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Real Estate Articles and Resources

Real Estate Investors: 2 Passive Loss Rules Can Save You $25,000

The biggest tax challenge for real estate investors are the passive loss rules. Under these rules, passive losses can only be used to offset passive income. A business activity is passive if the owner does not spend much time (typically less than 500 hours per year) participating in the business.

The challenge for real estate investors is that losses from rental real estate are generally considered passive regardless of how much time the owner spends working on the real estate. There are two exceptions to this rule.

The Active Participation Exception

The first, which is very easy to achieve, is referred to as the “active participation” exception. Any owner who spends some significant time on his/her real estate investments during the year qualifies, at least where the owner directly owns the real estate (that is, not as a limited partner in a partnership). This could include reviewing reports from the property manager, researching properties to buy, or handling the financing of real estate purchases. The IRS has been pretty generous in allowing this exception. The active participation exception allows up to $25,000 worth of losses during the year from rental real estate to be treated as ordinary deductions not subject to the passive loss restrictions.

This exception only applies, however, when the owner’s “adjusted gross income” (AGI) is not more than $100,000. If your AGI exceeds $100,000, then the $25,000 limit is phased out by 50 cents for every $1 the AGI exceeds $100,000. So, for example, if your AGI is $110,000, then the limit for that year will be $20,000 (or $25,000 minus $.50 x $10,000).

The Real Estate Professional Exception

The second exception to the rental real estate passive loss rule is the real estate professional exception. The real estate professional exception is the “get out of jail free card” for real estate investors. If you meet this exception, then none of your rental real estate income and loss are subject to the passive loss rules.

This is a much tougher exception to get than that for active participation, because you actually have to meet two criteria:

  1. You spend more than 750 hours per year (which comes to about 14 ½ hours per week) as a “material participant” in a real estate business, which could include management, brokerage, construction, development, leasing, rental, and operation; and
  2. You must spend more time in real estate businesses than all other businesses (including employment) that you’re involved in, combined. If you meet both of these criteria, then you qualify as a real estate professional.

For more information please see my book Loopholes of Real Estate.

About the Author

Garrett SuttonGarrett Sutton, Esq., author of Start Your own Corporation, Run Your Own Corporation, Loopholes of Real Estate, The ABC’s of Getting Out of Debt, Writing Winning Business Plans and Buying and Selling a Business in the Rich Dad Advisors series, is an attorney with over twenty-five years experience in assisting individuals and businesses to determine their appropriate corporate structure, limit their liability, protect their assets and advance their financial, personal and credit success goals.

Why You Should Transfer Titles Using a Grant (or Warranty) Deed – Not a Quit Claim Deed

By Garrett Sutton, Esq.

There are a few reasons a quit claim deed is not preferred to transfer title to your property. One big reason is because the quit claim deed severs an express or implied warranty of title. (This means you are just granting whatever you may own which may be something, or nothing.) As such, the title insurance doesn’t follow. While this may not seem like a big deal, let’s consider an example.

Why You Should Not use a Quit (not “Quick”) Claim Deed

You buy a property in your name. Part of your closing costs includes a policy of title insurance. Several years later you want to transfer title to an LLC for asset protection. Your friend says a quit claim deed (which they mispronounce as a ‘quick’ claim deed) is the easiest and quickest way to go. You file the quit claim deed and now the property is titled in the name of your LLC. Later, you learn that the boundaries weren’t properly surveyed. You seek recourse from the title company since they insured the boundaries were correct. But you now learn that by quit claiming the property into your LLC you have unwittingly cancelled your title insurance policy. The boundary issue is no longer insured.

Why Grant (Warranty) Deeds are Better

The way to avoid this problem is to use a grant deed or a warranty deed. A title insurance policy isn’t extinguished in such a transfer. As well, a grant deed is just as easy to prepare as is a quit claim deed. But in either case, remember that easy isn’t always best. If you are not an expert at title transfers, I would have an asset protection lawyer, or a title company handle them.

The Four Ways To Protect The Biggest Asset You May Own: Your Home

By Garrett Sutton, Esq.

There is one asset most people forget to get complete asset protection for. It’s an asset that for the average population, is the biggest asset they will ever own. What is it? Their home.

It’s an asset worth anywhere from around $100k to a million dollars. Sometimes more! And most people never even think about all the ways they can protect it. Some you know, but I bet #3 & #4 may surprise you!

1. Homeowner’s Insurance

The most common way everyone knows about is through insurance. Everyone has homeowner’s insurance, right? But let’s consider this method.  It is ironic that you can never ensure that insurance will insure you.  There are loophole exceptions buried deep in the four-point, magnifying glass required type that let insurance companies off the hook.

