IRS Provides Guidance on Using Tenancy-in-Common Interests in 1031 Exchanges
by Ronald L. Raitz, CCIM
On March 19, the Internal Revenue Service released Revenue Procedure 2002-22, which addresses the use of real property fractional ownership interests as replacement property in Internal Revenue Code Section 1031 tax-deferred exchanges. Commercial real estate professionals commonly refer to these fractional ownership opportunities as tenancy-in-common interests.
The potential advantages of using fractional ownership interests to complete a 1031 exchange are significant for both investors and their advisers. Tenancy-in-common interests offer increased opportunities to identify a replacement property within 45 days, the option to buy into institutional-grade product for less money, and the potential to diversify into multiple properties with fewer dollars.
Like-Kind Exchange Primer Under Section 1031, property owners may defer gain recognition on a sale by exchanging for like-kind property; however, they must meet numerous requirements to complete a successful exchange.
In order to achieve 100 percent tax deferral, the cost of the replacement property must be equal to or greater than the net sales price of the property being sold, and all the proceeds must be used. Further, the seller must identify a suitable replacement property within 45 days of the relinquished property sale. Finally, the seller must take title to the property he ultimately buys in the same manner in which he gives title to the property he sells.
In the past, tax professionals and other investment advisers were wary of recommending fractional interests as replacement properties because the IRS often considered the investor’s interest in the new property to be a partnership, thereby invalidating the exchange. Along with partnerships, Section 1031 prohibits owners from exchanging out of real estate and into a corporation or limited liability company.
This concern often prevented investors from buying shares of larger and potentially more attractive properties. In response to the need for high-quality replacement property in a range of prices, a niche group of companies began offering tenancy-in-common interests to complete 1031 exchanges. To meet the title requirements, investors receive a deed for a portion of the property, rather than a share of a partnership. To encourage referrals, many tenancy-in-common program sponsors offer referral fees ranging from 1 percent to 6 percent of the equity value placed in the product.
Fundamentals of the New Guidelines Rev. Proc. 2002-22 provides guidance on the use of fractional interests as replacement properties in 1031 exchanges. Although the IRS did not provide the ultimate safe harbor blessing for these investments, it outlined 15 minimum standards tenancy-in-common interests must meet to be considered as potential replacement property. A few of the key criteria are:
the number of tenants-in-common cannot exceed 35;
the sponsor of the interests may own the property (or an interest therein) for only six months before 100 percent of the interests are sold;
any decision that has material or economic impact on the property or its owners must be approved unanimously by the owners; and
the management agreement must be renewable annually and must provide for market rate compensation.
For the complete listing of requirements, visit the IRS Web site at http://www.irs.gov/. Investors should seek private-letter rulings on specific offerings for more concrete assurance that their fractional interest meets the specified qualifications.
Some investment advisers have found that recommending properly structured tenancy-in-common programs can result in a win-win situation for all parties. For example, one of your clients owns a small apartment building that requires an inordinate amount of time to manage. As he nears retirement, your client receives a $750,000 offer on the building and wants to exchange into an institutional-grade investment. With the amount he will be able to invest from the sale, your client doesn’t think he can afford a high-quality investment offering a strong yield and greater appreciation potential. However, in this scenario, your client should consider a tenancy-in-common program that complies with the recent IRS ruling. With his sale proceeds, your client feasibly could exchange into a 15 percent interest in a class A office building worth $5 million.
The new guidelines also open the door for investors who want to structure fractional interests in a desirable replacement property on their own. For instance, Jennifer Reed owns a high-quality rental property in suburban Atlanta worth $500,000. She notices a small strip shopping center for sale in the area and, after some due diligence, discovers the center can be purchased for $1.5 million. Though individually she cannot afford the center, she has two friends who would like to invest a portion of their portfolio in real estate. The three decide to purchase the property together. When Jennifer sells the rental property, she exchanges all of the debt and equity from the sale for a one-third interest in the shopping center as a tenant-in-common. The other two investors provide the balance of the funds necessary to close the deal.
