The impact of interest rates on a $200,000 loan

The interest rates for investment property ranged from around 7.75% to 18% my first three decades in the business. Let’s use a few rates to see the difference in monthly payments. Let’s assume you’re workin’ with a Net Operating Income (NOI) of roughly $19,000 or so.

• 7% —  $1,331/mo  –  $15,972/yr  $3,028 annual cash flow
• 8% —  $1,468/mo —  $17,616/yr  $1,384  annual cash flow
• 9% —  $1,609/mo —  $19,308/yr  (Oops) Almost break even cash flow.
• 10% — $1,755/mo —  $21,060/yr  (Bigger oops) No can do cash flow.

What the above numbers demonstrate is where one line — rates/payments — intersect with the line representing the investor’s comfort zone. We know the work we did with our own boots on the ground is reliable, in other words, the NOI is a real world number. However, it doesn’t factor in the #1 fact of life for real estate investors:

Murphy’s still alive, and he knows where all of us live. Oh, you haven’t heard of his Law? It says, more or less — If anything can go wrong, it will — and at the worst possible time.

Ever heard of O’Toole’s Corollary? Murphy was an optimist.

With those happy thoughts in mind, I always make it a point to tell investors that their spreadsheets, including mine, are fine as far as they go. The line items have all been vetted within an inch of their lives. They’re reliable — ’til they’re not. So what do we do? Well, keep on puttin’ your boots on the ground to ensure the credibility of your bottom line. Nobody wins with a fictional NOI. Still, regardless of how hard you or I worked on a particular spreadsheet, the resulting cash flow should only be viewed as the ‘classroom’ number. When figuring annual cash flow, eschew all the hard work you spent in the field, and simply divide the Gross Scheduled Income (GSI) by 2.

In this example that’d reduce the NOI to, give or take, just under $16,000. NOW look at the interest rates above and ask yourself when you’d pass up the investment due to the cash flow — or dearth of same. Seems around 7% is the red line. Yet according to a well prepared, boots on the ground spreadsheet, 9% would be just about a break even on cash flow. That is, as long as Murphy never showed up.

BawldGuy Axiom: Murphy always shows up — it’s only a matter of when, never if. At some point it will be your turn in his barrel. Real estate investors ignore that very real fact of life at their peril.

Now let’s take a look at today’s investor rates.

Single family is at — 4.625%

A 2-4 unit property is at — 4.5%

Let’s really bring home the impact interest rates have on real estate income properties. We’ll take the NOI we’ve been using, about $19,000, and apply it to a duplex loan of around $200,000 as we did for the higher rates, earlier.

$200,000 at 4.5% = $1,014/mo — $12,168/yr debt service.  That’s a cash flow of just over $6,800. Don’t forget to factor in Murphy. Doing that results in a cash flow of a tad over $3,800. (Remember: The ‘Murphy Factor’ means you simply divide the GSI by 2 to get your NOI.

What do all these numbers mean to the real estate investor in today’s market?

It means that at today’s rate of 4.5%, the investor generates more cash flow using the Murphy Factor than those who paid 7% decades ago did without invoking Murphy.

And that’s what I’m talkin’ about when referring to the impact of interest rates. Today’s interest rates will literally be the star of stories you’ll be tellin’ your kids — and their kids. That’s how low they are.

Get off the fence. Time ain’t your friend. These rates won’t last forever. The stories you’ll tell 20 years from now will either be about the low rates you paid ‘back in the day’, or about all the shoulda coulda woulda happy endings you never experienced. Your choice.

Gimme a call at 619 889-7100, and together we’ll figure out what’s up with your retirement Planning. If you’d rather write me, click the Contact BawldGuy button up top. Have a great weekend.

So, what are these extensive benefits and why should one consider a self-directed ROTH 401K?

1)  The obvious is that by having a checkbook-controlled ROTH 401K, you will have the freedom and flexibility to invest in any asset class permitted under IRS regulations.  As long as you do not invest into a Disqualified Asset (Item #1), the IRS does not preclude you from investing in assets other than stocks, bonds and mutual funds.

