Every real estate investor has received The Call from a tenant who is late paying rent. The Call takes different forms, but the end result is always the same. Here are some examples:

“Hi, this is Frank, your tenant. Sorry I missed the rent payment last week. We had a medical emergency and I missed some work. I’ll mail a check by the 20th.”

“This is Susan, your tenant. I was let go from work so am having trouble paying the rent. But I should be able to catch up next month.”

And of course there is the very common No Call. Rent was due by the 5th, it’s now the 10th or 15th of the month, and you’ve not heard from your tenants at all.

The big question here is–what do you do? The answer to this question turns out to be really, really simple. And the answer is the same regardless of the situation. But before we get to the answer, let’s look at a similar situation.

Let’s assume you, the real estate investor, can’t pay your mortgage because your tenant hasn’t paid rent. As a responsible borrower, you call up your mortgage company and explain the situation. What will the response be? Will the response change based on how heart-breaking your story or your tenant’s story is? Nope. The mortgage company has a process to follow when a mortgage isn’t paid, and they will follow that process regardless of what story you give them.

So now back to your late-paying or no-paying tenants. Your response should almost always be the same–an eviction notice.

When Mike and I first discussed this, I thought an immediate eviction notice seemed a bit harsh. Mike convinced me otherwise. And it’s not that we don’t care about the tenant’s situation. (Well, Mike probably doesn’t care.) But the simple fact is that we can’t financially maintain the properties without tenants paying the rent on time. We don’t debate with the tenants. We don’t try to work out a payment plan. We don’t pretend to be understanding. We don’t try to help them figure out a way to come up with the money.

We’re not mean to the tenants. We don’t threaten them. We don’t yell. In fact, if they leave a voice mail message, we rarely return the call. We simply serve them with an eviction notice if they fail to pay the rent. It’s as simple as that.

The eviction notice usually motivates the tenants to pay the rent. In some cases, after an initial problem, the tenant begins to pay on time. Fortunately, we have never had to actually evict anybody from the properties we own together.

As part of this process, Mike will contact a tenant who has failed to pay the rent before serving an eviction notice. The point of the contact is NOT to find out why they haven’t paid. We don’t care why they haven’t paid. The point is simply to motivate them to pay the rent on time. Our rental agreements provide for a late payment penalty, which we generally enforce. And sometimes, a single phone call or letter is all it takes to put the tenant on the right track. But after that, we move right to an eviction notice.

All of this leads to a very important aspect of the landlord-tenant relationship–distance. Tenants are not our friends, and we are not their friends. The relationship should be mutually respectful and professional, but perhaps unless you knew your tenants before they were your tenants, the relationship is not one of friendship. Being too close to your tenants can really muddy the waters when it comes to money.

You should have a set process when a tenant pays late or doesn’t pay at all. The process should be followed, and involve initiation of an eviction in short order if the tenant doesn’t pay.

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Allow me to rant for just a moment. This week President Obama hatched what he calls the “Making Home Affordable Refinance and Modification” program. Apparently the historic plunge in real estate values hasn’t made homes affordable, so he has a program that will in theory stabilize home values. We here at The Two Wise Acres’ School of Real Estate Investing (impressive, I know) are baffled at how slowing the fall of home prices will make them more affordable. I mean, exactly how does using our tax dollars to artificially prop up the price of an asset make the asset more affordable? But then again, we thought Joe the Plumber asked a very good question. Then Senator Obama promised to spread the wealth, and here we are.

With that rant out of the way, let’s look at the Home Affordable Refinance and Modification program and the potential impact on real estate investing. There are two components to the Making Homes Affordable plan, a refinance program and and a loan modification program. The refinance program simply involves Freddie Mac and Fannie Mae buying loans even if they represent up to 105% of the appraised value of the home. The idea is to allow homeowners to refinance into low rate fixed mortgages who, because of the drop in the value of real estate, wouldn’t otherwise be able to refinance.

Granted, a really good argument could be made that Fannie and Freddie are mistakes in the first place. But if the government is going to be in the business of buying mortgages, this change to allow refinancing doesn’t bother me much. It’s the loan modification program that is the real problem.

