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Using real estate to increase your wealth

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There are many ways to create wealth and, in Southern California, even owning your own home can sure make you feel wealthy.

It seems like every month the average price of a home breaks new records, but unless you move out of the area, you are not doing anything more than holding your own in this crazy market. Someone comes along and pays what seems like a ridiculous price for your home and you turn around and pay an incredible price for your next home.

True wealth is created not merely by owning your own home but by owning someone else's home.

Are you looking for a way to participate in the real estate boom but don't know where to start? In this article I will share some thoughts from my new book "Real Estate Investing for Dummies" on a long-term strategy for building wealth through real estate that virtually everyone can understand and actually achieve.

Many in our area still rent, but even if you have been able to purchase a home, chances are you have been content so far with your home representing the real estate portion of your financial empire. I firmly believe that investment real estate should be part of your portfolio and you need to start now.

The good news is that it is never too early or too late to formulate your own plan into a comprehensive wealth building strategy. For many, this will be their answer to the challenges of funding future education for children as well as a comfortable retirement.

I believe that real estate should be the foundation upon which you build a solid financial plan. The majority of wealth in America is in real estate, often our homes. The stock market and other diversified investments are essential to a proper asset allocation and diversification strategy, yet real estate has been the key for most successful people. Why not for you, too?

The challenge for most of us with real estate is that it takes some real planning to get started. It sure is a lot easier to call your broker and purchase a few shares of your favorite stock than to purchase your first rental property. But it is really not that difficult. You just need a financial and real estate investment plan, a lot of patience and some hard work and you will be on your way to building your own real estate empire.

My father retired a few years ago after a very successful career as a real estate attorney, yet I remember his advice nearly 25 years ago when I first entered the real estate field while attending college. He advised that I should plan to use my monthly income to primarily pay day-to-day living expenses, but if I wanted long-term financial security I needed to allocate money each month into long-term financial investments like real estate.

This is solid advice that has served me well over the years. With real estate investing, patience is much more than just a virtue -- along with persistence, it is essential!

If you are just beginning to think about your financial future, what are the first steps?

Well, you need to develop a written personal financial plan. Yes, I said a written plan.

This is where most of us have trouble. We know what we want in generic terms, but we fail to reduce it to writing. In order to determine realistic goals, you need to establish your own personal investment philosophy. This will depend upon your own risk/return comfort zone, which will be a function of your age, family status, current financial condition and even your personality.

Let's go through some of the basic steps that will prepare you for your first venture into the uncharted waters of real estate investing.

For many, the first step is to actually take care of some old financial problems to pave the way for the future. If you have any unpaid consumer credit, including even your car loans, I suggest you start by developing a game plan that will eliminate all consumer debt. You can't even make the excuse that it is deductible for tax purposes anymore!

If you are already a homeowner then you know that your credit report will have a significant impact on your cost of borrowing and your credit score is even more important for your non-owner occupied real estate investments. Get a current copy of your credit reports from the three main bureaus (Equifax, TransUnion, and Experian) and take the necessary steps to correct errors and clean up any negatives.

The next step is to establish a level of cash or highly liquid reserves for the proverbial rainy day. Real estate is very cyclical and most of your real estate holdings will not generate cash immediately so the time between "paydays" can sometimes be excruciating and a real budget buster. Again, determine the proper level of emergency reserves for you, however, a minimum of three to six months income in cash is reasonable.

After establishing your highly liquid assets or cash safety net, turn your attention to developing a plan to purchase your own home, if you haven't taken that step already.

But even if you have purchased a home, how long will it be before you own it and don't have the bank as your silent partner? With the recent rage of home refinancing, I am shocked at the number of people that refinanced their home to lower the monthly payments and actually began the loan amortization process all over again.

If you refinance (a great idea if you haven't already), strongly consider keeping your payment level or even going a little higher and shorten that amortization schedule. When you invest in a cyclical and illiquid asset like real estate you don't want to have the roof over your head in jeopardy!

While I do not believe that it is necessary to own your home free and clear before investing in other real estate investments, I think it is advisable to have a home ownership plan in which you own your own home in 10 to 20 years.

Ideally, you may even be able to get your finances in position that you have enough money in your rainy day account that you could pay off your home in full. That is a great feeling particularly with the inevitable ups and downs of the real estate cycles that one can experience with real estate investments.

I strongly take issue with the numerous investment advisers who suggest that you leverage your home to the maximum in order to take advantage of the lower cost of debt and the mortgage interest deduction.