2)  In your newly-established, self-directed ROTH 401K, you can make much larger contributions to the 401K that you can with any IRA.  Compared to your standard IRA plans (Traditional or ROTH IRAs), you can make elective employee deferral contributions of up to $17,000 (under the age of 50) or $22,500 (over the age of 50) on your first 100% of self-employment income.  Yes, in general terms, if you were under the age of 50 and wanted to contribute all $17,000 of your self-employment earnings into your 401K, you could do this.

Further, through profit-share arrangements, profit-share contributions (based on your percentage of profit/income) can take the total amount contributed to the self-directed ROTH 401K up to $50,000 (under the age of 50) or $55,500 (over the age of 50).  Oh, did we forget to say that your standard IRAs will allow you to contribute up to $5,000 (under the age of 50) or $6,000 (over the age of 50)!

3)  ROTH 401K contributions are NOT subject to the Modified Gross Income limitations imposed by the IRS.  Where you may not be able to fully contribute to an IRA based upon the MGI limitations, a 401K has no such limitations.  The contribution limits are placed based on earned income….so, where the MGI prohibits some from making full IRA contributions, that is not the case with a self-directed ROTH 401K.

4)  The ability to make BOTH Traditional (pre-tax) and ROTH contributions into one plan.  Now, the contributions have to be segregated into separate accounts (ROTH and Traditional) within the 401K, but his is a relatively easy process.  Plus, you would always want the funds segregated….even if not required…to protect the value and account of your ROTH funds.  The point, however, is that you can have both Traditional and ROTH funds in the 401K and use both funds for investment purposes.  You cannot do this with your father’s IRA.

Are there additional benefits associated with the ROTH 401K vs. an IRA….absolutely.  However, these four benefits sufficiently define why one might want to consider establishing a self-directed ROTH 401K account.  Remember, it’s not IF it is better, but rather do you qualify.

Non-stop learning

As I look back on this tax season I realize that I probably learned more during this season than any other. For me, that’s saying something because I’ve been at this for over 20 years.

Rules impacting the financial service industry are very much impacting the real estate world as well. Rules created to provide health insurance to all, also impose tax changes many of which are still in the process of being written.

It is not enough to watch and read the tax code. There are so many court cases and IRS private letter rulings that must be reviewed as well. Most states also impose an income tax and their rules vary widely and are also frequently changing.

To illustrate:

Imagine you live on a flat planet. The outer edges on all sides are less well defined. Segments are pulled and new segments appear. Some of these segments might quickly fall away while others slowly dissolve. Perhaps this is one of the most beautiful areas on the planet. The center of the world seems to change less and undergoes less radical change. Obvious the center of this world would be the safest place to live, but perhaps offer the least benefit.

The tax world is very much like this. While some areas of the law are very well defined there are other areas that are poorly defined. Even areas of the law that are well defined get muddied with special “facts and circumstances” issues.

There are many who might think they understand what a repair is. My guess though is that under the new rules you might be wrong. The new rules provide fewer bright line tests and will require more judgment.

A tax adviser can add some value by informing you of what is clearly within the law. They add more value though by shedding light on what is less clearly defined. It is not about trying to skirt the law, but about learning where you can safely operate.

The law allows many tax strategies: 1031 exchanges, cost segregation, installment sales, master lease arrangements, real estate in qualified retirement accounts and many others. Many of these strategies have tax pitfalls that go along with the advantages. Understanding where these pitfalls are is extremely important.

BawldGuy Here: That last sentence may be in the running for ‘Understatement of the Year’.

The first problem for real estate investors involves creating a California business entity. If you need asset protection or tax savings and are not willing to wait the obligatory 5 months for an employee in Fresno to file your entity then you should consider creating your business outside of California.  Currently, from the time you submit your business filing in California, it will appear as if it is a race between the Secretary of State to recognize it or the last judgment to arrive.  This is why it is beneficial to look at other States when deciding where to form your business.

The second and more disturbing issue for real estate investors is the Franchise Tax Board, also known as the FTB.  Most rational people could agree that if a LLC is formed in California to transact business, it should be subject to the FTB’s taxing authority.  (Whether or not a minimum tax of $800 a year, regardless of revenue, is reasonable is a matter of debate.)   However, as I have been reminded by my wife on multiple occasions during our marriage that I lack common sense, I believe even in this she must agree with me. The FTB’s position that any LLC, regardless of the State the entity is formed in, will be considered “doing business” in California if the LLC owner resides in California, is ultimately lacking in common sense.

