In the final analysis, investment boils down to sacrificing income and assets today in order to enjoy them at a point in the future.
The less you invest for the higher return, the less sacrifice and. the sooner you can start enjoying the profits you make in real estate investments. Several factors influence investment and net return. These factors are:
To the extent you can use these factors to your own advantage, the higher your yield will be. Almost all real estate investors and speculators use Debt Leverage to acquire and control assets, but this is risky and expensive. Let's review:
- Credit is usually obtained from institutional lenders at market interest rates and terms.
- Borrowers have to guarantee payments personally, thereby placing all their assets at risk for each additional loan they sign on personally.
- When net market prices after costs of sale and taxes are rising at a rate in excess of the rate of interest, the use of leverage is warranted, but .. .
- Appreciating property values don't offset negative cash flow unless the property is sold, or re-leveraged.
- Selling property to replace cash flow robs the seller of all future appreciation in a rising market.
- Borrowing at higher and higher interest rates to increase cash reserves with which to repay debt on negative cash flow property merely transfers equity to the lender.
- Risk for the debt-leveraged owner is increased by external factors such as the EPA (Lead Paint, Asbestos,
Formaldehyde, Radon), Social legislation (Rent Controls), Down-Zoning and restricted use policies.
- Control of a property through the use of leases + Options without ownership removes most of the risk associated with real estate investing and speculation.
- Leases and Options enable those without much money to leverage future profits without the need to qualify for, or to guarantee, acquisition loans, or repayment of them.
What is a Real Estate Option?
An Option is a marvelous tool that reduces risk while passing on to the holder most of the benefits that can be obtained from leveraged real estate. An Option can be used to pass on tax-free cash to a high-bracket seller, or to enable another seller to be able to cash out a personal primary residence tax free.
Options are ideal for building up tax free cash inside a Roth IRA which otherwise would be subject to tax if it invested in conventional debt leveraged assets. An Option can be used to extend the 45 day period allowed to identify a replacement property when doing a delayed tax free exchange. Options can also enable those who can't find loans with which to buy property with a low down payment to nonetheless buy properties on the installment plan. Let's take a closer look:
Anyone who sells a property within one year of its purchase pays ordinary income tax on the profit. This can be as high as 40% plus state tax. Suppose a seller had an opportunity to sell a property for a quick windfall profit after owning it only 9 months. He wouldn't want to turn down the offer, but would want to reap the benefit of the 20% long term capital gains taxes rather than pay 40+%.
Suppose, instead of selling the property itself, the seller sold an Option on it, then allowed the Optionee to close the Option only after a full year had passed. In this instance, he'd be able to receive the money tax free until the Option was exercised, and would only pay 20% tax on the sale. That could be a real plus for market traders and real estate investors alike.
The same market timing strategy would apply to anyone who wanted to sell a primary personal residence that they had only lived in and owned for a period less than 2 years out of the most recent five years. In such case, a buyer could buy an Option, give them the Option money tax free; then complete the purchase and move in after the two year period had elapsed.
In special situations, such as where a home owner is selling a residence that he has bought under a lease/Option, he might have lived in the property for 2 years, but not actually owned it for two years. In this case, the owner might sell an Option to a buyer for a significant sum, and let him move in on a lease until the two years had expired. Both the Option consideration and the final payment would be tax free to the seller.
Pure Options can be purchased for cash or for management effort. They can be written to capture all or a portion of any price appreciation as well as loan amortization. The trouble with Roth IRAs is that it is difficult to accumulate much money from contributions and build up in values in any significant amount until several years have elapsed.