How to keep the IRS from stealing your sh*t

Bad news: The government wants to take 50% of the profits from your building.

Good news: Some nice legislator long, long ago stuffed the concept of depreciation into the tax code, keeping the tax man from succeeding.

What’s “depreciation”? It’s a fake loss that allows you to use to reduce the amount of income you’re taxed on. Here’s how it works:

Example: Say you buy an apartment building for $500,000. Your accountant will divide that $500,000 between the value of the land and the value of physical structure that you’ve purchased. Say he divides it 50-50, $250,000 for the land and $250,000 for the structure.

As we all know, buildings age over time. To account for wear and tear, the government lets you take a paper loss each year equal to 1/27.5 of the value of the physical structure at the time of purchase. So your $250,000 structure depreciates by $250,000 / 27.5 = $9,091 each year.

That $9,091 sets off against your income. So, if, after paying your expenses, you have $10,000 in profit left over, the government would allow you to deduct $9,091 from the $10,000 and then only tax you on the remaining $909. So instead of paying 50% tax on $10,000 (which is $5,000), you pay 50% tax on $909 ($454.50) and keep the rest for yourself.

Note: I’m not an accountant and this is not tax advice. Don’t be cheap. Get yourself a good accountant who knows about real estate and do what he says.

From the Offer through Removing Contingencies

The advent of services like Redfin and Zillow have made everyone into a real estate genius. You can see what’s for sale, what’s sold, the comps, everything. Don’t let that make you think you know what you’re doing. You don’t. Buying real estate is really complicated. To get that wonderful property you see on Redfin, you will go through multiple rounds of negotiation, review and sign 25+ pages of legal contracts and disclosures, supervise various inspectors and brokers, and finally make a go-no-go decision regarding what is almost definitely the largest financial transaction of your life up to this point.

This post is designed to give you a peak into the process of going from seeing something online through removing contingencies, which is when you make the final commitment to go through with the deal. Remember: This process is no joke. Mistakes can cost you tens of thousands of dollars. If you’re confused about anything, consult a lawyer. That said, here’s a short guide to how the process works:

Step 1: The Offer

The buying process starts when you make an offer to buy at a specific price, on specific terms. In California, we usually use the Residential Purchase Agreement (for a single-family home) or Residential Income Property Purchase Agreement (for an apartment building), which are standard forms published by the California Association of Realtors (C.A.R.). The idea is to standardize on terms that are relatively fair to both sides. This allows most people to avoid paying real estate lawyers for simple buy-sell deals. Your broker will help you fill out the form with the key terms, which are:

  • The price
  • The good faith deposit (usually 3% of the price)
  • How the rest of the price will be financed (cash, first loan, second loan, etc.)
  • What is to be included in the purchase
  • Who pays for various reports and repairs
  • How long the buyer will have for due diligence during the contingency period
  • How long it will take to close the deal

Remember the seller has all the power at this stage. She can accept your offer and/or someone else’s, counter-offer you and others, or decline all offers. Because you don’t control the process yet, it’s best not to invest too much time, money or emotion at this stage.

Technically, the C.A.R. offers expire three days after submission (unless you have specified something else). But you should understand that sellers sometimes take a bit longer to make up their minds. Unless you’ve made a killer offer, you don’t have any leverage yet, so it’s best not to try to force the issue. If the seller wants to accept your offer after three days, it’s easy to reactivate it without re-writing the whole thing.

Step 2: Counter-offers

Unless you offered the list price, it’s very likely that the seller will counter-offer you and/ or other potential buyers. Technically, a counter-offer is a rejection of your offer coupled with an offer by the seller to sell on specific terms. Once the seller counters, she can’t then go back and accept your original offer; that has now been rejected.

The structure of a counter-offer in CA is “by exception”. What this means is that the counter “accepts all of the terms in the initial offer, with the exception of…” and then lists the exceptions. So Counter 1 might say, for example: “We accept your terms, except we want $50k more and we want you to close 15 days sooner.” For this reason, counter-offers are generally no more than one page in length.

If the seller’s terms aren’t acceptable, your broker will help you draft Counter 2. Just as for Counter 1, Counter 2 is a rejection of the preceeding offer along with an offer to close on revised terms. Counter 2 is also “by exception” and includes all of the terms in the original agreement, the terms from Counter 1 you are accepting, plus the new terms you are offering. To continue the example above, Counter 2 might say: “We agree to everything in the original offer plus your desire to close 15 days sooner, but we’ll only pay $10k more.” The seller then has the ability to accept Counter 2 as is, reject it, or respond with Counter 3.

