Residual Income, The Dream Killer or The Dream Creator?

This post has been moved to http://sizusfinlit.blogspot.com/2015/01/residual-income-dream-killer-or-dream.html.

Applying Izu's 100-200 Property Valuation Rule

This post has been moved to http://sizusfinlit.blogspot.com/2014/12/applying-izus-100-200-property.html.

Everyone Should Own a Small Business

I know, I know, 90% of small businesses fail. The failure rate of business in general is 70%. Then there is all that time and effort wasted getting out of your comfort zone.

However, lets look at the positives for a second. We are all taught not to put all of our eggs into one basket and building a business will give you the security of knowing you have a backup plan as well as an extra stream of income, even if it is small. If you are passionate about what you are doing and find value in it, you will look forward to the off hours and weekend times because you enjoy the time you are devoting to your venture. In building a business, you will undoubtedly build relationships that you never would have had and you never know who you will meet or reconnect with. All business owners get an automatic status symbol because standing for a cause and doing something out of the ordinary is admirable. Undoubtedly, you will grow and obtain skills that will ultimately make you more valuable to society, increasing your income potential, confidence and self-worth. Building a business will also stimulate the economy as well as your local community.

“Choose a job you love, and you will never have to work a day in your life.” ― Confucius

Of course, there are financial incentives and tax advantages associated with a small business. Please refer to your accountant and lawyer appropriately as I am not a tax advisor. Here are a list of business types for federal tax purposes (only the first 4 will be discussed below):

• Sole Proprietorship (1040 Schedule C)
• Partnership (1065)
• S Corporation (1120S)
• C Corporation (1120)
• Trust (1041)
• Non-Profit Organization (990)

DESCRIPTIONS

The sole proprietorship is the simplest type of business in which one person represents the business (ie direct sellers, contractors, consultants). Partnerships are unincorporated businesses involving two or more people (ie dentists, lawyers, firms). S Corporations are incorporated businesses with at least one shareholder and not more than 100 shareholders. C Corporations are incorporated businesses (may have 1 shareholder).

SETUP

To setup a sole proprietorship, there are no filing requirements with the Secretary of State but items like Ficticious Business Name Statement and other filings may be required. To setup a partnership, a Partnership Agreement must be filed with the Secretary of State. To setup an corporation, the Articles of Incorporation must be filed with the Secretary of State which typcially involve more time and money (also creates a Board of Directors).

TAXES

Sole proprietorships, partnerships and S Corporations are "pass through entities", meaning that they pass the losses and profits onto the shareholders. This allows shareholders to offset active income, thus reducing their taxes. Converting a hobby to a sole proprietorship business can create significant tax advantages (see http://taxes.about.com/od/taxplanning/a/loss_strategies.htm). According to IRS Publication 535, generating a profit every 3 out of 5 years will prove you are in business to make a profit, but even without this, you may still be able to prove you are in business to make a profit so that you can reduce your taxes.

Generally speaking, profitable companies should be setup as a C Corporation. In C Corporations, profits are determined as income minus expenses. The C Corporation then makes payments into the following categories in this order: taxes, secured debt/bond payments, unsecured debt/bond payments, preferred stock dividends, common stock dividends, retained earnings. Each category must be fully paid, before the next category may be paid. This shows why bonds are generally less risky than common stock. Any profits which are left over after paying the common stock dividends (the Board of Directors may determine to pay zero dividends to common stock holders) fall under retained earnings and are kept to operate the business. Dividends are taxable, which means that this money will be doubly taxed in a C Corporation both at the corporate level and at the individual level.

LIABILITY

Sole proprietors and general partners in a partnership have unlimited liability, meaning that they are legally responsible for all debts against the business (for example if the business is sued). A Limited Liability Company may be formed as a state designation, with IRS Form 8832 being used to determine whether the LLC will be taxed as a sole proprietorship, partnership, S Corporation or C Corporation. This is a strategy used to limit liability to the shareholders. Limited partners in a partnership as well as shareholders in a corporation have limited liability and are typcially only liable for their investment.

FINAL NOTE

One very common formation is a Limited Liability Company elected as an S Corporation. The Limited Liability Company allows limited liability protection at the state level and also allows asset protection since assets may be moved into the LLC. The S Corporation allows losses to be passed directly to shareholders via IRS Form K1 (not doubly taxed like a C Corporation) as well as the capability to raise funds or transfer ownership by selling shares.

