Last time I constructed a little fable to see how being a lender,rather than an owner, can capture the real estate benefits of USE,INCOME, TAX BENEFITS, APPRECIATION, LEVERAGE, AMORTIZATION, and as a hedge against inflation with minimum risk.
To Recap: Able wants to buy an expensive building as an investment. He wants to avoid management and risk. Able might find a reputable third party buyer in need of finance, or he might form a corporation or a limited liability company, contributing 20% of the property price to it for use as a down payment. The ownership of the company can be held in Trust if he chooses. The Corporation or LLC buys the property in its name after obtaining a loan secured by a mortgage from Able. So far go good. He's the lender not the owner, avoiding ownership risk of real estate.
The terms of Able's note are such that the property has break even cash flow after payment of the loan each month. This yields Able as much income as direct ownership of the property would have. The Note he holds also provides for 80% share in any appreciation that might take place in property value in excess of book value at time of sale. Thus, as the titleholder takes depreciation while the property rises in value, Able will get the benefit of this in the form of a higher yield on his investment at time of sale.
So far he's captured appreciation, income and amortization. What about use? If he has a real need to use the property, the owning entity can rent Able space. His shared appreciation mortgage will also capture gain from inflation, which might take place. What about tax benefits? The owner of the property will be entitled to the tax benefits. For purposes of this example, we'll restrict these to depreciation and capital gain or loss as well as operating losses.
If the owning entity were to be a regular corporation that issued Section 1244 stock upon inception, operating losses caused by property operations, depreciation and costs of financing would offset operating profits each year. As a result, the corporation might be losing money for tax purposes even while it was producing cash flow.
Suppose Able wanted to enjoy the benefits of capital gains? His shared appreciation promissory note might include a provision for an Option on the property with a buy-out formula based upon 80% of any gain over book value rather than being characterized as additional interest. This would lay the foundation for Able's reporting the profit as long term
capital gain.
If Able decided to use a Limited Liability Company to fund the loan, profits and losses could be passed through to the Able or another entity as he chose to minimize federal and state taxes. You can see that professional tax consulting fees might be a worthwhile investment for serious investors.
We started this series discussing avoidance of liability. Because Able is merely the lender, not the owner, and assuming that he doesn't restrict the activities of the titleholder's business, he should be well out of the line of fire in the event anything happens in connection with the building, which might create a liability for the owner. If the owner is a heavily indebted corporation out of state, there's little real threat of loss to Able as mortgagee.
A major source of potential liability stems from doing business with people you don't know. As you proceed along the road to riches, it's important that you seek out fellow travelers who share your sense of fair play and ethics. Start with a little deal and make it a point to give the other party 51% of the profits. Gauge reactions to see if your generosity will be reciprocated. Test the other party's tolerance to risk, financial capacities, skill and knowledge, ability and willingness to share profits and opportunity on transactions that are too big for one person. Make sure that you measure up to the same standards you impose.
As time goes on, gradually increase the stakes until you have full confidence in the other party. Repeat this process over and over again until you've formed a networking group. Hopefully, you'll have a mix of starters, finishers, speculators, managers, and financiers to work with carefully selected Accountants, Attorneys and Brokers through many transactions. The time spent forming your network will be repaid many times over as you work together to improve and support each other's financial position.
