Continuation from Part 5A)
To finish the remodel, we arrange to have a licensed electrician look over our shoulder and make sure we correctly installed the new breaker box, wall outlets, wall switches and ceiling light/fan assemblies. We hire a local plumber to run a snake through the bathroom drainpipe which is successful in cleaning out the clog. While we were cleaning the trash from the back yard, we found a central air conditioning unit of which we had not been aware. We knew we had central heat but didn’t realize it also included A/C. The same local plumber was called in to checkout the A/C system and make any repairs necessary. The only repair required was to replace the main circuit breaker for the A/C unit which we were able to do as part of our electrical upgrade. The compressor still had a full charge of refrigerant and the heating and cooling coils operated properly. We did have to remove a field mouse nest from the A-Coil in the furnace and replace the furnace filter element.
We had two roofers look at the roofing shingles and determine that the roof was serviceable as is. We noted, however, that a portion of the roof was completely missing over the front door. It was the portion that covered the eaves so there was no internal damage inside the house, but the roof had to be finished. We used 7-inch wide plywood covered by 30-lb tarpaper and then covered by two layers of asphalt shingles. The materials had been left at the house so no out-of-pocket expense was incurred.
While we were making the interior repairs, we noted that the central heat and A/C had been installed long after the house had been built. The house was built in 1952 but the central heating and A/C system was installed in 1976 based on the manufacturing date on the A/C evaporator. The ducting inside the house was made from ¼-inch plywood but they apparently never completed the job. The ductwork ended at a hallway wall but one bedroom at the front of the house was never connected to that duct. We fabricated a continuation of the ductwork so that all rooms were serviced by the heating and A/C system. The other end of the duct dead-ended at the outside kitchen wall. The den was located on the other side of that kitchen wall, so all we had to do was cut a hole through that kitchen wall for the diffuser vent in the den thus providing service via the kitchen duct. A complete puzzlement was a cardboard baffle we found inside the return air duct screen. It would have effectively blocked all the return air to the furnace. We never did figure out why someone would do that, but we did remove it to facilitate efficient furnace operations. After you’ve seen some of the insane things people do to their homes, you’ll conclude that these people should be permanently barred from owning tools or being allowed into hardware stores.
The last task we needed to complete was to paint the outside of the house. The most efficient method is to use an airless spray gun. You can rent one at your local tool rental shop but the cost approximates $75 per day. We found a new airless unit at Home Depot for $150 and now have that unit available for other future projects as well.
At this point in our project, we had completed all of the repairs for which we had agreed. Once we had all the electrical items replaced, we arranged to have the electric service turned-on. All of the electrical items worked properly as expected. Then, we arranged to have the natural gas service connected. The gas company service person checked all the interior fittings before turning on the service and noted a few corrections that would be required. The gas water heater has a pressure relief valve which then ducts any excess pressure to the outside of the building. The gas company noted that this overflow pipe was not of uniform diameter and in fact, was reduced down to a smaller size as the piping went from the heater to the outside, a very dangerous situation. We replaced the overflow with a uniform diameter pipe. Additionally, the existing vent pipe for the heater was a single wall tube. New building codes require double wall tubing to minimize the fire hazard. We obtained a new, prefabricated exhaust pipe at the local hardware store and it slipped into place very easily. Because this house was built without a central heating system, there were gas outlets in each room, which had originally been used to supply freestanding space heaters. The gas company recommended that we cap-off all of these outlets to avoid possible gas leaks in the future. Again, we obtained the required caps at the local hardware store and easily installed them. The gas company then connected the service and made sure all the gas-fired equipment operated properly. We now had completed all of the repairs and verified that all systems were operating properly. Six weeks had elapsed.
