Practical Real Estate Techniques
| | Friday, June 16, 2006 @ 09:39 AM EDT
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They say that "death and taxes" are the only two certainties in this life. When it comes to achieving financial independence, death and taxes are essentially the same thing. Just as friction wears the tread off your tires, tax friction rubs the shine right off your financial statement.
Over time, the friction of taxation will do to your financial future what the Colorado River has done to the Grand Canyon.
In order to build wealth, you must maximize your tax deductions, thus minimizing your recognized taxable income.
Many property Sellers mistakenly think they need to pull all of the equity out of the sale of their real estate. Uncle Sam doesn't seem to
think that's such a good idea, especially if you are an investor. That’s why he slaps our hands so hard by taxing us on our gains and rewards us handsomely with tax savings when we structure our transactions creatively.
The U.S. Tax Code provides several strong incentives for doing just that, and the effects can be extremely powerful in building wealth. Two of these incentives make it exceptionally profitable for you to "both a lender, and a borrower be!"
Section 453 of the United States Tax Code (Installment Sales) allows investors to avoid the bulk of their taxes due on capital gains. Utilizing the Seller Financing technique, we can defer these taxes by paying them in very small increments over a long period of time. There are several other benefits as well.
When offering Seller Financing it improves the marketability of our properties. If structured correctly it also creates an opportunity to maximize sale values. Although the value added appears more pronounced in a slow market, the tax benefits make Seller Financing extremely attractive regardless of economic conditions.
Seller Financing or a carryback note also provides us with a well-secured, high-yielding, near-cash asset that offers us a broad foundation and a great deal of flexibility in building our investment portfolio. Such notes strengthen our financial statements, while earning much better returns than saving accounts.
Interest payments can kill our efforts to achieve financial independence. There is an exception, besides the tax break, that lending our equity brings to the table. Uncle Sam throws investors another meaty bone as well: Tax Code Section 163, allows us to write off interest on debt used to finance the purchase of our investment assets!
Financing a high percentage of the purchase price provides a large interest deduction in the early years of ownership. This deduction generates a tax shelter, which shields any positive cash flow. It also shelters the non-cash equity buildup occurring through principal reduction on the loan. At times it may even shelter some of our other income from taxation as well.
Investment debt allows us to control more properties, so we can build our wealth portfolios more rapidly. At the same time the mortgage interest deduction reduces taxation. This allows more of our dollars to remain where they belong -- working for us to further speed up our accumulation of assets.
By loaning our equity in the form of Seller Financing, and borrowing more heavily on new acquisitions, we can maximize our yields through increased profits and reduced taxation. For the investor looking to pyramid real estate assets -- the use of these practical financing techniques is often the best way to go.
Here's a perfect example -- Say a client or an acquaintance owns a $75,000 rental home with $35,000 in equity. He wants to sell this rental in order to purchase a $120,000 duplex, which has $30,000 in equity. At first glance, a Section 1031 tax deferred exchange might seem like a good way to go. That could be an excellent strategy. But what about this…
Say, your client has a solid Buyer who only has $8,000 cash to cover the down payment for your client's property. The duplex Seller wants to cash out from the sale of his property. What do you do then? Here is a practical technique that will satisfy everybody and pump up our client's investment portfolio to boot.
Your client sells his rental home and carries back a Seller Financed second note of $28,000 for 25 years, at 11.5% interest with an eight year balloon payment due (charging the Buyer a $1,000 premium to offset your client's closing costs). Your client nets $7,000 after closing. But with only $7,000 net cash from the sale of the rental, he is still $23,000 short for closing on the duplex. If your client sells his note to a note investor or gives the note to the duplex Seller as part of the down payment, it will trigger a taxable event for your client.
Your client offers the duplex Seller $7,000 cash down and a new second mortgage for $23,000, which he will sell to an Investor for $20,500 at the close of escrow (a "simultaneous closing"). This new mortgage is amortized over 135 months at 10% with a balloon due in eight years. To make the note more attractive and reduce the discount, your client pledges his own $28,000 note (from the sale of his rental property) as additional collateral for the new $23,000 note he gave to the duplex Seller.
This strategy mitigates your client’s capital gains taxes, so his dollars go to work acquiring more investment assets. The financing structure also gives him a higher mortgage interest deduction and increases his tax shelter as a result of a new and higher depreciation basis. Meanwhile, the 11.5% mortgage payments he receives from his Buyer are covering the payments on the 10% second mortgage he gave to the duplex Seller.
At the end of the day, your client received all of the same benefits he would have realized from an exchange. The difference with this more practical approach -- your client was also able to loan out $5,000 of his equity and gain an additional $11,042 over eight years. This is a 14.66% annualized return on his $5,000, by the way.
Using a few practical techniques and the services of a good note broker, you accomplished your client's investment goals and made him an extra $11,042 in the process! We aren't surprised when he refers two of his friends to us.
By Richard Lawrence
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