Financing Your Investment

Now that you know why real estate investment is a good idea, it’s time to learn how to do it. But before we get into the nitty-gritty details of each investing method, let’s address the elephant in the room: To make money, you need to have money to invest, right? Well, yes and no.

While you do need money to invest, it doesn’t necessarily need to be your own. If your only reference for real estate information is house-flipping T.V. shows, you might assume real estate investing is all about cash buying. There are many investment deals that transpire throughout the real estate market on an annual basis. The majority are achieved through traditional lenders and institutions such as banks, but some are accomplished through less traditional means. In most cases, it’s because the investor couldn’t raise the capital or didn’t have the credit score to do so.

According to the most recent NAR® Investment & Vacation Home Buyers Survey, 47% of investors financed less than 70%. And more than half — 64% — used a mortgage. So, whether you’re reading this as a newbie or a seasoned pro, you shouldn’t feel bad — not even for a minute — if you don’t have the cash to use.

In fact, the ultimate goal for real estate investors is to not use any of their own money at all! This works to every investor’s advantage — those without the funds can still get in the game, and people who’ve been playing for a while can use other people’s money as a way to invest more, which leads to increased income.

Obviously, there isn’t a bunch of people out there willing to just hand over their cash so you can invest. This is when having a solid network is important. You’ve got to be clear on whom you access for help and how to best use the help they give you.

It’s also to your advantage to have a high credit score. Why does this matter in this business? First, you’ll get more access to working capital, but you’ll also have lower interest rates if you do take out mortgages or loans, which can lead to significant savings versus people with “so-so” or low scores.

WHERE TO GET MONEY

Investing without Your Own Money

The first and most common option is hard (i.e., private) money lenders. In this case, people or businesses loan you money as an investment for themselves. They make money through fees and interest rates, both of which tend to be higher than other types of loans. One way to make sure you still come out ahead in the deal is to use these loans to buy homes at 50 cents on the dollar.

Partnerships are another popular way to get funding. These can work in a variety of ways, but you want to make sure that you balance each other out well. For example, if you have a less-than-stellar credit score, make sure your partner has a great one. Perhaps you can be the one to find the ideal properties and your partner can get the financing, which will come with lower fees and rates thanks to that higher score.

Keep in mind that you don’t want to partner with someone just because you already have a good relationship. The key to a fantastic partnership is being in sync, such as agreeing on what kind of risks you’re willing to take, determining what short- and long-term goals you have, figuring out who will do what, and deciding what kind of return you’d like.

Investing with Your Own Money

If you don’t have access to private lenders or partners, you can still start your investing career without having all the money on hand.

One way to do this without paying any money upfront is through home equity. You can use this by taking out a home equity line of credit (which leaves your mortgage as-is) or rewriting your mortgage and getting a cash-out refinance. Of course, this works only if a) you currently own property; and b) there’s capital in it.

Another route is a lease-option, also known as option to buy. In this situation, you would rent the property, but sign an “option to buy” at a later date for an agreed-upon price. This legally binding path to property ownership might take a little longer, but is still a viable option if you have the funds.

Seller financing is just like getting a loan through a bank — except you agree to the payback and terms directly with the seller. This loan should include a repayment schedule, interest rate, and consequences, should either party default on their agreement. Often, these agreements include a significant down payment (sometimes higher than mortgages). Many of these agreements also involve the seller holding on to the deed until the buyer has completed all the payments.

An option that may or may not work for you is investing your retirement funds. This typically doesn’t work for people over the age of 60 because there’s not enough time for rental income to pay off the mortgages. The so-called “sweet spot,” age-wise, is around 35 to 40. This is because people this age have theoretically been paying into a retirement account for about a decade and might have a fair amount to spend. Also, there’s time to get a good return. Perhaps the mortgage will be paid off in 10 years; after that, the net income after operating costs is all yours.

Your retirement account can be used for purchasing and maintaining properties as well as collecting rent. However, none of that money can go directly to you until you’ve reached the age when you can start withdrawing money out of the account. (Well, you technically can withdraw in many cases, but if you’re younger than the legally allowed age for withdrawal, there might be a significant penalty. This could mean losing thousands of dollars, depending on how much you take out.)

