April 2006
Vol. 29 No. 7
With the spate of lay-offs and corporate bankruptcies over the past few years, Corporate America can no longer be relied upon to provide a secure job and comfortable retirement income. The government is waffling on Social Security and other entitlement programs; but it is making it increasingly easy for people to set money aside for the future. Roth IRAs are just one of the concessions the tax collectors are making so you'll have a secure future. Not only are retirement plans of all shapes and sizes being encouraged by current tax policy, so is health care.
User demands on the government sponsored health plans is exceeding the number of medical and health providers who are willing to work at Medicare rates. This can only get worse as the onrush of aging baby-boomers strains Medicare and Medicaid beyond its ability to pay. If you think insurance premiums and prescription drugs are high now, wait until an estimated 30 million more claimants are added to Medicare and Medicaid rolls. With so much additional demand for medical services, the cost of medical treatment and care is going to skyrocket beyond the ability of either individuals or corporations to pay. Don't despair; there's a way to deal with this if you think ahead.
A few weeks ago I attended a briefing on Health Savings Accounts (HSA) presented by long-time subscriber, Cameron Galway of Atlanta. HSA accounts are set up by individuals. Those already on Medicare can't use them, but for others, they provide a way to pay for health insurance that is funded with deductions from taxable income. Individuals under the age of 65 can create an HSA account in much the same way that they create an IRA — often with the same custodian with whom their current self-directed IRA is administered. They can then deduct $2600 each year ($5150 for families and $3300 for individuals who reach age 55 by the end of 2006). This is set aside to pay the uninsured portion of a high-deductible medical insurance policy. With a high deductible, insurance companies can afford to offer policies that would be considerably less expensive. Blue Cross and many other insurance companies are geared up to offer HSAs in conjunction with high deductible policies that can also include long-term care.
HSAs offer a lot of strategic possibilities, but first let's cover some basic applications. When up to $5000 for individuals and $10,000 for families are withdrawn from HSA funds to pay for medical care, it is tax-free. Until funds are withdrawn they can be invested aggressively to compound tax-free. Any unspent funds can be inherited and left in the tax-free account to continue to grow and compound tax-free for the benefit of a surviving spouse and heirs. Now the fun begins:
Unlike retirement plans, the contributions to HSAs need not be made from earned income. Suppose individual HSAs were established by two children and four grandchildren. Annual gifts from the grandparents to the heirs would in turn be used to fund their HSAs. In effect, these tax-free gifts could be deducted from the heir's gross taxable income, increasing their take-home pay. Each of the recipients could use the extra after-tax income to help pay for a high deductible insurance policy out of their own funds. Of course, additional gifts could be made to pay for this too. Up to $12,000 can be gifted tax-free by each grandparent to insure that their heirs have adequate insurance coverage; so, each year $15,600 could be gifted tax free to both the parents and four grandchildren, then deducted from their taxable income when placed into the HSA account. The plot thickens:
If a medical emergency should arise and a claim on high-deductible insurance policy made, HSA funds could be left intact to continue to compound tax-free. Instead, the grandparents could make additional annual tax-free gifts of money with which to pay the insurance deductible. This would remove money from their taxable estate while insuring their heir's health for generations.
LONG-TERM HOUSE INVESTORS ARE BETTER OFF . . .
It's provocative to be able to deduct money from your income and put it away to compound tax-free for your own use, but there are strings to any government benefit program. With HSAs, if you are 65 you can't have one yourself, but could use one to protect your heirs. Money withdrawn from your HSA account to spend on medical expenses is tax-free, but, if you use the money for other purposes, you have to include the amount in your gross income and pay a 10% penalty. This might not seem to onerous if you truly need the money and can't borrow it, or sell something to raise it, but that could be an expensive way to pay pressing bills.
Is there an alternative to HSAs? Just for fun, let's compare an investment in a house with a HSA: A lot of house investors walking around today with a net worth of over a million dollars. They didn't earn the money. They didn't negotiate for it. In many instances they paid the retail asking price. Their secret was that, once they bought a house, they never sold it — nor did they “pull their equity out” via re-financing. They just hung on and let their tenants pay loans. The combination of appreciation and mortgage amortization may have made them a lot richer than they might have realized. Here's how to estimate your own house values:
I just discovered a web site, zillow.com that will give a rough value for any residence in America. All you've got to do is to type in the street address, city, State and zip code and you'll get a satellite picture of the house along with its current value. Just for fun, jot down what you think your house(s) would sell for, then check with zillow to see what the current estimated price is. One long-term investor who did this discovered he was worth over $1,000,000 more than he thought. It's a fun experience; and it once again underscores an old truism; the real wealth that is accumulated with houses is owned by those who buy and hold rather than those who buy and sell.
