apartment building can be replaced with raw land or vice versa.
   • One rental property can be exchanged for two or more properties or the reverse.
   • A commercial building can be exchanged for land and equipment.

3. Replacement Property Title Must Be Taken In The Same Name as The Relinquished Property Was Titled.  If the property you are selling is owned in your name then the replacement property must be taken in your name. Similarly, if the property is held in a land trust, corporation, LLC or other entity, the replacement property must be taken in the name of the entity.

Planning Considerations for Entity Owned Property

The last rule can prove problematic for investors contemplating a 1031 exchange who currently own property in a land trust or LLC.  If financing will be involved in your acquisition of replacement property you do not want to show up to closing and be told to pull it out.  Your lender is not sensitive to your tax deferral strategy and will not close on the loan unless title is taken in your personal name.  You lender’s insistence on title will implode your exchange if you originally sold property held in an entity.  This is a violation of the 3rd rule “replacement property must be taken in the same name as the relinquished party was titled.”  Unlike other aspects of the tax code the IRS does not grant safe harbors for 1031 exchanges.

Pre-Planning is Your Solution

If you plan on entering into an exchange with property held in an entity and you anticipate acquiring residential real estate with the exchange proceeds, then my recommendation is to deed the property into your personal name prior to listing it for sale.  In so doing, you will ensure that the exchanged property will be sold in your name and acquired in the same. I recommend you adopt this strategy even if you do not plan on using financing for the replacement property to keep your options open.

After your exchange is finalized, you can transfer the property back into your entity.  Many CPAs will recommend you wait until the following tax year to make this transfer.  I disagree with this recommendation if you are transferring the property into a disregarded LLC.

Property Held in an Entity with Other Partners

The above approach is also useful in those situations when you have invested with other individuals and now it is time to sell the investment.  Frequently, one or more of the partners in a partnership desire to take cash when the property is sold rather than roll the proceeds into a replacement property. This presents problems that require careful planning and is not without tax risk.

To preserve your exchange options in a partnership setting, the prudent course of action is for the individual partners to deed the property out of the partnership and into the individual partners names in advance of the sale.  Deeding the property from the partnership to its partners as tenants in common does this.  In doing so, each individual partner is then free to sell or exchange his ownership interest in the real estate.  People familiar with 1031 exchanges will refer to this strategy as a “drop and swap”.

1031 exchanges are a great tool for tax deferral but with everything in real estate investing, it pays to invest in some pre-planning to ensure you are maximizing your benefits.  As I have stated before in previous posts it can be the little things i.e., an afterthought, that can disrupt the entire plan.

Why don’t people talk about real estate as a viable means for retirement?

It’s been part of my basic understanding of what I do. What with all the empirical evidence showing real estate is far safer, more reliable, and generates more wealth than the many alternatives, the vast majority choose everything other than real estate. Why is that?

I’ve had over 40 years to come up with a credible answer. People have figured out how to save money. Pay off their homes. Invest in stocks. Yet, they don’t go for the real estate. I don’t know how the ‘Invest for retirement’ pie is divided, but the percentage has to be single digit for real estate.

It doesn’t make objective sense. Americans flock to so-called qualified retirement plans at work that have been huge failures. The typical 50-something American (mostly male) has less than six figures in their account. Think they’re longing to retire? Or, are they hittin’ the panic button, their heads on a swivel as they frantically cast around for a viable solution to workin’ ’til they drop?

Based on my professional experience, most simply don’t think they can make it happen. They prefer the ‘experts’ provided by their employers, who guide them in choosing in what to invest for retirement, inside their 401k. By the time the results of that approach become painfully evident, it’s like runnin’ outa gas on the freeway in fly-over country. You thought you shoulda filled up at the last town, but decided it was easier to keep goin’.

How’s ‘easy’ been workin’ out for ya lately?