Consider the situation of my clients Groucho and Harpo Marx.  The Marx’s brothers, California residents, created Starship Holdings, LLC, a Interstellar limited liability company taxed as a partnership, to own Girmaldi crater on the moon. (I think they negotiated the purchase through Governor Jerry “Moonbeam” Brown.) After the creation of Starship Holdings, LLC, Charlie contracted with Marvin Martian to administer a new colony built on this location.  Two years after the establishment of Starship Holdings, LLC, the FTB contacted Groucho and Harpo and requested they file California Form 568 for their Interstellar limited liability company.  According to this form, the FTB views Starship Holdings, LLC as conducting business in California via Groucho and Harpo’s ownership.  Thus, the FTB subjected the Interstellar limited liability company to the $800 annual franchise fee.

Groucho and Harpo were not pleased with the FTB’s position.  Neither could understand how a moon colony was connected to California.  Unfortunately, those in the FTB can make the case with a straight face (see FTB Instructions for Form 568). I wonder if it is the water or a different flavor of Jim Jones Kool-aid that expands a person thinking to reach illogical ends.

You may be asking, what is a person to do who needs a business set up immediately?  How about the real estate investor that does not have the funds or desire to pay the FTB $800 per LLC?  Again, you may need to look outside of California.

Establishing a New California Business
If you don’t have 5 months to wait to begin conducting business, consider establishing a Nevada entity (these can be filed within 24 hours), then registering it as a foreign entity in California.  Although this approach will be slightly more expensive, it will give you the asset protection and tax benefits you are seeking much sooner than starting the formation process in California. Even though you must wait 5 months for California to recognize your foreign filing, you can begin business immediately while you wait.

Disregarded LLCs
If you are a California resident setting up an out of state LLC, best practice dictates that it be a disregarded entity.  If you choose partnership taxation, it will result in a K-1 that will be reported on your California State return.  Groucho and Harpo discovered this to their detriment.  The filing of a partnership return is a direct invitation for the FTB camel into your tent.  If you know the saying, once he is in the tent, there is no getting him out. So pile up your Benjamins because you will be forced to pay $800 per year for your out of state LLC.  A disregarded LLC is ignored for tax purposes; thus nothing is attached to your individual return that will invite the camel out for a look.

Land Trusts - a California Real Estate Investors Best Friend
Typically, a land trust is used as a tool to avoid the “due on sale clause” issue surrounding the transfer of real estate.  If an investor purchases property in Oregon, his first step in protecting the property would be the creation of a land trust, followed by an Oregon LLC to hold the beneficial interest of the trust.  Typically, the land trust and LLC are established in the State where the real estate is located.  However, this is just standard practice but I am not aware of any legal requirement that requires the LLC be created in the State where the trust is created.  This is dimply done for ease of administration e.g., the avoidance of multiple bank accounts.  However, if you are not adverse to added complexity it can result in an $800 per year savings.  Here is how:

Step 1 – Establish a Nevada LLC
Rather than create the LLC in the State where the property is located i.e., California, the real estate investor holding property in California should consider creating a Nevada LLC treated as a disregarded entity for tax purposes. When creating the Nevada LLC, be sure to use a Nevada address for your entity.  We provide such a service through our sister company, Business Office Suite Services, “BOSS”.

Step 2 – Form a Land Trust
Set up a California land trust to hold title to your California real estate.  Deed the real estate into the trust then assign the beneficial trust interest to the Nevada LLC.  The land trust will need a bank account to receive rents and pay bills.  If the LLC collects the rent then it will be transacting business in California and subject to registration.

A land trust is not subject to the FTB fees, therefore by keeping the rental business contained in the trust and not involving the Nevada LLC in the management of the property, it will remain outside of the FTB’s cross hairs.

Working in and around California can be time consuming and expensive.  Thankfully with a little effort and proper planning, many of these hindrances can be minimized.