Proceed With Caution As tenancy-in-common programs are in their infancy, commercial real estate professionals should review them carefully before advising clients to consider them as viable replacement property options. Because all programs are not created equal and may have been structured prior to the release of Rev. Proc. 2002-22, careful due diligence is essential. As more sponsors modify their programs to seek and receive private-letter rulings certifying compliance, less due diligence will be necessary.
Whether for groups sponsoring fractional interests or creative investors looking to pool resources into a larger property, the new IRS guidelines are good news for the commercial real estate industry. For investment advisers, this guidance provides exciting new options for clients who don’t want to forego the benefits of a Section 1031 tax-deferred exchange.
Consult a tax professional for further information on individual cases.
There are various forms of property ownership. Tenants in common (or tenancy in common) is one of these. While the term “tenants” might imply renting, tenants in common are the owners of the property. There is no maximum number of persons who can be tenants in common, and the tenants do not have to hold equal shares. For example, one tenant in common can own 75 percent of the property and the other tenant can own 25 percent. Such an arrangement frequently reflects the portion of the purchase cost the respective tenants paid.
Features of tenancy in common
Typically the tenants sign a tenancy in common agreement that sets out the percentage of ownership for each party and other relevant matters. This is significant, because each tenant is able to sell his or her shares separately. Also, unlike joint tenancy, tenancy in common does not involve the right of survivorship. This means that in tenancy in common, each tenant’s interest does not pass to the other tenants upon death. Each tenant can bequest his or her interest by will and if there is no will, the interest passes by applicable law.
No matter what the ownership percentage of the tenants, all tenants in common have the right to possess and to have access to the property. Even if just one tenant resides in the property, he cannot exclude other tenants from entering it. The tenants are each responsible for the mortgage, taxes, maintenance and other necessary expenses. But these costs are apportioned based on the percentage of ownership.
Advantages of tenancy in common
Tenancies in common can be created relatively easily through a simple written agreement. Similarly, the tenancy can be terminated readily in one of several manners. The tenancy can be dissolved by the tenants agreeing to sell their shares to one of the tenants. All of the tenants might sell their interests to someone who is not already a tenant. Each tenant is free to sell his or her interest to someone outside the tenancy. That purchaser would then join the tenancy in common. The individual percentage of the tenant’s contribution to the purchase price can be reflected in the ownership interest.
Tenancy in common disadvantages
Because each tenant’s interest can be passed on to the heirs, the remaining tenants may be forced to continue ownership with an undesired party. An heir might want to sell the property when the other tenants do not. A tenant’s sale of his or her interest to an outside party might also result in an unwelcome tenant in common. If the tenants cannot agree upon to whom to sell the property, there could be problems. In all of these situations, the tenants would need to turn to the courts in a partition action. A partition action involves asking the court to sell the property and to divide the proceeds among the tenants. It might result in one of the tenants buying the shares of the other tenants. In some cases, such as vacant land, it might be possible to divide the property, giving each tenant his or her own piece. In any case, partition actions are frequently lengthy, unpleasant and expensive.
Final notes on tenancy in common
Tenancy in common is one way of owning property that protects each purchaser’s interest. Each tenant holds an individual, separate share of the real estate as a whole. But there are legal ramifications of ownership by tenancy in common that might not be desirable in every situation. When considering tenancy in common as the form of ownership, purchasers should consider all the implications and obtain advice from knowledgeable professionals.
Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized.
Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets.
Like-Kind Property
Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. However, livestock of different sexes are not like-kind properties. Also, personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind properties.
Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.
Note: This page contains one or more references to the Internal Revenue Code (IRC), Treasury Regulations, court cases, or other official tax guidance. References to these legal authorities are included for the convenience of those who would like to read the technical reference material. To access the applicable IRC sections, Treasury Regulations, or other official tax guidance, visit the Tax Code, Regulations, and Official Guidance page. To access any Tax Court case opinions issued after September 24, 1995, visit the Opinions Search page of the United States Tax Court.
<:figure>A 1031 exchange helps defer gains taxes on the sale of a property.
