March 2008
Vol 31 No 6
I come from a long line of mid-Western farmers who made a good living long before government price supports and corporate farms made farmers little more than government dependents. Without an organized farm commodity futures market, farmers were held captive by the seasons. They planted in the Spring, cultivated in the summer, and harvested both their crops and their money in the Fall. In the winter, when there was little to do, they tended to livestock, mended harnesses, and maintained their equipment and property. Entrepreneurs are much like early farmers.
We have no price supports, no futures markets, and must be self-reliant.
We have slow seasons, such as this winter of our discontent, when we could be mending our financial harnesses and maintaining our property. An important step is to take stock of current fiscal positions and to make preparation for the amazing housing harvests that the current sub-prime fiasco is forecasting. If you’re going to cash in on future opportunities, you need to put yourself into position to jump out ahead of the pack. Below I’ve listed things that everyone should, or could, be doing to improve their current situation. When the market ramps up again, you’ll be too busy making money to spend time doing the things you have time to do today. Tidying up your personal financial affairs and paying attention to administrative details now might be the most productive way to exploit this slow season.
GET YOUR FINANCIAL ACCOUNTS UP TO DATE: Until you pay all your bills and expenses, add up all your income, write off all your losses, add in all your gains, and make both voluntary and required profit distributions; you won’t be able to make accurate estimates of the net assets you own and what your net worth really is. This will also provide an audit trail that both your tax preparer and the IRS (if you’re audited) can use to prove that you have paid all the taxes you owe when due.
MAKE ACCURATE RETIREMENT PLAN DISTRIBUTIONS: For those over 70.5 years who don’t have Roth IRAs, there is a 50% penalty for not taking distributions from your retirement plan that you should have taken. This is often caused by not valuing plan assets accurately. Accurate bookkeeping system and appraisals can remedy this.
UPDATE YOUR FINANCIAL STATEMENT: Forget about all those puffed up property and Note values that you used to assuage your ego. Get down to brass tacks about what your net worth is as of 2008 based upon true fair market equity in excess of loans. By being brutally realistic about errors in judgment and mistakes that cost money over the past year, and how they affected your finances, you can begin the process of changing what you do and how you do it. This way you can avoid repeating the same mistakes and being caught in the next real estate down cycle in your area.
ADJUST YOUR BASIS AND INCOME TAX LIABILITY: If you’re holding promissory Notes that have little prospect for being paid, by writing them down as of the end of 2007, you can increase the losses you sustained and reduce the amount of tax on gains that you made. If you took houses back from defaulting installment buyers, you need to adjust your basis on the houses by adding prior taxes on gain back to your basis.
ADJUST YOUR STRATEGIES TO CHANGES IN THE INCOME TAX LAW: In 2008, the top long term capital gains rates for taxpayers in the 10% and 15% income tax brackets will be zero. That boils down to a maximum taxable adjusted gross income of $65,100 for marrieds, and $32,550 for singles. Once their taxable adjusted gross income is high enough to push them into the 25% tax bracket, their long term capital gains rate will rise to 15%. This will be especially beneficial to those who have delayed exchange profits being returned in 2008 by Qualified Intermediaries; those who sell real estate or securities for a profit; and those who are receiving principal payments on installment sale profits from transactions made in prior years.
UPDATE YOUR FIRE, CASUALTY, AND LIABILITY INSURANCE COVERAGE.
One of the things it’s wise to do at the start of every year is to review insurance coverage and make adjustments as needed. When we’re paying for it, insurance is one of those things that we all resent; yet, by enabling us to spread uncontrollable risks, it serves a purpose like no other product. When fires, tornados, storms, law suits; and other events none of us can predict threaten our finances, we’re mighty glad we have adequate insurance coverage.
Despite the fact that we haven’t had a hurricane strike the mainland in a couple of years; in Florida, insurance companies are canceling policies and leaving the State in droves to avoid the risks of violent weather. This puts those with mortgaged property in a fix, because anytime the lender feels its collateral is in jeopardy, loans can be called even when all payments have been made on time. The State has moved in to become the insurer of last resort when borrowers can’t find insurance to prevent their loans from going into default.