Self-Directed IRAs (SDIRA) are traditional or Roth IRAs (individual retirement accounts) that allow you to invest beyond the usual mutual funds, stocks, etc. With an SDIRA, you can invest in precious metals, tax lien certificates, and — most importantly, for our purposes here — real estate.

When you use your IRA to buy real estate, there are some important things to keep in mind. First, you’re required to report the value of your investment to your IRA custodian every year. Also, the fee structure can be complicated, so you need to understand what you’ll owe and how that relates to your overall profit. Also, your investment needs to bring in enough money to pay for both regular maintenance and any expenses that come up without you having to add cash.

The major benefit of using an SDIRA for your real estate investments comes down to taxes. With a traditional IRA, it’s tax-deferred income, but with a Roth IRA, your gains are tax-free, and the money will also be tax-free when you ultimately withdraw it. If you go this route, you can move funds around from multiple projects without affecting your taxes. (Keep in mind that tax and another financial laws can change at any time, so make sure you keep on top of any changes, and make any adjustments, as needed.)

One tax downside is that if your property has a net loss, you don’t get the tax breaks other investors get. You also can’t claim depreciation.

Another advantage of real estate over traditional retirement accounts is the return. Real estate can net you perhaps an 18-20% return over 30 years, whereas the more common accounts, IRAs, 401(k)s, etc., might only get you 3-6%. Not only that, but you can use compounding to your advantage. If you keep investing your money for the first 20 years, you can leave it for the last 10 and just let it grow. Doesn’t doing almost nothing while still making plenty of money sound great?

As with any investment, there are risks to using an SDIRA. You might make a bad decision or get scammed, which is so common the SEC has an investor alert about the scamming risk for SD-IRAs.

Other risks include not having enough diversity in your investments (it’s hard when you have limited funds) and potentially not being able to access the money — even once you’re retired, due to liquidity issues. This means you might not be able to take out the required minimum distributions. Again, this is why diversification is important; you need to have enough cash to meet all the requirements.

Speaking of “following the rules,” it’s vital you know them all. If you do something wrong, you might accidentally disqualify the IRA, which means you’d owe taxes. This includes not purchasing property for yourself your immediate family members. (You can’t buy property from them or sell property to them, either), but there are many other more nuanced rules, as well.

TAX BENEFITS FOR REAL ESTATES INVESTORS

Because both federal change and state local taxes can vary, there’s no specific guidance I can give about that here. However, please understand that the tax ramifications of any kind of real estate investing will depend on your particular location and circumstances as well as annual changes in the tax code. I strongly recommended that you consult with a CPA or tax attorney before beginning any real estate transaction or investment.

With that said, at the time that I write this book, there are some general tax-related benefits for real estate investors that I want you to know about.

The first has to do with all the deductions real estate investors can get: mortgage interest; business expenses, such as property management, office, mileage, travel, educational events, etc.; repairs; and improvements made that increase your property’s value. All of these can be immediately deducted, with the exception of improvements, which are depreciated over time.

Depreciation of the property itself, regardless of any work done, is also a tax deduction, and it’s done over the course of time. Commercial properties can depreciate over a longer time than residential (currently 39 years versus 27.5 years). The land on which the property resides never depreciates. If you rent out a property, sometimes depreciation can get you a phantom gain. Here, on paper, the numbers look like a loss; however, because of the depreciation amount, you actually come out ahead. A tax attorney or CPA can help you figure out exact numbers for your situation.

1031 Exchange

Another benefit is the 1031 exchange, which allows you to put off paying capital gains taxes if you use your profit from a real estate sale to buy another property. This makes your income essentially tax-free, and you can put all your profits toward the next property, which is called trading up.

A 1031 exchange covers only business or investment properties. In general, vacation or second homes don’t qualify, but you should check with a tax expert to see if there are any exceptions, especially when it comes to the usage test.

There are three specific requirements to qualify for a 1031 exchange, and you must meet all of them:

• • The like-kind exchange. The property you buy must be similar to the one you sold. The purchase price of the new property must be the same as, or more than, the one you sold. There’s no switching from commercial to residential or vice versa; however, you can often exchange property and land.

