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The risk of investing in real estate in a down market. Is it real or imagined?
Many people sit on the sidelines when real estate is down, instead of buying up at the bottom. The main reason…Fear.
Real estate does have its risks, but then again, so do all businesses. Risk is relative, mostly relative to potential reward. For example, if you keep your investments in cash, money markets, and CDs, you are pretty much free from risk. You are also free from earning any money, since inflation will rise faster than your investments. Being safe in this case can actually mean a signicicantl risk of loss, more than if you buy something like a tax lien certificate or higher yielding bonds.
Real estate is in a different risk category than cash and CDs, simply because you can lose more than your investment – you can be liable on a loan, you could get sued by tenants, you could have negative cash flow. However, these risks can be managed to an acceptable level, and your return will be commensurately higher.
You could take it to the highest level of risk and reward and bet on the dog races, but for most people, this level of risk is not acceptable. So, most people end up in the middle, investing in real estate, the stock market, and other medium-risk investments.
The good news about real estate is that risk is directly correlated with education, that is, the more you know, the less risky it becomes. The more you understand the techniques, the market, and the financing, the less chance you have of losing money. Compare this to the stock market, where risk and education have very little correlation in that even the best fund managers have a difficult time consistently making profits in a turbulent market. True, real estate means more work and has a higher learning curve, the in the long run, the education will pay off.
In conclusion, real estate risk can be managed by learning the ropes and researching your market. Become a master of your field of real estate endeavors, and your rewards will become greater as you become more experienced.
This is my call-out to the Romney campaign on how to fix the housing market, and thus the economy. Neither candidate has mentioned how to get the housing market going, and since Obama has already tried and failed, this is my recommendation to Romney: Tell America how you are going to get the housing market going and you will win the election.
First, I don’t believe the Government can unilaterally turn around the housing problem because housing is about supply and demand. Supply and demand is different from city to city, so the old saying that “real estate is local” is still true for the most part. Local migration trends, local job markets, and local economies mostly drive local housing markets. However, there are things that the Federal government can do to set up an environment where supply flows more freely and demand is satisfied by making it easier for buyers to purchase. While, the government cannot fix the housing machine, it can add some lubrication to it.
Here’s my 10 point plan for Government Romney (please steal it and take all the credit).
- Stop all Government Bailouts. Demand comes from job growth. Bailouts cost money and incur more government borrowing and more government debt, both of which hurt business hiring and thus real estate demand.
- Expand Borrowing Programs for Investors. Investors did cause some of the bubble because of easy-qual loans, but investors can also bail out the bank owned inventory. The problem is that borrowing is too difficult. The government can ease restrictions for well qualified investors to borrow and buy investment properties. Bring back stated income loans for high FICO borrowers who put 25% or more down. Even with “liar” loans, a 25% down payment likely eliminate negative cash flow and thus borrower defaults on investor loans.
- Expand the FHA Program. FHA 203k program allows buyers to borrow most of the purchase price + repairs, but ONLY if you buy the property as your primary residence. This loan program is designed to move HUD inventory and help increase home ownership for lower income people. What about low income people who need to rent? The increasing demand for rentals has driven rents higher and vacancies lower. Because supply of low-income rental housing is short, many landlords are gouging low income tenants. Here’s a way to solve two problems at once: expand the 203k program to investors who can buy HUD homes at discounted prices with low down payments in exchange for a requirement that they rent to low-income people at a more reasonable rate. Rent control should not be forced on landlords, it should be volunteered by landlords with profit incentives.
- Capital Gains Rate Must Stay Low. President Obama has already said he would raise capital gains rates. This would discourage landlords who have owned properties for a long time from renovating and selling their properties. When properties are sold, contractors, brokers, title companies, and appraisers get paid. When landlords have a disincentive to sell, property sales will drop and everyone in the industry will suffer. Plus, investors who buy any commercial property will not be willing to risk their capital if they know their tax rate at the end will be higher. Romney has said he will keep the capital gains rate at 15% or lower. If the capital gains rate for real estate were cut to 10%, more people would buy real estate because the net profit is more commensurate to the risk. Also, there should be a lower short-term capital gains rate for people who flip real estate.
- Keep the Mortgage Interest Deduction. Both sides have discussed reducing or limiting this deduction for people who make more money. This is a mistake. It is not worth owning an expensive home vs. renting one if there’s no tax writeoff. This will hurt the high end of the real estate market. If Romney plans on lowering the income tax rates and eliminating deductions, this is one that must not be eliminated or it will backfire.