In some instances, rather than to call loans, lenders have “force placed” insurance with insurance carriers, some of which are owned by the lenders. The premiums can be quite high, but often not as high as the insurance provided by the State. In other instances, property owners have been able to find small insurance companies that will insure homes; but they are often very picky about the age, construction, and condition of the homes. One company insists that any home it insures must be brought up to 2001 construction standards. This makes many rental houses that were built in prior years to different standards uninsurable by it.
Sometimes, when most of the value of a house is in the lot on which a house is situated, insurance premiums can be reduced by electing to buy insurance only in an amount necessary to cover the outstanding loan balance. An alternative is to build in large deductibles. Sometimes this can make a lot of sense. Last year I reduced my homeowner insurance by over $2000 per year by increasing my deductible to $5000. Another device for people with free and clear property is to self-insure the property, but to carry a separate liability policy to cover other risks of ownership. And yet another way to reduce premiums is to insure only the original cost of the property rather than the replacement value; especially if the house wouldn’t be rebuilt in the event of its destruction.
Last but not least, when property is being passed around through various entities and Trusts; and/or when an Option or a Remainder Estate is being held on a property, it is important that the property, the entity in which it is being held, and the individuals who have an interest in the property, or who manage it, or who lease it are appropriately named in all the policies. I discovered in my own case that I hadn’t named replacement Trustees and entities in my own policies, so I immediately included myself and them as “Additionally Named Insured” parties.
HEALTH, ACCIDENT, AND LIFE INSURANCE:
With taxes, insurance, and energy prices going through the roof, people are tempted to drop insurance coverage in order to make ends meet. This decision should be taken as judiciously as possible to offset perceived risks. Life Insurance may not be as important to younger people as Health and Accident Insurance. Loss of a paycheck could result in the loss of a home, a car, and the ability to find work when the wage-earner is well again. A major reason for one spouse to continue to work for wages is to get company insurance. Entrepreneurs might find it useful to become licensed Brokers to be able to get group insurance.
Those who have access to employer or group insurance should probably focus on Life Insurance that will provide minimal support for a period of years until minor children grow up and become self-supporting. By shortening the period covered by the insurance and stretching payouts over longer periods, often, premiums can be reduced. This makes sense when business income support a surviving spouse.
IMPROVE MAINTENANCE AND MANAGEMENT . . .
Just as harness gets mended only when there’s nothing better to do, management and maintenance take a back seat when sales are brisk. Rents just can’t compete with the profits to be made by buying, fixing, and selling houses. Today, when there are far more properties for sale than there are buyers, it makes a lot of sense to focus on the opportunities available to those who are ready, willing, and able to manage and maintain houses owned by themselves and by other investors.
I originally became a serious property manager when I was stuck with a lot of unsold inventory in the market slump of the 70s. Until then, I had viewed management as a necessary evil best left to others to do. Then I found myself with monthly payments that were twice my net income. With absolutely no extra cash flow with which to pay professional managers, I had to face the fact that the only way I could avoid the loss of my houses was to learn how to manage them myself.
A first step was to volunteer to manage houses owned by my Broker for free. It made more sense to me to work for free while making my mistakes on his property instead of on my own. I also signed up for a property management course taught by a professional apartment manager that was offered in my local vocational high school. I not only learned tricks of the trade, but also met 40 or so property managers who I could call on for help with my own maintenance and management problems thereafter.
This course also taught me how to keep financial records on each property in order to account for the disposition of rents received, and to identify problems that were peculiar to a certain property or to a certain occupant. Once these had been identified and segregated, depending upon the reason for high vacancy, maintenance, and personal effort, I could either change tenants, or sell off the property with seller financing and replace it with a better house.
The current real estate market slowdown is presenting tremendous opportunities for entrepreneurs to begin building a long term rental portfolio, or to upgrade existing portfolios to produce cash flow. Upgrading means more than simply replacing one property with another; it also means improving income by substituting creative financing, lease/Options, and equity sharing for conventional financing that robs a rental property of all its cash flow. If the foregoing sounds like so much gibberish, you need to brush up on leases, Options, and creative financing techniques. To help you do this, in July in Reno, Peter Fortunato and I will be teaching a special three-day seminar that will show you how to use them.
