From Business to Real Estate
By Diane Kennedy, CPA
It was over 20 years ago that Robert Kiyosaki came up with the 4 ways you can make money:
Job
Self-Employed
Business
Investments (primarily real estate)
The big distinction that stuck for most business owners is that they really weren’t building a business. They were building a job.
Maybe you’ve felt the same thing. If you don’t show up, you don’t get paid. When you’re ready to retire, you may be able to sell a business but most likely you’re lucky to just be paid a pittance compared to what you would get if it you have a business. This is even more true today when the old bricks and mortar type businesses are going the way of the dinosaur. You need systems and online presence to get paid for your business when you’re ready to exit. Otherwise, you’re left just selling equipment and furniture at swap meet prices.
If you’ve been successful at saving money, you may end up with a pile of cash and no good route to turning it into cash flow. That’s also a common scenario I’m seeing now.
The answer for a lot of people is to turn to real estate. There is no need to wait until you retire, though. You can start now and in fact, it’s better to get the learning curve out of the way as soon as possible so you can hone right in on your personal strategy for real estate.
Before, we jump into this, though, I’d like to ask you a question.
How About Turning Self-Employment into a Real Business?
The difference between a business and self-employment is that a business pays you whether you are there or not. Self-employment means you’re not an employee, per se, but you do have to show up to be paid. You have a business, technically, but really you just have a whole bunch of bosses instead of one
If your goal is to have a business, it’s possible to turn what you have now into a real business. Or, at a minimum, create sideline businesses that build off the self-employment part of your life. In some ways, this may be easier and faster than attempting to launch a new career as a real estate owner.
So, why can’t you make that change with your business?
There are two reasons that I hear:
(1)There is no known way to systemitize the current business (self-employment), and
(2)There is no real value being built with the business
I want to acknowledge those concerns. And this Home Study Course is about using your business income to build real estate passive income. That’s what we’re going to focus on. It is worth a mention now of 18 other ideas of how you can build passive income directly from your business. Those ideas are at the end of this Home Study Course.
Five Ways Your Business Income Can Be Turned Into Passive Income
(1)Fix n flip.
(2)Real Estate business.
(3)Real Estate for your business.
(4)Pension plan investing
(5)Real Estate long term rental.
Now let’s look at these five in more detail.
Fix n Flip
There are a few versions of the Fix n Flip strategy. Maybe you are buying at lower prices with the idea that you’ll sell them to a buyer at a higher price with little to no changes. Maybe you’re going to upgrade the property. Maybe you’re going to do a major change, complete with zoning changes. Whatever the specific strategy you’re using is, they all have the same basic goal. Buy low, sell high.
You are not creating a passive income stream with this. You could be building a business if you’re willing to invest the time and energy it needs to become an expert in this area.
I have some clients who move to this strategy in an attempt to create passive income. However, it’s not passive income. Again you have to show up to be paid and in this case, you are constantly looking for both sellers and buyers. You have to know your market and valuations before you even buy so that you don’t get stuck with something that will cost a lot of money.
I’ve seen a lot of things that didn’t work. Instead of doing a cautionary tale, I thought I would share a real life story of something that did work.
A friend of mine bought a building at a really cheap price from the bank. It wasn’t a particularly busy street and it was in a part of town where there weren’t restaurants or other things that drew people to the area. And, with the changes over the past few decades bricks and mortar retail just wasn’t making it. There were a lot of “for rent” signs on the street already
So, he looked around for ideas on what he COULD do with the building. What did the area need? What would work with current zoning or with zoning that would be relatively easy to get?
He found that the area needed a funeral parlor. He didn’t want to run a funeral parlor and so he went searching for someone who wanted to expand. He found a company, but they weren’t ready to buy just yet so he began renting to them, once he had made the necessary remodeling and gotten the proper zone changes
In about a year, the company bought the building from him, almost doubling his money.
It was a great deal. But, even though there was a short term rental component, it was a fix n flip.
The fix n flip strategy works best for people who are looking to build some cash for other investing. It’s not a strategy to create long term passive income.