Dedicated to Jordan Misiura

Support My Mission

1. You can support my mission by donating via my e-mail address (scottizu@gmail.com) and PayPal.

2. You can support the mission of SAGE by donating at http://sagescholars.berkeley.edu/. The UC Berkeley SAGE (Student Achievement Guided by Experience) is a self-funded experiential leadership program that provides education, professional development, mentoring and internships to UC Berkeley students who come from poverty and low income backgrounds.

3. You may also contact me for a free 1-hour consultation to discuss how I can help you.

How Dividends Work

I am a huge fan of dividend paying stocks. I like companies that are paying back their investors now and only use their investor's money so they don't get into a situation where they have a deal on the table that they can't do because they don't have the capital to back the deal.

So, let me talk a little about how dividends work. This discussion is inspired by a talk with a good friend who asked me why a person would not just buy a stock before the dividend paid out and then sell the stock after the dividend paid out. He also did not know about the x-dividend date, so I will clarify that here.

If a stock pays dividends quarterly, the board of directors will meet after each quarter to declare a dividend (or decide not to pay a dividend). In this scenario, I will just assume the second quarter has finished and the board of directors are meeting on July 10th to declare a $1 dividend. We can just call July 10th the "meeting date". This means the company will pay $1 to each shareholder for every share owned. In the meeting, let's say they also decided to make the "record date" on July 20th and the "payable date" on July 30th. Then, the "x-dividend date" is July 18th, which is determined by FINRA to be two business days prior the "record date".

• June 30th - End of second quarter
• July 10th - Meeting date (determined by board)
• July 18th - X-Dividend date (determined by FINRA)
• July 20th - Record date (determined by board)
• July 30th - Payable date (determined by board)

If the stock cost $50 per share on July 17th, the price would automatically be adjusted to $49 per share on July 18th. Whoever owned the stock on July 17th would be paid the $1 dividend, even if that person sold the stock on July 18th. The owner of the stock on July 17th would be recorded by the company as the owner of the stock on July 20th and would be paid the $1 dividend on July 30th.

The important thing to note is that you do not want to purchase the stock on July 17th because you will buy the stock for $50 per share and then be paid a $1 dividend per share and then taxed on the $1 dividend per share. It is better to purchase the stock after the "x-dividend date", once the stock has been discounted to $40 per share.

Support My Mission

1. You can support my mission by visiting http://www.izuservices.com and donating. A dollar lets me know you support my mission or like my posts. Thank you for those who have already donated.

2. Donate to SAGE via http://sagescholars.berkeley.edu/. The UC Berkeley SAGE (Student Achievement Guided by Experience) is a self-funded experiential leadership program that provides education, professional development, mentoring and internships to UC Berkeley students who come from poverty and low income backgrounds. I serve on the Leadership Council for SAGE and want to help raise money for their cause.

3. Call toll-free (877) 855-8111 or log on to www.PrimericaSecure.com to save yourself some money on either your home or auto insurance policies. Be sure to use my last name (IZU) and solution number (2MTFT). PrimericaSecure automatically compares rates from multiple companies such as Progressive, Travelers, Safeco, Hallmark, etc.

Izu's 100-200 Property Valuation Rule

According to the United States Census Bureau (reference), in 2011, there were about 312 million people in the US of which 38 million lived in California. In California, there were nearly 14 million housing units. According to an analysis done for San Mateo County (reference), in 2009, close to 503 thousand of these were pre-foreclosures and about 390 thousand of these were foreclosures. That means, nearly 892 thousand of the 14 million housing units or about 1 in every 15 homes was in jeopardy of being lost to the bank.

The statistics above state why I am such a fanatic about following specific rules when you purchase your home. I know that one of the four d’s (death, divorce, disease, disaster) could cripple you down the road. While many renters feel their entire rent is going down the drain, in reality only a small portion of the rent money is paying down the house. When I purchased my first home, I estimated only saving $70 a month based on tracking expenses, even after factoring in the equity being built (this is plenty when you are actually ready to buy, because you will be getting rich slowly). In addition, renters have the flexibility to move in case they lose their job and they can find a cheaper place to live if necessary. So here are my rules of thumb for buying your home:

• Only purchase after your car loans, student loans and credit card debt are paid off.
• Don’t purchase over 3 times your annual household income.
• Put 20% down on your home.
• Don’t pay over 200 times the monthly rent in the area.

When it comes to business ventures, leveraging can be very profitable. However, if you are a new investor, at least for the first investment, I would modify these rules:

• Put 25% down.
• Don’t pay over 100 times the monthly rent in the area.

Lets look into where the numbers 100 and 200 come from in the 100-200 rule.

During March 2012, the California median home price for single-family detached homes was $291,080 and average interest rates for thirty year fixed mortgages were 3.95 percent (reference). So typically, people are paying $1381.28 for 360 months. That is $497,261 it total payments and $206,181 in interest over 30 years.