- Eliminate Gains on Short Sales. Many underwater homeowners are avoiding short sales because of the negative tax consequence of the short. Currently, the tax rules punish a homeowner by taxing as income the amount of forgiveness of the debt. For example, if a homeowner owes $200,000 and the bank shorts it to $150,000, the homeowner now has “earned” $50,000 in taxable income. While some this has been waived temporarily for owner-occupants in some cases, it should be make permanent for all real estate owners, including investors. Much of the banks’ shadow inventory can be cleared if investors and non-owner occupied homeowners would volunteer for a short sale and not get taxed on the forgiveness of debt.
- Allow Homeowners to Take a Capital Loss. If investors can take a loss on a house, why not a homeowner? Many people who lost in the last round are afraid to buy a house again for fear of losing money. If they would write off their losses like an investor, it would make them feel more confident to buy again.
- Change FNMA Rules for People with Short Sales or Foreclosures. Once a person has a short sale or foreclosure, then have to wait 4 or more years to buy another home because of the credit hit from the foreclosure or short. Allow these people to buy again within a year if they put 25% or more down and can prove “undue hardship” that caused the foreclosure or short sale (such as a loss of job, medical problems, or the zip code in which they lived dropped more than X% and they could not resell).
- Rent Out Existing Inventory. Banks have endless supply of shadow inventory of houses in default because people are upside down. Banks have not been willing to lose all their equity by taking drastic short sales. These banks should be allowed to offer homeowners to take a deed in lieu and rent bank to the homeowner with an option to re-purchase. This will get the income coming back in and avoid the cost of a foreclosure and resale of the house If the property comes back in value, the homeowner can buy the house back at a pre-determined price. Everybody wins.
- Loosen the Banking Rules. While loose rules led to some of the cause of the bubble, the pendulum has swung too far in the other direction. Regs like Dodd-Frank have made it almost impossible to banks to lend in a reasonable manner. Bernanke has tried to stimulate lending by buying mortgage with government money and it has not worked. Printing money is not the solution – lightening the regulatory burden on banks is what will stimulate them to lend more.
Whether you are getting started in real estate investing, or have reached a “plateau,” the following will help “jump-start” your real estate investing career.
Surround Yourself With Like-Minded People
“Creative” real estate is non-traditional, which means that most people don’t do it this way. Thus, most people you speak with will tell you it won’t work. If you tell them you heard it in a seminar or a course you bought from a late-night television “guru,” they will laugh and call you “gullible.” Attorneys and other professionals will denounce it, because it sounds unusual. Keep in mind that these people are either threatened by their own lack of success or are looking to protect their own butts.
The first thing you should do its join a local real estate association. A complete list can be found here. These associations will help you keep your thoughts in the right place and prove to your subconscious that it really does work, despite the opinions of the 20/20’s, Datelines, 60 Minutes and other self-proclaimed “consumer watchdogs.” If you cannot find a group, form a “mastermind” group that meets for breakfast once a week. If you don’t know what a mastermind group is, you should read “Think and Grow Rich” by Napoleon Hill. If you already read it, read it again, again and again.
Have a Team
Don’t wait until you have a deal brewing to find the players. You need to find the following players on your team:
Attorney - preferably one that does real estate deals for himself as well as others
Title or Escrow Co - stay away from the big name companies; find one that caters to investors. Make sure they understand double closings, land contracts etc.
Insurance Agent - find one that understands land contracts, landlords, etc.
CPA - find one that is aggressive and owns real estate.
Contractor - one that will give you free estimates and knows how to “cut corners” in the right places.
Mortgage Broker - one that is savvy, creative and experienced with investors.
Partner - in case you need it for money or experience.
Mentor - someone you can call to smooth out the rough spots.
Don’t Talk to Unmotivated Sellers
This is the biggest mistake I see beginning investors make. They waste time talking to sellers who are marginally motivated. Even worse, they drive by the house and look for comps without even talking to the seller first! Never visit a house before speaking with the seller over the phone. I love Ray Como’s Mastermind Script Book. It has hundreds of questions designed to extract the seller’s motivation over the phone. Heck, the course will save you enough gas money to pay for itself!
Anyone who has ever been in sales will tell you that few deals are ever made on the first try. In fact, most deals are made after contacting a prospect for the fourth or fifth time.
Let me give you an example. I contacted a person in May 1998 who had a junker house he was thinking of selling. I met with him once and made him an offer. He didn’t like it. Did I stop there? No way! I called him twice a month for the last year. I mailed him two more offers he rejected. We finally came to an accord and closed this month.