Why the Mortgage Modification Program is a Bust

The modification program is a complicated beast. It involves lowering the interest rate on mortgages to as little as 2% and extended the terms up to 40 years so that the homeowner’s monthly mortgage payment is no greater than 31% of their monthly income. But wait, that’s not all! You also get a free set of steak knives, a $49.95 value! Ok, you don’t get steak knives. But what homeowners will get is up to $5,000 over five years paid directly to their mortgage company to pay down their mortgage. Where does the $5,000 come from? Uncle Sam, also known as the government, also known as you and me.

That’s right, the government is now going to pay people to stay in their “American Dream.” And we also are going to pay the mortgage companies that agree to modify the loans in the first place. Happy times are here again! All of these handouts add up to $75 billion, which a long time ago was a lot of money.

Real Estate Investors are Evil

So what does this have to do with real estate investors? Plenty. To begin with, neither the refinance nor the modification program apply to investment properties. That’s fine, but it’s the stated reason why that really toasts my 1031. Here is how HUD Secretary Donovan described the situation on Face the Nation:

We have designed this plan to make sure that the folks who did take advantage of people — whether it was lenders or speculators or flippers — that they’re not eligible for this plan,” Donovan told host Bob Schieffer on CBS News’ Face The Nation. “We’re going to have a very strict program to make sure that people who participate are what they say they are. We’re not going to benefit those who took advantage before.”

So now real estate investors are all evil speculators and flippers who take advantage of people and are not what they say they are. Thank God we have the government to figure all this out for us and protect us from these evil people.

FYI, Mike and I are NOT flippers. We tried to flip the last HUD foreclosure we rehabbed, but nobody would buy the damn thing.

Why can’t the Obama administration simply say the program is for owner-occupied homes? Why are real estate investors now speculators and people who take advantages of others? Do Mike and I take advantage of others when we risk our capital to buy a crappy looking home, fix it up, and rent it at a reasonable price? I can tell you that the neighbors who have had to look at the dump sit there for months or longer are thrilled when we buy it and fix it up.

And furthermore, it’s been real estate investors that have been buying many of the foreclosures over the last 12 months. If it weren’t for investors, the current housing market would be a lot worse than it is. Did speculators contribute to the housing bubble? Of course they did. And some of these speculators are called homeowners!

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If you invest in real estate, I sure hope you’ve been following the Stimulus bill as it makes its way through Congress. Yesterday President Obama signed into law The American Recovery and Reinvestment Act, and it contains a provision that could help a lot of investors. Here’s how CNN described the provision I’m talking about:

Homebuyers: First-time homebuyers who purchase this calendar year get an $8,000 tax credit which does not have to be repaid like a similar measure last year. This phases out for people making more than $75,000 individually or $150,000 jointly. “First-time homebuyer” is defined as someone who has not owned a home for the past three years. Cost: $6.63 billion.

You should be aware that buyer’s will have to repay the credit if they sell the home within three years. Otherwise, they never have to pay the money back. Now that’s a big benefit for first-time homebuyers, but it’s also a big benefit to real estate investors. Let me give you some background into our investments, and then I’ll explain how we intend to use the first-time buyer tax credit to our advantage.

As we’ve written before, Mike and I invest in single family homes located in the mid-West. All of our homes we currently own were purchased from HUD. The deals we’ve gotten range from good to great. Our last investment is a perfect example.

Last year we bought a three bedroom one bath home on a slab for $41,000. The home is in a good school district and a reasonably safe neighborhood. It’s on about .2 acres with a fenced yard and carport. We put about $23,000 into the home. This included painting the house inside and out, a completely new kitchen and bathroom, and a lot of other cosmetic work. With a total investment of about $65,000, we have a property worth $90,000 to $95,000.

Our original intention was to flip the property, something we never do. All of our other homes are on a lease purchase deal, which I’ll explain in a minute. For our new property, we put it up for sale with a broker, and it just sat there. Like so many other properties on the market, we got little interest from potential buyers. But we did get somebody interested in a laease purchase deal, which we ended up taking. Here are the terms:

Lease-purchase fee: $2,400. This fee is non-refundable, but is credited against the purchase price of the home if and when the tenants exercise the option to buy.
Purchase price: $94,900. We always set the purchase price at the high end of the market, but never above what the comps will support.
Term: 3 years. The tenants have three years to excersie the option, and the purchase price never changes, even if the market goes up (or down for that matter).
Rent: $1,045. We often include a yearly rent escalation clause in our long term agreements, but we didn’t here.
Rent Credit: $100. Every month the tenants pay rent on time, they get a $100 credit toward the purchase price of the home. That means that over three years, they can earn a credit of $3,600. Add to that the lease-purchase fee, and they have a $6,000 down payment on a $94,900 home.