  • Time restrictions. You must officially record identifying a new property within 45 days of selling your old one. There are different ways to identify replacement properties:

  • Find three properties, not worrying about their fair market value.

  • Identify as many properties as you can, as long as their aggregate fair market value is less than 200% that of the sold property on the date of the transfer.

  • If the above two rules are exceeded, you can buy 95% of the aggregate fair market value of the identified properties.

 

You also have to close on the new property within 180 days of the previous property’s sale.

• • A qualified intermediary. Not only can you not be directly responsible for the transactions or money, your intermediary must be someone with whom you haven’t worked for at least two years.

Savvy strategies can significantly impact an investor's tax liability and overall investment growth. In an interview that investing advisors The Motley Fool conducted with Thomas Castelli in 2019, Castelli describes the 1031 exchange as a powerful tool for investors, allowing the deferral of capital gains taxes when the proceeds from a property sale are reinvested into a new property: What a 1031 allows you to do is invest that entire amount so you’re not paying the taxes today, and you can purchase a larger property. This mechanism not only defers tax liability but also enables the continuous escalation of property investments. As Castelli explains it, In theory, you can just keep purchasing larger and larger properties, making more and more cash flow, but never actually paying any taxes on that property.

Moreover, it holds the potential for tax elimination on capital gains if the properties are passed on to heirs, as they are revalued at the market rate at the time of inheritance. So investors could leave their appreciated properties to their heirs. The heirs would then inherit these properties at the fair market value at the time of the investor's death, effectively resetting the tax basis and potentially erasing the capital gains tax that would have accrued during the investor's lifetime.

Castelli also discusses opportunity funds, which present another avenue for tax-efficient real estate investment, particularly in designated low-income areas known as opportunity zones. These funds offer a variety of tax incentives, including the deferral of capital gains taxes on a broad spectrum of assets. The tax benefits escalate with the duration of the investment: a 10% step-up in basis after five years, increasing to 15% after seven years, and culminating in a complete tax exemption on the fund's capital gains after a decade. However, these benefits come with stringent requirements, such as substantial asset improvement or ground-up development, and a minimum holding period of ten years. Castelli notes the potential of these funds, stating they aim to raise the status of those communities and opportunity zones.

Both the 1031 exchange and opportunity funds offer pathways for real estate investors to not only defer and diminish tax liabilities but also to contribute to community development, albeit with certain conditions and requirements.

RENTAL TAX SPECIFICS

Rental property owners are open to a variety of benefits, which I’ve listed below. You’ll notice that several are the same as for other real estate investments.

Also, as with all properties, if you sell within a year of buying, you’ll be taxed at your income rate. If you hold on to a property for a year or more, as is usually the case for rental properties, you’ll deal with capital gains tax, which is a lower rate.

Your overall tax deductions can depend on what type of investment business you have (sole proprietorship, partnership, or corporate entity). And, as always, do your research to make sure you’re up-to-date on all the latest tax laws, as these can, and do, change.

Rental property tax benefits:

• • home office, office supplies, computer software

  • mileage

  • travel

  • meals (50%, as long as you’re having a business meeting while eating)

  • mortgage, unsecured loan, and credit card interest

  • loan origination fees or points (they’re considered kinds of interest)

  • utilities, trash, and recycling

  • property taxes

  • licensing fees

  • occupancy taxes

  • insurance, including liability, hazard, fire, sewer backup, flood, and loss of income (talk to a tax professional if you have an umbrella liability policy or a landlord liability policy)

  • maintenance, repairs, improvements, and cleaning

  • advertising

  • commissions to real estate agents or property managers who find tenants and renew leases (this is considered part of marketing, not property management)

  • property management fees, salaries, and benefits (if you manage yourself and your business is an LLC or corporation, you may be able to be employed and have your salary be deductible)

  • homeowners’ association fees (HOAs), as well as whatever HOA requires, such as specific “For Rent” signs

  • professional and legal fees, including bookkeeping, filing taxes, and all legal work

  • any losses incurred up to $25,000 per year; anything over that can be carried over to the next year. Note that your tax savings will be less than you lost

  • Social Security (FICA) or self-employment taxes (the benefits vary, but can range from about 7.5% to 15.3% of your profit)

  • second/vacation homes rented out for at least two weeks per year might allow you to write off advertising and rental commission and prorate other expenses

  • some states have historic tax credits that include both the rental operation and/or any renovations

  • incentives from your state or locality to invest in lower-income areas

You’re also required to take a deduction for depreciation. Just know that when you sell a rental property, you’re subject to depreciation recapture. Any gain that has to do with depreciation is taxed at 25% (as opposed to 20% for regular capital gain). The depreciation-related gain is also called unrecaptured section 1250 gain.