The IRS treats the income you earn from a fix n flip just like any other business income. You will want to have an S Corporation or LLC that is taxed like an S Corporation (LLC-S) to hold the property. If you don’t, you’ll be looking at self-employment tax of 15.3% on your taxable income on top of your regular state and federal income tax.
Real Estate Business
If you own property that is used for short term stays and for which you provide substantial services, you have a business not a passive investment. This is according to the IRS definition, so don’t get hung up on definitions that you might think are passive or active. In fact, a real estate business like this could easily produce passive or highly leveraged income if you set up and use systems.
Typically, the real estate business that would fall under this category would be motel, hotel, RV trailer park, vacation rental or the like. People stay for short period of time, the IRS tells us that it needs to be one week and the substantial services are maid service or daily landscaping and clean up.
If you have a real estate business, you need to be thinking of the type of entity you use. Just like with the fix n flip business, you want to have an S Corporation or an LLC that is taxed like one. Otherwise, you will be subject to the 15.3% self-employment tax on top of your federal and state income tax.
If you’re willing to put in the time to develop, document, train and enforce systems, you could create a nice side business that creates income that you don’t need to work in. This is especially true with RV parks or vacation rentals. Hotels and motels can be brutal businesses and turn into money pits if you aren’t paying attention. That may not be a good way to diversify income sources if your primary goal is to work less.
However, you can take deductions for losses on your real estate against other income.
Real Estate for Your Business
One of the common real estate investment strategies for real estate investors with businesses is to buy a property to house their business.
There are a couple of things that make this type of investment different from buying a standard house, apartment building or commercial space to rent out.
If you buy a property to rent out to your own business, the rental is considered a self-rental. The IRS regulation on self-rental provides that when a taxpayer rents a property to his or her business, the rental profit is not treated like a passive activity. That means you cannot use the self-rental income to offset passive activity losses.
One important distinction is that this is applicable only if you have materially participated in the business using the 5 out of 10 year rule. This could be come back to trouble you if you sell your business and retain the building, to rent out to your business purchaser. It will still be a self-rental until that 5 years has expired.
The 5 out of 10 year rule states that the self-rental rules apply if you’ve had the property as a self-rental for any 5 years in the past 10 years.
Pension Plan Investing
There is a whole Home Study Course on Pension Plan investing. We don’t want to repeat all of it here because there is just too much to cover. So, let’s instead focus on why pension plan investing may work best for a business owner, what you can’t invest in and who you can’t invest with.
The theory with pension plan investing is that you take a deduction when your income is high with a deductible contribution to your pension plan. This generally works best if you don’t have any other full time employees. If you do have employees, you will have much higher cost and you may need to look at the cost/benefit of putting an aggressive plan in place.
If it works for you, the pension contribution is a deduction and then you can build up passive income inside the pension. Later, when you retire or cut back on your earned income, you can start to distribute out assets from the pension. It’s taxable when you do it, but your tax rate should be lower.
There are two more things I want to cover now. These are the things you can’t do.
Disqualified Persons
Internal Revenue Code Sections 4975 & 408 prohibit fiduciary and other disqualified persons from engaging in certain type of transactions. The definition of a disqualified person (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, and includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest.
Let’s break that down into plain English.
The following are generally considered disqualified persons:
- The IRA holder,
- The IRA holder’s spouse,
- The IRA holder’s ancestors and lineal descendants,
- Spouses of the IRA holder’s lineal descendants,
- Investment managers and advisors,
- Anyone providing services to the plan (IRA), e.g., the IRA trustee or custodian, and
- Any corporation, partnership, trust, or estate in which the IRA holder has a 50% or greater interest.
You can’t participate in self-dealing. That includes any kind of dealing between your parents or your children and real estate owned by your self-directed pension.
You cannot use any property your self-directed pension owns for your own personal use or for your spouse’s use.
Your ancestors and descendants, their spouses and families also cannot use any property your self-directed pension owns.
You cannot lend money to or borrow money from your self-directed pension. That also includes any entities that you control. Your ancestors and descendants and their companies are also precluded from lending or borrowing as well.
You cannot sell property to or buy property from your self-directed pension. Same is true for your lineal family and entities any of you may control.
You cannot directly provide services to your self-directed pension.