I must admit that I have been in both camps. For thirty years I bought and held houses until they paid off. Then I sold most of them and went into the business of buying, selling, and financing houses for other people. This has been a good business, but there's been a lot of slippage. The Tax Code penalizes people in the house business while it rewards those who invest in houses. Investors can write off their investment through depreciation and amortization. They can expense many things that others must capitalize. Most of the money required to pay down a mortgage loan and maintain a house is paid by tenants, and only by holding houses over the long term will you have time to accumulate those millions of dollars. Fess up, wouldn't you love to buy your old houses back at the price you sold them for?
The tax-code allows investors to “up-grade” their holdings by selling them for cash so long as the cash is re-invested in more real estate. This enables them to move their equity around from a colder market to a hotter market, even if it is at a remote distance from them. At the time a person is ready to retire, the houses can be sold for cash that will be taxed at low capital gain rates. If the tax bill is too high for comfort, it can be stretched out over many years simply by selling the houses on installment contracts to other investors, or to owner/occupants.
Now, let's contrast HSAs with houses: You can invest in houses at any age, but can't have a HSA if you're over 65. Most HSAs can be funded up to $2600 per year with unearned income, or gifts. House purchases can be funded the same way by using mortgage financing; plus, there's no limit to how much money can be invested. HSA funds can compound for decades tax-free. So can house investments. HSAs can be used to pay the deducible on high deductible insurance that covers medical and long-term care costs. The house investor with largely free and clear houses can use rental cash flow to provide the money for the deductible. Anyone who uses HSA funds for non-medical purposes, addition to having withdrawn funds taxed at up to 35% plus State taxes, will pay a 10% penalty. The house investor can use borrowed money for non-medical purposes tax-free and let tenants repay the loan, or sell a house and only pay 15% capital gains tax. HSAs can be inherited. So can houses, after which they can be sold tax-free and the money used for any purpose.
ANYBODY CAN GET INTO THE HOUSING ACT . . .
Jimmy Durant used to complain that “Everyone wants to get into the act.” That's because he did a solo act. The house business is one of the most accessible of all professions or careers. Regardless of the role you want to fill, there are few requirements and stunning opportunities. In the foregoing pages, I've touched on dealers who buy and sell houses, and investors who buy and hold houses. I haven't dealt with those who finance both short term dealers and long term investors. Nor have I mentioned builders, property managers, inspectors, buyers, maintenance men, appraisers, construction trades, salesmen, or brokers.
When you consider all the tasks related to each of these facets of the house business, only a few require formal licenses, and fewer still have specific educational requirements other than the ability to pass a test and to do basic arithmetic calculations. High school dropouts compete very effectively with those who have college degrees. Firemen, who have lots of time off, can be found everywhere immersed in real estate ventures. People drop out of professional careers every day to go into real estate. The field is populated with former Accountants, Dentists, Doctors, Lawyers, and Indian chiefs who realized that their clients were making a lot more money in real estate than they were.
There's a place for everyone willing to earn their success. For instance, the highest paying job in real estate is being able to find motivated home owners and getting their house under contract at a discounted price. At a recent investor meeting, a 16-year old asked me how he could get into the business without any money or credit. I told him to be a “bird dog”. All he'll need to invest will be time and energy. Almost everyone, whether they expect to fix and re-sell, or buy and hold, is willing to reward the person who can find profitable opportunities. Wholesaling a contract to someone else is certainly a way to earn money quickly, but being willing to wait a little bit to be paid can increase profits.
In some States, it is illegal to pay a “bird dog” to find a house. In others it's illegal for non-brokers to sell a contract. The solution is for the “bird dog” to joint venture the opportunity with someone else. In return for a share of the eventual profit, investors could put up the money and lend their expertise to the venture. The more skills the bird-dog contributes the larger his share. It's not uncommon for an investor to divide profits 50/50 with someone who can find a property, prepare it for sale, and sell it. If a young person could find, fix, and sell just four houses per year and divide a $30,000 profit on each, his share would be $60,000. That's more than most people earn annually.
