KSS 13 | Real Estate Notes

 

Sometimes, the simplest things tend to be easily ignored. The same goes for finding the right techniques to use for real estate and real estate notes. Kevin shows you how you can lower your risk, minimize your taxes, and maximize your returns by simply combining the best of real estate techniques with the best note techniques. He talks about capital gains taxes to that of combining lease options with property sale, discussing the benefits it gives tenant-wise to cash flow. Giving you case scenarios, find out more how you can make the best out of the best techniques out there because there is really no magic to it, only having the right person showing it to you.

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Lower Your Risk, Lower Your Taxes By Combining Real Estate And Real Estate Notes

I have got a good one for you here. We’re going to cover some ground here and combining the best of real estate notes and also considering taxation. We’re enveloping another criteria within this because there’s a technique that I love and more and more people will start applying it once they understand how it works. There’s no magic to it. Sometimes having someone like myself pointing these out to you, it almost becomes where you go, “Of course, why didn’t I think of that?” That’s what these techniques are. It’s taking a real estate technique, combining it with a note technique and taking advantage of the way our taxes laid out, specifically our capital gains taxes. What is this technique? What is the strategy and how do we do this?

Capital Gain Taxes

Let’s talk a little bit about capital gains taxes. Capital gains are profits when you sell an asset like property, stocks, businesses, and what have you as well. Any time you sell an asset, you’re going to pay a capital gains tax. What tax you pay depends upon your income bracket in the time that you keep it. You will have short-term capital gains if you have bought the asset and sold it within one year or less. A short-term capital gain equals your ordinary tax bracket, whatever that might be. That can be a variety of things going anywhere from on the low end 10% all the way up to 37%, depending upon your individual tax bracket. Long-term capital gains can have a tax rate of 0%, 15% or 20% depending upon your income and filing status. That can be a significant difference. Long-term capital gains are paid if you hold an asset for longer than a year, let’s say a year and a month or thirteen months. That’s going to completely change your bottom line because capital gains tax on a long-term basis, depending upon your income. If your income is less than $38,000, it will be zero.

Combining Lease Options With Property Sale

For most people it’s probably going to be 15% which is an income of $38,000 to $425,000. If it’s above $425,000 income, it’s 20% capital gains. 15% is the number that I’m going to use on that, but you would much rather pay 15% taxes than you would at your regular income tax bracket? If you’re in a 35% income tax bracket and you’re doing short-term capital gains. That would be a much bigger hit than 15% if you kept that asset for over a year. Now, that we have a very brief understanding of what those are, what is the techniques that I’m applying here? The application of this technique is to combine lease-options or in some cases a lease-purchase agreement with the property sale with seller financing.

It has a couple of side benefits to that. When you have somebody enter a lease-option agreement with you, they’re technically a tenant at that point in time. Then they have the option to purchase that at predetermined prices in financing and everything else. In some places, they call it also a lease-purchase option. You might have both in your area. A lease-purchase would be they’re agreeing to purchase it, but they have to lease it for a period of time. You want that period of time to be thirteen months. That’s going to put you past the twelve-month period of time, so right away you have dramatically reduced your capital gains taxes at the end of the transaction here but think about the byproduct.

The byproduct is you have a much better tenant in place than you would under a regular lease. People go under a regular lease or regular rental agreement. Let’s face it, they’re moving on at some point in time. They’re not taking care of the house as if it’s their own. If you enter into a lease-purchase or lease-option agreement with somebody, in their mind, they own that property. That is a huge difference. They want to take care of that property because they know at the end of the year, they’re going to buy it. That is a big difference in those two. We get a better tenant. We avoid short-term capital gains and what have we done on our cashflow? We have also cashflowed this property out.

When we renovate the property, we’re going to rent it as if we’re selling it to a buyer, not a tenant. I want to make that distinction because some people when they do renovations, they think of what their exit strategy is. They go, “This is going to be a rental so I’m not going to fix it up to the way I would if I was going to sell the property. I’m going to cut some corners, cut back on some expenses and rent it because I know my tenants aren’t going to take care of it.” This would be a case where you want to put it in a condition where you’re going to sell that property but under this new condition. Also, another benefit here is many people can’t afford to get a loan right away anyhow, but they want to be buyers.

They want to own that property at the end of the day, but they simply don’t have the down payment. This gives them the opportunity to pay that down payment over time to you. You can create cashflow that property through lease-purchase money and also the rent. You can maximize your cashflow that way. The more money they can put down, the great. The more they can put on the lease option. Maybe you don’t have to do some monthly payment on the lease-option. All these deals can be structured a variety of ways. It’s a meeting of the minds between the leasor and the lease and eventually the buyer and the seller of the property, which will probably be the mortgagor and the mortgagee at that point in time as well.