For real estate speculators and families who live in areas with an expensive real estate market, capital gains can pose a significant tax burden, particularly if real estate was held for a long time or through a volatile time in the market. Although it’s impossible to completely avoid capital gains assessments, a 1031 like-kind exchange allows property owners to sell one property and purchase another with the proceeds, and, if handled correctly, shields investors from immediate gains taxes.
The Internal Revenue Service allows investors to liquidate one property and exchange it for one of a similar kind — all domestic real estate qualifies as like-kind — and postpone gains taxes from the original sale. To qualify for a 1031 exchange, taxpayers may not take possession of the money generated by the sale of the property. To do this, investors must simultaneously sell the old property and purchase the new one, or route their funds to a qualified intermediary so they don’t take possession of the money, even if it’s reinvested in the new property. Any personal acquisition of the funds, even if it’s momentary, incurs gains taxes.
Maintaining Equity
A 1031 exchange is only valid if the property owner’s equity in the new property is equal to or greater than that of the old property. Because of this, investors may not cash in equity on their old property during the exchange, though they can invest more into the new property.
Qualified Intermediaries
If property owners don’t simultaneously sell and purchase the properties involved in the 1031 exchange, a qualified intermediary — a real estate broker — must serve as a go-between for the sale and purchase of the properties. Money gained through the sale of the original property is placed into an exchange account managed by the intermediary, so taxpayers never come in direct contact with the funds.
Time Frame
Property owners must identify one to three potential properties to purchase within 45 days of the original sale if a qualifying intermediary holds the funds. The exchange must be completed, with a new property purchased, within 180 days of the sale of the original property or by the date the taxpayer’s taxes must be filed.
Reverse Exchanges
In the case that a taxpayer purchases a replacement property before the original one is sold, a reverse exchange may be engineered. Amendments to 1031 rules were introduced in 2000 to allow a safe harbor for reverse exchanges in this situation.
Tax Basis and Gains
A successfully executed 1031 exchange allows a taxpayer to avoid paying gains on the sale of the original property, but those gains are only deferred to a later date. When a property purchased as part of a 1031 exchange is sold, its tax basis is calculated as the gains between the original property and the final one’s sale price. For example, an investor purchases a property for $100,000, and sells it as part of a 1031 exchange for $150,000, and purchases another property for $200,000. When that property is sold for $220,000, the investor’s tax basis is the difference between the purchase price of the original property and the sale of the second one. This investor faces gains taxes on $120,000 ($220,000 – $100,000) in this situation.
Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including “TV Guide” and “The Dallas Observer.” Schnotz holds a Bachelor of Arts in journalism from Colorado State University.
If you want to invest in short sales, then you need to learn about them first.
Want to invest in a short sale property? You need to learn what to expect before you get involved. Read the following article to learn all about the short sale process and what to expect.
Many potential investors are curious in regards to the short sale process when contemplating real estate investment. Concentrating on short sales and foreclosures is an excellent way to be a champion investor, but the procedure can be baffling to the unpracticed. The most desirable way to manage the beginning bumps is to find a knowledgable guide who can anticipate what to expect and what to do in order to endure the things that can hamper a smooth deal.
The short sale process itself has several phases. Once someone has made the decision to seek deals in short sales, the initial step must be finding a home that is risking the possibility of being foreclosed on. There are several optionss to find a home that is experiencing pre-foreclosure and might be a great candidate for a short sale deal. Searching for an experienced short sale expert that can drive an investor through the many ways out there is a fantastic plan. While it often takes some time for a financial institution to start foreclosure actions, it can begin the paperwork as soon as the day after the second missed payment on the loan. Pre-foreclosure officially starts when the lender files a public default notice.
Once a home is discovered that is in a decent situation for a short sale, it is important to converse with the homeowner and begin the documentation imperative for a short sale package. There are several varying papers that a bank or other financial institution will want to look over in order to think about a short sale, and it is critical that they be organized properly. Some of the documents need to be signed and submitted immediately, and others won’t be submitted until the full package with an official offer is ready to go.
