Finances – Bedrock and Blueberries

The Summer Prequel, Part Two: the Gordian Knot

The state of things at the Cabin last summer.

“Children and lunatics cut the Gordian knot which the poet spends his life patiently trying to untie.”

— Jean Cocteau

I got an email from my caretaker yesterday. He couldn’t figure out how to activate the electricity in the Anchorage, which I had turned off for the winter. Emera, the service provider, told me that all he needed to do was press a button underneath the meter. In the end, this turned out to be true, but it caused Dave to make several trips out to the house as we both puzzled over what it could mean — Had they activated power to the wrong house? Had they even bothered to turn on the power in the first place? Are you sure they said “a button”?

This feels like a metaphor somehow.

Restoring a historic Maine homestead is more difficult than I thought it would be.

There, I said it.

When I first walked around the place, I realized that both foundations needed work. The Anchorage needed a new roof and some paint. There was water damage on the west wall of both buildings from ridiculous gutter systems that leaked storm run off directly down the outer walls. I soon learned that no one could even locate the septic tank for the main house.

On the whole, this was not discouraging. My ex and I had basically disassembled our Austin home and put it back together. I had sanded floors and stripped acres of wallpaper on my own in various rental properties to make them more appealing. Besides, my Realtor showed me six other houses, and all of them had flaws that would require extensive remodeling. They also had impediments to water access or no way to tap into passive income once I moved up there. I didn’t want to cash out my retirement funds without having a property that paid for its own taxes and maintenance, at the very least, because then all the cash would be tied up in the house, and the only way to liquidize the equity would be to sell or refinance. I wanted a property that I could rent in the summer — and still live on. And with my budget, that meant renovation and restoration was in the cards.

The inspector’s report contained mostly good news, especially considering the age of the Anchorage. Thanks to conscientious attempts to counteract the forces of gravity, there was remarkably little structural damage. For all practical purposes, the Anchorage was move in ready.

Nevertheless, as the previous owner wryly remarked once the closing papers had been signed, the place “has a lot of moving parts.”

The first sign of systematic trouble came in the form of the water testing report, which showed high concentrations of arsenic and heavy metals in one spring, the one that feeds the Cabin, and lower concentrations of arsenic (but no heavy metals) in the Anchorage spring. The springs themselves are enormous; one has a cistern that is thirty feet long. Falling down “houses” in the woods cover them both, and plastic tubes run through the boggy woods to the property. These springs once fed a property up the road as well, through a system of pipes that run hundreds of feet east to what must have been a pump house.

There is no shortage of water. It flows all the way down Caterpillar Hill, through my woods and into the marshy foot of my meadow, where it inundates my neighbor Pat’s careful landscaping in the spring. The dampness below is what’s kept the wood of both houses in pristine condition all these years.

Thus, it was a bit ironic that the well guy, a taciturn Yankee who looked for all the world like a sea captain, had to bring in special equipment to fracture the bedrock once he got down to 400 feet and still was coming up dry. That cost a pretty penny. The well, now full, sits amidst a glorious expanse of sand that Ben Webb, the excavator, trucked in to support the weight of the concrete mixer that poured the foundation last summer. I’m set to tap it this summer when the plumbers reconnect the Cabin’s plumbing. If it contains arsenic, I’m going to cry.

Last summer was all about the Cabin foundation. The house was sinking into a bog at the northwest corner; in another decade, the support beams would have snapped. Since this is the house I’m going to live in, I needed to act fast.

The house was in the air for almost two months, while Ben built roads and moved dirt around to create new pathways for the water to go, and the very handsome — sorry folks, no pictures of that crew — family of Joel Wilson built forms and poured the concrete in stages. Finally, it was carefully lowered back on to the new foundation with system of many hydraulic jacks jerry rigged into a control board.

This summer is all — or mostly — about plumbing and water. Ben dug the leach field in my front yard last fall before the first frost, and sometime soon — ahem — he is going to put in the tanks and lay the connecting sewer pipes. The plumbers need to

divert some pipes.
install a pump beneath the foundation on the west wing to help the water flow.
install a pump in the well itself.
reconnect the plumbing in the Cabin.
insulate the pipes so that I can have water year round in the Cabin.
connect water to the Anchorage, either from its spring or from the new well.