It was now time to add-up the numbers to see how well we did. We always keep all receipts because they are a tax-deductible expense from what otherwise would be taxable income. We spent a total of $1278.91 at Home Depot, $331.17 at Wal*Mart, $1159.85 at the hardware store and $888.36 on installed carpet for a grand total of $3658.29. We add that to the $14,698 paid for the original tax lien for a total building cost of $18,356.29. The only other cost was $536 for one-year’s fire insurance policy for a grand total of $18,892.29. Because we updated the electrical and the plumbing and because the central heating and A/C were installed in 1976, the insurance company later gave us a $28 rebate against the $28 original surcharge because the property had been built in 1952. Not too shabby for a 3-bedroom plus den, approximately 1400 square foot house on a large lot. Furthermore, at $500 per month rent, the rental income alone will repay us our entire cost including repairs in 3 years. Of course we’ve leased the house with an option to buy at the end of the lease. The tenants have agreed to pay us $49,900 if they elect to exercise that option. So let’s see where all these numbers lead. Our total cost including repairs was $18,864.29. We’ll collect $6000 in rent for the year lease. We also received an up-front, non-refundable option payment of $1000. So our gross profit will be $38,035.71 ($49,900 + $6000 + $1000 minus $18,864.29).
Financial Summary:
$14,698.00 Initial purchase price at the tax lien auction
1,278.91 Home Depot purchases
331.17 Wal*Mart purchases
1,159.85 Hardware store purchases
888.36 New carpeting installed
$18,356.29 Total purchase plus repair costs
508.00 One year’s fire insurance policy ($536 less $28 upgrade allowance)
$18,864.29 Total overall cost
$49,900.00 Contract sales price
6,000.00 Received as rent for one year
1,000.00 Received as non-refundable option payment
-18,864.29 Less cost of tax lien plus repairs
$38,035.71 Net Profit
This is somewhat on the low side especially since we did much of the repair labor and gave the tenant/buyer a discount on both the rent and the sales price. Remember, we did the work ourselves so that we would have a much better understanding of how much repairs really cost. That understanding will help us better negotiate with contractors on other projects in the future. We now have a worry-free property requiring no additional attention from us. The tenant has agreed to make all future repairs as necessary and at their expense. We set-up a savings account at a local bank within walking distance of the property and then gave the tenant twelve deposit slips. Each month, the tenant deposits the rent into our savings account and the bank keeps the books. When it comes time for the tenant to qualify for a loan, our independent bank records will verify their deposit record showing that the tenant kept their promise and paid in a timely manner. We just sit back and wait to collect the profits.
Well, not exactly just wait to collect. We actually benefit during the holding period because we get to deduct the repair expenses plus the depreciation on the house while we wait. One of the first laws of investing is “Thou shall pay no tax before its time.” Defer, defer, defer is the golden rule. We’re collecting $6000 in rental income which would normally be fully taxable as ordinary taxable income. We can, however, subtract the $3658.29 that we spent on repairs and the $508 for the cost of the fire insurance; a total of $4166.29 from the $6000 so that only $1833.71 is left as taxable income. Then, we also have a depreciation allowance to offset the taxability of the $1833.71. The chances are, we will pay no income tax on the rental income and we will probably have some deductions left over that can reduce income taxes on other taxable income. We’ll devote an entire chapter to reviewing and evaluating the tax benefits of owning investment property. In fact, investment property has been described as being an “I.D.E.A.L” investment:
I: meaning positive income or cash flow
D: meaning depreciation which is a paper accounting that reduces income taxes
E: meaning equity build-up because the tenant pays down the mortgage monthly
A: meaning appreciation because the property becomes more valuable over time
L: meaning leverage because you can use another’s money to make still more
In our example, we don’t have the mortgage or leverage but we certainly have a nice cash flow and depreciation allowance plus we’ll benefit from further appreciation if the tenant does not exercise their option. We defer ordinary income taxes now and later pay greatly reduced capital gains taxes on the profits. And we have other options that will enable us to defer the capital gains taxes if we so choose. Recall that we’ll discuss all the tax benefits later in a separate chapter.
So, how do you think we did on our first property? Was a $38,035.71 profit worth six weeks work? How many of these properties would you have to do each month to equal your current monthly income? Can you visualize doing two or three of these each month using hired labor instead your own? Can you better utilize your time finding still more deals while others do the actual physical repairs, as necessary? We think so!
NOTE: Stay tuned for Part 6