Interest rates these days are very low but historically, they have not always been this low. Holding a 9% interest rate would mean paying 190% in interest which means almost paying 3 times what the home is worth over 30 years!

California counties collect an average of 0.74% of a property's estimated fair market value as property tax (reference). The average home insurance rate was $803 (reference). Average maintenance costs for home owners are about $672 for the year (reference). In addition, home owners tend to tack on projects around their home, which I will assume cost about the same as maintenance. Based on these numbers, one can expect to spend 1.5% of their home price yearly to cover property taxes, insurance and maintenance.

Suppose you see a home that rents for $1455 a month and you are interested in purchasing this home for personal use. Then, I would advise not paying over $291,080 for this home, using the 200 factor from the 100-200 rule. The reason is that every month, you should expect to pay $1381.28 to your mortgage company and $363.85 for additional expenses. This is a total of $1745.13 a month. Many people make the mistake of thinking that since the mortgage is lower than the rent, they have a good deal. Making a mistake here and losing this home would cost you about 11% of your home price (loan closing costs, legal fees, buyer and seller commissions) which would be about $32,019 for an average home in California.

Following my 100-200 rule gives you staying power. It allows you to hold the home long enough to have something great happen, like appreciation. Banking on appreciation because you know house prices will go up is gambling. Doing the numbers ahead of time and make sure you can afford the home is good business. Later, people will say that you are lucky, when you know different. You have planned ahead of time, just in case you hit some hard times. Doing this, I have no doubt you will get lucky and when you move into a bigger home, you will have rental property which still fits the numbers. This means rather than selling and losing that 11%, you now have an investment property, adding an asset to your collection.

As a landlord, one should factor in repair costs, appliance costs and additional costs (changing tenants, new carpet, painting). A renter should also assume 2 months of vacancy per year. If property management is involved, one might also include a $300 lease fee and 10% of the monthly rent going toward property management. In addition, unlike owning the home, an investment property should make a return like 2.5% of the property’s value (this is 10% of the 25% down). Using the 100 factor from the 100-200 rule, the same home which rented for $1455 a month, should not be purchased for more than $145,500 as an investment if you expect to make a good profit. Many investors just hope to make some profit. However, it is a good idea to compare to expected returns with the returns expected from other investments.

In terms of taxes, rental income may be considered active income if this is your job. Otherwise, it is passive income. This is important to calculate your depreciation deduction. In general, active income can offset active income and passive income can offset passive income. If you make major decisions, you might say that you actively manage your properties, but the income is still considered passive. This is a whole blog topic in itself, so I won’t cover it. In either case, both depreciation and appreciation should be considered icing on the cake and should not be factored into the equation, because one might not ever see these benefits if they can’t own the home long enough to see them.

Support My Mission

1. You can support my mission by visiting http://www.izuservices.com and donating. A dollar lets me know you support my mission or like my posts. Thank you for those who have already donated.

2. Donate to SAGE via http://sagescholars.berkeley.edu/. The UC Berkeley SAGE (Student Achievement Guided by Experience) is a self-funded experiential leadership program that provides education, professional development, mentoring and internships to UC Berkeley students who come from poverty and low income backgrounds. I serve on the Leadership Council for SAGE and want to help raise money for their cause.

3. Call toll-free (877) 855-8111 or log on to www.PrimericaSecure.com to save yourself some money on either your home or auto insurance policies. Be sure to use my last name (IZU) and solution number (2MTFT). PrimericaSecure automatically compares rates from multiple companies such as Progressive, Travelers, Safeco, Hallmark, etc.

The Second Tier of Building Wealth

The second tier of building wealth is learning how to have your money make money. If you don't know how to earn money, you won't have any money anyway, which is why the first tier is so important.

Managing Your Money

The first part of this tier is learning how to manage your money. Rather than flying by the seat of your pants, it is important to have a game plan and set goals. Learning how to make a budget and having the discipline to stick to that budget are key.

"A penny saved is a penny earned."

"Those who make 4 dollars and spend 3 will always be better off than those who make 5 dollars and spend 6." - me

“Most people don’t receive a formal education about financial matters, but it’s an important life skill.” - http://www.northbaybiz.com/General_Articles/General_Articles/Amazing_Savers.php

Avoiding Debt

Debt is a cancer. Debt is a disease. It affects stress, health and relationships. On the national scale, we are about 70 trillion in debt, if we include future debts such as Social Security and Medicare (http://www.truthin2008.org/"http://www.truthin2008.org/). On the individual level, "Credit card debt is the third largest source of household indebtedness, averaging $15,587 per indebted household as of June 2012" (http://www.nerdwallet.com/blog/credit-card-data/average-credit-card-debt-household/). While some people believe debt increases productivity, I think we should be attacking the statistics above head on.