Of course, their advice is predicated on the track record of historical equity investment returns that have consistently been higher than the cost of home financing. While this may be true, I personally believe that the "pillow test" is important. Namely, as you go to sleep each night, you don't want to toss and turn all night worrying about all the equity you pulled out of your house to invest in those "can't miss" technology stocks!

Real estate investing has always had some advantages in the tax law, but for new real estate investors there is an excellent investment strategy that utilizes the tax law change in 1997 that is extremely favorable to homeowners. The federal tax laws provide for up to a $250,000 home sale tax exemption (or $500,000 if you are married) on any gain from the sale of your personal residence.

Best of all, unlike the previous home sale tax laws, the $250,000/$500,000 home sale capital gain exemption is very easy to utilize and can be used as often as every two years. Basically the only requirements are (1) the property must be your principal place of residence, and (2) you must own and live in this home for an aggregate of 24 of the last 60 months. The IRS has even recently issued certain extraordinary conditions in which you do not have to meet the full 24-month test and can earn a pro-rata exemption.

This law created a great investment and second income strategy for many homeowners. I call it "Serial Homeselling." What is "Serial Homeselling?" It is a variation on the tried and true real estate investment strategy of investing in well-located fixer-upper homes where you can invest your time, sweat equity and materials to make improvements that add much more value than they cost.

The only catch is that you must actually move into the fixer-upper yourself to earn the capital gains exemption of up to $250,000/$500,000 of the gain upon sale.

Therefore, be sure to buy a home in need of that special TLC in a great neighborhood. This is usually where you would have invested anyway.

To illustrate the significant benefits: You purchase a fixer-upper for $375,000 that becomes your principal residence, then over the next 24 months you invest $25,000 in improvements (paint, landscape, appliances, decorator items, etc.) and the amount of sweat equity that suits your skills and your wallet. You now have one of the nicer homes in the neighborhood and you can now sell this home for a net price of $500,000 after your transaction costs.

With your total investment of $400,000, your efforts will have earned you a $100,000 profit completely tax-free.

Thus, you have earned an average of $50,000 per year, which is not bad for a tax-exempt second income without strict office hours. Note that currently many states, including California, also allow you to avoid state income taxes and the limitations and requirements are the same as the federal tax laws.

While real estate has many advantages and is an extremely attractive investment, it is very important to remember the principle of diversified investing through an asset allocation model.

Stated simply, this means that you should not put all your eggs in one basket. Invest in equities and other financial investments. Many financial advisers suggest that their clients have 15 percent to 25 percent of their portfolio in real estate, however, I believe that it is prudent for many investors to have 30 percent to 50 percent of their long-range assets in real estate.

Of course, long-range assets do not include your cash reserves. Naturally, as your real estate portfolio grows over the years, it should be diversified to minimize exposure to risk and ultimately should contain a variety of property types in different geographic locations.

Also, real estate investors that "materially participate" in their real estate investments enjoy the ability to shelter up to $25,000 of non-passive income from wages and other active income if your adjusted gross income does not exceed $100,000. Above $100,000 the deduction is phased out until at $150,000 there is no deduction available and all losses are carried forward until the time of sale. You can even hire a property manager and still met the material participation requirement. See your tax adviser for details.

What types of real estate should you consider for wealth building strategy? Well, discounting the cyclical nature of real estate for a moment, I would recommend that you invest in the property type that you know best. If you know the office market inside out, then this is where you can make the most of your talents and connections.

In "Real Estate Investing for Dummies" a variety of real estate property types are explored but for most novice real estate investors I believe that a solid foundation can be built on residential income properties.

Everyone knows and understands the basics of renting a home or condo and in most areas of Southern California there is consistent high demand as we are faced with a severe shortage of affordable housing.

Entry-level homes and small multifamily apartment properties are also easy to purchase, finance, maintain and manage. Also, most residential rental properties will experience continued, albeit modest, rent growth that is crucial to increasing value and protecting your investment against inflation.

Regardless of the type and location of your real estate investments, there is often truth in the saying that "you make your money at the time you purchase the property."

While the overall economy has improved dramatically in most areas of the country, don't think the infamous "motivated seller" is extinct. The number of large income properties in receivership is almost zero, however, there always seems to be a number of homeowners with financial challenges that could lead to foreclosures if they cannot sell their home quickly. They need a quick sale and they have probably let the property go cosmetically.

For real estate investors that have a financial plan and can perform extensive due diligence to avoid properties with challenges that cannot be addressed with a little sweat equity and cosmetic upgrades, this is the perfect starting point. Take the first step today towards building your personal residential rental property portfolio.

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