We financed all but $3,000 of the total cost of the home, over a 20 year variable rate loan that adjusts once every five years. Our current interest rate is 7.5%. So even with a 20 year note, we have immediate cash flow of about $300 less maintenace costs.

So let’s get back to the tax credit. Assuming our tenants would be first time home buyers and have income within the allowable range, they qualify for an $8,000 tax credit if the buy a home before Decmeber 1, 2009. Simply put, they have every reason to buy now, if they can.

So our plan is simple. We are preparing letters to each of our lease-purchase tenants laying our the terms of the tax credit and how it would affect the purchase of the home. We also have mortgage brokers they can talk to as well, if they’d like. The key here, however, is to get the letters out now so that the tenants have time to think about their decison and to do the necessary planning if they indeed want to buy.

The first time homebuyer tax credit really does offer a great opportunity for buyers. And we think many of our tenants will want to take advantage of it. If they do, we end up selling the property without a real estate agent fee for a fair price. We can then do a 1031 exchange into a new property that, in the present market, can be had for a great price.

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Want to make your real estate investments more profitable?

Ok, that was a silly question. Of course you do. And you probably want to make the time you spend on real estate investing as productive as possible. While there are many, many ways to build wealth with real estate, there are some common techniques that can make investing in real estate easier, more productive, and most important, more profitable. So here are 20 real estate investing tips to help make your investments more profitable.

