“The major fortunes in America have been made in land.”
John D. Rockefeller
Real estate investment is traditionally cited as one of the primary means that Americans have used to build wealth; a trend that continues to this day. Whether it is the stability and comfort attained by the middle class or the luxuries enjoyed by the wealthy, with due diligence and hard work, real estate investment can help most Americans achieve their financial goals. This post is part one of a series designed to provide useful and relevant information to both seasoned and green investors alike.
Types of Investments
The first step when diving into the market is determining what type of investment is most appropriate under the circumstances. While purchasing a personal residence is the most ubiquitous type of real estate investment, there are many opportunities to invest home ownership including: (i) holding rental properties, both commercial and residential; (ii) buying, renovating and selling properties; (iii) subdividing and developing raw land; or (iv) depositing money into real estate investment trusts. There is no single avenue best suited for all investors, so it is important to gauge your options relative to your goals.
An ordinary purchase and sale requires only two parties, a buyer with cash and a seller with property. Pragmatically, however, there can be a dozen or more parties to any transaction, which may include, but are not limited to: realtors/brokers, lenders, mortgage brokers, legal counsel, title companies and examiners, surveyors, environmental consultants, qualified intermediaries, accountants, tax professionals, etc. Each party to a real estate deal is responsible for one or more roles in the process, but they must all work together seamlessly to complete the transaction in an efficient manner.
The biggest roadblock to jumping into the real estate market is knowing where to begin. The good news is that there is no correct answer per se. For example, the first-time homeowner might find it beneficial to meet with one or more lenders prior to searching for a home in order to determine: (i) what is in the buyer’s price range; (ii) what kind of programs might be available as a first-time homeowner; and (iii) to have the sense of certainty that comes with a mortgage pre-approval. On the other hand, the experienced investor may want to start by meeting with his or her financial and legal advisors to better understand how a new purchase might affect the investor’s bottom line. Thereafter, for both the seasoned and the green investor, the process is relatively similar: (i) find a property and get it under contract; (ii) perform any remaining due diligence, which includes getting a title examination; and (iii) close on the purchase and sale.
For those seeking to invest in property other than a personal residence, it is important to decide whether the use of a limited liability company (LLC)—or another vehicle with a liability shield—is appropriate or desirable under the circumstances. The main reason for purchasing through an LLC is to ensure that personal assets are protected from any claims associated with investment property. This protection is invaluable in the event someone brings a lawsuit against the investor, but it is valueless if the investor fails to follow certain formalities when creating and maintaining the LLC. An investor should always speak with an attorney when establishing an LLC or if there are any concerns regarding the ongoing formalities.
Realizing a Return; Tax Consequences
The term “investment” is defined as the action or process of investing money for profit or material result, which begs the question, how does an investor obtain a profit or a material result? There are two primary ways to turn a profit with real estate investment: rental cash flow and appreciated value. Rental cash flow is exactly what is sounds like, cash paid to the investor/landlord by tenants of a rental property. Appreciated value refers to the increased value due to the passage of time. Additional means of turning a profit include: (i) the increase in resale value after improving the investment property (e.g., updating appliances, replacing a roof, etc.) and (ii) ancillary income from things such as vending or laundry machines, or parking facilities. Additionally, as with any type of investment, it is essential to understand how taxation will impact the ability to realize a profit.
The savvy investor looks for ways to increase his or her profit margin on a regular basis. Two of the more prevalent means of doing this include: (i) engaging in 1031 or like-kind exchanges and (ii) purchasing via drop and swap transactions. The 1031 exchange allows an investor to defer paying capital gains taxes following the sale of an investment property so long as the proceeds therefrom are reinvested in “like-kind property” within a certain period of time. The drop and swap transaction, which can be performed alongside a 1031 exchange, allows the investor to shield the purchase price from publication, which would inhibit an automatic increase to the tax basis if the purchase price exceeds the auditor’s value of the property.
This introduction to real estate investment is just that, an introduction. Stay tuned for an in-depth analysis of each section and, as always, be sure to contact a lawyer or tax professional when seeking legal or tax advice.