Real estate is simple on paper, just like every other route to a solid retirement. But, like most things in life, simple is the last thing it is once execution is the word of the day. The long and short of it is this:

Getting to a magnificently abundant retirement through real estate investing is anything but simple. Sometimes it’s a gigantic pain in the butt, and I’m being kind. However, if retiring well was easy it’d be like Grandma said — “If it was easy, everyone’d be doin’ it.

You’ve been goin’ down the Yellow Brick Road for how long now? There’ve been roadblocks, some scary, on the way to Retirement Oz. Yet it never dawned on ya what was waiting for you behind that final curtain.

Thing is, you ain’t Dorothy, and you’re not dreamin’. Retirement Oz doesn’t exist — and there’s no ruby shoes that’ll take you back home.

Ruby shoes AND callin’ me at 619 889-7100 will get things started on the road to a real retirement. Rather write me? Click on the Contact BawldGuy button up top. Have a good one.

Then 2008 came and not only did it seem that many of these professionals became aware of such plans, it almost seemed that “self-directed” anything became the new buzz words.  Heck, it even seemed as if everyone wanted to set up such plans (evidenced by the fact that I have had more than a handful of people ask PGI if we could train them to enter the field).

So, I never thought I would be doing a post on this topic…hey, it’s been so long, I almost feel like I am going retro .  But, I was speaking to a new client this week and he actually told me that he reviewed a self-directed 401K with his broker first and was told that such a plan was “absolutely illegal.”  Feeling discouraged, he felt as if his broker may have selfish interests, so he reviewed it with his CPA.  Guess what?  Well, his CPA never said it was illegal, but said he had “never heard of it before.”

Before placing me on a three-way conference call with his CPA, the client (well, now he is a client) asked, “I’ve gone to  both my broker and my CPA and they both, basically, told me I couldn’t do this….why?”  Well, some of these individuals truly are ignorant of the IRS code and have never dealt with it.   As they say, sometimes it is just easier to take the path of least resistance.  However, especially as it relates to brokers, it MAY not be in their self-interest to encourage their clients to take money away from their management.  I mean, how do they make their commissions?!

So, the client, I think, undersood this concept, but still asked, “Well, once my broker DOES learn that this is legal, surely, he would give me the green light to move forward, right?”  Well, in theory, yes; however, mutual fund companies, insurance companies and security brokers don’t earn commisions when you buy non-traditional assets (e.g., real estate). It is kind of like the hamster wheel….the brokers keep telling us to get on the investment wheel and keep running strong.

This didn’t deter the next question….“Well, what about my local bank?  They should have an interest in setting up self-directed plans, right?  Or at least know about them?”  Well, I don’t think it is really any secret that banks make their money by using their clients’ deposits and loaning that money out to your neighbor…or maybe even you!  What a great deal, huh…well, maybe for the bank!  Think of it this way….if they are borrowing money from you and paying you 1%, that should mean that if they are really fair that they would loan the money out on that car loan for 1%, right?!  Or, anyone out there paying 1% interest on their credit cards?!  I didn’t think so.

We all have to “bring home the bacon”, but suffice to say that banks, brokers and insurance companies just don’t feel that, compared to their financial products, they can “earn” enough by offering self-directed plans.  As a result, they are not interested in providing this service.  And, for those of you who have worked with banks, trusts, etc. that are involved in non-traditional asset management, you KNOW their fees are very steep.

Will banks, brokers, etc. eventually get into the service of offering self-directed IRA and 401K plan?  The answer to that may very well depend on whether we have another 2008.  But, I will also make this proclomation…for anyone who has an interest in investing in both traditional and non-traditional assets, isn’t it nice to know that they can do BOTH from ONE account?!

As my clients approach the April 15 filing deadline questions are raised as they look at their existing planning after conversing with their CPA. Invariably, a few will ask themselves if tweaks should be implemented for the upcoming year. My answer is always the same; you could, but at what cost?  I am not referring to money, although some changes will definitely cost you, but the cost from a practical investing standpoint.  As an active real estate investor who is currently in the process of closing on three properties in Texas, I am reminded that although asset protection is very important, so is practicality.

