July 16, 2007

Then Again, the Kepple Land Corp. Has a Nice Ring to It

AS I MENTIONED IN MY POST below, I'm perfectly happy with renting my present accommodations and, at least for the moment, see no reason why I ought change this state of affairs. However, only God knows what the future holds and it's entirely feasible that within a few years I'll find myself owning a place.

One big advantage of owning a place, as I see it, is that it would eventually open the door for me to pursue future real-estate development. If there's one thing I've learned over the past several years, it's that there's real money to be made in holding real estate. That's not simply because property values tend to go up with time, but because property investment generates cash while offering plenty of swell tax incentives along with it. Plus, arrangements can be made so that one doesn't have to have to deal with backed-up drains and broken windows and all that maintenance stuff that can cause so many headaches for a landlord.

I remember being shocked when I first learned that one can actually depreciate the value of one's residential real-estate holdings over time for tax purposes. I mean, it's counter-intuitive -- values generally go up over time and yet one can gradually write-off the cost of one's holding. That only applies to the buildings on a property and not the land, but still -- being able to depreciate a residential investment property over 27.5 years is a pretty amazing deal. At nearly 4 pc per annum, that expense is large enough to shield a good portion of one's cash flow from the tax man.

Of course, the IRS doesn't let an investor keep the gain forever. When one sells an investment property, the accumulated depreciation reduces the cost basis for the building, and the Government will demand its due accordingly. But since buildings have a way of standing the test of time, one could conceivably hold a property for decades, thus enjoying tax-free growth until the time came to sell. And even then, careful planning can ensure the Government is held at bay for the tax, through the miracle of the 1031 exchange. A 1031 exchange is a clever little tax plan in which an investor can essentially trade up on his gain.

For instance, let's say an investor buys a condo (Condo A) for $50,000 and ten years later that condo has appreciated in value to $100,000. Let's also say the value of the underlying land has stayed flat at $10,000. If Investor A decides to sell, he would have to pay tax on the gains, which would be $50,000 in appreciation plus his depreciation recapture, in this case, $14,520 (36.3 pc of $40,000) for a total of $64,520. But through doing some planning beforehand, the investor can plow all his money into Condo B, priced at $100,000, and defer his gains for tax purposes.

The beauty and power of this scheme can't be understated. Taxes eat wealth. As a result, deferring tax for as long as possible while enjoying gains increases one's wealth. This is a big reason why Warren Buffett is so rich; instead of churning his holdings here and there over the years, he held on to everything and as such deferred his gains. That turned what would be a $2 billion or $3 billion fortune into a $50 billion one.

I recall a Chinese tycoon who, when asked about how one could be successful in real-estate, summed up his philosophy as follows: "wait, wait and wait." Yeah, that sounds about right.

Oh, I almost forgot. As I've learned from other folks involved in real-estate investing, one doesn't have to be a hands-on guy dealing with clogged drains. Instead, one can procure the services of a property management company, which for a share of the rent will handle all the affairs related to a property, allowing one to sit back and feel particularly clever. True, one will have to find a good management firm and the returns one would enjoy would be less than if one was a direct landlord. But there's more to life than dealing with angry tenants and cleaning out gutters.

Posted by Benjamin Kepple at July 16, 2007 09:28 AM | TrackBack
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