Meanwhile, putting a solid foundation beneath the Cabin has led to problems of its own. The carpentry crew needed to cut around and stabilize what were then two Cabin chimneys in order to do the lift. Sadly, I lost the chimney in my bedroom in that maneuver; it had been poorly built and was cracked. No romantic fires in there for me. The silver lining will be a larger master bath, complete with skylight.

Creating clearance around the stone chimney and hearth in the Cabin’s great room cost thousands of dollars and has left structure damage that still needs to be repaired. Moreover, stabilizing the foundation, which settled all the windows down into their sashes for the first time in many years, has caused damage to the roof, last shingled when the house was crooked. A mason needs to come in and re-flash the chimney, and the whole building has to be re-roofed.

Move one thing, and two others break. It’s a Gordian knot, all right.

Fortunately, I am a poet.

Part Three of Financing a Second Property: Passive Activity Loss

The world of tax deductions for small businesses and second properties is a labyrinth of schedule E vs. schedule C forms, allowable deductions, exceptions and special circumstances. I thought I knew many of the rules because, as a freelancer, I had written a 17,000 word series of video scripts designed to train Realtors in selling vacation homes. But it truly is a complex and overwhelming area of the tax code, and I am learning new things all the time.

Case in Point: The Passive Activity Loss Exception

One of the things I didn’t realize when I purchased the Anchorage and Cabin is I would be able to take advantage of a special tax deduction designed for individuals who experience passive activity loss (PAL) with an investment property. Provided that you are “materially involved” in the management of the property — that is, you take an active role rather than letting a management company handle the details — and provided that you have at least a 10 percent ownership interest in the property, the IRS makes an exception to their general rule that rental losses are passive and can only be offset against other passive income. The upshot is you get to claim a tax deduction up to $25,000 against all income gains, including ordinary income, each year you meet the qualifications.

Okay, this sounds awesome — but of course it’s not that simple. Nothing in the world of small business taxation is even remotely simple; exemptions and exceptions volley back and forth schizophrenically, sometimes in the same document. The problem here? This deduction gets phased out once your modified adjusted gross income (line 38 on your 1040) rises above $100,000 a year, and if your MAGI is over $150,000, you can’t take the deduction at all. In other words, divorcées who don’t usually make squat but decide to cash out their retirement accounts to purchase a historical Maine homestead don’t get to deduct a goddamned thing for that tax year. Goddamn it.

The IRS does allow you to carry the deduction forward into subsequent tax years — at least that’s what I hear from my accountant. What I’m not entirely sure about is if I’ll be able to take the deduction against ordinary income or just against my passive rental losses. If the former, it seems likely that I will be able to recoup about a third of the taxes I’m paying in 2015, though I may have to phase that out over several years.

Beyond that, there are a number of variables:

Is it better to manage the property myself or have a company take care of these details for a fee?
Would I make more money renting out both houses and using a service or occupying the Cabin and taking a hand’s on approach to renting the Anchorage during the summer season?
Should I run the Anchorage as a small business venture, or would it be more advantageous simply to rely on the passive seasonal rental income?

Fortunately, these are questions I don’t have to answer right away.

Nest Egg or Cash Flow

I want to finish this post by touching on a particularly insightful bit of information that one of my freelance clients shared with me. I told him what I was about to do, and rather than try and talk me out of it, he pointed out that the rental revenues I’d have coming in would be equal to the interest on a large nest egg.

I’d never thought about it that way, but it’s true. By the time I retire, annual rental income from the Anchorage will be equal to 4 percent interest on a $500,000 capital sum, and unlike money placed in a safe investment, like a CD, this income stream is tied to inflation.

One of my favorite moments in cinematic history occurs in Albert Brooks’s 1985 comedy, Lost in America, right after the character played by Julie Hagerty gambles away all of the money she and her husband, played by Brooks himself, were going to use to support themselves in their quest to touch Indians and sleep beneath the stars.

“The egg is a protector, like a god,” an irate Brooks rants at her, “And we sit under the nest egg, and we are protected by it. Without it, no protection.”

The Nest Egg Principal is what most of us emulate as we move toward retirement. The goal is to accumulate a large sum money so that we have enough interest income to supplement what we will receive in the way of social security and pension. Without the “nest egg,” we’ll barely have enough to scrape by.

I’m not knocking this principle. But there’s something to be said for taking a gamble as well.