So while insurance is the first line of defense for any real estate holding–be it your home or an investment property–because it is never bulletproof we need to develop other secondary lines of defense.

2. Homestead Exemptions

For your primary residence another line of defense is the homestead exemption. Texas, Kansas, Oklahoma and Florida offer unlimited homestead protection. Massachusetts offers $500,000 in home equity protection, whereas Kentucky only offers $5,000. Each state has different rules and dollar limits.

The remaining two defense lines may surprise you. The first is debt.

3. Debt

Many people assume that debt does not provide asset protection because debt is money owed to someone else. This is true. But while you owe the money, remember that protected assets are in the eye of the attacker.

As an example, suppose you live in Nevada and own a $750,000 house with a $250,000 mortgage on it secured by a first deed of trust.  You have $500,000 in equity and have just put a homestead on your house, which in Nevada offers $550,000 in homeowner protection.

How does an attacker see your situation?  They don’t care that you owe the bank $250,000 on your mortgage.  All they care is that the bank has a secure and superior claim to the first $250,000, which means they can’t get at it.  Looking at the remaining $500,000 it is now protected by your Nevada homestead exemption. This means you as the homeowner have first dibs on that money. As such, with the first deed of trust and the homestead in place the attacker cannot get at any equity in the property.  It is already spoken for to your benefit.

In this case, and in many like it, mortgage debt is to your advantage because it discourages and prevents an attacker from coming after you.  What about the situation where your primary residence has a great deal of unprotected equity above the mortgage and the homestead exemption? Say your mortgage is $50,000, your homestead exemption is $10,000 and the remaining equity on the mansion is $1.2 million? How do you protect so much equity?

4. Limited Liability Companies (LLCs)

The last line of defense is the single-member limited liability company.  As you may know, a limited liability company (or LLC) is an excellent way to hold real estate. You can elect favorable flow-through taxation and, especially with LLCs formed in Nevada and Wyoming, achieve outstanding asset protection.

For more information on how to make one or more of these strategies work best for you, please call our office today, and create an asset protection plan that is right for you.

Seven Steps for Successful Asset Protection When Buying Real Estate

You have made your decision to invest in real estate. You know what property you want to buy. Your offer has been accepted. Now what do you need to do to make sure your property is protected from the start? Here is a checklist of the seven steps for asset protection when you are buying real estate.

1. Getting in Escrow.

If your entity is already formed, you will list the entity name as the buyer on your offer to purchase the property. If it isn’t yet formed, list your name and the right to assign the contract to an assignee (your new LLC or LP). So the offer would be from “your name and/or assigns.”

2. Form your Entity.

If you are going to be in escrow for a period of time (30 to 45 days) in order to get your due diligence inspections done you will have time in most states to get your entity formed. Also know that Nevada has an expedite service whereby LLCs and LPs can be formed in a matter of hours. Remember, your entity must be in existence at the time of transfer.

3. Financing Issues.

Some lenders do not want you to take title in the name of your LLC. Some will offer very technical arguments for why they don’t allow it, others will tell you they straight out they think you are trying to hide assets. The way around this is to take title in your individual name and then transfer the title from you into the new LLC. More and more lenders are okay with this solution. The banks I work with are. Know that in such a transfer the lender’s position hasn’t changed. They still have your personal guarantee and a first deed of trust against the property. There is still a ‘continuity of obligation,’ – a technical term you can use with them. But I personally wouldn’t ask the lender if such a transfer is okay. If you have you heard the old saying, “It is better to ask for forgiveness than permission,” it applies here. Pay the mortgage from an LLC checking account. Virtually all lenders are not going to call a performing note. Have a title company or attorney prepare a grant or warranty deed and transfer to your LLC.

4. Transfer Taxes.

If you immediately transfer from your name to the LLC beware of transfer taxes. Many states make an exception and don’t charge a fee when you are transferring from yourself (your individual name) to yourself (your new LLC). Others, like Nevada, don’t charge when the property goes from you to the LLC, but do charge, as in a refinancing scenario, when you transfer from the LLC back to yourself. The key state to be careful in is Pennsylvania. They charge a 2% transfer tax no matter what. So say you have a $1 million property with $900,000 in financing on it and you want to transfer into your LLC. A 2% tax on a $1 million property is $20,000. Ouch!

5. Insurance.

As I have often said, insurance is the first line of defense. When you insure the property make sure the insured is the LLC. (There have been cases where the title has been transferred from an individual to an LLC, the insurance company wasn’t notified and, using their contract loopholes, claims were denied because they didn’t insure the LLC.) If the insurance company says an LLC is a business and higher fees apply (which is nonsense – since they are insuring the same property) ask them to list the LLC as an additional insured. So the policy is in your name and the LLC is also listed as an additional insured. Send a C.Y.A. letter to your insurance agent notifying them that the LLC is on title to the property.