Many of my prior posts have discussed the importance of the Limited Liability Company or “LLC” when holding property long term.  The LLC not only provides great asset protection for real estate but can also protect your excess cash that patiently waits on the sidelines for its next deal (Bear in mind that you would never hold your investment cash with real estate. A separate LLC should be used to protect your savings.)  If you have followed some of these exact structuring techniques, how will it affect your future purchases or 1031 exchanges?  Hopefully not at all because simplicity is at the heart of your plan and you conduct your business accordingly.  Here are some ideas to consider when purchasing real estate when you have existing business entities or when you plan to sell via a 1031 exchange..

Preparing to Buy – “KISS Principle”

My axiom – “less is better when acquiring financing.”   I am not referring to the actual investment, but your personal preparation.  Some people make the mistake of standing out in a crowd when they really want to be left alone. When dealing with underwriters your structuring might be the thing screaming to “take a look at you” and from personal experience, this is never to your advantage.  Fact is, the majority of underwriters are not sophisticated investors themselves, so do not try to impress them with your knowledge or the complicated structuring.  It will only backfire.  Your primary purpose should be to obtain financing, so take these early steps to stay out of the way and ensure the process is as smooth as possible.

Here is my short punch list to expedite the financing process:

• Keep your FICO score above 700   You are aware that high credit card debt will negatively affect your FICO score.  High balances is a major contributor in reducing your score.  One solution to this problem is to open up a business credit card and transfer your existing personal balances to the new card.  If you obtain the proper bankcard, this balance will not appear on your credit report, thus improving your personal score.

• Reduce the Number of Personal Credit Cards   Keep fewer than 3 personal credit cards and those that you do hold, it is sound practice to keep your overall credit utilization below 50% on each card.

• Move Money Early     If you are holding your investing funds in a LLC for asset protection you should know that this ideal for asset protection but not so great for obtaining a loan.  When applying for a new loan, your lender will request 3 months of personal bank statements to track available funds.  If your personal account lacks sufficient funds for the purchase because you were planning to transfer money out of your LLC for closing, then “Houston, we have a problem.”

So, do you have a conversation with your underwriter and explain that the money is in your “savings” LLC and these funds will be used for closing? Doubtful, unless you like making life difficult for yourself. The underwriter will not grasp the concept of a savings LLC and will look it as a separate business. Therefore, you will be asked to provide 3 months of bank statements for your savings LLC, plus any tax returns for the LLC.  Guess what?  My LLC is a disregarded entity and it does not prepare tax returns.  Now you have compounded your problems because the underwriter will likely not understand how a LLC can be active and not file a tax return.  (Give him a link to my blog and tell him to get educated)  SOLUTION – Move the investment funds out of your savings LLC and into your personal account 3 months prior to looking for your next deal. Leave any discussion of your savings LLC out of the picture all together.  Less is better.

• Obtain Insurance   Find an insurer in the state where you expect to purchase so you can obtain a quote after your offer is accepted.  When looking for an insurer take the opposite approach when dealing with an underwriter — more is better. The more information you provided an insurer about your structuring the greater the likelihood you will obtain a policy uniquely suited to your needs. For example, you explain to him that you plan to place your investment into a land trust or LLC after closing.  Ask him if this will be a problem with the policy.  Also inquire about an umbrella policy for your various investments.  Each state has different regulations regarding policy issuance but it is possible to acquire this additional protection.  For example, in Washington State, Allstate will allow me to add up to 4 properties under my personal umbrella policy even though the properties are held in separate LLCs.

Working With Your Lender

In my experience, one surefire way to hold up underwriting is by providing too much information either intentionally by talking too much, or unintentionally via your tax return.  I can’t help a chatty Kathy but I can help you with your tax reporting.