One way to mitigate this is to always keep track of passive activity losses. While they may not be deductible while you own the property, they are when you sell it, which means the amount you’ll owe will be less.

By the way, if you’re thinking, “Well, I just won’t claim depreciation, then,” I’m sorry to tell you that this simply won’t work. The IRS states that the recapture’s calculation is based on “allowed or allowable” depreciation, meaning that even if you didn’t claim it, you’ll still have to pay it. You might as well get the deduction while you can, and perhaps consider setting it aside for when you do end up selling the property.

ALL ABOUT CREDIT SCORES

As I briefly mentioned, credit scores can play an important role in getting financing and the rates you’ll need to pay. I want to talk in detail about what makes up a credit score so you’ll know what you need to do, should you want to improve it.

First, your score is a number that tells lenders how likely you are to pay back the money. When you have a higher score, you get better rates, which leads to long-term savings and more money in your pocket.

Credit scores are often based on the FICO scoring model. They can range from 300 to 850:

• • Bad credit: 300-600

  • Poor credit: 600-649

  • Fair credit: 650-699

  • Good credit: 700-749

  • Excellent credit: 750-850

The determining factors and how much weight they carry vary between credit agencies (TransUnion, Experian, and Equifax). However, the following five are the major contributors to your score:

• • Payment history: 35%

  • Outstanding balances: 30%

  • Length of credit history: 15%

  • Types of accounts: 10%

  • Credit inquiries: 10%

By knowing your credit score, you’ll have a clearer picture of your investment strategy. If your score is high enough, you might be able to get a traditional loan and help with down payments. If your score is lower than you’d like, take a look at the determining factors and see where you can improve — making on-time payments should clearly be a priority. You can also consider paying down balances as you’re able, and not opening up a bunch of new credit cards.

BEWARE OF SCAMS

With so many people out there looking to make money in real estate, it’s pretty much expected that there will be people out there ready to take advantage. The two main types of scams to watch out for are seminar scams and lending scams.

Seminar scams can give some truly helpful tips, but it’s always used as a way to gain people’s trust. Once they have the trust, they’ll offer “limited-time” investment properties or expensive classes.

When people fall for the trick and buy a property, they often find that it’s got a lot of issues and is quite likely a money pit. However, signing up for classes can be negative, too. Why? Because people often end up spending thousands of dollars for little to no new information when that money (and their time) could’ve gone toward their investments.

To make things even worse, people who get taken in by scammers often sign agreements without reading them through. These documents often include a section that keeps the scammed people from taking legal action against the scammers.

So how do you find genuinely helpful seminars? (Yes, they do exist.) Do your research! Look up the organization, the presenter, the properties, and the courses. You can also start by looking up certified experts and see if they offer any educational opportunities.

Lending scams are another common scam in real estate. It’s a fairly easy type of scam for real estate investors to fall into because often they’re looking for alternative financing (i.e., private lenders) that doesn’t have the same qualifications required by traditional mortgages.

This kind of financing often has a requirement to pay back the money more quickly and tends to have higher interest rates than mortgages. Those things alone don’t mean they’re a scam, though. The problem is that lenders don’t have to be licensed to hand out money, so it can be a bit tricky to make sure the lender’s legit.

So, how do you make sure the lender you’re working for is on the up-and-up? First, you find the lender through one of the following ways:

• • Through a certified real estate investing website

  • Through referrals from people in your network who’ve personally worked with the lender

Second, you should ask the following questions (and if the answer to any is “yes,” it’s probably a red flag, pointing to a scam):

• • Does the lender seem to know details about investing and lending, including the correct jargon?

  • Is there a major upfront fee?

  • Does the lender seem a little too eager to give you the money? In other words, do they skip asking you essential questions and get right down to the “money talk?”