Have a follow up system like a salesman. I use Microsoft Outlook. I allows me to schedule follow ups and keep a running history of calls and conversations.
“If you think education is expensive, try ignorance.” I am not sure who first said it, but I give him credit. You can lose more money with a mistake than you can learning how to avoid one. Even if you have been at this business for years, you need to keep up with current trends and laws. As an attorney, I have to go to seminars every year. Some are boring, but I always learn something that either makes me more income or prevents a lawsuit.
Have a Plan
Don’t just wander around looking for deals. Have a plan. Make X number of phone calls a week. Spend $X a month on advertising. Make X number of offers per week. Pass out X number of business cards each day. Eventually, you start to get “lucky.” I mean that facetiously, because luck always happens to those who are at the right place at the right time. If you plan and persist, you get lucky.
Treat This as A Business
People are lured to real estate because of the quick buck that it promises. Don’t hold your breath, you won’t get rich quick. An “overnight sensation” usually takes about five years. I would guess that 90% of the people who take a seminar quit after three months. This is a business like any other. It takes months, even years to cultivate customers and have a life of its own. You need to treat it like any other business. Give it time, effort, attention and professionalism, and it will flourish before you know it.
The LLC taxed as S corporation – good idea or bad?
By default, a single-member LLC is a “disregarded” entity, that is, the entity is ignored by the IRS and the sole member is the taxpayer. Thus, an individual as a sole member running a business would be taxed on his personal return as a schedule C, sole proprietor. Many businesses run this way, which has no tax advantages and high risk of audit.
Most tax professionals would recommend running an operating business (especially with employees) as an S corporation.
But, what if you already formed an LLC? No worry, you can convert the LLC for federal income tax purposes to an S corporation. This involves several steps:
1. Get a federal tax ID# from the IRS.
2. File IRS form 8832 to choose an entity election as a corporation
3. File an S corporation election form (IRS form 2553)
4. Amend your operating agreement to allow for the new taxation rules (or, if you don’t have one at all, CREATE an operating agreement).
The LLC tax as S corporation may require the assistance of a tax advisor and/or attorney to complete, depending on how comfortable you are with the forms and documentation.
The next issue is whether the LLC taxed as S corporation must ACT like a corporation for tax purposes even though the state LLC laws may not require it? For example, do you need to issue stock certificates, have annual meetings and resolutions like a corporation. While the state may say “no”, the IRS auditor may say YES! So, even though you like the informality of an LLC, you still may need to issue certificates and keep annual minutes and document resolutions for all activity your LLC does that is out of the ordinary course of business (such as large purchases or leases, loans in and out, etc).
While still rather new, the LLC taxed as S corporation can be a feasible proposition for someone who formed a single member LLC and should have really created an S corporation.
Need to convert a single member LLC to an S Corporation? Visit www.bronchicklaw.com/legal-forms for the appropriate operating agreement.
The Series LLC, while not available in every state, can be used in other states if properly done. This article discusses the feasibility in particular of using a Delaware Series LLC in other states that don’t have a Series LLC statute.
The series LLC is a form of a limited liability company that provides liability protection across multiple “series”, each of which is theoretically protected from liabilities arising from the other series. It is similar to a parent/subsidiary structure, such as GM and it’s various brands. For a real estate investor with 3 properties, protecting the equity would require that each property would be owned by a separate LLC, all three LLCs being owned by a master LLC. In other words, each LLC is single member, with the sole member being the Master LLC. This would require forming four entities and filing annual reports and documentation for the four entities.
A series LLC is like any other LLC, except it can have many self-contained “cells” (series), each like its own subsdiary LLC. According to state law:
“The debts, liabilities, obligations and expenses incurred, contracted for or otherwise existing with respect to a particular series shall be enforceable against the assets of such series only, and not against the assets of the company generally or any other series thereof,” 6 Delaware Code Section 18-215.
Thus each series would insulate the liabilities of its assets from the other series and the master LLC. The structure would look as follows:
The series LLC was first offered in Delaware, and is also now available in about 9 other states (DE, IL, IA, NV, OK, TN, TX, UT, WI, KS) . A Delaware Series LLC in other states can be accomplished by registered in other states as a foreign entity, theoretically making it available in all states. I say theoretically because if, for example, a Delaware series was operating in New York, would New York courts look to Delaware law or its own law to resolve the liability issues. Some legal commentators believe so, and others are not ready to give the stamp of approval without some guidance from courts.
When LLCs first came on the horizon, many legal commentators were unsure as well, and now LLCs are universally accepted by the legal community. With 10 states now authorizing LLCs by statute, it appears that the many states will likely follow, and my guess is that courts will follow the law of Delaware for a Delaware Series LLC. Of course, each client should be advised of these risks.
