Whether a client is looking to purchase a vacation home, multifamily apartment building, or primary residence with the purpose of renting out space, he or she will surely have questions about the process. Remember that while you should have answers, it’s wise not to give legal, tax, or financial planning advice. Learn how to appropriately field five of the most common questions you’ll likely receive from investor clients.
1. What are the rules for doing a 1031 exchange?
A 1031 exchange is a way to sell an investment property and defer the capital gains tax by purchasing another property of “like-kind.” Here are the main rules all real estate professionals should understand:
While the law says the exchange property must be of like-kind, the definition is pretty broad. An investor can sell a single-family home and exchange it for a multifamily property, office building, or industrial building and vice versa. Some real estate investment trusts (REITs) and Delaware statutory trusts (DSTs) also are allowed, but not all. The most important rule is that exchanges can only be for investment purposes and not for personal use, and the funds must never be deposited into the investor’s personal bank account. It must all go through a third party 1031 exchange intermediary. The seller has 45 calendar days to identify the replacement property, and the exchange must be completed no later than 180 days after the sale of the original property OR the due date of the income tax return (with extensions) for the tax year in which the relinquished property was sold, whichever is earlier. The value of the replacement property and loan amount must be the same or higher than the sold property. Also, the entire property must be used for investment purposes; a primary residence is not allowed—even if some rooms are rented out. However, under some circumstances, the replacement property can eventually be used as a primary residence at some point in the future.
Advice: The most important thing to tell your client is that 1031 exchange rules are strict, and even a small mistake can jeopardize the deferment of capital gains taxes. First and foremost, advise them to speak with a 1031 exchange company to make sure they are getting the right advice before you help them with any offers.
2. How can I finance my real estate investment?
People are often shocked to learn that they can qualify for up to 10 investor loans through conventional banks. Those 10 loans can be used to purchase one- to four-unit properties. The investor will need a down payment of 20 percent to 25 percent for each property and approximately six months’ worth of reserves in place in order to qualify. However, he or she can use a portion of the rental income to qualify. These can be 30-year fixed-rate loans, which are recommended today given low interest rates.
If your client is buying residential property with more than four units or a commercial property, he or she can apply for a commercial loan. These are generally shorter-term loans, though some long-term debt is available today. Investors need to be aware that if they obtain a short-term loan on commercial property, rates could be higher at the time they need to refinance or pay off the balloon note. This can radically affect the net operating income (NOI), which could force the investor to put more money down. Investors should always have a back-up plan when taking on short-term debt.
Advice: I always recommend that my investor clients speak with a lender and get pre-approved for financing before we start looking at properties.
3. Can I use my IRA or 401(k) to buy real estate?
The answer is yes, your clients can borrow against their 401(k), but make sure they understand the rules. He or she will have to pay that money back within a set timeframe or else they will pay penalties.
In order to use an IRA or 401(k) to invest in real estate, the investor must work with a self-directed IRA company that acts as a custodian or third party administrator. The IRA funds must always be handled by the custodian, never the investor. Any real estate purchase must be used for investment purposes only. For example, you can't buy a vacation home and then use it personally. The investor also can't be actively involved with the property—meaning he or she can't bang a nail or paint a wall on a property owned by their IRA. They must remain a passive investor and direct others to do the work for their IRA. There are massive penalties for violating these rules. With that said, billions of dollars are transacted in self-directed IRA accounts, and it is totally legal to purchase property within an IRA or 401(k).
Advice: Tell your clients they can self-direct their IRA or 401(k) to buy real estate, but they must speak with a custodian first to fully understand the rules. Some custodians I recommend are U-Direct IRA Services, The Entrust Group, and Equity Trust Company.
4. What is a cap rate?
The capitalization rate (cap rate) is the ratio of NOI to the asset value. NOI is the income generated after deducting all expenses. Simply put, you calculate your client’s return by subtracting all expenses from all income, and then dividing that number by the current value of the property.
Cap Rate = Net Operating Income / Price
Let's say your investor purchased an $80,000 single-family rental home in Detroit, and it rents for $975 per month. His or her total monthly expenses, including taxes, insurance, management fees, and repairs, might be around $393.50 per month, or $4,722 per year. This would leave your investor with an NOI of about $6,978 (cash flow). The cap rate would then be $6,978 divided by $80,000, which equals 8.74 percent.
If the investor is looking to finance, then the cash on cash return might increase. In this case, the investor might only have to put down $18,000 to buy the property, including closing costs. The mortgage payment would increase expenses, but the NOI would be divided into the $18,000 versus the $80,000. Adding a monthly mortgage payment of $344 to the expenses would result in $737.50 in monthly estimated expenses, or $8,850 annually. Subtract that from the gross income of $975 per month, or $11,700 annually, and you get an NOI of $2,850.
$2,850 / $18,000 down payment = 15 percent cash on cash return
Advice: Tell your clients that financing will generally give them a much higher return. Also, tell them to make sure to calculate all potential expenses plus 5 percent of rent set aside in a reserve fund for future maintenance and vacancies. I also highly advise that investors set aside at least six to 12 months of the projected rental amount into a reserve fund. This will help pay for expenses in the case of vacancy or evictions. Even if there are occasional evictions or rogue tenants, after 30 years, renters will have paid off that loan for the investor, and he or she will own that property free and clear. Minor blips are to be expected along the way, but in the long run, investors are creating enormous wealth. Imagine if you used conventional financing and were able to buy 10 homes. Those could be paid off in time for retirement.
5. What should I look for in a property management company?
Most landlords need help, especially if they don't know the local tenant laws or how to fully screen renters.
Advice: Good property management is the key to success for your investors. If you don’t have an in-house property management division at your brokerage, tell your investor clients that the property manager they choose should be fully licensed within the state and have at least a two-year track record of solid business experience. They must have a thorough tenant screening process, as well as a system for dealing with late payments or delinquent tenants. With today's technology, every property manager should use a software that allows the owner to see what's happening in real time with their property for full transparency. Tell your clients to always review the management agreement to make sure they understand the property manager’s terms.