The short sale process will take many weeks to finish. As soon as the real estate investor has authorization from the homeowner to negotiate on his or her behalf (and the paperwork stating so in writing), the bank will take some time to consider the case. Before any offers are made, the bank will want to to determine what the home is valued at in comparison to the amount of money owed through the original mortgage that has now been defaulted on. The banks use a BPO (or Brokers Price Opinion) to determine this value, and this is a critical step in crafting an offer on the home that will be acceptable to the lender as well as most beneficial to the investor.
As soon as the BPO has been determined, it is time to collect and submit the whole short sale package. While it’s helpful for a homeowners to be at least peripherally involved during the short sale process, this is the step in which their works are most needed. Part of getting a bank or other financial institution to accept a short sale offer is presenting evidence that the homeowner is beyond the power to pay the loan. They must to write a letter of hardship explaining the situations that have put them in the unpleasant financial position they are in now, as well as attach financial documents which show the contrast between their income and expenses.
After submitting the short sale package, the short sale process changes to offers and counter-offers between the bank and investor. Once a deal is decided in regards to the price, the investor moves on to a different phase of real estate investment: what to do with the home.
About the Author
Mark Sumpter is the short sale expert that can show you how to use risk-free techniques to turn a part-time business into a cash gushing part-time business. Visit http://www.getshortsaletraining.com to get a FREE report and FREE videos to find out how!
Compared to flipping properties, landlording is a long-term commitment with demanding requirements of your time. Before you take the steps toward the job of landlord, examine your capabilities and desires, and make sure that you’re up to it. If you are, it can be a wonderful and profitable experience. <More>
Wall Street Journal | WEALTH MANAGEMENT JOURNAL | October 29, 2012
A Real-Estate Primer
Direct ownership offers income, but REITs might be better for some By GREGORY ZUCKERMAN
Q: What’s the best way to invest in real estate today? “Hard” real-estate investments or “soft” shares and ETFs?
A: As housing finally rebounds, investors are searching for the best ways to take advantage. Tim Courtney, chief investment officer at Exencial Wealth Advisors, says an investment portfolio of more than $10 million could benefit by including both “hard” real estate, meaning direct ownership—either full or partial—of commercial, residential or other properties, as well as “soft” real estate, such as shares of real-estate investment trusts or other securities. <More>
Buying real estate is about more than just finding a place to call home. Investing in real estate has become increasingly popular over the last fifty years and has become a common investment vehicle. Although the real estate market has plenty of opportunities for making big gains, buying and owning real estate is a lot more complicated than investing in stocks and bonds. In this article, we’ll go beyond buying a home and introduce you to real estate as an investment. <More>
If you want to invest in short sales, then you need to learn about them first.
Want to invest in a short sale property? You need to learn what to expect before you get involved. Read the following article to learn all about the short sale process and what to expect.
Many potential investors are curious in regards to the short sale process when contemplating real estate investment. Concentrating on short sales and foreclosures is an excellent way to be a champion investor, but the procedure can be baffling to the unpracticed. The most desirable way to manage the beginning bumps is to find a knowledgable guide who can anticipate what to expect and what to do in order to endure the things that can hamper a smooth deal. <More>
After five years of sitting on the sidelines, Augie Byllott is ready to throw his hat in the ring and make some offers on short-sale properties. He’d bought several before the housing bubble burst. “But when the market changes, I stopped”, said Byllott, a managing member of Homeowner Resource, A Champions Gate, Fla., real estate investment firm that buys mostly foreclosed properties. <More>
Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031. If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized. <More>
There are various forms of property ownership. Tenants in common (or tenancy in common) is one of these. While the term “tenants” might imply renting, tenants in common are the owners of the property. There is no maximum number of persons who can be tenants in common, and the tenants do not have to hold equal shares. For example, one tenant in common can own 75 percent of the property and the other tenant can own 25 percent. Such an arrangement frequently reflects the portion of the purchase cost the respective tenants paid. <More>
IRS Provides Guidance on Using Tenancy-in-Common Interests in 1031 Exchanges
IRS Provides Guidance on Using Tenancy-in-Common Interests in 1031 Exchanges
by Ronald L. Raitz, CCIM
On March 19, the Internal Revenue Service released Revenue Procedure 2002-22, which addresses the use of real property fractional ownership interests as replacement property in Internal Revenue Code Section 1031 tax-deferred exchanges. Commercial real estate professionals commonly refer to these fractional ownership opportunities as tenancy-in-common interests. <More>
Compared to flipping properties, landlording is a long-term commitment with demanding requirements of your time. Before you take the steps toward the job of landlord, examine your capabilities and desires, and make sure that you’re up to it. If you are, it can be a wonderful and profitable experience.