The majority of LLCs I create are set up as disregarded entities i.e., the LLC does not file a federal tax return.  This is the ideal entity structure for the real estate investor because everything is reported on his 1040 Schedule E.  To the loan underwriter reviewing such a 1040 return, it will appear as if all of the investor’s rental real estate is held personally and not by a business entity.  (Again, keeping everything simple and practical.)  However, if have a CPA who plays in left field and suggests you to change your tax classification from disregarded to a “Partnership Tax Status” be warned.  I bring this up because I spoke with 2 clients this week who were inclined to do so after meeting with their CPA.

Both clients were told that partnerships have a reduced risk of audit, therefore such a change would be in their best interest.  Most likely the only person to benefit by such a change is the CPA who will obtain additional work through the preparation of 1065 partnership returns. However, regardless my opinion on what the IRS is looking at when it comes to audits, I can confirm that a loan underwriter will scrutinize your 1040 with multiple k-1s resulting from LLC’s that file 1065 partnership returns.  The net effect, each time you apply for a loan you can expect a request for additional documentation on each LLC in which you hold greater than 20% interest.  (Remember more is not better.)

This is the classic conflict between people who invest and those who only work with the investor.  If you aren’t investing, then making recommendations without regard to their practical implications is like instructing my wife on how to get the kids ready for school.  If you aren’t actively involved, you will not understand that the simple things can often pose the greatest hurdles.

After Closing

The deal is done and the property is in your personal name, so what do you do?  If you haven’t done so already, create a land trust and a LLC in the state where the property is located.  Deed the property into the land trust, and then assign the beneficial interest to your LLC.  Do not leave your insurer out of the loop. It is imperative that you have your insurer list your trust and/or LLC as an additional insured under your policy.  From this point on all rents should be paid to your LLC and accounted for accordingly.

Preparing to Sell via a 1031 Exchange

When selling via a 1031 exchange many of the same rules apply but they work a bit differently. Next week I will discuss how to properly structure your exchange when using entities.

BawldGuy again: And now, dear readers, you understand why Clint contributes to this site. The promised topic next week is near and dear to my heart, as lenders often cause problems during tax deferred exchanges when ‘things’ aren’t the plain vanilla to which they’re accustomed.

Welcome back, Clint.

It’s fun watching conversations go from, “I think we can do this little bit” to, “We can do that? Really?! Sweet.”

I’ll be talkin’ soon about a youngish couple who’ve now been clients for a short few months. They’re textbook examples of what happens as real analysis weaves its way through the financial forrest of facts and fiction. When I say fiction, I mean in the sense that sometimes we find what we thought was this way, is actually the other way, plus a couple right turns. Add a little knowledge, a little expertise and experience, and before ya know it, KaBoom! Your Purposeful Plan is suddenly bursting with the promise of a magnificently abundant retirement.

As long time readers here know very well, I’m an addict to this stuff. Nothing beats sharing the fun epiphanies of first timers or those with just a bit of experience, as they begin gettin’ a glimpse of what’s truly possible. It’s amazing what happens when knowledge/expertise/experience meets desire/discipline/determination.

I wouldn’t trade those sudden moments of clarity for anything. They’re priceless, and the real pay for which I work. Gettin’ regular folk from where they are when we meet, to the retirement they’ve envisioned is more fun than I can convey. What I do is the furthest thing from work.

Try to imagine the thrill of tellin’ a 30-somethin’ mom that she has enough cash flow to become a stay-at-home mom with her two year old. Absolutely freakin’ best day of that year, no contest. I was walkin’ on air for a week.

If you’re 45 or younger, start the process of clearly understanding where you are now, financially. Sit down and apply truly serious thought to when you’d like to retire, and with how much income. DON’T prejudge what’s possible.

Over 45? Do the same thing — but double time it.

Once you’re done with that, gimme a call at 619 889-7100. Click Contact BawldGuy up top if you’d rather write me. Together we’ll figure out what it’ll take to get ya from today to the best retirement possible. Have a good one.

For those who’ve never seen a quick, down ‘n dirty explanation of a Purposeful Plan, this should help.