Part Two of Financing a Second Property: Self-Directed IRAs

If you cash out your retirement account in one lump sum, you stand to lose far more of your money to the IRS than you would if you took your distribution payments over time. The reason is, by cashing out the entire account, you put yourself in a much higher tax bracket for that single year since distributions from a retirement account are taxed as ordinary income. Instead of being in the 25th percent bracket consistently throughout your retirement years, for instance, you might be in a 33rd percent bracket for one year. While you don’t pay 33 percent on all that money, you may pay that rate on the lion’s share of the distribution.

The IRS has made it hard, but not impossible, to recoup some of the losses. I will be able to cushion the blow in two different ways. This post talks about the first, self-directed IRAs.

Self-Directed IRAs: A Quick View

When I told my brand-new accountant what I was about to do, he flipped out. “Do you realize what tax bracket you’ll be in?” he asked me.

He told me I should look into self-directed IRAs. This is a little known investment vehicle that allows you to invest in “anything you like” rather than sticking to the stocks and bonds that make up most investors’ portfolios. Well, anything except collectibles, S-corp capital stock, and a short list of other prohibited investments.

You can, however, invest in real estate and land, which were the only things of interest to me.

Here’s how it works. The IRA holds the real estate through a company that acts as a custodian of the account. The big investment companies, like Vanguard and Charles Schwab, do not handle self-directed IRAs. You will have to research the companies that do handle these accounts, compare their fee schedules, and check their track records yourself.

The custodian purchases the real estate with rolled over funds from an existing IRA or 401k account after reviewing the purchase sales agreement. They then write checks to pay for ongoing property tax and maintenance and receive rental payments and other revenues on your behalf. It all stays in the IRA. The custodian files the appropriate paperwork with the IRS and charges a variety of fees to maintain your account.

You can theoretically be your own custodian by holding your investment in a so-called “checkbook” IRA as long as you adhere to the rules that govern self-directed IRAs. Checkbook IRAs purport to cut out the middleman — though even these accounts have someone who does the IRS reporting for a small annual fee. However, checkbook IRAs are hanging on to their legal status by the slender thread of one court decision, and the IRS has had its eye on them. I decided not to pursue that course.

Although the IRA shelters your money from taxes, there are a lot of rules that make self-directed IRAs a less than desirable choice for an investment property, especially if you need to pay for a lot of repairs on the property before it generates cash flow:

You can’t work on the investment property yourself (there is some disagreement about whether individuals can perform routine maintenance such as mowing the lawn). Thus, sweat equity is out.
You can’t live in it or even stay there one night out of the year. Nor can your parents or children live there (siblings are okay).
You don’t get any of the tax advantages typically associated with owning an investment property.

How a Self-Directed IRA Worked for Me

Because there is an extensive list of prohibited transactions, I wouldn’t recommend that anyone use this vehicle to purchase a home they plan on living in eventually. Even if you wait until you are old enough to avoid the IRS penalty, you still have to take the entire property as a distribution (and pay taxes at a higher marginal rate). If the property appreciates enough — normally a good thing! — you could conceivably price yourself out of ever buying it from the IRS because you would not be able to afford to pay the taxes.

Because there are two houses on the lot I purchased, and I plan to keep one as a seasonal rental, I toyed with the idea of purchasing the Cabin outright and holding the Anchorage in my IRA. That would have increased my restoration budget for the Anchorage considerably and decreased my tax burden. I already had a good survey of the property, and the surveyor was willing to divide the lot on short notice so that I could make the closing date. The two houses already had separate spring houses, septic systems, electricity accounts, and insurance policies.

But the more I thought about it, the more I realized how difficult it would be to live on one house and keep the other in the IRA. It might raise flags with the IRS. More importantly, I’d never be able to host friends or family at the Anchorage, not even for a few days during the off season. And what’s the point of having a place like this if I can’t use it to host the occasional gathering?

Fortunately, the family who sold the property had already divided it into two lots; there was a 3-acre field across the street that they listed separately in order to boost interest in the place. The offer I made included both parcels, so I ended up placing the land in a self-directed IRA. Deferring the income tax on that portion of the sale reduced my tax burden considerably, and because it is undeveloped land, there is little that needs to be done in the way of maintenance, so I won’t have to make a lot of future payments into the account.