The rates have remained at the historic lows they hit last week. The ‘Perfect Storm’ for real estate investors, about which I’ve written many times, on these pages and elsewhere, is still at Force-5 strength. How long this window will remain open is anyone’s guess, as my crystal ball hasn’t emerged from the repair shop since the ’70s. The message there is to move it or lose it if you’re thinkin’ of employing real estate as part of your retirement income. This ain’t gonna last forever.

The Rates

If you’re purchasing a SFR your rate, with a 20% down payment, will be 4.75%.

Prefer 2-4 units? At 25% down, you’ll be able to benefit from a 4.625% interest rate.

Let’s talk, OK? Gimme a call at 619 889-7100, and together we’ll make it happen. If you like email better, go up top and click on the Contact BawldGuy button. Have a great weekend.

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.

In blog post titled:  “Can an IRA be Co-Jointly Owned (Remember the “I”)? (May 3, 2012), we spoke of Jim and Susie’s question about whether they could co-jointly own each other’s IRA accounts.  We spoke of both of their IRAs having values of $60,000 (Jim) and $40,000, respectively.  Jim and Susie inquired about establishing self-directed IRAs so they would have checkbook control of their retirement assets.  They learned about how both of their IRAs could fund (or purchase the assets of) one LLC that could hold their IRA assets.  Ownership of each IRA into the LLC would be directly proportional to the amount of funding into the LLC from each IRA.

Okay, that was THAT conversation….Jim and Susie were all set…or were they?! (the mystery deepens!!)

Jim mentioned in the conversation that he was self-employed while his wife was a W-2 employee.  With Jim’s  business, he had no employees other than himself.  And, to answer your next question…Susie was not employed by or with Jim’s business.

The debate

What occurred next was a spirited conversation on the merits of Jim establishing for his business a self-directed 401K plan.  It wasn’t a matter of qualifying for the plan….Jim did qualify.  But, why should he consider the 401K vs. the IRA?  Further, Jim’s primary interest was the ability to use both he and his wife’s funds from one IRA LLC account, where each IRA had proportional ownership interests.  Wasn’t talking about a 401K messing this whole thing up?  Needless to say, he was perplexed.

Jim’s eyes grew large (metaphorically speaking…I couldn’t tell as I was on a call with him), when he was informed that by having a 401K, he could see the following benefits:

1)  Both Jim and Susie being able to “rollover” their Traditional IRAs into one 401K plan of which they would both serve as co-trustees.

2)  To further benefit Jim and Susie, while they would have all $100,000 ($60,000 for Jim/$40,000 for Susie) in the 401K plan and available for investing purposes, both Jim and Susie’s respective funds would be segregated into 401K sub-accounts in each of their respective names.

3)  While they could also have an LLC established for their 401K, they had “checkbook control” of their 401K plan without the LLC….and, immediate access to their funds for investment purposes.  Also, since they ended up electing NOT to have an LLC, they would save the LLC set-up expense (where they would need the LLC for the IRA, in comparison), which in their case totaled $750.00.

4)  Finally, since they were not establishing IRAs (two total; one IRA for Jim and one IRA for Susie), they would save almost $250.00 per year in IRA custodian fees.  Jim was even amazed how PGI could possibly establish the 401K with no annual fees. Remember, the 401K does not require a custodian when there are appointed Trustees that the plan documents permit.

5)  As both Jim and Susie were co-trustees of the plan (by virtue of being married), Susie was permitted to rollover her funds into the 401K plan even though Susie was not an employee of Jim’s.

6)  Finally, in the case of death of either Trustee, the other Trustee can carry on the plan even after death.

Guess what?………Jim and Susie established the 401K!

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.

The Rates

As of today the rates for real estate investment properties — 1-4 units specifically — are as follows:

Single family units — 4.75% — assumes 20% down payment.

2-4 unit properties — 4.625% — assumes 25% down payment.

NOTE: The above mentioned down payments will rise 5% each once the investor/borrower has four (4) such loans in place. In other words, the single family loan would then require 25% down, and the 2-4 unit loan would require 30% down.

Meanwhile, back at BawldGuy Ranch, BawldOperators are waiting for your call. 619 889-7100 will find me. You many send me a note, no matter how long or short, by clicking Contact BawldGuy up top. Have a good one.