20 Real Estate Investing Tips

1. There is always another investment property: Keep emotion out of the buying and selling decisions. However great a real estate investment deal may be, even if it gets by you, another one is always just around the corner. And one of the great things about real estate investing is that the next deal is often better than the property you just lost.
2. Develop and nurture relationships: Relationships are the lifeblood of successful real estate investing. Whether it is a relationship with a bank, a plumber, or a real estate agent, good solid contacts can make your life easier and more profitable. And if you are looking for folks to help you with any aspect of your investments, start with a real estate agent with experience buying and selling investment properties. If they have been around for any length of time, they will have many contacts that can help you.
3. Avoid rental vacancies like the plague: Vacancies can turn a profitable property into a money-loser faster than just about anything. We work hard to avoid to keep rental properties occupied, and you can check out some of our tips on how to avoid vacancies. But one key to remember when forecasting profits is to include an allowance for vacancies, because no matter how hard you try, at some point your property will be unoccupied for some period of time.
4. Take advantage of free money (part I): Particularly during a rehab or when maintenance on a property is required, getting your hands on capital can be a challenge. While we do not charge up credit cards, we do take advantage of 0% balance transfer offers. They offer free money for up to 15 months, which is a great way to finance needed repairs or other expenses without paying interest.
5. Take advantage of free money (part II): Another way to get “free” money is to buy Home Depot or Lowe’s store gift cards at a discount. On my money management blog, I wrote about how you can by store gift cards online at a discount of 10% or more: How to Turn Gift Cards into Cash.
6. Respond to tenant calls quickly: When a tenant calls about a problem with the rental unit, responding quickly accomplishes several things. First, it reduces the risk that the problem will get worse, causing more damage and requiring more money to fix. Second, it can have a positive impact on the relationship with the tenant. And the problem is going to have to be dealt with anyway, so why not get it fixed immediately
7. Understand portfolio lending: For most mortgage lending, the originating lender will sell the loan to an investment bankers who package mortgages to sell as investments. For this type of conventional loan, the loan terms must meet certain requirements in order for the originating lender to be able to sell the loan. For these types of loan, for example, a 20% down payment is almost always required for investment property. Portfolio lending describes those banks that do not plan to sell the loan. The benefit to the real estate investor is more flexible terms. Mike and I have a relationship with a portfolio lender that enables us to borrow 100% of the purchase price and rehab costs. If you can’t find a portfolio lender, ask a local real estate agent experienced with real estate investing. He or she should be able to recommend several.
8. Overestimate rehab costs: Estimating rehab costs is as much an art as it is a science. It involves not only identifying everything that needs repair or replacement, but also estimating the cost of the work and materials. As with any estimate, the estimate of the cost of a rehab will come within some range. When forecasting your rehab, assume the high end of the range and include an allowance of 10-20% for unexpected costs. In almost all big projects, the unexpected should be expected.
9. Include maintenance costs in your financial forecasts: Maintenance costs are a reality of real estate investing. And unlike mortgage or insurance, they don’t come in regular intervals. You may go a year or more without spending a dime on a property, and then its air conditioner and roof may need replaced at the same time. So put aside a monthly allowance for maintenance costs both in your financial forecasts and in your bank account.
10. Include automatic rent escalation costs in rental agreements: On a $1,000 a month rental property, even a $25 rent increase can go a long way. Unless other costs have gone up, that $25 goes right to the bottom line, and we’ve found that tenants do not object to modest rent increases. By putting the increase in the initial lease agreement, you avoid having to negotiate this point every year.
11. Aim for two or three year leases: As noted above, vacancies can kill your profit. A multi-year lease agreement can reduce vacancy rate. This can really increase your profit when you consider that a vacancy, in addition to lost rent, will cost you additional advertising expense and repairs to the property that are inevitable when no tenants come in.
12. Have capital available, even if its credit, not cash: Because the unexpected should always be expected, you have to have available capital. The ideal situation is to have cash in the bank, but real estate investors’ affinity for leverage sometimes depletes the bank account as they move into more and more investments. So whether its credit cards, a home equity, or cash, you need to have capital at the ready.
13. Invest in real estate located in good school districts: Homes in bad school districts are harder to rent and harder to sell. They also are worth less. At times we’ve been tempted to buy in questionable school districts because of the lower price, but the quality of tenants are also generally less.
14. Advertise rental properties on the Internet: With our first rental property, we spent about $500 in advertising, mostly with newspaper ads. With the last until we rented, we spent just $39 in advertising cost using the Internet. Advertising can really eat into your profits, so take advantage of online real estate advertising options.
15. Find a real estate investing mentor: An experienced mentor is critical when you begin your real estate investing journey. Mike is my mentor (God, help me!). And Mike’s dad, who has been in real estate forever, was his mentor. Learning from an experienced investor will save you time and money, and teach you things quickly that otherwise may take years to learn. If you do not know anybody in the business, reach out to real estate agents or attend a real estate investing club in your area.
16. Understand tax depreciation: Depreciation offers a significant tax advantage for real estate investments. But getting depreciation right can be tricky. Neither Mike nor I are experts in the field, but we know the basics. If necessary, speak to an accountant or tax expert to understand how depreciation works, even if you do not do your own taxes. You can also check out some of our articles on depreciation:
    • Calculating Depreciation for Residential Real Estate Investments
    • Real Estate Investors’ Potential Tax Trap: Depreciation Recapture
    • Tax Benefits of Depreciation for the Real Estate Investor
17. Do not make tax benefits the primary driver behind your your real estate investment decisions: I may take some heat for this one, but too many real estate investors let the tax consequences of their decisions lead around by the nose. Yes, the tax consequences of investments in real estate are important, should be understood, and advantage of tax breaks should be taken when they are consistent with sound real estate investing decisions. But I would never make a lousy investment in real estate just to take advantage of a 1031 exchange.
18. Do not over-improve or under-improve a property: Rehabbing a property, whether it is a rental unit or you plan to flip the home, requires just the right level of improvements. If anything, Mike and I tend to over-improve our properties. While much of this comes with experience, it is important to assess whether the improvements will (1) increase the sales price or rent, (2) decrease the time it takes to rent or sell the property, or (3) reduce future maintenance costs. If the improvement does not satisfy at least one of those three criteria, ask yourself why you are making the improvement.
19. Expect foreclosures to need new HVAC and a water heater: Time and again we buy a foreclosure thinking the HVAC and water heater look fine. Two months after our first tenants move in, the air conditioner goes. It’s happened repeatedly, to the point where we just expect to replace everything. If it turns out we don’t have to, we view it as a bonus. Foreclosures often sit unoccupied for months, and for whatever reason, this seems to take a toll on the mechanicals.
20. Understand 1031 exchanges: Tax-deferred exchanges offer a great opportunity to shelter profits from the taxman. But like everything else related to our beloved tax code, it can be a bit convoluted. As with depreciation, it is important to at least understand the basics of 1031 exchanges, particularly when you are planning to sell a property.