All those number-crunching skills that serve you well in selecting, buying and selling real estate properties for investment are valuable. However, as soon as you take on the roll of landlord, people skills are also quite important.
Maintain your life’s balance, and plan your management activities to maintain profitability of your rental properties without letting your investments manage you. This is particularly important when making a decision to move up to multiple properties when one has been a positive experience.
One of the most important tasks confronting the real estate investor-landlord is the selection of tenants. Shortcut this process and it can cost you more than money down the road. Learn the simple steps to intelligent tenant selection.
Some might think that deciding on the rental amount for a property is only a matter of matching the market rates. That’s an important factor, but there is room for manipulation of the rent price based on other factors. Learn how changing the rent amount at the beginning can influence tenant choices and long-term occupancy.
A rental property is a home or office also. Using the property on a day-to-day basis will cause wear and tear, and repairs will become necessary. Plan and budget for these problems, and learn how to handle repairs to keep your tenants happy. How you treat the property speaks to their treatment of it.
In recent years, there’s been a great deal of media coverage of property and health problems related to mold. A few large damage awards, as well as many insurance companies dropping mold coverage, have caused a great deal of concern among real estate professionals and landlords. Learn how to react to and handle a mold call from your tenants.The Author: Chris Smith is a real estate investor, founder of an online reference for investors and real estate professionals and has published articles in Corporate Finance Magazine, Euromoney, and the Business Journal Network. More about Chris Smith.
Wall Street Journal | WEALTH MANAGEMENT JOURNAL | October 29, 2012
A Real-Estate Primer
Direct ownership offers income, but REITs might be better for some By GREGORY ZUCKERMAN
Q: What’s the best way to invest in real estate today? “Hard” real-estate investments or “soft” shares and ETFs?
A: As housing finally rebounds, investors are searching for the best ways to take advantage. Tim Courtney, chief investment officer at Exencial Wealth Advisors, says an investment portfolio of more than $10 million could benefit by including both “hard” real estate, meaning direct ownership—either full or partial—of commercial, residential or other properties, as well as “soft” real estate, such as shares of real-estate investment trusts or other securities.
Those with smaller portfolios who want to invest in real estate generally should stick with real-estate investment trusts, or REITs, exchange-traded funds, shares of real-estate-focused companies and other investments that provide more liquidity than direct property ownership, experts say.
Properly researching and monitoring hard real-estate investments generally requires a significant commitment of time, making shares more attractive for most individual investors. It also can take longer to see gains from hard real-estate investments, though these investments do have the potential to provide sizable, steady income, says Deann Morgan, a managing director with Bank of AmericaBAC -4.43%Merrill Lynch. Matthew Tuttle, president of Tuttle Wealth Management LLC in Stamford, Conn., adds that while investment properties can be attractive investments, they can be hard to value.
For those going the soft route, Mr. Courtney notes that U.S. REITs have done well this year, and says they are no longer bargains. He says international REITs are more attractive, some offering dividends of about 5%.
“It’s best to own an index fund that provides exposure to a large basket” of REITs, Mr. Courtney says, to avoid the volatility of individual shares. He’s a fan of REITs funds offered by Dimensional Fund Advisors and Vanguard Group Inc.
