Secrets of the Rich
In the past four editions, we have covered the Seven Proven Steps that the rich use to make and grow their money. In the first edition, we covered the overview of the system and debuted the seven steps:
- Create a Business.
- Discover Your Hidden Business Deductions.
- Pay Your Taxes.
- What's Left Goes Into Real Estate.
- Real Estate Income Comes Out Tax-Free.
- Buy a House the Right Way.
- Make Your House Give You Money.
Last month we discussed innovative ways to leverage your taxes. The first three steps all dealt with your business. With Step Four, we move into investments. And, since we're looking at tax-advantaged wealth-building tips, we're going to talk about real estate.
Why Real Estate?
There are two main benefits to real estate. These are:
- Ability to Leverage
- Tax Advantages of Real Estate
Real estate investing allows for leverage. In other words, you can use the bank's money to buy property with little (and maybe even no!) down. Contrast this to the stock market. You can, if you are sophisticated enough, leverage to buy stocks with options or margin borrowing. But, if the value goes down you can immediately lose everything or have a "cash call." If the value goes down for your real estate investment, you haven't lost money unless you sell.
Our website, www.taxloopholes.com, has a calculator called the Real Estate Wealth Builder. This free resource allows you to see how leverage can make you millions!
The easiest way to look at how leverage works is to demonstrate buying a $100,000 house versus buying $100,000 in stock. You should only need $10,000 to buy the $100,000 house. But, you'd need $100,000 to buy the stock.
Then, let's assume that both stocks and real estate appreciate by 5%. Your house is now worth $105,000 and your stock are now worth $105,000. But, how much did you put down on the house? The $10,000 investment (for the down payment) has shown a return of $5,000. That's a 50% cash on cash return on your investment. Yet, the $5,000 increase for the stock investment required you to put up the entire $100,000. That's a 5% return on your investment. That's the value of leverage.
The second benefit of real estate investing is the tax benefit. There are a number of benefits available from real estate tax laws. The biggest advantage of these are all of the innovative ways that you can get money out of your real estate without paying tax. Some examples of that are (1) refinancing (2) passive cash flow without taxation and (3) ability to sell and "roll" into another property with no current tax due. We'll cover these strategies in more detail in Step Five.
Determine Your Plan
Before you buy, first consider what your goals are with real estate. The easy answer "To make money" isn't enough. There are really three types of investments plans that the long-term investor needs:
- A plan to be safe
- A plan to be comfortable
- A plan to be rich
The plan to be safe is your fallback position. For many people, this means having an emergency fund. At the very least, you should have one month's of income in a very liquid account. Many financial planners advocate six month's worth of income. Personally, my husband and I keep three months of all expenses (including all mortgages on our properties) in our money market account.
Once you have your plan to be safe handled, move on to the plan to be comfortable. This plan covers the things you need for your "living" needs. The simpler you live, the less you need to cover in this plan. My husband and I for example, love to fix up properties. We are making plans right now to buy a fixer-upper this winter in Phoenix. We'll move into the house while we fix it. And, we'll then be able to sell it with tax-free gain exclusion. I'll share those strategies in Step Six and Seven. Not everyone is willing to leave a beautiful home to move into a fixer-upper. But, we have a lower need for the "comfort" and that equates to more flexibility for our plan to be comfortable and rich.
Now on to the plan to be rich! I see people trying to skip the first two plans and jump right to the plan to be rich. That's dangerous. The problem is that you will then lack the basic foundation. You might get stuck making decisions based on short-term circumstances because you have no cushion. This ends up hurting your long-term investment strategies.
Now let's cover the problem with leverage. Just as leverage can make your wealth increase faster, it can also turn against you. Leverage is dangerous. That's how people get in trouble with debt.
I strongly suggest that you increase your liquid funds as your leverage increases. I remember meeting a client for the first time in the late 1990's and talking to her about the benefits of real estate investing for her tax plan. She was adamantly against investing because of her bad experience in the late 1980's. She explained that prior to that time she had 10 properties that were providing cash flow. But then values dropped and she lost everything. I asked her more questions, trying to understand why she had sold the properties. You see, she had renters in place and was making great cash flow. Yet, when she saw property values dropping, she panicked and sold. She felt real estate was risky. She failed to see that the loss didn't occur until she sold the properties.
Too Much Money Is a Problem
The other problem I'm seeing with investment strategies occurs when someone has a lot of money. Instead of buying properties based on their own merits, they attempt to use money to turn a bad investment into a good one. They do that buy paying a tremendous amount down in order to try to create a positive cash flow. They might succeed in getting a positive cash flow, but the return is low!
Need for Education
Real estate investing is different than stock investing. You will need to learn a whole new vocabulary, learn how to assess and shop for financing and learn how to protect the property. We have two books available for learning more about real estate – Real Estate Loopholes and Easy Accounting for Real Estate Investors. These books are both available through my website – www.taxloopholes.com.
Diane Kennedy is a CPA/Tax Strategist and the author of the best-selling book Loopholes of the Rich: How the Rich Legally Make More Money and Pay Less Tax and co-author of the best-selling book
Real Estate Loopholes: Secrets of Successful Real Estate Investing. For more information on how to legally use the tax loopholes and make the IRS your partner, contact Diane's CPA firm, DKA, at 888-592-4769 or www.dkacpa.com. Tax law is constantly changing! Keep up to date for free by signing up for a free e-newsletter at www.taxloopholes.com