When it comes to maintenance, in more prosperous times it didn’t pay to do things yourself to keep a property maintained or to improve it, but now, for re-habbers and landlords, maintenance could be a very profitable thing to start doing. Do the math: Even with skilled workers being laid off from construction jobs, to hire them to maintain a house you’re going to have to pay about $12 per hour. You’ll pay more for plumbers, electricians, heating and air conditioning people, window installers, etc. When you can do some of the work yourself, you’ll not only save money but in the process also reduce dependence on hired hands. You’ll also be able to put some distance between yourself and the wolf at the door.
By becoming personally knowledgeable about the houses you manage and maintain, and those who occupy them, you’ll be able to attract better tenants who will do less damage, rent for longer periods, and pay rents on time as promised. Even though at first managing and maintaining your houses can be very daunting, at some point in the future, all the lessons you learn doing this will pay very large dividends the next time you need to produce cash flow. At that point you’ll be able to create income streams by sandwich leasing other people’s property and building in a cash flow spread between what you pay them and the rents you receive. A case in point is one guy who was forced to start managing his own property in 2006. Today, he is generating $10,000 per month in net rental income to replace the earnings that he can no longer earn flipping houses.
PUT YOUR ESTATE PLAN IN PLACE; NOW
One of the things that everybody seems to put off is creating an estate plan that will provide for two things: The first is to give someone the legal right to make medical and financial decisions in the event of mental incapacity. If you overlook this it can be a real trap. A case in point is a 43 year old subscriber whose wife contacted me following a head injury that completely robbed him of his mental capacity. In his case, there were no medical problems since the hospital posed no objection to her agreeing with their suggested treatment. On the other hand, on the advice of his attorney, he had placed all his financial assets and real estate into a solely owned single person Limited Liability Company for which he was the manager. He held all the shares as the Trustee of his Living Trust.
The Living Trust really didn’t come into play while he was alive. Worse; nothing in the Living Trust provided for his affairs being handled by his wife or anybody else. Nor had he executed a Durable Power of Attorney that would enable her to manage the LLC. Even more lethal was the fact that he failed to share any of the details of his business operations with her, so, even if she had had the legal power to manage his affairs, she didn’t have the insight and judgment to keep out of trouble. Nor did he identify anyone on whom she could call for advice and counsel.
As a result he found himself in the precarious position of not being dead enough for his life insurance to pay off and his estate to pass to his heirs, nor alive enough to manage his own affairs; while his continuing care wiped out all his liquid assets. He was too young for Medicare, and although he had adequate life insurance, he had insufficient health and accident insurance for long term care. His business affairs were in legal limbo waiting for a laborious court process to appoint a custodian. Ask yourself whether or not this could happen to you if you suddenly became incapacitated today! What do you intend to do about it?
The second reason to get an estate plan into place right now is because nobody really knows when their last day on earth might occur. In January, a massive traffic disaster involving 70 trucks and cars tied up a 40 mile stretch of the interstate the connects Tampa and Orlando. A number of people were killed; suddenly without warning. Thirty eight people were hospitalized. How many of the victims had provided for this event with a Living Trust and Pour-Over Will? How many of them had adequate insurance? How many families saw their dreams and the futures of their children destroyed in mere seconds?
If you are a real estate entrepreneur or investor and don’t have a Durable Power of Attorney, a Medical Power of Attorney, a Health Care Directive, a Living Trust, and a Pour-Over Will, you are condemning your surviving family members to months of legal turmoil, financial deprivation, and loss of much of the success that you might have attained. Even if you have to settle for standard form documents that might be available for your State as a stop-gap measure, you should get some sort of temporary plan in place until you can have a custom tailored comprehensive estate plan drawn up to meet your particular needs and intentions.
One final word: You may think that devoting time and expense to having all this done is going to be too much trouble, but once you put your plan in place, you will have done as much to build your estate and protect your family as anything else you could do during these days when the press of business is not nearly so demanding. On the other hand, if you don’t put an estate plan in place, regardless of much you achieve during your lifetime, all of your hard earned success could all go down the drain.
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