Welcome to Part 2 of my Residual Income in Real Estate guide. This section covers obtaining properties through tax liens and the basics of rental properties.

Understanding Tax Lien Investments

What is a tax lien? Tax liens occur when a property owner has not paid local taxes on a property. The local government will issue a lien against the property that states that it can’t be sold and ownership cannot be transferred until the owed amount has been paid in full.

How do you make money on someone else’s tax lien? It’s called a tax lien sale. An auction is held by the public authority who sells the property in order to settle the tax lien. The winning bidder is purchasing the right to own the property if the original property owner doesn’t repay the tax debt to the winning bidder.

There are 3 kinds of liens that may be placed on property:

1. Judicial liens (also called “judgments”): Come from lawsuits by a creditor.
2. Statutory liens: Typically tax liens, either from the IRS, state taxes, and property tax.
3. Consensual lien: Missed mortgage payments.

What is the Tax Lien Process?

First, the home owner does not pay their local property taxes. So the local government makes a lien against the property, which prohibits the sale or transfer of the property until the tax debt is paid in full. After that the local government offers a tax lien at auction to cover the unpaid taxes. You attend the auction and bid. Be sure to research before bidding; thoroughly inspect the property and do a lien and title search. The lowest interest bid or most favorable fixed interest goes to the highest bidder. Next, you’ll have to wait and see. If the property owners don’t pay the lien, action is taken. In some states, the owner of the tax lien certificate needs to apply for, and then gets, the property deed. In others, there is an auction for the property. You bid on the unpaid lien plus the interest due to you as the certificate owner.

To illustrate two successful lien certificate investments, review the following scenarios:

Example 1:
A real estate investor purchased a tax lien certificate on a commercial property for $12,000. The property owners were unknown, and all of the required notices were sent out but there was no redemption. The certificate holder acquired the property which was appraised at over $365,000. The return on investment for this real estate investor was over 30 times his initial investment!

Example 2:
Mississippi pays lien certificate holders 17% interest. After 20 years, a $2,000 certificate would have grown to more than $30,000 with earnings that are tax-deferred.

Making Residual Income Through Rentals

The two attractive features of rental investment are: the ability to make money off the rental income, and the likelihood that the property value will increase over time. First, you will need to find income-generating property. Income-generating means that it has a positive cash flow. You cannot determine if a property has a positive cash flow simply by asking the seller, because you might not get the whole truth. The best way to garner this information is by requesting the past 5 years worth of bank records and expenses from the seller. If they can’t pull them together or aren’t willing to share them with you, get out of the deal.

If you do get the financial records, add up the income per year to get the net income. Add together the expenses per year to get the property’s net operating expenses. Subtract the expenses from the income and you have the property’s net operating income. Find the debt service fees, and subtract them from the net operating income to get the property’s cash flow.

Here is an example:
Susan finds a great property in a prime urban location in the District of Columbia. It’s a condo that is 300 square feet and selling for $100,000. A steal by city standards!
Susan had a 20% deposit, and got a mortgage for the remaining $79,200. She did not get Personal Mortgage Insurance (PMI) because she had more than 20% down. The debt service costs her an annual amount of $6,403. During the first year of her rental, she earned $1,107 (a 4.5% profit). During the second year, she didn’t have to pay the closing costs, so she brought in $5,683 (a 22.9% profit). As time went by, Susan increased the rent and she went for 25.3% profit in the third year to a 30.6% profit in the fifth year. Her five year average, pre-tax, was an impressive 22.2%.

If you multiply this example by, say ten different situations, you would have a positive cash flow of over $75,000 per year. If you prefer to not take care of the ten properties yourself, you can hire a maitainence man for $30,000 and still take in $45,000 without the headaches!

Finding the rental properties before they become public knowledge is important for getting a good deal that will make you rental income. Network with area CPAs, lawyers, real estate agents, financing companies, etc. to get the insider information on properties that might be coming onto the market.

Insurance for Rental Properties

It’s important that you are properly insured for complete coverage on your rental property. As a landlord, you need to make sure your policy covers more than just the building. You will need to have protection against:
• Purposeful damages caused by tenants
• Accidental damages
• Personal and property liability
• Loss of income
Also, if you reside on the property you should consider mortgage disability insurance.

Taking Advantage of the Tax Breaks

One of the main reasons people invest in real estate is for the beneficial tax breaks it provides. The tax breaks are most substantial for middle-income investors who are their own property managers. The value of tax relief depends on your annual income and what type of job you have. Even though the breaks are most significant for the middle class, there are also tax shelters for income produced by passive investors and high-income earners.

An example of the tax benefit for real estate investors is that the maintenance costs and marketing costs associated with a rental property can deducted from the income on a property, no matter what tax bracket the owner is in. Other expenses that can be deducted are interest on the mortgage, property insurance, utilities, general maintenance and repairs, management fees, marketing costs for renting the property, and depreciation.

Depreciation is the fact that tangible assets diminish in their value over time. For example, if you buy an oven for a rental house, it’s assumed that it will wear out over the upcoming years. The value of the oven can be claimed over a five year period as a deductible expense on your taxes.

Depreciation is used by some people to shelter taxable income so that it is not taxed. Here’s what they do: The rental property owner depreciates the value of the rental house’s structure. Land does not depreciate because it doesn’t wear out. So if the owner claims that the value of his rental is going to go from its purchase price down to $0 over 27.5 years, the annual amount is sheltered as depreciation, which can be deducted from property income before paying taxes.

Consider the following example of depreciation:
You invest in a four-family house for $500,000, finance $400,000 and put down a $100,000. The $400,000 mortgage is at a 7% interest rate, which costs about $2,662 in interest per month. Add in the additional costs which are $500 per month and include management fees, repairs, insurance, and advertising costs. Monthly rent income is $1,000 per unit, for a total of $4,000 for the property. The positive cash flow (income minus expenses) in this situation is $838 per month. This totals $10,056 annually. Usually this would be taxable income, and at a 30% tax rate, that would cost you about $3,000.

The money saving tip here is that you can depreciate the building over time, thus reducing the amount of taxable income that you will need to pay taxes on. First subtract out the appraised cost of the land - in this example it’s $75,000. This means the cost of the structure is $425,000. Divide that out over 27.5 years, and you’ll have an annual depreciation expense of $15,454. This eliminates your tax obligation on the $10,056 in rental income.

The next logical question would be, “What happens to the remaining depreciation expenses totaling $5,398?” This is where it is important to consider your occupation and income level. Most people who are not real estate professionals cannot claim a passive loss on rental real estate investments. Passive losses by real estate professionals can sometimes be used to offset money earned on other rental properties. Most often they cannot be considered to offset your wages from other income or investments.

The following are two exceptions to this rule:
• Real estate professionals that spend more than 750 hours involved in real estate can write off passive losses.
• If you are not a real estate professional, and your annual income (modified, adjusted gross) is less than $100,000, you can use up to $25,000 as a write-off on any other income (non-rental) per year. To do this you must be actively involved in the rental business, for example you decide the rents, accept tenant applications, etc.

That's it for Part 2, keep a look out for Part 3, "Taking the Plunge".