Per usual, Deborah has an EXCELLENT post on DOING INVESTMENTS RIGHT! The last one * DIVERSIFY * is fairly new and should be considered more. Many new investors buy units all together for ease of management when they would be better served to purchase in high-employment areas with good schools for long term investment.
Here is a list of things to consider and things to avoid, that may help your real estate investments be more profitable and your life less stressful:
Set Up a Trust
The main advantages of setting up a Trust are to avoid probate and keep your estate private. What is probate? Probate is a court supervised legal process that includes determining the validity of your will, gathering your assets, paying your debts (and taxes) and distributing the remaining assets to your heirs. Probate is part of the public record and probate fees are set by law (and are not cheap). Spending a bit of time now setting up a Trust will certainly pay dividends later.
Adding Family to Title
Don’t add your son/daughter/niece/nephew/etc. to the title of your property unless absolutely necessary. Adding someone to title may be as simple as filing a quit claim deed, but it may have unintended tax consequences. When you add a person to title, the IRS views that as a gift. If, for example, a daughter is added to title and is now a 50% owner of a $1MM property, she just received a $500K gift. When you gift any one person more than $13,000 during a single calendar year, you must file IRS Form 709 and either pay a gift tax or use part of your lifetime estate tax exclusion. When you pass away, the amount of your lifetime estate tax exclusion will be reduced by the gifts you reported on IRS Form 709's during your lifetime. Always talk to a tax advisor regarding these issues, but a better solution may be to simply set up a Trust and name the daughter as the beneficiary of the Trust. Once you pass away, the daughter will receive the property and an additional benefit will be that she will receive a 'stepped up basis' – more of which is discussed below.
Don’t Ever Sell
‘Buy and hold’ can be a good strategy for building wealth. Real estate investors who own property until they die will pass the property to their heirs at a “stepped up basis” (1). Under Section 1014(a) of the Internal Revenue Code, an heir’s basis in a property will equal the fair market value of the property at the time the descendant passes away. This can effectively eliminate all capital gains and depreciation recapture taxes. Remember, in the State of California, taxes are as follow: 9.55% state capital gains tax, 15% federal capital gains tax, 25% federal depreciation recapture tax.
Defer, Defer, Die
Conducting a 1031 Exchange allows for the deferral of capital gains taxes. An investor who cashes out, after doing a series of 1031 Exchanges, will pay taxes on all past transactions. For investors who have done many exchanges, cashing out may come with an enormous tax bill. Smart investors, however, take advantage of the step up in basis discussed earlier by using the defer, defer, die strategy. After conducting a series of 1031 Exchanges the investor goes into a 'buy and hold' mode until death. Having never cashed out of real estate, all capital gains taxes will be eliminated for the heirs.
Utilize Equity Lines Strategically
In many instances, accessing an equity line may be a smarter decision for raising cash than selling real estate. Cash from an equity line is non-taxable where as the sale of real estate may trigger capital gains taxes. Obviously the investor needs to be cautious of the extra debt burden on the property, but access to tax free cash via an equity line may be a very smart move.
Make Strategic Acquisitions
The next 1031 Exchange replacement property you acquire may have a pool, an ocean view and a large yard where the grand-kids can play. Those amenities may be nice for your tenants, but even better for you after you boot the tenants out and move in. Acquiring a future primary residence via a 1031 Exchange is not illegal, but needs to be done with caution. Making a strategic 1031 Exchange acquisition may be a nice way to purchase your dream home.
Make Strategic Moves
Moving into a rental property, converting it into a primary residence and then selling it will allow you to reap the benefits of the Homeowner’s exemption. If you are married, up to $500K of gain will be tax free. Time of residence and ownership rules will apply, but the strategy has been used effectively by our clients throughout the years.
Wall Street has been advocating the benefits of diversification for decades; a diversified portfolio allows you to reduce the volatility of your portfolio and either increase return for a given risk or decrease risk for a given return. With real estate you can diversify either by geography, by asset class or both. If you own all of your real estate on a fault line, it may be time to start thinking like Wall Street.
Enjoy Your Investments
Your investments should work for you. If, at some point, they become too burdensome, it may be time to rethink your strategy. This doesn’t necessarily mean cashing in all of your chips (and god-forbid paying taxes) but it may mean transitioning out of difficult to manage properties and into easier to manage ones.
Deborah A. Stone, Realtor Integrity-Solutions-Results-
Hogue and Belong Realty-Bankers Hill
San Diego, CA
"Representing clients with the experience of an investor"