For some investors, though, hard investments remain more attractive. “The returns on REITs and similar investment vehicles, after management expenses, aren’t substantial enough to deter our clients” from investing directly in real-estate properties, says James Carolan, a partner and head of the U.S. real-estate practice at the international law firm Withers Bergman.
Jeff Leventhal, managing director and partner at financial-services firm HighTower in Bethesda, Md., is focusing on parts of the market that held up during the downturn, such as self-storage facilities, college housing and medical office facilities. Those sectors should hold up again if the economy slips into another recession, he says.
Mr. Leventhal also is targeting distressed residential markets, “but given most of our clients own their home, we prefer to look outside this space, for enhanced diversification.”
One option for deep-pocketed investors: Funds focusing on real estate managed by private-equity firms, which typically offer higher returns than public REITs, says Jack Foster, head of real assets at Franklin Templeton Real Asset Advisors. But, he adds, the private funds also entail significant risk.
“Investors need to consider lockup periods that can be as long as five years,” says Mr. Foster. Still, the expanded pool of distressed property owners after the recent financial crisis and economic downturn “has created significant opportunities in private-equity real estate,” he says.
On the whole, “the days of flipping for a quick profit are dead,” says Scott Miller Jr., a managing partner of Blue Bell Private Wealth Management LLC in Blue Bell, Pa. “But for an investor who understands their local market, is willing to do the research, is patient enough to get a great buy and has the skill set to perform the necessary and ongoing maintenance, hard real-estate investments will prove to be more profitable” than soft ones.
Mr. Zuckerman is a special writer for The Wall Street Journal in New York. He can be reached at gregory.zuckerman@wsj.com. Send questions about alternative investing to reports@wsj.com.
A version of this article appeared October 29, 2012, on page R5 in the U.S. edition of The Wall Street Journal, with the headline: A Real-Estate Primer.
Buying real estate is about more than just finding a place to call home. Investing in real estate has become increasingly popular over the last fifty years and has become a common investment vehicle. Although the real estate market has plenty of opportunities for making big gains, buying and owning real estate is a lot more complicated than investing in stocks and bonds. In this article, we’ll go beyond buying a home and introduce you to real estate as an investment.
Basic Rental Properties This is an investment as old as the practice of landownership. A person will buy a property and rent it out to a tenant. The owner, the landlord, is responsible for paying the mortgage, taxes and costs of maintaining the property. Ideally, the landlord charges enough rent to cover all of the aforementioned costs. A landlord may also charge more in order to produce a monthly profit, but the most common strategy is to be patient and only charge enough rent to cover expenses until the mortgage has been paid, at which time the majority of the rent becomes profit. Furthermore, the property may also have appreciated in value over the course of the mortgage, leaving the landlord with a more valuable asset. According to the U.S. Census Bureau, real estate has consistently increased in value from 1940 to 2006, then proceeded to dip and rebound from 2008 to 2010. (To learn more, read The Benefits of Mortgage Repayment and Understanding Your Mortgage.)
There are, of course, blemishes on the face of what seems like an ideal investment. You can end up with a bad tenant who damages the property or, worse still, end up having no tenant at all. This leaves you with a negative monthly cash flow, meaning that you might have to scramble to cover your mortgage payments. There is also the matter of finding the right property; you will want to pick an area where vacancy rates are low and choose a place that people will want to rent.
Perhaps the biggest difference between a rental property and other investments is the amount time and work you have to devote to maintaining your investment. When you buy a stock, it simply sits in your brokerage account and, hopefully, increases in value. If you invest in a rental property, there are many responsibilities that come along with being a landlord. When the furnace stops working in the middle of the night, it’s you who gets the phone call. If you don’t mind handyman work, this may not bother you; otherwise, a professional property manager would be glad to take the problem off your hands, for a price, of course. (For further reading, see Tips For The Prospective Landlord.)
