Posted by marc on March 19, 2006 at 14:41:26:
I haev often heard this comment that you lose by borrowing from your 401K because you are paying back pre-tax dollar with post-tax dollars. i think this is incorrect, and I’ve heard it so many times that I actually wrote out an explanation on a web site:
Am I crazy? - Posted by AnInvestor
Posted by AnInvestor on March 17, 2006 at 15:20:23:
Hi,
I bought an investment property last year and I invested about $18000 into it (downpayment & closing costs). I already received $3000 back from taxes. The rent covers mortgage,taxes, insurance & other costs. So, although I’m only breaking even, I’m not paying anything from my pocket.
I’m in the process of closing another unit in the same development with the same parameters, although on this one, I’m only investing about $14000 and I expect to get some money every month. I have taken a $10000 loan from my 401(k) to buy this one.
I’m planning to buy another unit, similar to the ones above and I’m planning to take another loan from my 401(k) for the downpayment. I’d like to know if I’m making a big mistake by using my retirement money towards buying these properties and if I should stay away from it.
My argument is that I believe that I’ll get more returns from the rental properties than I would from 401(k), which is the reason I’m doing this. Am I wrong? I’m planning to keep them for at least 10 years. I’m also hoping to payoff the loan in less than 5 years…
I need your opinion. Please let me know what you think…
Thanks,
Srini
Re: Am I crazy? - Posted by Dave T
Posted by Dave T on March 18, 2006 at 12:46:40:
There are three primary reasons for investing in rental property. Cash Flow, Appreciation, and Tax Benefits. You need to have at least two of these working for you to make the property viable for a long term holding. Since appreciation is slow and not guaranteed, I would prefer to see a property cash flow well to even consider the property as a candidate for my rental portfolio.
Ordinarily, I would not advise a new investor to acquire a break even rental property and you have already received that advice from other responses in this thread.
However, it is already a done deal and you are contemplating another one. Hopefully, you acquired this property with a fixed rate mortgage. For your first deal, you need to have strong appreciation, and a good tax benefit to still make this viable. Strong appreciation gives you equity buildup, and at the same time, allows you to raise rents over time so that your cash flow becomes positive. In the meantime, lets hope that your vacancy rate and repair needs are minimal so you don’t invest much more out of your pocket before your cash flow becomes positive.
Your second deal seems to be better constructed than your first since you will have a positive cash flow. Even so, if the cash flow is not at least 25% of your debt service, you may not have enough of an income stream to deal with the unplanned repairs or the occasional vacancy. For example, if your monthly mortgage payment (PI) is $500 per month, then you want your cash flow after all your operating expenses are paid to be at least $125 per month.
The drawback to using your 401K to finance your investments is the double taxation on your loan. Money you contribute to the 401K is pre-tax, right? That it is not taxed to you as income in the year you earned the 401K contribution.
When you borrow from your 401K, you pay back your loan with after tax dollars – money you will to pay income taxes on at the end of the tax year. Now, when you take distributions from your 401K, you pay taxes on your withdrawals at your ordinary income tax rate. You are paying taxes again on the same money you used to repay your loan.
There are two faults with your plan. First you are investing in break even property (that often turns negative) and you are using a tax advantaged account to fund your purchase. If you can find another way to finance your acquisitions, that would be preferable to using your 401K. Buying property that will generate a positive cash flow property will put you way ahead of any property that is simply break even.
Re: Am I crazy? - Posted by Natalie-VA
Posted by Natalie-VA on March 18, 2006 at 08:01:56:
You might be putting all of your eggs in one basket by buying all of your properties in the same development. It might be convenient, but it could also have negative conqequences if something happens to the market there.
Also, where are your returns that you’re talking about? Are you hoping for appreciation?
–Natalie
Re: Am I crazy? - Posted by Mike-OH
Posted by Mike-OH on March 18, 2006 at 06:18:09:
I don’t think that your big mistake is using your retirement money. However, you are making a HUGH mistake by accepting “break even” cash flow. Even worse, you don’t seem to have a grasp of the numbers for your property.