If you have more real estate investing tips, please leave a comment with your idea.

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Credit balance transfers with 0% introductory interest rates are a great way to tackle one of the toughest obstacles to real estate investing–raising capital. As Mike and I begin the process of rehabbing and flipping a HUD foreclosure we just bought, the need for short term capital is critical. But whether you are a real estate investor or not, balance transfer credit cards offer a great way to get free cash.

0% balance transfers are a great way to transfer high interest rate debt or to simply put the money in a high yield savings account to earn some extra cash. In our case, we can use credit balance transfers to help pay for rehab costs, and then pay off the debt once we sell the house.

So with all that in mind, what follows are a list of some of the best balance transfer cards available. I’ve included how long any transferred balance will remain at 0%, although you should read the terms and conditions carefully as offers can change without notice.. Clicking on the link for each card will take you to the card issuer’s website where you can get more information about each balance transfer card and apply for the card online if you’d like.

Chase 0% Credit Balance Transfers

» Chase Business Rebate Visa 12 months
» Chase Platinum Visa 12 months
» Chase PerfectCard MasterCard 6 months
» Chase Free Cash Rewards Visa 12 months
» Chase Platinum Business Card 12 months
» Chase Platinum MasterCard 12 months
» Chase Business Cash Rewards Card 12 months + Up to 5% cash back

Advanta Balance Transfer Offers

» Advanta Platinum BusinessCard with Rewards 15 months 0% balance transfer offer
» Advanta Platinum BusinessCard 12 months
» Advanta Kiva BusinessCard 15 months + rebates on charitable contributions

Discover 0% Balance Transfer Offers

» Discover Business Card 0% 12 months on purchase + $100 Cash Back Offer + up to 5% Cashback bonus
» Discover Business Miles Card 12 months
» Discover Miles Card 6 months
» Discover Open Road 12 months
» Discover More (Clear) 12 months
» Discover More (American Flag) 12 months
» Discover More (Wildlife Collection) 12 months
» Discover More (Sea Life Collection) 12 months
» Discover Monogram Card 12 months

As you review these offers, remember that the longest 0% balance transfer offer is not always the best for your particular needs. These cards often come with a variety of benefits, including cash and other rebates and travel rewards. In addition, with balance transfers, you may get a higher credit limit for shorter 0% APR offers.

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Flipping real estate involves buying a property, usually upgrading it, and then selling it (hopefully for a profit). Unlike investing in rental properties, flipping houses offers the potential for short-term gains and keeps your capital tied up for a relatively short period of time. Through this case study, Mike and I will be sharing with you in detail a foreclosure we just purchased and plan to flip.

As with all of our real estate investing, the investment property we purchased was a HUD foreclosure. HUD listed the property for $65,000, but we won the home with a gross bid of just $41,000. If you are wondering how we did that, check out our article on how to determine HUD’s minimum acceptable bid. In this case though, we just submitted a lowball offer and won. Sometimes it is better to be lucky, than good, not like Mike and I have much choice in the matter.

We expect to put about $23,000 in to rehabbing the property, but more about that later. Add a few thousand dollars in transaction fees, and our total investment will come in at around $65,000. The property appraised for $94,000 based on the improvements we intend to make, so there is a potential for a nice profit.

The property is a real “peach,” as Mike likes to say. It is a three bedroom, one bath home on a slab (no basement). It has a carport and a fenced 1/4 acre yard. Built in the 1950s, the home is in a good school district in a suburb of a large mid-western city. It won’t make the cover of Architectural Digest, but we do expect it to add nicely to our bank account. Here is a photo of the home taken a few years ago:

Flipping houses is not our primary real estate investing model, but it should provide additional capital as we continue to buy longer term rental properties. Stay tuned for more updates on our flip. The next article will walk through how we pick homes that we think make for a good investment in flipping homes.

