Jeff Schnepper

The Basics

3 ways you can go broke in real estate

Real estate investing is no slam dunk. A market can turn on you in a heartbeat, and a property can drain you.

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By Jeff Schnepper

I've been involved in real-estate investing for years, and I've learned some hard lessons based on what was purported to be great advice. Like: "Buy property. Buy it now. It will always rise in value, and you'll never go broke."

Trust me, you can not only go broke, but you can actually pay taxes as you do it. Let me show you three ways you can get creamed and suggest some strategies to limit your risk.

Neighborhood change

I once had a client who bought an apartment complex for $1.5 million. He held it for several years, just about breaking even on a cash-flow basis and enjoying the tax benefits. Unfortunately, the neighborhood changed. The fair market value of the property fell to only $800,000 -- on a good day

Because of the decline in the neighborhood, rents also dropped. His cash flow wasn't sufficient to cover the mortgage, and he faced bank foreclosure. Seeing nothing but further price decreases, he panicked and sold.

Here's where he got killed. While he got $800,000 for the property, he owed the bank more than $1 million. He had to take out a second mortgage on his home to cover the $200,000 difference.

The pain, however, was just beginning. Because of the depreciation he had deducted, his basis in the property was only about $700,000. That meant, according to Internal Revenue Service rules, he had a taxable gain of $100,000 on the property.

We're not done yet. Even though the gain was a capital gain, the depreciation-recapture rules subjected it to a 25% tax. That was another $25,000 hit in the pocket, not counting what the state sucked out.

Don't tell him you can't go broke investing in real estate.

But, you might suggest that he not invest in properties bordering on severely depressed neighborhoods unless the gentrification is going in the right direction.

  • The lesson: Do your homework on the neighborhood before buying.

The tenant leaves

You can also get hurt on real-estate investments in good neighborhoods. Another client built a new rental property on the Jersey shore. He looked forward to full summer rentals that would cover his expenses for the rest of the year.

Unfortunately, in his first rental year, drug needles were found washing up on New Jersey beaches and stories of HIV infections from contaminated needles were grabbing headlines. A tenant my client thought he had signed up for two months disappeared, and it was too late in the season to find a replacement.

Financially, my client got clobbered. Without the summer cash flow, he couldn't meet the mortgage payments. He sold out for more than the property had cost him, but he had to pay transfer costs. So, on a cash-flow basis, he was substantially out of pocket.

The good news was that this client didn't have to pay any taxes. The bad news is why: He'd lost his shirt.

  • The lesson: Figure out all the ways a tenant might decide to leave and plan for the contingencies. At the very least, make sure you get first and last months' rent up front.

Interest-rate changes

Don't be tempted by what looks like a low-rate mortgage. These days, interest rates are going up. So, if you have an adjustable-rate mortgage, your basic nut will go higher, too.

If you borrowed $300,000 on an interest-only 3% loan, you'll pay $9,000 per year. If the interest rate goes to 7%, you'll have to pull $21,000 out of your pocket each year -- $12,000 more than before.

The odds that you'll find $12,000 a year in additional rent aren't good. So, I hope you've got deep pockets. Otherwise, you're gonna have problems.

  • The lesson: If you're buying rental property, financing is nearly as important as location. Run cash-flow projections to test your ability to repay a mortgage at a given rate. Consider the worst case scenario. An adjustable loan may be cheap to start, but it can come back to bite you. An interest-only note has the potential to consume your wealth.

Soaring prices, but ...

Many of us have made a lot of money on real estate. According to Merrill Lynch economist David Rosenberg, 70% of the rise in household net worth in recent years can be attributed to gains in home values.

Sales have been at or near record levels all summer. In fact, sales of existing homes set a record in June and generated the third-best sales rate ever in July.

Let's also be real. This real-estate boom has been fueled by rock-bottom interest rates. Federal Reserve Chairman Alan Greenspan has become increasingly outspoken in his concern about excess speculation, especially in markets like New York and California. Others worry the housing boom could be snuffed out if property simply becomes too expensive for all but the richest buyers.

I'm not singing a song of disaster. I'm singing a song of prudence.

Successful real estate investing really boils down to three rules:

  • Do your homework. Know the market and its risks.
  • Prepare for the worst. It will happen.
  • Think location, location, location.

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