Real Estate Investment Groups Real estate investment groups are sort of like small mutual funds for rental properties. If you want to own a rental property, but don’t want the hassle of being a landlord, a real estate investment group may be the solution for you. A company will buy or build a set of apartment blocks or condos and then allow investors to buy them through the company, thus joining the group. A single investor can own one or multiple units of self-contained living space, but the company operating the investment group collectively manages all the units, taking care of maintenance, advertising vacant units and interviewing tenants. In exchange for this management, the company takes a percentage of the monthly rent.
There are several versions of investment groups, but in the standard version, the lease is in the investor’s name and all of the units pool a portion of the rent to guard against occasional vacancies, meaning that you will receive enough to pay the mortgage even if your unit is empty. The quality of an investment group depends entirely on the company offering it. In theory, it is a safe way to get into real estate investment, but groups are vulnerable to the same fees that haunt the mutual fund industry. Once again, research is the key.
Real Estate Trading This is the wild side of real estate investment. Like the day traders who are leagues away from a buy-and-hold investor, the real estate traders are an entirely different breed from the buy-and-rent landlords. Real estate traders buy properties with the intention of holding them for a short period of time, often no more than three to four months, whereupon they hope to sell them for a profit. This technique is also called flipping properties and is based on buying properties that are either significantly undervalued or are in a very hot market. Pure property flippers will not put any money into a house for improvements; the investment has to have the intrinsic value to turn a profit without alteration or they won’t consider it. Flipping in this manner is a short-term cash investment. If a property flipper gets caught in a situation where he or she can’t unload a property, it can be devastating, because these investors generally don’t keep enough ready cash to pay the mortgage on a property for the long term. This can lead to continued losses for a real estate trader who is unable to offload the property in a bad market. A second class of property flipper also exists. These investors make their money by buying reasonably priced properties and adding value by renovating them. This can be a longer-term investment depending on the extent of the improvements. The limiting feature of this investment is that it is time intensive and often only allows investors to take on one property at a time. REITs Real estate has been around since our cave-dwelling ancestors started chasing strangers out of their space, so it’s not surprising that Wall Street has found a way to turn real estate into a publicly-traded instrument. A real estate investment trust (REIT) is created when a corporation (or trust) uses investors’ money to purchase and operate income properties. REITs are bought and sold on the major exchanges, just like any other stock. A corporation must pay out 90% of its taxable profits in the form of dividends, to keep its status as an REIT. By doing this, REITs avoid paying corporate income tax, whereas a regular company would be taxed its profits and then have to decide whether or not to distribute its after-tax profits as dividends.
Much like regular dividend-paying stocks, REITs are a solid investment for stock market investors that want regular income. In comparison to the aforementioned types of real estate investment, REITs allow investors into non-residential investments such as malls, or office buildings, and are highly liquid, In other words, you won’t need a realtor to help you cash out your investment. (For further reading, check out How To Analyze Real Estate Investment Trusts, How To Asses A Real Estate Investment Trust and The REIT Way.)
Leverage With the exception of REITs, investing in real estate gives an investor one tool that is not available to stock market investors: leverage. If you want to buy a stock, you have to pay the full value of the stock at the time you place the buy order. Even if you are buying on margin, the amount you can borrow is still much less than with real estate. Most “conventional” mortgages require 25% down, however, depending on where you live, there are many types of mortgages that require as little as 5%. This means that you can control the whole property and the equity it holds, by only paying a fraction of the total value. Of course, your mortgage will eventually pay the total value of the house at the time you purchased it, but you control it the minute the papers are signed.
This is what emboldens real estate flippers and landlords alike. They can take out a second mortgage on their homes and put down payments on two or three other properties. Whether they rent these out so that tenants pay the mortgage or they wait for an opportunity to sell for a profit, they control these assets, despite having only paid for a small part of the total value. (For more on taking out a second mortgage, read Home-Equity Loans: What You Need To Know and Home-Equity Loans: The Costs.)
The Bottom Line We have looked at several types of real estate investment, however, as you might have guessed, we have only scratched the surface. Within these examples there are countless variations of real estate investments. As with any investment, there is much potential with real estate, but this does not mean that it is an assured gain. Make careful choices and weigh out the costs and benefits of your actions, before diving in.
D5 Creation