The two parties get together, they agree upon what lease will be, what the option money will be, what the purchase price will be and they can even agree upon the financing. You can do a plan A or plan B. At the end of thirteen months, they can finance it through you or if they can qualify at the bank, get a bank loan. You don’t care either way in particular, although you might, but let me put it this way. Perhaps you don’t care because you’re either going to get a lump sum in thirteen months because they get a bank loan or you’re going to create a note and got positive cashflow. You can add those options in or you can simply say, “I will seller finance it and put it down that road as well.”

Many people can't afford to get a loan right away yet want to be buyers. Click To Tweet

I have got a couple of case studies here. I’m going to use this as a guideline to explain that. One that stood out for me was this concept that this particular investor fell into. It wasn’t something that they have thought about in terms of capital gains. I’ll talk about that one first and then I’m going to talk you through another one where they very specifically got into that deal to avoid those short-term capital gains. Case study number one, the investor purchased a nonperforming note. They didn’t purchase a property or foreclosure or anything like that. This nonperforming note was owner-occupied. Initially going in, buying a nonperforming note when it’s owner-occupied, normally your first out is, “Let’s go ahead and see if we can get this loan reperforming.”

If you’re following this blog or you have been to one of my live training or online training, you know I always talk in terms of never go into nonperforming notes with one out. You always go in with multiple outs. Plan A was to get this note reworking. That didn’t work out. She simply had dug in her heels at that point in time and decided, “No, I’m not going to refinance it. I’m going to let the house go into foreclosure.” Sometimes that happens. It’s an odd thing to happen. It’s not in that delinquent borrower’s interest to have a foreclosure on their record, but sometimes people do stupid things simply out of ignorance. They don’t know how it works. The fallback became, “Maybe I can give her some Cash for Keys,” where they move out of the house gracefully and they sign over the deed in the property in lieu of foreclosure.

You get a deed in lieu. It’s a two-page simple document. You sign that over. You have a servicing company go out there and make sure that the people haven’t done further damage. They’re moving out of the property. They relinquished the funds. Everybody has a camera on them at all times in their phones and they can verify that information with you. In this particular case, that was the flow of events. Non-performing note, try to do some workout with them, that wasn’t happening. Explaining to her that foreclosure is going to make her situation even worse, she finally agreed to take Cash for Keys by signing over a deed in lieu.

This investor ended up with the deed to the property, which started with the nonperforming note. Now he has the hard asset in the term of the property. As things have it, a lot of times, especially in a more rural type of areas, which this happened to be, the neighbors can be a good source for sales for you. They know people and they have people who are looking to buy into the neighborhood. There’s not a great turnover sometimes in those rural areas. That was along the lines of this case. What ended up happening is the neighbor next door had a son and that son was engaged and they were looking for their first home. They said, “This would be great because we do have a child on the way and mom is right next door, but it’s got some land.”

KSS 13 | Real Estate Notes

Real Estate Notes: It’s not in the delinquent borrowers’ interest to have a foreclosure on their record.

 

It was on two and a half acres and mom’s place had about five acres. This became a good scenario for them. A young couple with a child on the way, looking to get married and they simply don’t have the money to go to a bank to put down for a down payment. No problem, I can finance it for them. They got into a discussion about that and the kids weren’t quite sure if they wanted to stay long-term there or not. Let’s see how things work out here. That led to another creative decision here. I mentioned in this case study, they fell into a lease-option agreement because of the circumstances and that’s ultimately what happened.

They looked at the rent in the area and everything else and said, “The rent for a property like this is $513 per month,” which this couple couldn’t afford. Why don’t we do this? Rent the property for a year, but I will also give you the right to buy it any time within that first year. If you do decide to buy it, I will finance it for you according to these terms or at that point in time, if you’re able to get a bank loan, go ahead and get a bank loan. These two young people are buying this property. We can rent the property next door. We can see how things go here. We can afford the monthly payments and if we decide that we do want to become owners of this property, we can get a bank loan if we can or this person will seller finance it for us.

They already knew that they could afford those payments. Everything was working out perfectly here for them. That’s what they ultimately did. They moved into this place and they stayed in the place. They enjoyed the area. Things were working out well with having mom next door. They were paying comparable rents in the area and ultimately, they decided this is a good deal. “We should buy this property.” They did. You have to lease it for twelve months. Part of that was for them to prove to this investor that they could afford the payments and then by circumstances going, “Capital gains tax, I can pay a lot less on this thing if they do end up cashing me out after the twelfth month here.”