A word about counter-offers: Remember that until you have an agreement, the seller still has all the power. She is free to sell to someone else or decide not to sell. If the seller at any point offer terms that you consider acceptable, I strongly urge you to accept. You’re not committing to anything (as we’ll see in a second) and trying to over-optimize the terms in your favor can lead to nasty surprises. I once lost a deal I would have made $200,000 or so on because I thought the seller was desperate. I chose to counter a fair counter from the seller. He turned around, called his friend and offered him the same deal I had stupidly rejected. The friend accepted and I lost the deal. I curse my greed every time I drive by that 30 unit building on Santa Ynez in Echo Park. Argghhh.

Step 3: Agreement and Opening Escrow

At some point, there will hopefully be a “meeting of the minds” between you and the seller. This happens when one side or the other makes an offer or counter which the other accepts. At that point, the seller’s agent will take the contract over to an escrow company and open escrow. Escrow is a neutral third party whose job it is to make sure the transaction is carried out according to the terms of the sale contract. You will transmit a good faith deposit to escrow (the amount will have been agreed in the contract, usually 3% of purchase price or less). Escrow will send you and the seller “Escrow Instructions”, which re-state the terms of the contract and remove any ambiguity about how you are going to proceed. Both you and the seller will sign the escrow instructions.

A word about your deposit: Your broker will tell you that your deposit is safe and that you’ll get it back if you decide not to go forward with the deal. The truth is that an unscrupulous seller can tie your money up in escrow. They can’t get it themselves, but they can make you fight to get it out. This has happened to me before and it really sucks. Make sure you can live without that money, just in case you run across a jerky seller.

Step 4: The Contingency Period

After you open escrow, two things happen: 1. You apply for any loans you’ll need, and 2. You investigate the property.

During this “contingency period”, power flows from the seller to you. The seller is obligated to sell you the property on the agreed terms. If she doesn’t, you can sue and she will have to sell you the property and pay your legal fees. You, on the other hand, have the right to back out if the property is not what you thought it was. This is why it’s called the “contingency period” – the deal is contingent on you finding the property acceptable.

The length of the contingency period will be specified in the contract. Generally speaking, it will be 10-14 days, though it can be longer or shorter. My advice is not to let it be any shorter than 7 days, unless you’re very, very confident you know what you’re doing.

During the contingency period, it’s up to you and your broker to research the property. You want to bring in professional inspectors, check all the sellers books and records, check with the city, review the title report, and generally confirm that you’re happy with the property. This is one of those times you want a really experienced broker, particularly for apartment building purchases. There are all kinds of hidden issues that can come back to bite you if you don’t discover and plan for them during the contingency period.

You’re now in a great position to negotiate with the seller. Say you find something wrong with the property. You can request a “repair credit” for the estimated value of fixing the problem. Maybe the foundation has some issues. Go back and tell the seller: “Give me a repair credit so that I can pay someone to fix this, or I’m walking.” The seller, wanting to close the deal, will likely respond favorably to reasonable requests for repair credit, since she’ll figure that, if she tells you to take a hike, some other buyer will raise the same issues. Negotiating the repair credit works the same way as the offer/counter offer procedure.

Step 5: Removing Contingencies

Eventually, you will either reach an agreement with the seller about repair credits or not. If not, you will have two choices: Buy the property at the price detailed in the contract, or walk away. If you haven’t made up your mind at the end of the contingency period, the seller will issue you a “notice to perform”, giving you a specified period (usually 24 or 48 hours) to fish-or-cut-bait. If you decide to walk, you and the seller will sign cancellation instructions, escrow will return your deposit less any fees charged (usually 0.5% split between you and the seller), and you can go on to the next property.

If you decide to move forward, you will sign a “Removal of Contingencies”. This says, in effect, I have satisfied myself as to the condition of the property and I intend to buy it. Once you remove contingencies, that’s it… if you don’t buy, you’re generally going to lose your escrow cash.

One final note about negotiating during the contingency period: Some people think this is an opportunity to try to re-negotiate by finding all kinds of tiny problems with the property and then demanding the seller reduce the price. My advice is not to do this. If there’s something majorly wrong, ask the seller to fix it. But don’t be a jerk.

Why you should NEVER release money to a seller prior to closing

If you learn nothing else from this post, learn this: Never release money from escrow to the seller prior to the closing.

Let me tell you a story:

On our first deal, my brother and I let an inexperienced broker talk us into offering to close in 30 days. 30 days is fine for a residential transaction, but you need at least 45 days (and, ideally, 60) to close on a commercial property like a 16-unit apartment building.

As the 30 days ticked down and we realized we’d need more time, we asked our broker to request more time from the seller. Now, ordinarily, if a reasonable seller sees you’re making a good-faith effort to move forward, he’ll grant you a extension. In this case, our seller was desperate for cash and therefore unreasonable, though it wasn’t clear to us at the time.

Knowing we were inexperienced, the seller requested the following, in exchange for an extension of the escrow period: That we release our $50,000 earnest money deposit from escrow to him. At that moment, we absolutely should have held firm and told him to take a hike.