6. Banking.

You will open up a bank account in the name of the LLC. You will take a copy of your state filed articles of organization into the bank along with your EIN (tax id) number. If you are a single member disregarded entity (and work with your CPA on this) you will use your Social Security Number instead of the EIN. If you are a foreign national investing in the U.S. the procedures are a bit different and too far afield for this section. Consider calling our office for an explanation. (Please know that it is not a problem and can be done.) The bank may ask for a copy of your operating agreement. Have it with you in case they do. Your checking account will list the name of the LLC (including the designation LLC) right on the check. You want the world to know you are doing business as “XYZ, LLC” and not as an individual. Have your tenants make out their rent checks to “XYZ, LLC.”

7. Succeed.

Do all your business in the name of the LLC. Contracts, vendor work and the like are all done not for you personally but for the LLC itself. Always pay the annual LLC filing fees and prepare an annual tax return for the LLC. You want ongoing protection and to get that you have to follow all the rules. For more information on following the formalities see Run Your Own Corporation. Consider segregating properties into separate LLCs. We don’t want to create a target rich LLC. When you sell the property it is sold by the LLC, which receives the money and then distributes it to you. Enjoy the process and succeed with protection.

What if property values go down on my investment rental property?

Keep in mind that in cash flow investing, your rent determines your income. If the property value goes down slightly but you are still able to charge the same amount of rent, you will see no change in your cash flow.

However, if your property depreciates so much that you are forced to charge less rent, you would see a decrease in income from the property. You would have a negative cash flow – but only for the period of time that the rents were down. However, as we have learned in recent years, rents may go down for a significant period of time. Can you withstand a prolonged downturn?

Although the geographic location should not be the sole basis for your decision, some geographic areas are predictably influenced by the economic conditions there. These are characteristics that you can capitalize on if you are aware of them.

For example, geography and the economy make a difference in certain areas of the northeastern United States. In some cities, you can purchase a duplex or two-family home for as low as $30,000. Property values are not increasing, and income levels are dropping. Many people are even moving away. However, properties still rent for $500 to $800 per unit. By plugging these numbers into the calculation chart, it is easy to see that buying property in this area can bring in decent returns.

Another entirely different example is shown by the property values throughout California. At one time certain areas were increasing by 20 percent or more per year, showing great appreciation potential. However, the rents could not keep up with this growth, so it was not easy to bring in positive cash flow on such properties. Recouping negative cash flows with annual appreciation gains worked until the merry go round stopped. Many investors were caught, and not only in California. Make sure you analyze your area’s economic patterns when investing in rental properties and research area rents.

The Two Goals for Real Estate Investing

By Garrett Sutton, Esq.

There are two goals for real estate investing. One is for the value of your property to appreciate over time so you’ll be able to sell it for more than you bought it. Those are the two crucial points in time for your property: When you buy it, and when you sell it. This is capital gains investing.

The other goal is for your property to generate a positive income for you each and every month. You want the revenue from rental income to exceed the operating costs and mortgage payment. This is cash-flow investing.  Having your money generate passive income for you — monies that come to you whether you are at work or on vacation — is a Rich Dad investment principle. An income-generating property is like an employee working for you. This passive income from a property would end if you sell that property. You may enjoy a capital gain from the sale, but you no longer have that money actively working for you to earn you even more money. To replace it, you may need to reinvest that money into another investment that yields positive cash flow.

A person who is solely a capital-gain investor looks at the optimal time to buy a property (i.e., when its market price is relatively low) and the optimal time to sell (when it appears the market value has peaked or risks plummeting). A cash-flow investor looks at the income history and potential of a property, and usually considers selling only when indicators (such as a decrease in an area’s population) point to a drop in cash flow; or when money from capital gains can be parlayed into a more lucrative income-generating investment, such as a larger property; or when the property has fully depreciated over time and this tax advantage can no longer be enjoyed.

Rich Dad’s philosophy is that once you have your dollar in your asset column, you want to keep it working for you, generating even more dollars that, in turn, will work for you, too. And so on. You may not want to do what most small investors do, which is park your money and hope that it will increase in value (appreciation) over time.

When it comes to real estate, you want to enjoy its appreciation and its generation of income. You want capital gain and cash flow.