People often get upset when taxes are raised, yet will gladly pay a 3% tax to use their credit cards. Of course credit card companies are smart so they charge businesses and people think they are not being charged if they pay off their credit cards on time. Even worse, people don't pay their credit cards off each month which leads to 10%-25% in additional fees.

A quick side note. There are arguments that businesses should have debt because they leverage money and increase investor returns. I absolutely believe in the power of leveraging money, but that is another blog posting.

Create an Emergency Fund

Everyone should have 3 to 6 months of living expenses saved up for emergencies. I have heard it quoted that for every $10,000 in your annual salary, it may take a month to find that pay in a job, if you were to lose your job. That is, to find a 100K job, if that is your salary, it might take 10 months to find that job. In addition to losing your job, you may have to replace your car or take care of another emergency.

If you do not have an emergency fund and have credit card debt, I would advocate eliminating your credit card debt and building an emergency fund at the same time. An emergency fund can be placed in a checking, savings, money market account or certificate of deposit. This purpose of this fund is not to make money, but be liquid, meaning that you have access to the fund within a week's time frame.

Playing the Money Game

Once you have followed the above rules, you will be able to start playing the money game. You will become a lender and not a borrower. That's right, I said you be the bank. Rather than give the money to the bank, find out where the bank is investing the money you are giving it. I think that its very sad that we have become a society where we go to the bank to get loans, rather than visiting that rich uncle. What has happened to the strength of an individual's word? Why not register a promissary note which is based on a mere handshake?

Besides, the emergency fund and the 529 plans for college savings accounts, you should have a couple more buckets used to build your financial house. Diversification is an important word. For those who had all of their savings in mutual funds or stocks in their 401(k) plans in 2008, they may have had 50% of their estate taken out. On the other hand, suppose you had something like a 50% real estate, 25% stocks and 25% bonds. Now, imagine you lost 50% in stocks. This means you really only lost 12.5% of your estate.

Any well built financial house will include a diversified portfolio along with tax considerations. It will also include considerations on liquidity (like short or long term).

More importantly, realize that "No one will protect your money better than yourself." If your financial planner is not teaching you about money, they are not doing their job. A good financial planner will give you information and then let you make decisions about your money. They will not give you a single option and tell you that its the perfect plan, because no one can predict the future. Rather than pass the buck to your finanical planner, learn enough to be able to ask the right questions.

Most people who lost money in real estate, lost because they didn't know how to evaluate home prices or do other number crunching. This is true because over the past ten years while many were losing, those who knew were still making money. It is shocking to me that right after the sub prime mortgage crisis, people are still putting 3-5% down on homes and taking out a 30 year loan.

Most people who took a huge hit in stocks, also lost because they didn't know what they were investing in or how their investment worked. With the advancement of the internet, people can now invest in any publically traded company with the click of a button. They do not look at the investment, they just tell themselves, "Well, Apple is a great company with a great product." So, if someone told me that, I might respond, "If you had 1 trillion dollars, does that mean you would be willing to purchase Apple with that 1 trillion dollars?" It is shocking to me that right after the stock market crashes of 2001 and 2008 people continue handing their money off to someone who is making money whether they gain or lose money.

Whether in real estate or in the stock market, based on many people I have interviewed, I have found a huge difference between people who know how to have their money make money and people who don't. Those who do, often live by this phrase, "If the numbers work, I will do the deal. If they don't, I won't."

Support My Mission

1. You can support my mission by visiting http://www.izuservices.com and donating. A dollar lets me know you support my mission or like my posts. Thank you for those who have already donated.

2. Donate to SAGE via http://sagescholars.berkeley.edu/. The UC Berkeley SAGE (Student Achievement Guided by Experience) is a self-funded experiential leadership program that provides education, professional development, mentoring and internships to UC Berkeley students who come from poverty and low income backgrounds. I serve on the Leadership Council for SAGE and want to help raise money for their cause.

3. Call toll-free (877) 855-8111 or log on to www.PrimericaSecure.com to save yourself some money on either your home or auto insurance policies. Be sure to use my last name (IZU) and solution number (2MTFT). PrimericaSecure automatically compares rates from multiple companies such as Progressive, Travelers, Safeco, Hallmark, etc.

Breaking Down the HUD for Tax Purposes

This post has been moved to http://sizusfinlit.blogspot.com/2014/12/first-off-i-am-not-tax-advisor.html.