Before telling you what we did, know this: Once you release funds from escrow to the seller, you’re never getting the money back, whether you close the deal or not. So releasing the money to him meant we were in, “hard”, with no way to get out without losing $50,000.

As you probably guessed, we agreed to release the money. Big mistake.

Later, before closing, the seller demanded $15,000 from us in order to finish the repairs necessary for the bank to lend against the property.

Ordinarily, as a buyer faced with a seller like that, you tell the seller to buzz off. But as a normal person of limited means doing my first deal, there was no way on earth I was walking away and lighting $50,000 on fire.

So I ended up loaning a deadbeat $15,000 as a fourth trust deed on his house in order to buy my first building, on top of paying him the agreed-upon price.*

Learn from my mistake: Do not release money to a seller unless you are strong enough to walk away from the deal and lose the money.

*I got the notice of foreclosure on his house a few months later. Suffice it to say that I never saw that $15,000 again.

How to find out what an LA property owner paid

One of the hardest things to do when buying a property is figuring out what price to offer. You obviously want to pay the lowest price possible. But most owners are not willing or able to take a loss. So you need to consider what the owner paid for the property.

There many different tools for finding out how much the current owner paid. Most of them either cost money or are only available to real estate professionals. In Los Angeles, though, we have a powerful tool called Zimas to help us get at the information.

Here’s a quick step-by-step guide to using Zimas to find out what the owner paid:

  • Go to zimas.lacity.org
  • In the white “Search By Address” overlay that pops up, type the street number and name in the relevant boxes
  • Click “Go”
  • On the left side of the page, click on “Assessor”
  • Scroll down and check out “Last Owner Change” – that’s the date of the last sale of the property
  • Then, check out “Last Sale Amount” – that’s the price the current owner paid

Caution: Remember that many property transfers take place among and between family members and friends, so sometimes the price the current owner paid didn’t reflect what the actual market value of the property was at the time of sale.

One other important thing to note: With properties that have increased in value since their last sale, often the owner will have re-financed the property to take cash out. For example: Imagine an owner who bought a house in Silverlake for $200,000 in 1993. You might think that you could offer him $600,000 and he’d be very happy to sell. But it’s possible that, somewhere along the way, he went to a bank, got the property appraised at $800,000, and took out a loan for 80% of the value, or $640,000. He can’t sell to you for $600,000, because he needs at least $640,000 to pay off the mortgage.

In future posts, I’ll discuss how to figure out how much the other guy owes and how to pick an offer price.

How Prop 13 advantages Los Angeles apartment owners

How would you like to be in a business where the law dictates that your biggest expense grows more slowly than your revenue? That’s what happens for owners of rent controlled apartment buildings with under-market tenants in Los Angeles.

Here’s how:

As an apartment building owner, your biggest operating expense every year is the property tax bill. For example: In 2010, for my first apartment building (a 16 unit building near Silverlake in LA – read about it here), out of operating expenses of around $62,000, property tax came to around $14,000 (22% of total expenses). The next largest individual expense lines were utilities, at around $12,000 (this building has one gas meter and I pay it- ouch) and general repairs, at around $7,000. Nothing else was more than $4,000.

Ah, but what about rents? Under Los Angeles’ rent control (called the Rent Stabilization Ordinance), annual rent increases for rent-controlled buildings (anything built before mid 1978) are limited to between 3-8%, with the actual number determined by a committee each year.

Imagine you buy a small building for $350,000. Maybe you have four one bedroom units that could rent for $1,000 on the open market, but you have tenants paying $700 and they have the right to stay forever. Bummer, right?

Not necessarily — check the numbers: In year one, your property taxes are 1.25% x $350,000 = $4,375. Let’s assume your other expenses are around $7,400 (I’ll explain this assumption in a later post). Your total expenses (before mortgage payments) are therefore $11,775.

Your rents are $700 x 4 units x 12 months = $33,600.

So your net profit (again, before mortgage) is $33,600 in rent – $11,775 in expenses = $21,825. Not bad.

Now, let’s zoom ahead 10 years. We’ll make the following assumptions: Property taxes grow by 2% per year (by law!). Rents grow by the minimum legal amount in Los Angeles (3%). Other expenses also grow by 3%.

Here’s what your profit and loss statement looks like now: Rents have risen to $45,155. Property tax is up to $5,333. Other expenses are now $9,945. So your operating profit before paying your mortgage is now $29,877. That’s around $8,000 more per year in your bank account!

And here’s the best part: This building is a piece of cake to own. It’s like a savings bond with upside. Your tenants NEVER move out, because their rents have remained at least 30% below market the entire time.You just collect the rent, make sure the place is in decent shape, pay the bills, and collect your profits every year.

In the unlikely event a tenant moves out, you throw a party and raise the rent by $300 per month, adding an additional $3,600 to your annual profit.

It’s amazing how that 1% difference in growth rate of rents and property taxes makes so much difference to your bottom line. For that, you can thank Prop 13.