Other Issues Remain
Holding Title. Can a series hold title in its name and will title insurance companies outside of the 10 states insure it? This is an unanswered question, which is why I recommend titling each real estate asset in a land trust with the beneficiary being a series. This will satisfy the title underwriters because trusts can hold title without major issues.
Insurance. Can a series be insured as a series?
Can a Series File Bankruptcy? This issue is unanswered.
Tax Returns. Does each series file a tax return? The IRS answered this question last year, saying that each series is a separate entity, depending on the structure of the particular series. In the example above, each series would be a disregarded (single member) entity. Thus all income from the different series would be reported on the main LLC’s return. Theoretically, each series can choose to be taxed differently, for example an S corporation.
Bank Accounts. Each series should have a separate bank account and set of accounting records, whether or not state law requires it (not all states do).
Forming a Series LLC
A series LLC is filed with one of the 10 states that authorize it by statute. The articles of organization must contain relevant references to the series LLC statute. The operating agreement of the Company will permit individual series, and then each series is created by paper. Thus, there is theoretically no filing of each series with the state. Particularly in non-series states, the company, at a minimum, must be registered with the secretary of state as a foreign entity, then a dba should be filed for each series. California and Tennessee have come to the odd conclusion that each is a separate company for franchise tax filing. Thus, the series may lose its luster in those states.
In conclusion, one should be cautious but optimistic that the series LLC will be the ultimate asset protection tool for real estate investors and those with multiple classes of assets they want to protect. Using a Delaware Series LLC in other states might be the solution in some cases to bridge the gap.
Visit www.legalwiz.com to form a Delaware Series LLC – best price on the Internet!
This articles discusses what a self directed IRA for real estate is, and how it is different than a regular IRA.
An IRA is an individual retirement account.
Each person can set up his or her own account, and can have more than one IRA account.
IRA accounts fall into several categories, including:
- Traditional – most common type of IRA account. The individual can contribute money each year and receive a tax deduction for the money contributed. The income earned in the account is tax-deferred, and subject to income tax when withdrawals are made after age 59.5.
- ROTH - The individual can contribute money each year and does NOT receive a tax deduction for the money contributed. All income earned is tax free, and withdrawals at retirement are tax-free.
- SEP – A Simplified Employee Pension is tied to a company are adopted by business owners for their employees. Contribution limits are MUCH larger than Traditional or ROTH IRAs, but since SEP accounts are treated as IRAs, funds can be invested the same way as any other IRA.
- SIMPLE – Similar to a 401k, it is an employer-sponsored plan which the company can match employee contributions.
- Education IRA – Also known as a COVERDELL ESA, it allows contributions to a plan which is eventually used for education.
ALL of these can be a self directed IRA for real estate investing.
So, what is a self directed IRA?
Technically, all IRAs are self directed, in that you can direct which investments your IRA account is placed into. Traditionally, IRAs are invested in securities, CDs, money market, etc. A self directed IRA is one in which you can direct your IRA funds into all assets permitted by law.
Is it Legal to Invest my IRA in Real Estate?
The IRS only excludes IRA investments in two assets – collectibles and insurance. That leaves pretty much everything else in play.
So, can I invest in real estate using my FIDELITY IRA?
In a word, “no”. Most of the larger financial institutions limit what you can direct your IRA investments into, namely securities, CDs, money market, etc. If you want to have a TRULY self directed IRA, you will need to roll your funds into a different IRA custodian who will allow non-traditional assets as a permitted investment. Such custodians are more “boutique” operations that are set up to handle real estate, precious metals, private placements, etc. within an IRA.
What is the cost of using a Self-Directed IRA Custodian?
The self directed IRA custodians charge more than the large financial institutions, in fact, a LOT more. Depending on what and how many assets you move to a self-directed custodian, the cost can be as much as $300-$600 per year! However, if you are earning double-digit returns in real estate with your IRA, you will quickly forget about the hefty fees and be grateful for the self directed custodian.
Can I Manage the Real Estate IRA Assets?
Managing rental property or real estate construction projects for your IRA account is definitely in the grey area of the law. You may get away with ministerial tasks, but you cannot take a management or construction fee on behalf of the assets, and you certainly cannot personally perform services or work on the assets.
Can I Borrow Money from my IRA to Buy Real Estate?
No, you cannot borrow from the IRA; the IRA account itself purchases the real estate in its own name, for example, “XYZ IRA CUSTODIAN, INC. FOR BENEFIT OF ACCOUNT #12534″.
