In this week’s case study, the “Money Talks” hosts take a look at a professional who is ready to retire early at 58. Currently, he earns a healthy salary, but is willing to take a part-time board position, significantly reducing his salary. However, his main reason for the decision is he has a desire to invest in real estate, purchasing a 4-unit rental property. Although he may someday sell the property at a profit, the greater part of his return will likely come from rental income.
He could purchase the residence in his IRA, but this would require a self-directed IRA, and most of the major custodians do not accommodate this type of investing in IRAs. The risk for the institution is high, and the fees charged are significant. The risk lies in disqualifying the IRA through what may be construed as prohibited transactions. In general, he cannot sell property he already owns to his IRA. Additionally, he nor certain family members can use the real estate while it’s owned by the IRA. Self-dealing transactions can result in the entire IRA being disqualified or becoming taxable. The home must be one that he has purchased with the funds in his IRA specifically for the purpose of renting it. Moreover, he cannot easily mortgage a house in an IRA as banks are wary to lend money to an IRA, since the note is not personally guaranteed. It takes away some of the advantages of real estate: the leverage of a mortgage and tax deductions.
The problem with real estate is the misconception that we, as homeowners, have experience. Just because you are a homeowner and may have rented your home or vacation home does not mean you have the experience to manage a real estate business. First and foremost, real estate is not a passive activity; it is a job. This is something you have to pour your heart into. People often think they will buy a house and rent it for $1,000, and then every year, raise the rent 3%. On paper, this is an incredible business. There is a great potential to make money, as real estate is generally considered a long-term growth investment.
The risks come in the form of a tenant who doesn’t pay the rent and requires eviction proceedings, or one who causes extensive damage to the home. Before he is able to rent it to a new tenant, he would have to put time and money into the house to repair it, making it an attractive place to live. Other substantial risks include local political or economic changes, as well as, changes in tax laws, zoning laws or traffic patterns—all which could affect occupancy rates and property values. In our opinion, real estate is not a passive activity. An investment in McDonald’s is passive, because the CEO does not call an investor to tell him that someone has flushed a t-shirt down the toilet.
In reality, regardless of whether it is real estate, what this individual is doing is starting his own business. With a new business, he has to consider his business structure as that can affect his personal liability. He also needs to consider establishing a retirement plan to take some of the money he’s earned off the table. There are tax benefits he may be eligible for, including home office deductions, mileage or even health insurance for his wife and him. He will likely need more than a C.P.A. to do his taxes. He could benefit from a tax consultant to guide him through the decisions that will affect his taxes, as well as help with bookkeeping, accounting and possibly hiring a management company to oversee his properties. He will also likely need the assistance of a lawyer to look over contracts, help evict tenants when they do not pay rent, and to appear in court when necessary.
Creating a business is a huge decision—one not to be taken lightly. If you have questions regarding how starting a business will affect your overall financial plan, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
