By Janet C. Arrowood

The stock markets have been down for so many years, and mortgage interest rates are so low that many of your clients have probably been showing an interest in real estate as an investment option. You’ve seen the commercials with announcers touting low mortgage rates and buying property for little or no money down, and “real” investors talking about how they made thousands of dollars buying, fixing up and then selling houses, all in just a few short months.

So, when Joan and John Client tell you they want to liquidate their nonretirement accounts and become real estate investors, you should encourage them to see a tax professional before they buy. Many would-be real estate investors, especially those who plan to acquire and manage rental properties, only look at the near-term tax advantages of these investments. Yes, there are many write-offs, and it isn’t hard to generate a positive cash flow, particularly in a tight rental market.

But we aren’t in a particularly tight rental market right now in most of the country, so these investors may find the cost of acquiring and keeping tenants is much higher than they ever imagined. A few months every other year with an empty property or with tenants not paying their rent, and all the write-offs in the world won’t ensure a positive cash flow. Tenants can also be incredibly destructive, and repairs cost money.

Investors may find the cost of acquiring and keeping tenants much higher than they imagined.

The hidden costs
Ask your clients if they are comfortable with the thought of paying all the carrying costs, plus possible court costs, to collect rent if their properties are vacant or their tenants aren’t paying rent as expected.

Then there are the ongoing maintenance and repair costs. Every time a tenant moves out, and while tenants are in residence, there are scheduled and unplanned maintenance expenses to consider. While these are generally deductible, they still cost money. If your client gets to write off a $1,000 repair bill, the fact is he still needs $600 or more in actual cash to pay the bill. Write-offs are not tax credits; they are tax deductions, and many novice landlords don’t understand that. It takes a significant cash reserve to be a landlord.

I have a client who boasted for years about his fabulous real estate investments once he made it through the terrible Denver rental market in the 1980s. About four years ago, his wife (a joint tenant with rights of survivorship), told him she was going back to Australia and getting a divorce, and she wanted her half of the value of the rental properties. She got a court order for him to sell, and he ended up selling for about 85 percent of market value to meet the court-imposed deadline to give her the cash. Of course, the court order required him to pay her share based on market value rather than sale price, so he lost money there. Then she refused to pay her share of U.S. taxes, and he had significant depreciation to recapture. As a result, he ended up with next to nothing on properties he had owned for almost 20 years.

This client was fortunate he had owned the properties for so long--if he had been in for the short haul, like so many would-be real estate investors, he would have owed significant money at closing and in taxes.

Even if all goes well, the market is booming and your clients have all the time in the world to wait for the best possible price, there are many tax ramifications to consider. This is the part of the investment that most clients fail to plan for.

"Back-end" expenses
If your client is working with a tax professional and is willing to do some current and future planning, most of what follows can be less stressful. However, if your client is ignoring your financial advice, he is probably not keen on listening to an accountant’s advice about planning, deductions, expenses or taxes. So, here are a few things these so-called investors need to consider on the “back end”--when they sell their investment properties:

• Even if they don’t depreciate the property, they will owe taxes on the amount of depreciation they should have taken. This can be a real shocker. Also, if the “investors” do not do the depreciation calculation correctly (and most don’t), they may owe taxes and penalties for over-depreciation. It is easy to take excessive depreciation if you don’t understand that the value of the land must be subtracted from the amount to be depreciated.
  
• They will owe taxes on any capital gains. Since they will have deducted the cost of many improvements in the year they were made, and/or put the improvements on a depreciation schedule to maximize current write-offs, their basis in the house may be much lower than they realize. This means much higher capital gains. Because these are investment properties rather than personal residential properties, they will need detailed records of everything to establish a basis at time of sale. If they can’t do this and didn’t use the services of a tax professional, the IRS will be glad to help, but your clients may not like the answers they get.
  
• If the property has to be sold as part of settling an estate or dividing assets among heirs, and is sold for less than fair market value, the IRS may also have something to say.

In every example, there are many alternative tax scenarios, and accountants differ at almost every turn. Make sure you do everything possible to encourage your client to do some serious tax planning before signing the real estate contract.

Insurance plays a part
There is a silver lining to this. You may have a wonderful opportunity for a life insurance sale. Because real estate is generally highly illiquid, and investment real estate even more so, several life insurance options are worth presenting to your clients.

If Joan Client is actively involved in managing the real estate and John is not, a term policy on Joan might be a good idea. This will give John the liquidity he needs to hire managers, ride out times when there are no tenants, and have the means to prepare and sell the properties without resorting to a fire sale.

If both clients are actively involved in the investment property business but the heirs aren’t interested, a second-to-die policy on the owners will give the heirs the same advantages as John gets with a term life policy on Joan.

If John and Joan co-manage the investment properties, and the survivor doesn’t want to continue when his or her partner dies, first-to-die insurance could be the answer to providing the needed liquidity to dispose of the properties in an orderly manner.

In these examples, the sale of the properties will almost certainly involve unexpected expenses and possibly capital gains and/or estate taxes. Life insurance is a great way to ensure that survivors or heirs can sell when they want to, at a fair price, and still pay the costs that can’t wait until settlement.

Janet C. Arrowood is a freelance financial writer and the managing director of The Write Source, Inc. You may reach her at www.thewritesource.org or thewritesource@earthlink.net.

Web Exclusive Articles

Finding Your Niche in the Women's Market

Seven Secrets of Seminar Success

Talking Points on Association Membership

The Five-Question Interview

Unlicensed Sharing

The Changing Face of Estate Planning

Top     LEGAL NOTICES     Contact Webmaster    

Change/Renew NAIFA Membership     Get Advisor Today: Join NAIFA

© Advisor Today 2003. All Rights Reserved.