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A real estate investor’s own personal finances can play a big role in managing profitable real estate investments. One of the biggest mistakes anxious investors make is to take on a lot of leverage and financial risk with rental properties when their own finances are in shambles. Having your own finances in order is important to your real estate investments for at least three reasons: (1) you may need cash or available credit to address a major repair to the property; (2) you need to able to weather prolonged vacancies or non-payment of rent, and (3) you want to qualify for the best available financing when you buy or refinance a property.

So here is a quick primer on sound personal finance habits every real estate investor should know.

1. Supercharge your emergency fund: Most personal finance experts recommend keeping three to six months of living expenses in a savings or money market account. For the individual real estate investor, however, this isn’t enough. You should consider how much you would need to keep your properties afloat if rental income wasn’t coming in the door. There’s no magic formula here, but some suggest keeping a year’s worth of expenses (mortgage, taxes, insurance, repairs) for each property. That’s extremely conservative, but the point is that your emergency fund should be above to cover your rental properties for at least three to six months in addition to your own household expenses.

2. Pay EVERYTHING on time: Avoiding late payments on your debts is critical to the real estate investor. Late payments can have a major impact on your credit score, which can result in raising the interest rate you’ll pay for a mortgage on a rental property. In extreme cases, it can even disqualify you for traditional financing, particularly given the tight credit market we’re in now.

3. Maintain available credit: I have available credit on both my home equity line of credit and on a number of low interest credit cards. It’s never my intention to use this credit for real estate investing (except on perhaps a very short term basis), but the available credit is important for at least two reasons. First, having unused, available credit can improve your credit score. Second, it’s nice to have the available credit in the even of an emergency. Of course, you should be relying on an emergency fund when the air conditioning unit goes out, but some extra financial cushion never hurt.

4. Diversify your investments: I know I’ll take some heat on this one, but in my opinion, real estate shouldn’t be one’s only source of investment income. I have a fair amount invested in stocks and bonds. I also invest in REITs. These investments, along with my real estate holdings, provide a nice diversification that reduces the overall risk of my investment portfolio.

5. Shun consumer debt: Many Americans are buried in consumer debt. They use credit cards and home equity lines of credit to a fund a life style they can’t afford. Before long, they are mired in debt and working harder and harder just to stay afloat. The goal of real estate investing, at least for me, is to achieve some significant degree of financial freedom for me and my family. But I’ll never achieve that if I have consumer debt that is growing each month.

6. Maintain an updated personal net worth statement: It’s a good personal finance habit to know and track your net worth. With real estate investing, it’s doubly important because you’ll need this information when you apply for financing. In addition, a net worth statement will also allow you to see how your real estate empire is growing.

7. Stick with fixed rate mortgages: Particularly if you dabble in variable rate mortgages on some or all of your rental properties, financing your own home with a fixed rate mortgage is critical. Mike and I have financed some properties with variable rate mortgages, at least for a time. These investments expose us to enough interest rate risk; we don’t need to add to it by financing our own homes with variable rate mortgages. Besides, interests are still at historic lows, so with perhaps a few exceptions, there is little reason not to lock in the low rate now.

We could add many more to these, but these are seven of the more important personal finance habits I’ve found helpful to my real estate investments. Perhaps you can add to this list. If so, by all means leave a comment. If you disagree with any of these points, email Mike.

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The Mrs. once remarked, “When you and your father get together, you can talk about real estate until there’s no more oxygen left in the room.” Yep, we can get going pretty good. We’ll talk about his properties, my properties, the market, the last deal, the next deal, the tenants, the banks, and, if Rob’s in town, we’ll occasionally break for cards.

This morning, my father and I were doing our best to deplete breathable air, on this occasion, via phone. The conversation began when he called to ask if I had any interest in a Ford Expedition. It seems that he finds himself a bit vehicle-heavy as a result of his latest real estate deal. He had a double that he was looking to sell in an area that required a bit more management than my father was interested in continuing to provide and was approached by a newer investor that didn’t mind the time and effort. The newer investor was looking to buy but was shy on cash. He did, however, have this car that he was looking to sell. So, my father came down some on price, the investor came up some, and the Expedition bridged the gap.