When I turn 60 I can decide whether to leave it in the IRA for my daughter to inherit or take it as a distribution then.

Financing a Second Property: Part One of a Quick Guide

Although most financial experts will advise you not to cash out your retirement funds to purchase real estate, it was the right choice for me. I’m going to walk you through the steps I took to make it happen. There are at least two special circumstances that stacked the deck in my favor, but some of the practical advice I give below is worth considering regardless of what your case may be.

Some Background

When the ex and I split, in 2011, the United States was still recovering from the recession. Although we had more money saved for retirement than the average couple, I had invested everything in equity funds, which were still down considerably, as was the value of our modest house in Austin. The lawyers with whom I consulted about asset division did not believe that I’d be able to remain a homeowner, let alone purchase a second home.

“What will you do? Move in with your parents?” one of them asked.

Among other things, these gloomy speculations made me realize that if I retained an attorney, I could stand to lose a great deal of money, especially if my ex and I got embroiled in a court case. I resolved to employ attorneys on a consultation only basis, hiring one to write up the final divorce paperwork for a flat fee. The whole thing, which included advice from two of the top family lawyers in Austin, cost about $4,000.

In order to keep the house — pretty much the only way I could remain a property owner, given my lack of a stable work history and the stringent mortgage qualifications at the time — I did a cash out refinance while we were still legally married, tapping into our existing equity. My ex got most of that so he could purchase a house for himself; I reserved a small amount as an emergency fund.

This turned out to be a wise move. Austin recovered more quickly from the economic downturn than the rest of the country, and the value of my home rose 26 percent in the next four years. Early last spring, I checked the account balance of the 203b funds I’d been awarded in the form of a Qualified Domestic Relations Order (QDRO). I didn’t log into the account very often; the whole thing reminded me of the difficult days right after the separation. This time, however, I was pleasantly surprised to find that my stocks were up almost 100 thousand dollars as well.

Assessment

I sat down with a pencil and paper and made a complete accounting of my financial situation under various scenarios. I estimated approximately how much I would receive in Social Security and how much the Federal Government would offset the modest pension I’d receive from the community college if I stuck in the plan long enough for it to vest. I also had some Roth and regular IRA funds that were not marital property — not a lot, but not nothing, either.

I realized that I would not be in bad shape even without the QDRO funds. There was not a lot of money, but my needs are modest, and even if I became seriously ill, I was never going to be wealthy enough to afford top-notch assisted care, which these days exceeds even the cost of attending a liberal arts college per year. I would have to be proactive about my health — watch my weight, reduce stress, keep up regular exercise — and hope for the best.

I had been searching MLS listings in coastal Maine for months; now I contacted Realtors and narrowed the field of choice. My best friend and her husband had connections with the Blue Hill Peninsula, so I focused my real estate search there. Good restaurants and a strong artist community were definitely bonuses.

Gathering the Funds

I decided how much money I would need at minimum to afford a house that fit my requirements. Ideally, I wanted a place that would continue to bring in rental income even after I moved up to Maine for good, and properties like that were slightly more expensive. Although QDROs are exempt from the 10 percent penalty that one ordinarily has to pay on an early distribution, I would still be taxed heavily on the retirement funds — more on that in Part Two — so I decided to supplement this amount with another cash out refinance.

For what it’s worth, I love cash out refinances. For an initial $15,000 downpayment on the house in Austin, my ex and I have purchased well over a million dollars worth of real estate. If I had to guess, I’d say we have about $400,000 in equity stemming directly from that initial investment. Subtract the mortgage payments, and that still leaves $150,000. That’s about 17 percent interest over 15 years. Not bad. If we had bought on the west side of town, like our Realtor recommended, we’d be millionaires.

I had my excellent mortgage broker, Jim Loughborough, dig deep to try and get me the maximum amount he could manage out of the refinance. Since I freelance part time and work at the community college part time, the paper chase was excruciating; the lender wanted to know everything about me, and after we ran into problems with the IRS that pushed the closing date back into June, they wanted to know it all over again.

That was nothing, however, compared to my last minute realization that the tax burden from the QDRO distribution would be tens of thousands of dollars more than I initially thought.

Parts Two and Three of this guide discuss some of the ways in which I will be able to cushion the tax blow. I’ll also impart some of the wisdom I learned about the importance of cash flow from one of my freelance clients, a successful Realtor in the Bay area.