The Purpose of any such Plan is to get where you are today, to retirement. The idea is to make the trip safely, always aware that Murphy knows where we all live, and is a very vigilant pain in the butt. Two goals are what fuels most of us when retirement is the topic.
Retirement is appreciated sooner rather than later — and — a magnificently abundant income is held in high regard.

I’m gonna be going over the steps of Purposeful Planning this month. I’ll be weaving in a few ongoing case studies involving real people. We’ll be able to see how the process works, beginning with, “This is Jeff . . .” when the phone rings.

The first coupla steps are to figure out two things. One you know pretty much intrinsically. Are you a first time investor, some would say, novice? Do you own investment property already? Several? More than several? What’s your level of ‘investor know-how’? It’s important to not only know what you know, but also to know the questions for which you don’t have answers.

Most importantly, however, is to understand there are answers to questions out there, you don’t even know to ask. Those are the answers that can and often will make or break your retirement plan.

The second step is to figure out exactly where you are now, financially. Like any other trip, we can’t get from ‘A’ to ‘B’ if you don’t know precisely where ‘A’ actually is. Sounds simple, but not having a complete, in depth understanding of where you are now, will almost always end up causing problems down the road.

That’s it for today. Next time we’ll look at steps 3 and 4.

I’m thinkin’ your next step is to gimme a call. You’ll find me at 619 889-7100. If you prefer, click the Contact BawldGuy button up top, and jot me a note, long or short. Have a good one.

Then there are this space’s stellar contributors. It’s tax time. How many extra seconds do ya think Chuck Perkins has these days? I wouldn’t be him at tax time for a million extra bucks in depreciation. Then there’s Mr. Emerson. Chad’s been very busy gettin’ loans funded for BawldGuy clients. ‘Course, the investigation is ongoing, lookin’ into exactly who it was that granted him time for a family vacation, short or not. Who does he think he is, anyway? The gall is impressive, I’ll give him that much.

Then moi decided to visit Denver as an invited speaker. Seems there was a real estate investor Summit. In fact there was, and it rocked. You should seriously consider attending next year’s event. I’ll give ya plenty of lead time on these pages.

The thing is, posting has been thin lately, but it’s about to resume the pace and consistency you’ve come to expect. Thanks for your understanding, it’s much appreciated.

Wanna Purposeful Plan you can call your own? call me at 619 889-7100, and together we’ll make it happen. Prefer writing? Click the Contact BawldGuy button up top. Have a good one.

Same about expectations on investing for retirement.

Some years are really good while others pale in comparison. But, unlike skiing, if you don’t set it up correctly the bad years can really hurt you. Here is what generally happens in bad years. People question their strategies [which is good], and many simply give up and stop what they are doing. This is even more intense when people are invested in instruments that go negative dramatically.

A critical point when thinking about investing for retirement

Somewhere along the way people’s expectations were set that this couldn’t happen. This is, perhaps, the critical point when thinking about investing for retirement. Set your expectations realistically and use strategies that don’t trigger psychological pain in bad years. If you have well placed real estate, then you might suffer some downward movement in your received rent during a recession, might even have some issues with vacancy rates, but this should have been all cooked into the numbers. Same with EIULs.

You might have a couple of years of no-gains, but on the other side you will get good gains. Same with your rentals. As long as you have set your expectations correctly, you will be fine in the long run and not do something dumb. And you made good progress even during recessions, just like my son improved his skiing even during a short season! Sometimes because of your expectations you don’t realize how much progress you really made.

BawldGuy Here: This might be one of Dave’s most valuable posts so far this year. The ups and downs of the national and sometimes local economies come and go like the seasons. That’s exactly why real estate and EIULs are worth their weight in gold. Over the long run, for different reasons, they both yield the results expected by investors. The investment world, like anything else is relative. When compared to the multitude of options from which the investor has to choose, real estate and the EIUL have been kings of the mountain so long, few even know what vehicles are next best.