What about the person willing to invest time to find a reasonably priced house and invest the effort to maintain and manage it for years? One such person teamed up with several investors over the years and is now sharing the income from 80 houses that have been completely paid off. Do the math yourself. If each house averaged $10,000 in net profit each year, how much has his enterprise earned for him? Incidentally, his partners don't resent paying him this much; in fact, they are deathly afraid that he'll quit and want to sell out. The question you should ask yourself is whether you could do better doing this than what you're doing now?
Let's see, we've covered finders, fixers, sales people, and managers and maintenance men who earn their profits by what they do. What about the investors who let their money earn their profits? They may do this by making loans directly to the entrepreneur for a share of the short-term profit, or in the form of mortgage financing? A house is a “big ticket” item that requires a lot of credit to buy. In recent years, mortgage money has been abundant at low interest rates. This has enabled lower income people to buy homes who were frozen out of the market decades. As they entered the market and drove up demand, prices followed. Now as interest rates creep upward, we're heading back to a housing market much like that of the mid-90s. Fewer buyers will be buying from more sellers. The demand/supply ratio will force prices down in some areas and price ranges. House prices will have to be “marked down in order for them to be sold. Creative marketing will be needed.
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MARKETING = SELLING + FINANCING . . .
When houses are being sold within hours of being offered for sale, it's amazing how swiftly we forget how important marketing skills and techniques are to making money in real estate. Now, with the condo market being flooded with unsold units — soon to be followed with speculators' un-sold high-end houses — being able to market creatively is going to be critical to success and financial survival.
There's no real trick to marketing; all you've got to do is to have a product that buyers want and are ready, willing, and able to pay for. The foregoing sentence is loaded with traps: (1) You've got to have a product. (2) Buyers have to want it more than comparable items on the market. (3) They've got to be ready to act. (4) Willing. (5) Able to pay. Let's bring this down to the level of a single-family house:
If a house is going to be your product, what kind of house? Statistics tell us that most American homeowners live in detached three bedroom single family houses. That boils down to about 40 million families. They're your market. They prefer at least two bathrooms and two car garage, but will settle for less if necessary to meet their financial means and other needs. They'll pay more for clean, attractive houses in safe, convenient neighborhoods and good school districts. They usually want to buy what they see, and not a job to do once they move in. That is a prescription for the product that will sell fast, but there are three additional factors that influence whether buyers buy:
Home buyers must be willing to give up their present quarters to reside in those being offered for sale; so a seller needs a “hook”. For men, the hook is often easy payments or extras pertaining to a hobby such as space for a workshop, golf cart, RV or boat. For women, it is convenience to shopping, schools, and amenities; and the overall utility of the floor plan and kitchen. We know that women make the vast majority of house-buying decisions, so our first task, if we can afford it, is to build in a terrific kitchen with lots of cabinets, sexy appliances, and pizzaz such as tile or granite counter tops. We'll supplement these with easy maintenance ceramic or wood laminate floors and a split bedroom floor plan.
Given, we can motivate people to buy our house, but what's the hook we need to make them ready to make their move. We might offer a today-only discount, or be willing to pay all closing costs to motivate them to buy NOW. Go to any tapesale seminar and notice how many times buyers are spurred to buy with “at the seminar only” prices. Tomorrow the price will rise, but lucky you, you're here on the last day of the year that you can still buy at our low, low price and terms.
You've got to make a house easy to buy. Terms are often critical. No matter how much buyers want a house, and how ready they may be, they've got to be financially able to buy it? That will depend upon their financial capacity and the loan terms YOU can arrange for them. You'll notice that YOU'VE got to line up the financing that will enable them to buy your house. Buyer's may not know how to do it. If you don't either, you'll need to find a real “can do” mortgage broker who can find institutional or private financing that will enable our buyers to buy.
You might take the buyers' house in trade to ease the financing problem, or agree to carry back a second mortgage with no payments for a time so they can qualify for a new loan. You might lease their old house with a purchase Option until it can be sold in order to provide buyers funds with which to pay their new mortgage. You might place a mortgage over several properties — theirs, their families, or your own — to give a lender more security when a low credit score creates a problem. You can see, when loans dry up, that at the end of the day, being able to solve buyers' financial problems is what is going to sell houses. That's about all I've got time for this month. I'll cover ways to finance sales creatively without using institutional lenders in next month's newsletter.
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Quotation not permitted. Material may not be reproduced in whole or part in any form whatsoever.