Common Prohibited Transactions
There isn’t a lot of grey area when it comes to the rules about pension plan investing. If you break one of the rules, if your pension plan deals with yourself or another disqualified person or your pension plan has a disqualified transaction, you can face some big penalties.
Here are some common prohibited transactions that can trippeople up:
- Borrowing money from a self-directed IRA (you can borrow from a Solo 401(k) however),
- Using the self-directed IRA as security for a loan,
- Selling personal assets to the self-directed IRA,
- Buying property in the self-directed IRA for personal use, or
- Purchasing property from a disqualified relative i.e. Spouse, Children, Parents of the self-directed IRA holder.
Prohibited Investments
In addition to being prohibited from engaging in certain types of transactions, IRAs are also prohibited from investing in certain investments.
These prohibited investments are:
(1)Collectibles such as art, rugs, antiques, metal, gems, stamp, coins, alcoholic beverages or other tangible personal property; and
(2)Life Insurance
What Can You Invest in?
Now that we’ve gone through prohibited transactions, prohibited investments and disqualified persons for activities within the pension plan, let’s look at what you can do.
The law that pertains to IRA investments is an exclusive list, not an inclusive one. You are told what you can’t do, not what you can do. If it’s not on the “don’t do” list, it’s okay to do it. Your pension plan could invest in:
•Mutual Funds,
•Stocks,
•Bonds,
•Certificates of Deposits ,
•Private Placements,
•Limited Partnership Interests,
•C Corporation Stock,
•Promissory Notes,
•Trust Deeds (or Mortgages),
•Real Estate, and
•Much More!
Pension investing works best if you have higher income than you expect to have in subsequent years.
Real Estate Long Term Investing
Usually long term real estate investing is what people mean when they talk about creating passive real estate income.
There are three reasons why people invest in real estate:
Appreciation
Cash flow
Tax breaks
The appreciation is not always certain. If that’s your only reason for investing, then you’re better off with a fix n flip investment strategy. Otherwise, you’re hanging on to an investment that costs you money month after month.
Cash flow is king when it comes to long term rentals. Your property should, at a minimum, provide positive cash flow after you deduct the direct expenses such as mortgage interest, property tax, insurance, HOA dues, utilities, repairs and the like. If your property is not doing that now, consider what you would need to do to get that investment up to speed.
Paying down debt and refinancing may reduce your mortgage payment and thus give you cash flow, but if that’s what you have to do to make cash flow it’s not a good use of your funds.
One of the calculations I always do on properties is the COCR (cash on cash return). Divide your annual net cash flow by the cash you have invested. Your COCR goes down as you invest more cash to bring your debtand payments down. It might mean you have cash flow when you didn’t have it before, but your return on your cash will be less than optimum.
There are a couple of ways to look at the tax advantages. Thanks to the benefit of depreciation, which lets you take a deduction against rental income that doesn’t actually cost you cash, you can create a tax loss, or zero income when you actually have cash flow income.
It’s a legal way to keep a second set of books. One shows your return and one show what you tell the tax man. And it’s all legal.
If you have a tax loss, you may be able to take that loss against other income you have. That’s the best of all worlds but there are a couple of gotchas.
First, if your adjusted gross income is less than $100,000, you can take up to $25,000 in write offs against your other income. If your adjusted gross income is over $150,000, you can’t take any write off. Between $100,000 and $150,000, the amount you can write off phases out.
There is one exception. If you or your spouse (if married, filing jointly) qualify as a real estate professionally, you get the write off no matter how high your income is and no matter how high the write off is.
Let’s look at the real estate professional status in more detail. We do have an entire Home Study Course on the nuances and strategies with the Real Estate Professional status, so even the “more detail” is not going to include everything.
The Real Estate Professional Tax Loophole
Real estate tax breaks occur because you can use real estate losses to offset other income. Of course, you can look at the cash flow you receive as being tax free, and it is. That alone can make a big difference. Would you rather make money and pay tax or make money and not pay tax?
Sometimes real estate investors, especially ones who are new to the investment world, buy properties that create loss. They have negative cash flow right from the beginning because the rents aren’t in sync with the high cost of the property. That has to be the worst of all worlds, paying money out of your pocket each month to keep your property afloat and then not being able to take a deduction