Many consider foreclosures to be the most lucrative aspect of real estate investing for several reasons:

1.  Less competition – “underground.” The foreclosure marketplace is often tagged as the “underground” of real estate investing as opposed to the usual retail world of real estate. This means less competition from retail or uneducated buyers.

2. Less competition – specialized knowledge. While you do not have to be a brain surgeon to be successful in foreclosure investing, you should have above-average acumen to understand the legal aspects of foreclosures in the state (or states) in which you will be doing business. (Each state has its own set of laws pertaining to foreclosures.) Many investors and wanna-bes will be discouraged by the additional complexity in the foreclosure business.

3. Overpaying and overleveraging in the retail market. In many parts of the country, real estate has experienced a rapidly escalating market in a relatively short time. In this type of market you have a frenzy of buying, in which anxious and highly emotional retail buyers overpay for properties and, in may cases, also overmortgage them. These types of buyers often find themselves in over their heads with other types of debts as well (e.g., leased automobiles and credit cards). When the economy slows down and companies start to downsize, these homeowners often lose their jobs. Recent substantial stock market losses worsen this recessionary scenario even further. Homeowners find themselves in a financial bind, unable to meet their obligations, including their mortgage payments. We now have a highly motivated seller.

The combination of less competition and more distressed sellers renders the opportunity for substantial profits in foreclosures for the savvy, educated entrepreneur. Large profits from foreclosure “flippers” and “keepers” translates into potential tax liabilities that can drain your foreclosure gains unless you plan correctly in advance of the transactions.

Keep in mind that the tax strategies pertaining to foreclosure transactions are pretty much the same as for nonforeclosure transactions. However larger foreclosure profits mean larger and often unexpected tax liabilities that significantly deplete your gains.

Therefore, there is the necessity to implement tax reduction planning with a specialized and focused approach.

Many of you will generate quick cash from flipping your foreclosure bargains. If you are just beginning to flip properties, you will follow the appropriate investment strategies and take the position that you are not a dealer and do not start off as a corporation (with its many disadvantages). Instead, start off as an LLC partnership (or as a limited partnership if your state heavily taxes LLCs). Because you are taking the position that you are not a dealer, your slip profits will not be subject to Social Security taxes. With a partnership as a pass-through entity, you can also use rental losses from your keepers to offset the flip profits to reduce income taxes in addition to the Social Security taxes. Also, because you are taking the position that you are not a dealer, when you sell you can defer income taxes on the gain via a 1031 exchange. If you hold any of the financing, you can defer income taxes on the gain via installment sale reporting under Internal Revenue Code Section 453.

If you do not immediately need the cash from your foreclosure flips, then use a self-directed retirement plan to buy and sell your nondealer foreclosure slips, free of all taxes. Again, because you are taking the position that you are not a dealer, you can defer taxes within a retirement plan. The tax-deferred profits in the plan will compound to a much larger accumulated sum than they would outside the plan. These tax-deferred accumulated sums can be further invested into more flips or other profitable investments. Besides an IRA, you can also have a self-directed SEP, Simple, or Keogh retirement plan, thus doing foreclosure transaction that are highly profitable, but tax-deferred. Plus, with a Roth self-directed IRA, the profits are permanently tax-free!

Tax tip on taking cash out of your IRA: Take out penalty-free and income-tax-free cash from your retirement plans. One of the ways you can receive IRA funds without incurring penalty (even if you are younger than age 59.5) is to receive a lifetime annuity schedule of essentially equal payments. (Have a pension specialist do this for you). There is a way to tap your plan for not only a penalty-free annuity, but also one that is income-tax-free and payment-free. This is done by obtaining a home-equity loan with a loan payment about the same as the IRA annuity. Here, you will have two every positive offsets:

After determining the amount of annuity payments you can receive, you take out a home equity loan at the same amount of payments. Assume you can take out $500 a month as an IRA annuity and that $500 a month will enable you to obtain a home-equity loan of $50,000. The $500 incoming IRA annuity offsets your $500 outgoing loan payment, which the loan interest offsets your taxable IRA annuity.

You’ll have a $50,000 lump sum of penalty-free, tax-free, and payment-free cash, which you can invest to earn more income!