Here’s what typically happens in a situation like yours. A newbie investor buys a few properties with a “break even” cash flow. Things seem to go very well for the first year or two. Suddenly, several things go wrong - almost at once. Here’s an example: one of your tenants suddenly moves out - leaving a bunch of personal belongings in your property. Since their property is still there and they haven’t given you the keys, you’ll have to evict them to legally get possession. A week later, a second tenant decides to stop paying the rent. Tenant #2 says that they’ll have the rent in two weeks. Being a new landlord, you take the tenant at their word. In two weeks, they tell you that their check has been lost, but another is being issued next Monday. You believe them again and wait another week. This goes on for several weeks before you finally decide to evict. Each eviction takes 6 weeks. You finally get possession of your first house with four months lost rent and $1,000 in legal fees, court costs, and dump fees (getting rid of the tenant’s stuff). Unfortunately, you’re not so lucky on your second house and when the eviction is finally done, the tenant had punched a hole in every single wall and poured concrete down the commode and both sinks. The legal fees court costs, and setout costs were again $1,000. And by the way, the tenant stole the furnace on the way out.
Am I being alarmist with this scenario? NO. It happens all the time!
Here is my true story for this month (March). I have my properties divided up into LLCs for asset protection reasons. One of the LLCs has five SFHs. Just this month, one of the houses was involved with a big drug bust. There was $2,300 in damage cause by the drug task force. The tenant in another property lost his job and stopped paying. I immediately filed the eviction and should have him out within the next three weeks. A third tenant is having job problems, but was able to get public assistance to help her with the rent THIS MONTH.
The big difference between me and you is that I understand that these things DO happen (with some regularity). I won’t accept anything even close to break even cash flow and I have a bunch of other properties producing excellent cash flow to overcome the loss.
Without a strong positive cash flow, you’re almost certain to lose the properties in the long term. If you’re lucky, you can get away with “break even” cash flow for a while, but eventually this fundamental error in your business plan will catch up with you. Unfortunately, this often happens sooner rather than later and the result is a disgruntled and broke landlord. It happens every day!
Therefore, I’d suggest getting educated on these issues and adjusting your purchasing parameters accordingly. Cash flow is King with rentals!
Good Luck,
Mike
Just A Little Crazy - Posted by JT-IN
Posted by JT-IN on March 18, 2006 at 01:32:42:
Srini:
So you got a little taste of this thing called RE and it is a little addicting… and looks profitable long term… You look at things VERY conventionally, which is how most folks look at RE… except here, where… as you might guess from the name, CRE… Creative RE, we try to use techniques that not only accomplish what you THINK you see, and like, but do so in ways that exceed the best case scenario of the mirage you are seeing as the oasis…
Suppose you learned how to make those same purchases of properties, w/o investing that 18K from your pocket…? and had a pos cash flow from the start, and besides walked away with some cash in your pocket from closing…? Those are things that many here at CRE focus on accomplishing, in order to call it a “good deal”.
The comparison that you make, between the Conv. RE investment and your 401K is a valid one… and you are certainly planning your future well. Most the slant from this board is how to accomplish far greater returns than what you allude to as being cool, using cash out of your pocket to purchase, as opposed to putting cash into your pocket… immediate c/f as opposed to break even… in other words, immediate benefits, as opposed to slower equity build up… Don’t get me wrong, many a folks has made significant money and wealth, just as you describe above… but there are potentially far more profitable ways of doing what you elude to… Read up on some of the posts here, as well as in the archives, and your perception of a good deal may change. Then you will be fully crazy…
JT-IN
Re: Am I crazy? - Posted by Craig (IL)
Posted by Craig (IL) on March 17, 2006 at 19:23:26:
DON’T take money from your retirements accounts. Instead, you can set up your retirement accounts in self-directed accounts that allow THE ACCOUNT to buy the property, and take all proceeds into the account TAX FREE. It’s perfectly legal, but here are apparently only a few compaines that do this. “Entrust” is one of them. You will find a coupla others. Your current retuirment account holders problably don’t. (I assume, because most don’t.)
Aside from that you may be doing OK, in that if you can keep your head above water, you’re bound to learn more as you go. Your post doesn’t say anything about equity, maintenance, insurance, taxes, appreciation, plans for vacancy periods, or dealing with really bad tenants who end up costing you money. Remember that at some point you should be able refinance your rentals and get your investment in full back and sitll have postive cashflow.