Being a Real Estate Professional Can Save You Taxes

Recently I was asked for more information about what a Real Estate Professional is, and why investors should consider it. As this has many tax implications, I’ve asked fellow Rich Dad Advisor, Tom Wheelwright, for his thoughts on this important strategy, which is not to be confused with a Real Estate Agent. Here is what Tom has to say:

The biggest tax challenge for real estate investors are the passive loss rules. Under these rules, passive losses can only be used to offset passive income. A business activity is passive if the owner does not spend much time (typically less than 500 hours per year) participating in the business. The challenge for real estate investors is that losses from rental real estate are generally considered passive regardless of how much time the owner spends working on the real estate. There are two exceptions to this rule.

The first, which is very easy to achieve, is referred to as the “active participation” exception. Any owner who spends some significant time on his/her real estate investments during the year qualifies, at least where the owner directly owns the real estate (that is, not as a limited partner in a partnership). This could include reviewing reports from the property manager, researching properties to buy, or handling the financing of real estate purchases. The IRS has been pretty generous in allowing this exception. The active participation exception allows up to $25,000 worth of losses during the year from rental real estate to be treated as ordinary deductions not subject to the passive loss restrictions. This exception only applies, however, when the owner’s “adjusted gross income” (AGI) is not more than $100,000. If your AGI exceeds $100,000, then the $25,000 limit is phased out by 50 cents for every $1 the AGI exceeds $100,000. So, for example, if your AGI is $110,000, then the limit for that year will be $20,000 (or $25,000 minus $.50 x $10,000).

The second exception to the rental real estate passive loss rule is the real estate professional exception. The real estate professional exception is the “get out of jail free card” for real estate investors. If you meet this exception, then none of your rental real estate income and loss is subject to the passive loss rules. This is a much tougher exception to get than that for active participation, because you actually have to meet two criteria: 1) You spend more than 750 hours per year (which comes to about 14 ½ hours per week) as a “material participant” in a real estate business, which could include management, brokerage, construction, development, leasing, rental, and operation; and 2) You must spend more time in real estate businesses than all other businesses (including employment) that you’re involved in, combined. If you meet both of these criteria, then you qualify as a real estate professional.

The good news is that for a married couple, only one of the spouses has to qualify. But one trap here is that you still have to meet the passive activity rules for each property as if it were a regular trade or business. In other words, the real estate professional status only gets you out of the rental real estate trap. You still have to meet the 500-hour criteria for each property.

This could be a problem, since most people don’t spend 500 hours on a single property. The tax law provides a simple way around this. On your tax return, you may elect to treat all of your properties as a single property. This is called a Section 469(c)(7) election. The election is made on your personal income tax return. Doing so is permanent (and there can be some unintended consequences of electing to do this), so be sure to meet with your tax advisor before you make this decision.

How to Save $500,000 When Selling a Home

By Garrett Sutton, Esq.

One of the greatest tax gifts is the principal residence rule for capital gains on the sale of your home.  So great is the principal residence tax exclusion that even married couples filing jointly are benefited to the same, if not greater, extent as single taxpayers.

Now, some people may argue that there have been, are and will be greater gifts, but not much beats the simplicity of the rule. The basics of it are immediately easy to grasp: you own a house, you live in it for at least two years out of five, you sell it and you don’t have to pay any taxes on the first $500,000 in gain.  Gone are the days when the young homeowner (not wishing to sell and upgrade) had to save every receipt for every upgrade, every repair, and every minor item bought at the hardware store.  If you have lived in your own home for two years you probably don’t have to worry.

The Basics of the Rule: you own a house, you live in it for at least two years out of five, you sell it and you don’t have to pay any taxes on the first $500,000 in gain.

Of course, there are some technical points associated with the general rule.  They are pretty simple so first let’s bullet-point the main ones:

  • If you are single your capital gains exclusion is limited to $250,000.00.
  • If you are married your capital gains exclusion is limited to $500,000.00.
  • You have to own the home and it has to be your “primary residence” for two of the previous five years.

What is a Primary Residence?

What is your “primary residence?”  Basically, it is a home that you personally live in the majority of the year.  If you have a house in Palm Beach and one in Lake Tahoe and you spend 8 months of the year at the Tahoe home then that is your primary residence.  But, keep in mind the two year out of five year part of the rule.  Let’s say that the next year you spend 7 months at the Palm Beach house.  Then the Palm Beach home is your primary that year.  Do you see where this is headed? You can primary more than one home at once over a five year period so long as each is your main home for at least two years during that five year period.  Temporary absences are also counted as periods of use – even if you rent the property during those absences.

Be sure to work with your accountant in this area. Rules and regulations do change and you want to go into it with the most up to date understandings. For more information on capital gains issues, please read my book Loopholes of Real Estate.