It fell into place very nicely for them, which was not the ultimate intention on this particular deal, but it could be and should be for many of you. What they ultimately did was create a rather unique lease-option. The lease-option agreement was for 24 months. They had two years of which they could exercise that option, but before they could exercise the option, it had to be twelve months. In other words, at the end of twelve months, they could exercise the option or they had an additional eleven, twelve-months still left in the original agreement. At the eighteenth mark the price started to increase.

Sometimes, people do stupid things simply out of ignorance. Click To Tweet

They agreed upon a purchase price within the first eighteen months, but after that, the price went up. It’s very creative and very legal. Both parties agree to those terms. In this case, in addition to lower capital gains, the person who owns the property and is putting this lease-option on it, the investors are gaining some of the appreciation in the property if it goes beyond the eighteenth-month mark. That makes this even better for these investors here. The renters are going to make their own repairs on their own dime. That was in the agreement as well. They will have renter’s insurance and you want to get a landlord policy for that as well. The young couple moves in, they put a small down payment for the option money on this and that was $2,700.

They had $2,700 and they agreed that they would buy the property for $63,000. “We’re going to give you $2,700. That’s going to be a nonrefundable option deposit and our rent will be $513 per month.” They’re happy with that. They can keep that for up to 24 months. Option one, you can buy it for $63,000 and you can get your own loan from a bank. Option two, I will finance that purchase price of $63,000 for you at 10% interest and that brings your payments up from your rent a little bit to about $585 per month.

They can afford that down the road. Two years, they can afford to make those payments not going up that much. Their rent would have gone up either way. They worked out all of those details. The short end of that story is within the twelve months after that, they did want to buy the property and they asked this investor to finance it for them. They created a note. Twelve-months goes by. The thirteenth month they become the property owners and the investor becomes a note owner. The investor owns a $63,000 note at 10.6% interest. This young couple wasn’t worried about 10.6%. It was how much is the monthly payment? $585. “We can afford that. This is a great deal for us.” In their mind, they were tenants for a period of time. They took care of the house. They fixed it up on their dime. They now own the property and if they can get to a point where their bank financeable, they can always cash out of that loan. For them it’s, “Can we afford the monthly payments?” The answer was, “Yes, we can. Let’s buy this property from this person under those terms and then we can refinance it later.” Whether that happens or not, who knows? That is the mentality of them throughout this entire process.

Let’s take a look at this from the note investor side. From the note investor side of this, they have been receiving monthly rent for 24 months. That’s about $12,000. They also received $2,700 in down payment. That’s about $25,000. The note investor is out of pocket $23,500 in 24 months in this deal, including the Cash for Keys, the purchase of the nonperforming note and the renovations on the property. They have got all of their money back out of this deal plus a small profit. They got about $25,000 back. They now have $0 in this deal, nothing. They got all of their investment capital back. They also own a $63,000 note at 10.6% interest for 30 years with no money in it. They got all their money back through the rent and the nonrefundable deposit. Once they own that note, they can keep the note, make a very passive monthly income of $585 to proven tenants for two years. That’s a great track record of payments. Payments haven’t gone up that much and keep that passive monthly income.

KSS 13 | Real Estate Notes

Real Estate Notes: A lot of investors pass up low price band rehabs because they think they can buy them cheap.

 

Payments To Sell For A Decent Yield

As far as the note investor is concerned, the note was written at 10.6% but is that how much the note investor is making at this point in time? No, that’s not their annual yield because they have no money in this deal. This is like a free note. Think of it that way. They have got a free note that’s paying them $585 a month for 30 years. That’s over $200,000 and they have got nothing in it. Their yield is incalculable, but they also want a valuable asset. If this investor decided to, for example, they could turn around and sell part of that note. They could sell all of that note. They could do a lot of different things with that note. In fact, they could cash out and calculate, “I need to pull $50,000 out of this note.” How many payments do I need to sell for an investor at a decent yield? 8%, 9% to get $50,000 out. What about $60,000? What about $30,000? Whatever they needed.

If they needed to pull capital out of this deal, they could certainly do that as well. Reduce their tax through the capital gains. They’re crushing it in this deal. Just keep the note as cashflow. Sell all of the note. Sell part of the note, which would be smarter in this case and you have got a fantastic deal. You have lowered your tax basis throughout this the whole time. That’s a very creative way to structure these deals. That one happened by circumstance, but because of this and the effectiveness of this and recognizing that, we’re seeing a lot of investors who are starting to realize that they can make some big profits in low price band rehabs.

