Should Five Office Workers Pool Resources and Form Corporation?
QUESTION: I plan to invest with four other people from my office in a real estate investment group. We will buy two rental townhouses. Do you think we should form a corporation?
ANSWER: No. Corporate ownership of small real estate investments offers virtually no advantages but many disadvantages. Limited liability is the major advantage. However, you can limit your liability by carrying adequate liability insurance. But corporate disadvantages of real estate investments include possible double taxation of profits and limitations on pass-through of losses.
A far better alternative is a limited partnership, which limits your liability but allows pass-through of tax benefits to the limited partner investors. A real estate attorney can prepare your limited partnership agreement.
Types of Investments Beginners Should Seek
Q: What do you recommend as the best type of realty investment for a small investor just getting started? A business associate owns small apartment buildings but he is always complaining about his troublesome tenants. Are apartments good investments?
A: Yes, apartments can be excellent investments. However, as a former apartment investor, I am prejudiced toward single-family rental houses. I find them much easier to manage. Also, houses rise in market value as neighborhood values appreciate. But the value of apartments depends on their net income.
To be more specific, I recommend buying run-down “fixer houses” which you can upgrade to increase their market value. After you renovate, then you can either sell for an immediate profit or hold for long-term investment. Further details are in my special report “How to Earn Big Profits Fixing Up Houses” available for $3.50 from Newspaperbooks, 64 E. Concord St., Orlando, FL 32801.
Making Tax-Deferred Trade for Apartments
Q: If we sell our large old home our profit will be about $150,000. We would like to use our profit to buy an apartment building where we could live in the manager’s apartment and run the building. Is there any way we can avoid paying tax on our home sale profit?
A: Yes. Move out of your home and rent it to tenants, thereby converting it to investment or business property. Then it is eligible for an Internal Revenue Code 1031 tax-deferred exchange of business or investment property such as apartments. Personal residences do not qualify for this preferred tax treatment. Please consult your tax adviser for further details.
How to Decide Whether to Rent Out or to Sell
Q: About six months ago I bought a run-down house, which I have now fixed up into first-class condition. I paid $119,000, which was a bargain. After spending about $25,000 on fix-up, the house is now worth close to $200,000. However, the problem is it will only rent for about $1,100 per month. Do you think I should sell or keep this house?
A: Congratulations on your successful and potentially very profitable purchase and fix-up of that house. You have a very pleasant dilemma.
Although you didn’t give details of the financing, I presume you have substantial mortgage payments to consider. If the rent will not pay your monthly expenses, I strongly suggest you sell the house to avoid the negative cash flow.
I often encounter the same situation you describe. I hate to sell property because it usually skyrockets in market value just after I sell, but I also dislike negative cash flow. Since you have a handsome profit and the low rent attainable does not justify keeping the house (unless it is appreciating nicely in market value), I vote for selling.
Be Wary; Out-of-Area Investing May Be Risky
Q: I hear from a very reliable source that the real estate market in Houston has bottomed and is starting to rise slowly. A real estate company there will buy and manage rental homes for me. They already have tenants for these houses. Do you think this is a good deal?
A: No. Please don’t invest money you can’t afford to lose. I do not advocate investing far from home because too many long-distance investors lose money since they cannot manage their out-of-town properties.
For example, just a few days ago I heard from a reader who owns an Idaho rental house that has declined in value the last few years and is now worth $20,000 less than the mortgage balance. If this lady lived in the community she could have observed local economic conditions and sold the house while she had a profit or her loss was small. Now she has a very costly problem.
Yes, I have heard the Houston real estate market is recovering. However, watch out because mortgage lenders are holding thousands of foreclosed properties off the market there in hopes of rising prices. If prices rise, don’t be surprised when the lenders try to unload their foreclosures.
The grass is usually greener close to home within a half-hour to one hour maximum drive. As I’ve often said, you can see, feel and smell your investment property when it is nearby. That means you can easily manage nearby investment property to maximize its benefits.
Deducting a Loss on Home Brother Rented
Q: About two years ago we moved out of our home in Louisiana. We rented it to my brother and his family. However, he just lost his job and has decided to move away from Louisiana. Our problem is the house has declined in value about $25,000 from what we paid for it. Stupidly, we paid all cash when we bought the house, so the loss will come out of our pocket. My attorney told me a loss on the sale of a personal residence is not tax deductible. Is this true?
A: Yes. Losses on the sale of your personal residence are not tax deductible. However, when your brother and his family moved into your former principal residence that converted it into business or investment property. Losses on the sale of business and investment property are tax deductible. Please consult your tax adviser for full details.
Be Prepared for IRS Tax-Deferral Challenge
Q: About a year ago we tried to sell our home but were unable to do so because of local economic conditions. So we rented the house. Now we want to sell as the market has improved considerably. Will we be able to defer the tax on our sale profit which we expect will be about $30,000?
A: Probably. As you surely know, Internal Revenue Code 1034 allows you to defer your home sale tax when selling your principal residence if you buy a replacement principal residence of equal or greater cost within 24 months before or after the sale.
However, this law does not say if a temporary rental due to local economic conditions will disqualify the tax deferral. But a Tax Court decision (Clapham 63 T.C. 505, 1975) allowed tax deferral in similar circumstances where the seller took three years to sell his former residence which he rented in the interim. If you claim tax deferral be prepared for an IRS challenge which you may successfully meet. Please consult your tax adviser for full details.
He’s Cash Poor, but Income Property Rich
Q: I have never seen my problem discussed in your excellent column before and hope you can help. My wife and I own a small apartment building free and clear. But if we sell we will owe a huge tax. However, if we don’t sell we will be facing repairs that we can’t afford. What do you recommend? Should we sell?
A: You are property rich and cash poor. This is a common situation among real estate tycoons, so don’t feel bad.
I never recommend selling sound, well-located real estate without a very good reason. Unless Congress reduces the capital gains tax rate to make selling your investment property a viable alternative, you might want to obtain a new mortgage to solve your cash crunch problem. Since you can surely afford the payments from the rental income, this is probably your best alternative.
Letters and comments to Robert J. Bruss, a San Francisco-area lawyer, author and real estate broker, may be sent to the Real Estate Section, Los Angeles Times, Times Mirror Square, Los Angeles 90053.