Assume you invest the $50,000 in real estate at an annual yield of 20 percent a year. You’ll have $10,000 a year annual income that is totally sheltered by property deductions, and is therefore tax-free!

You used your IRA annuity in a tax-favored manner to generate another $10,000 tax-free income every year … plus the equity buildup in the property.

Money makes money, but tax-free money makes a whole lot more money!

Another way to take out penalty-free and tax-free cash form your retirement plans is to borrow from your Keogh plan. As of January 1, 2002, single proprietors and partners can borrow from their Keogh plans, and S corporation shareholders can borrow from their plans. The loan cannot exceed one-half of the vested interest in the plan up to $50,000. However, this is tax-free money to you, plus you deduct the interest on the loan, and the plan does not have to report it (double taxation the right way – your way!).

You borrow $25,000 from your Keogh plan and must pay the plan 8 percent interest for five years. The $25,000 is tax-free money to you, plus you deduct the interest on the loan, and the plan does not have to report it. You invest the $25,000 in real estate for an annual yield of 20 percent a year, or $5,000 a year income form the tax-free borrowed money.

While you can borrow from Keogh plans, you cannot borrow from SEP, Simple, and IRA plans. You also cannot use any of these plans (including Keogh’s) as security for a loan. If you do borrow from these plans (SEP, Simple, and IRA) or use any of them as security for a loan, there can be substantial taxes and penalties.

If you do not have earned income eligible for retirement plan contributions, from a separate management company for your keepers. From your keeper property income, you pay the management company fees for various services the company performs. These fees are earned income and thus eligible for retirement plan contributions.

To acquire foreclosures at sheriff’s sales within your self-directed plan, you must draw the money in advance from the retirement plan account with the bank check payable to the sheriff (or whomever, just not you). Here, you may have to estimate. It is better to be over. Any excess could be directly returned to the plan account.

If you want to keep and rent out your foreclosure bargains, then generally the ideal ownership entity is an LLC partnership. If your state heavily taxes LLC profits, then you may need to use a limited partnership.

Generally you do not wan to buy keepers in a self-directed retirement plan. However, if you follow the techniques of buying foreclosures from the experts (such as Ernie Kessler or Dwan & Sharon), you will be buying your properties at deep discounts. This will include properties that you intend to keep and rent out. If you buy these discounted bargains for cash and own them free and clear, then these properties can generate substantial cash flow even after tax deductions for depreciation, taxes, and operating expenses.

You acquire a bargain property for all cash. Taxes, insurance, and other operating expenses are $3,000 a year. You obtain a tenant for $700 a month, or $8,400 a year, leaving you with appositive cash flow of $5,400. Tax depreciation is $1,000 a year. Your after-taxable net income on the property is $4,400 ($5,400 less depreciation of $1,000). In a 31 percent tax bracket, you would have to pay $1,360 in taxes on the $4,400. in a rounded 40 percent tax bracket, you would have to pay $1,760 in taxes on the $4,400. if you owned 10 of these properties (many investors own much more), you would have to pay 10 times the amount in taxes - $13,600 or $17,600, respectively.

You can avoid all of these taxes by acquiring these properties within a self-directed plan.

Also, you pay no taxes on the profits! Keep in mind that if your self-directed plan sells any of these properties, the profit, regardless of size, is not taxed. Remember, while there is a limit on the amount of annual retirement plan contributions, there is no limit on the amount that a retirement plan can earn, tax-free.

You may not want to acquire these types of properties within your retirement plan if you have other deductions to offset the property’s taxable income.

All retirement plan mortgage loans must be nonrecourse: Any loans on property that you acquire within your plan must be nonrecourse. A non-recourse mortgage is one for which the debtor is not personally liable on the debt. With a nonrecourse mortgage, you and your plan trustee are not personally liable. In the event of default, the lender takes only the property, not the other assets of the buyer-borrower. (Note: Many hard moneylenders give nonrecourse loans.)

It is the author’s opinion that little or no debt should be used to buy real estate within your retirement plan for these reasons:

The interest is not deductible against your income outside of the plan.

Any debt (even nonrecourse) could increase risk. For the most part, free-and-clear properties should be the preferred retirement plans where safety is especially Important.

The loan must be nonrecourse as just explained. While this is favorable to you and your retirement plan, it could involve more hassles to find these types of loans.