Can I Spend the Income Earned from the Real Estate?
Not before age your legal retirement age, and at that point the income taken out would be considered a “distribution”, which could be taxable.
How Difficult is it to Run a Self Directed IRA?
Well, put it this way – there’s no instant, click-trading anymore. You have to fill out and fax a form to your custodian for each transaction, and it may takes days for them to execute the transaction. And, a real estate rental can have several “transactions” a month (receive rent, pay mortgage, pay repairs), and each transaction has a fee associated with it. This can get expensive, not to mention cumbersome and time-consuming.
What is a “Checkbook” IRA?
A checkbook IRA is a self-directed IRA setup so that you have checkbook control of your IRA funds rather than directing the custodian what to do with the funds in and out of the IRA account. You can read more about it by CLICKING HERE.
The “standard” real estate contract usually has a provision spelling out the legal remedy of the buyer or seller upon default of the agreement. In most cases, the buyer wants to limit his risk of loss by offering a small earnest money deposit and inserting a “liquidated damages” provision.
A liquidated damages provision states that if the buyer breaches the agreement by failing to close title, the seller’s sole legal remedy is to keep the buyer’s earnest money. Without a liquidated damages provision, the seller could sue the buyer for his actual, provable damages or force the buyer to purchase the property (called “specific performance”). The liquidated damages provision is thus an agreed-upon, estimated guess of the actual damages the seller would sustain if the buyer breached the agreement by failing to close.
Many court battles have been fought over the validity or enforceability of liquidated damages clauses, since they often result in unfair consequences to the buyer. For example, if the buyer placed 10% or more of the purchase price in escrow with the seller or his agent, the seller would get a windfall if the buyer did not close. The seller could resell the property for full price, even more, and still legally keep the buyer’s earnest money. The buyer’s legal argument in challenging the clause is that it result in a civil penalty which is against public policy.
In determining whether a liquidated damages clause is unenforceable as a penalty, the courts generally look at whether the amount settled upon is a “genuine pre-estimate of damages” in the case of breach. C. McCormick, Damages, §149. In most cases, the issue in litigation is whether the amount is too large and thus penalizes the buyer. However, McCormick further states that if the stipulated amount is unreasonably small in relation to the actual damages sustained, the Court will disregard it and permit the injured party to recover actual damages.
The Federal Bankruptcy Court in In Re Ilana Realty, Inc., 154 B.R. 21 (S.D.N.Y. 1993) applied this rationale in awarding damages to the plaintiff upon breach of a real estate contract. InIlana Realty, the purchasers wrongfully refused to close and then sued for return of their earnest money deposit held in escrow. The earnest money was only 5% of the purchase price. The Court used its equitable powers to award damages beyond the amount of the liquidated damages. The Court did so because it found that the amount stipulated was disproportionately lower than damages actually sustained by the sellers. The Court further reasoned that the buyer’s breach and failure to release the earnest money upon breach resulted in further consequential damages to the sellers.
This case brings up another point: what if the buyer is in breach of contract, yet refuses to let the escrow agent release the earnest money to the seller? Courts have sometimes ruled that the liquidated damages provision may not apply and the seller could sue for further damages. The rationale is that the release of the earnest money is a condition of the limitation of liability afforded to the buyer under the liquidated damages clause
This exact issue was presented in Fuels Research Company v. Roberts, 458 P.2d 751 (1969). In Fuels Research, the defendant agreed to purchase a business from the plaintiff, which involved holding certain papers in escrow (stock certificates, formulae, trademarks, etc.). The defendant defaulted on the payment of purchase money after making total payments of $1,000 and refused to return the escrow items to the plaintiff. Plaintiff then sued for breach of contract, and the trial Court awarded the Plaintiff a judgment for $15,000. On appeal, the defendant argued that the liquidated damages clause limited plaintiffs’ recovery to the purchase money paid, that is, $1,000. The Court rejected this argument:
“[W]e consider the return of the escrowed items as a condition subsequent to the effectiveness of the liquidated damages provision . . . The condition subsequent not having occurred, the provision limiting plaintiff’s recovery to liquidated damages is not operative.”
The liquidated damages clause is for the benefit of the buyer, to limit their liability in the case of breach. If the buyer has breached a real estate contract by failing to close and have refused to forfeit the escrow money, the seller is not bound by the liquidated damages clause.
There is little case law on this subject, so the result of a court trial would be unpredictable. The moral of the story? If you fail to close on a contract, don’t play games. Do the right thing and release the earnest money from escrow to the seller.