Sometimes, real estate investors can find their best deals, buying or selling, by using a little creativity. While the Ford Expedition may not be on the lot in every deal (nor would you want it to be), considering options other than just money changing hands at the closing table opens up possibilities. As a fellow real estate investor recently considered, alternative financing may frequently provide the mechanism to make the deal work for buyer and seller. Particularly at times like these when banks seem to be forgetting that they are in the business of lending money, the real estate investor has to be open to other possibilities. Consider lending money to your buyer, borrowing from your seller, providing a purchase option for your tenant, taking a property in trade, or maybe even taking that for-sale vehicle off your buyer’s hands.

My father’s real estate dealings over the years, besides being fodder for wisecracks, certainly serve as my reminder to watch for opportunities to create the deal, and a good real estate investor sometimes has to find those opportunities for both sides. So, in the spirit of inspiring the deal and just for a little fun, I thought I’d share some of my father’s more creative side purchases over the years that made the deal. Over more years than I care to admit, here are the “side purchases” that stick out in my memory:

a 1974 Volkswagen beetle
a 1975 Buick Riviera
5 acres of undeveloped land in Maine
a plot of desert property in New Mexico
some swamp land in Florida
an antique (here, insert “old”) desk
office furniture
labor on the rehab
10 asphalt driveways

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Last week, PMI Group, of private mortgage insurance fame, released its “risk index” rankings for U.S. major metropolitan areas for the 4th quarter of 2007. PMI’s risk index measures the likelihood that housing prices will be lower in two years than they are now. As the map above shows, Phoenix, Las Vegas, and well, pretty much all of Florida and California were the big winners with the highest probability of declining prices over the two year period (i.e. the highest risk index). PMI’s Risk Index derives the probability by considering the amount and rate of recent historical appreciation and price volatility, housing affordability, and other local economic conditions including unemployment rates.

Does a high likelihood of price declines translate into putting the breaks on investment purchases there? I don’t think so. While price declines impact returns and the possibility or even probability needs to be considered, the risk of any real estate investment and the resulting returns will be determined by the price at which you buy your investment, not price movements in the market as a whole. For our part, we continue to keep a close eye on market rents to determine price, and we hope to find even more opportunity during the difficult markets.

If you would like to read more detailed information about PMI’s Risk Index and the areas depicted above, you can find the full report here.

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If you didn’t catch the first part of the TwoWiseAcres quick and dirty guide to taxes for the real estate investor, you might want to check it out. In the first part, I walked through reporting income and expenses for rental properties on Schedule E. In this part, I’m going to cover the basics of depreciation. I’m going to focus on calculating depreciation for the first year of a new investment purchase, but I’ll touch on depreciating capital expenditures incurred later on as well.

If you followed my advice in part one, you should now be well rested and/or liquored up. So, once again, let’s get busy.

Starting to Depreciate a Residential Rental Investment

Depreciation is essentially recovering the cost of an item (or “expensing” an item) over a number of years. To determine depreciation for tax purposes, you have to know three things: the basis, your start date for depreciation, and the depreciation period for the property.

Basis is generally cost. For a rental property, the cost includes a portion of the purchase price, expenses associated with the purchase (i.e. closing costs), and initial rehab or fix-up costs. The “portion” of the purchase price is the portion attributable to the house, and not the land. Since land is not depreciable, you’re required to divide the purchase price between the land and the building by their fair market values. There are a couple of ways to tackle this. First, you can base the allocation of the purchase price between land and building based on the assessed value for property tax purposes. For most, this means that you can go to your county auditor website which will assign a separate taxable value for the land and building and then use the percentage allocation used by the auditor to allocate your purchase price. Second, you can make your own fair market determination, as long as there’s a basis to do so. I use a standard percentage division between land and building of 20% and 80%, respectively, which I pretty much came up with from looking at assessed values to begin with. For those starting out, you’ll want to refer to the tax assessed values for your area rather than just adopt my percentage split.

Depreciating Closing Costs

For the closing costs component, you’ll probably need to refer to your Settlement Statement (or “HUD-1 Form”), but you’ll need to exclude any “pre-paids” that are typically listed as buyer’s expenses, such as pre-paid interest, property taxes, and insurance. Those items will generally be reported as expenses for the year of purchase, so they are not included in the cost basis of the property.