A lot of investors pass up low price band rehabs because they think in terms of, “I can buy them cheap. I can fix them up cheap, but who am I going to sell them to? Nobody can get financing.” What they’re missing out on is this technique. What you want to do is acquire that inexpensive property, fix it up, then lease option it. Get it to that thirteenth-month and then close on the sale. That’s how it’s best structured. Another example here, this person purchased a double-wide. I know sometimes people have different opinions about double-wides. A lot of you would probably pass up those deals. Let’s look at the numbers. Let’s look at pure deals and not with the prejudgment that we have about double-wides.

They’re cheap to buy. They’re inexpensive to fix. In this example, they purchased one and rehabbed it. It was a 2,200 square foot four-bedroom double-wide. They fixed up and purchased everything. The all-in investment is $27,000. Other investors driving by this deal every day pass it up, “No money in that.” He turned around and sold this by simply putting signs out in the yard. There are people driving by every day that would love to buy in this area. They’re probably renting in the area. They don’t think they can afford to buy, but when you put a sign out there that shows your offering terms. All the sudden your phone starts to ring. That’s what happened in this case. After reviewing the people who responded, he chose the people that had good money to put down.

By the time you created the note, that becomes the investors' present value. Click To Tweet

In this case, the resale price on this was $70,000. Remember, this investor was all-in for $27,000. He’s able to sell it for $70,000 with terms. The people put $5,750 down. Their rent on this was $650 per month and that’s what they were paying to lease this. They had the purchase agreement after the twelfth month. In this case, they structured where the monthly payments started to chip away on the sales price. By the time they got past their twelfth month, the actual sale price was not $70,000. It was $64,900. That’s what they created a note for. 180 payments at 9% interest on that one. The payments on that equals to $658 a month. You add in the taxes and insurance, that’s $787 per month for these people and that’s a great affordable deal for them.

The note investor, in this case, wasn’t the note investor until the note was created. They bought this property through regular real estate techniques. They found a motivated seller. They bought the property outright here. Once they bought the property, they fix it up, they renovated it. The key was “What is my exit strategy?” The best one was let’s get a proven potential buyer here by setting up a lease-purchase agreement. Let them lease it for a year. We will agree upon the purchase price. We will even lower that purchase price as long as they’re consistent in making their payments. We are incentivizing them to do that. At the end of it, I will sell it to them by creating a note and mortgage and the amount of about $65,000.

I want to create a good quality note, so I’m going to shorten that term from 30 years to fifteen years, and I will plug it at 9% interest rate, which is a great interest rate. This investor at this point in time didn’t have a whole lot of money left in this particular deal. If you figured that they were paying $650 a month for rent and they collected $7,800, maybe $8,000 for that, you got $27,000 in the deal. You’re in it for $27,000 and you got $8,000 back through the rent. Then you also got $5,750 in the form of their option money. You only have about $13,000 left in this deal. If you got $13,000 in this deal and you’re receiving $658 per month. That is a huge annualized return.

I will throw that in my financial calculator here. $65,000 is the present value of that note created at 18 months. That’s our number of payments and it was done at 9% interest. Your payments should come out to $650 and change per month. If you only have $13,000 left in this deal, by the time you created the note, that becomes the investor’s present value, then if you solve on a financial calculator for interest per year, you’re looking at a 60% annualized return. Another way of saying that more simply I suppose if you invested $13,000 into anything and that anything kicked off $650 per month, you would have an annualized return of 60%. Can you make big returns in small deals? Absolutely.

Don’t forget this investor lowered their tax base as well by keeping it past the twelfth month. It’s the best of real estate techniques with the seller financing, with the note aspect of this that can rocket these returns while minimizing your capital gains taxes. All of this could have been done through IRA, 401(k), some tax-sheltered account and then you have none of those issues if it’s done through a Roth account. We don’t always want to do that. Retirement accounts are one thing. That’s not spendable money, so there are other times when you want to keep money outside of that retirement and do it this way. To do it the right way, combining real estate, lease-option technique or lease-purchase agreement with the seller financing will get you there and get you those returns.

Don’t worry about thinking, “At the end of thirteen months, I need to cash out and get some lump sum.” If you create the note the right way, that is still an option because then you can sell all of that note or part of that note to another investor and be able to get that lump sum that you want or need. I hope you enjoyed this episode and I hope you apply that technique. You can learn more by getting involved with me at KevinShortle.com. Send me an email there. Sign up to my mailing list to make sure that I can stay in contact with you and maybe I will see you at training at one of these times as well. I do some one-day trainings and some three-day trainings. Stay in touch. I look forward to talking to you again in the next episode.

 

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