Gathering all of your information together in one place — Known more commonly as “Yer kiddin’ me, right?”

First off is your age(s).

This is crucial for many of the Captain Obvious reasons you’d suspect, but for some, other reasons as well. Under 40ish? The world is your oyster if you have at least starting capital, a reliable income, and reasonable financial discipline.

40-50? You can still kick major bootie in the arena of retirement income. You’ll just hafta get on your horse and hit the trail with serious intent. Regardless of those who’re constantly tellin’ us otherwise, real estate investing for retirement is definitely a contact sport. Never forget — one of the most important ingredients in every Purposeful Plan is FLEXIBILITY.

Over 50? That age group must pay rapt attention to three factors.

• You have access to investment capital

• You have the will to use it

• You realize that pesky birthday keeps showin’ up every dang year

If you’re already retired, but are deeply dissatisfied with your current income, you can probably count yourself among the younger age ranges. This is due to the real life fact that you are likely sportin’ a sizable amount of cash and/or equity in one form or another. It simply means you’ll be rearranging your net worth in order to better enjoy your many trips. That’s code for you hate your income now, and will move Heaven ‘n earth to double it if you could. If that hint wasn’t broad enough, that means you’re in bonds.

Under 30? At any one time this group represents around 10-15% of my clientele. Their potential for a magnificently abundant retirement is almost always virtually unlimited. Their weapons of choice are time and an almost always increasing income.

Next up — Make sure you completely understand what’s possible with your current 401k/IRA/Pension at work. For many this can prove pivotal. What can you borrow? CAN you borrow? Are they convertible to something else you’d prefer?

What about any annuities you may own? What are the terms — exactly? When do they kick in? Have they already kicked in? Is the income gonna be taxable or tax free? Is there a ‘cash value’ involved?

What do ya think of your current job?

This where the conversation can sometimes take a real turn into the Twilight Zone. They love it, but it doesn’t pay as much as another job they wouldn’t like as much. Or, it pays great, but I’m bored to tears, or worse, hate goin’ to work every morning. There’s a buncha different answers.

You should ask yourself the question if only to find out if you’d even consider making a change, if that change would enhance your actual retirement income, shorten the time ’til retirement, or both. It’s amazing what we’ll put up with when we’re focused and motivated. I’ve seen clients not only change jobs, but industries — then move to another state to boot. Ask yourself the question if only to check the box.

Are your retirement goals doable — are they realistic?

Here’s something I learned long ago that surprised me big time. About 30-40% of folks completely underestimate what’s possible. It’s understandable. After all, how is the average person supposed to know and understand all this stuff? Once you learn what’s possible, I’m bettin’ your approach will change too.

When I ask, “So, when would you like to retire?”, many quote me right back — “Oh, around 4:30 yesterday afternoon sounds about right.” If you’re 33 and can afford to start your plan modestly, retiring by 40 may be a tad ambitious. It’s all about playin’ the cards you’ve been dealt as wisely as possible.

Age can matter a lot, or not much at all. In the end though, age combined with beginning assets does matter when figuring the approximate distance to your personal finish line.

Then there’s ‘Whatever else pops up’

When you’re gathering information, it’s pertinent to include the fact that Uncle Henry will be gifting you $50,000 upon your 40th birthday. Or, that you and your three sibs plan on selling the house Aunt Frieda left you five years ago. There’s a million and one things that qualify as grist for ‘Whatever else pops up’. The point, is to include it if only to learn if it matters or not. You’d be surprised how many times my clients begin sentences with, “Oh, by the way, Jeff . . .” which have radically changed their entire Plan, or sent it happily careening in an entirely different direction.

BawldGuy Takeaway: I made Gathering Information a separate step for a good reason. More times than not a piece of that info can change an investor’s Purposeful Plan. It matters not whether it’s a huge change or not, cuz when you’re measuring time in terms of a decade or three, even small changes can result in wonderful results at retirement.

If you’d like to gather some info from me, it’s as simple as calling 619 889-7100. Rather jot me a note? Love to hear from you — just click the Contact BawldGuy button up top. Have a good one.