Depreciating Initial Rehab Costs

Fix-up costs include every expense that you incur to put the property in rent-ready condition. This is going to include items spent during the initial fix-up period that might otherwise be treated as current deductible expense items down the road. For example, your rehab will likely involve interior painting, which has to be treated as part of the basis of the property at the outset, but which would be fully deducted in the current year when you re-paint, say, at the time a tenant leaves. Why? Well, that’s what the tax code says.

Determining the Start Date for Depreciation of Rental Property

So now you’ve calculated the basis—i.e. the amount that you’re going to depreciate–now you need a start date. You start depreciating a rental property not when you buy it, but when the property is rent-ready. There’s a little bit of a judgment call here. If you buy it in January, but you’re doing a major rehab into March, then depreciation starts in March. But I almost always find that I have some punch out repairs that might even extend after the property has been rented. So, I’m generally going to pick a start date right around when I can show or advertise the property as a finished product.

For the start date, you actually just need a start month. The IRS helpfully has determined the day during the month that depreciation begins. It’s the 15th. The story goes that the IRS had originally started drafting a complicated set of rules to narrow the start date right down to the day, but got tired and ended up with the 15th, collectively reasoning “close enough.” Now, I could use some fancy IRS terminology like “mid-month convention”, but I’m going to just repeat—it’s the 15th. So if you finish your rehab on March 2, you’re depreciation start date is March 15. Close enough.

Determining the Depreciation or Cost Recovery Period for Rental Property

The last piece in the depreciation puzzle is the depreciation period (or “cost recovery” period in IRS parlance). Here’s where the IRS starts with its explanation:

MACRS consists of two systems that determine how you depreciate your property—the General Depreciation System (GDS) and the Alternative Depreciation System (ADS).

Since the whole purpose of this article is specifically not to use terms like “Modified Accelerated Cost Recovery System,” I’ll just cut to the chase. For the most part, two periods will be applicable to about any depreciable property for residential real estate investing. The first is the depreciation period for the house itself. It’s 27.5 years. This depreciation period also applies to about any major depreciable item that you attach to the house—such as a roof, a major kitchen remodel, window replacement, etc. Then there’s the period that applies to about anything that you put in the house. It’s 5 years. This applies to things like kitchen appliances, carpet, and furniture.

The Depreciation Calculation—the Straight Line Method

Now we have all of the necessary information to do the math. For most, depreciation will be calculated using the straight-line method—which means the depreciation deduction for each full year of depreciation period will be the same. To calculate a year’s depreciation, you divide the cost by the depreciation period. For the year that you start depreciating (as well as the last, when you sell it), you’ll be calculating depreciation based on the partial year. Let’s take our example of the property that was ready for rental on March 2 and assume that the cost including rehab is $100,000.

The annual depreciation amount is $100,000 divided by the depreciation period of 27.5 years which equals $3636.36. For the first partial year, the depreciation amount is calculated for 8 full months plus ½ month for March (if you didn’t catch it before—our start date is the 15th). The calculation is 8.5 months divided by 12 months times the annual depreciation of $3636.36 which equals $2575.76. If you bought some appliances for the home, the calculation is essentially the same but using a 5 year period to determine the annual depreciation.

The depreciation deduction for subsequent years, until the year of sale, will be the annual depreciation amount each year. In the year of sale, the partial year’s depreciation calculation will be the same as the first year’s. That is, you’ll figure the partial year’s depreciation up until the date of sale, but will treat the sale as occurring on the 15th day of the month in which the property was sold. Again, close enough.

Depreciating Capital Expenditures for Rental Property

If you incur a capital expenditure after the year of purchase, such as replacing a roof, the expenditure will be depreciated as a separate item. In other words, for tax reporting purposes, you’ll separately depreciate the roof over a 27.5 year period, calculating depreciation in the same way as you calculated depreciation of the home itself, including using a start date of the 15th day of the month in which the roof was installed.

As a final note, I’ll point out that there are alternatives to using a straight line method of depreciation and alternatives to using the depreciation periods referenced above. Different rules may also apply to property purchased prior to 1986. But this, my friends, is where I hop off the train. If you need more information on depreciation or alternatives available, a tax advisor may be in order. In the meantime, I’ll just wish you all a happy tax freedom day, which I believe falls somewhere in late April these days. Here’s hoping that taking advantage of some depreciation deductions will move it a bit earlier.

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