Boost your monthly income in retirement by investing in residential real estate? Learn the pros, cons, and mistakes to avoid, things to consider before buying investment properties, rental real estate finances, and how to minimize taxes through real estate investments.
Transcript:
Andi: Hello and welcome and thank you all for joining us for this Real Estate Income webinar with Alan Clopine, CPA of Pure Financial Advisors. Alan, you have certainly had your plenty of personal experiences with the joys and the challenges of real estate investing, right?
Al: Well, first of all, thank you for that great introduction, Andi. And so right off the bat, let me just say, yeah, I’ve been a real estate investor for over 30 years. I’ve had some big successes. I’ve had some pretty big failures. I’ll try to weave in some stories here and there as time permits, but I love real estate. It’s a great way to get a cashflow to build net worth, but we’re gonna get into that quite a bit. I’m gonna spend a little time going over maybe 3 main things. One is kind of basics on how to think about properties, maybe picking the right property, how to do some financial analysis. And then I think I’ll pause and take a few questions. Then I wanna get into taxes. I’ll pause and take a few questions. Then I will get into what happens if you wanna sell a property, how do you do that tax efficiently? So we’ve got a lot to cover. We probably won’t get to every question on the webinar, but rest assured I will answer those back when I get a chance. So, Andi, I think this is a topic that’s near and dear to my heart, so I’m happy to be here.
Andi: I can’t wait to hear the stories because I know we’ve talked about some of them on the podcast and they’re just- it’s incredible that after all of the things that you’ve been through, that you continue to be such an advocate for real estate investing. And I know that that’ll be very entertaining for our viewers today.
Al: Okay. So with that, should I get started, Andi?
Andi: Yes, please do.
Al: Okay, awesome. Well, okay. Real estate income, a webinar. So the very first thing I think you have to think about when it comes to real estate is, what’s your goal? Why are you doing this? What are you trying to achieve? And there’s different answers for different people and that may determine what kind of property you’re trying to buy. So give you a few examples. Some people want- they want a cash flow, they want an income stream, either while they’re working or in retirement, or allowing them to retire early because they’ve got a cash flow. That’s a great strategy, great way to think about it. Another is, sometimes people just wanna build wealth. They wanna buy properties that are gonna appreciate in value so that when they retire, then they’ve got assets to have a cash- have a lifestyle that they want. So that’s a great way to go. Sometimes people in retirement, they just want a second career, right? They want something to do in retirement. This can certainly provide that. So I think right off the bat, you need to think about what you’re trying to accomplish because different properties can accomplish different things for you. But with that, let’s hop right in. Okay, today we’re gonna talk about real estate, pros and cons. We’re gonna get into picking the right property. Make sure you consider cashflow. That might be the most important thing I’m gonna go over today. Because if you have appropriate cash flows to weather various storms, you can hold onto these properties in good times and bad. And then we’ll get into cashing in your profits. Like, okay, now I’ve owned this property a while. Now what? Maybe just keep the property, get the mortgage paid off and you have great cash flow, or maybe you wanna sell it and have a lot of proceeds to do with whatever you want, but you don’t necessarily want to pay a lot of taxes. So that’s kind of what we’ll get in today. So first of all, pros. Let’s see, what are the pros? Creating steady cash flows. I’ve done that. I didn’t do that in the early days. I’ll be honest. I’ve always invested for the- well, not always- mostly in Southern California. I live in San Diego. It was very hard to get cash flows even in the late 80s when I started investing. But steady cash flow is a great goal. It can- a property can appreciate in value. I have seen that. Properties can go down and make no mistake, properties can go down dramatically. I saw that in the Great Recession where properties- I had some properties in Las Vegas that went down over 60%. So be aware, properties can go up and they can go down, but there’s the opportunity for appreciation. Active investment control. Okay. Unlike a stock, bond, mutual fund, you have more control, right? You own a property, you own a condo, you own a house, you own an apartment building, you own a commercial building, whatever it may be, you’ve got a measure of control over that investment. And then finally, tax advantages. And there are quite a few that we’ll get into. Okay? Now, as far as cons, it’s time consuming if you’ve never done it. Rest assured, it’s time consuming. So, if you’re doing this just because, oh, I, you know, I wanna retire and this sounds kind of fun, maybe I’ll do a little- it’s, it’s, it takes some effort and energy, right? It’s a non-liquid investment, meaning that you can’t just cash out immediately. You’ve gotta put it on the market and sell it. But that’s also an advantage because then it’s harder to sell. So you tend not to sell as quickly, which can be a good thing. Leverage effects can be negative. Okay. What does that mean? Well, you buy a property, you use other people’s money, usually a bank, right? I’ll use a real simple example. Property worth $100,000, and I know there’s no such thing, but just follow the math, right? $100,000 property, you put $20,000 down, you have a loan for $80,000, so you only invested 20% or $20,000. If the property goes up, you get all that appreciation. If the property goes down, you have- your responsibility is all that loss. I just mentioned I had properties in Las Vegas that went down 60%, and in all 3 cases they were condos. I had about 40% equity. In other words, total value- loan to total value- loan was 60%. Equity was 40%. Properties went down 60%. I was under water. And if you have to sell quickly, that can be rather troublesome because you can’t even afford to sell. So when it comes to leverage, it’s your friend when properties go up. But it’s a double-edged sword, so never forget that. All right, let’s start by picking the right property. Now this particular webinar is gonna focus a little bit more on residential, but it’s only one type of property. You can invest in various types of commercial, whether it be apartment buildings, office buildings, warehouses, and the like. Most people when they invest start with residential cuz it’s easier to understand, there’s a huge need for it. So that’s what I’m gonna focus on in this webinar. So right off the bat, where do you buy? Well, number one, I would say it’s not that really cool home that has the ocean view. That’s not your best candidate for a rental property. You’re better off buying in a working class neighborhood, suburbs, places where people- they work each day, they go to work, they come back, they’re living with their family. These are the kinds of neighborhoods that generally work better because they have better cash flows, right? We call those bread-and-butter properties. Number two. Think about the neighborhood itself. Is it upcoming? Is it improving? Is it declining? Well, how do you know? If it’s upcoming, maybe there’s a new Home Depot or Costco nearby, right? Maybe there’s some new development in the area. Maybe some older homes are being refurbished, right? These are signs that things are improving. On the other hand, if it’s declining, you generally see just the opposite, so it’s not too much of a mystery. You’d rather buy in upcoming neighborhoods rather than those that are declining. If you’re going for appreciation, which most of us that’s at least part of this equation. The condition of the property, very important, right? I am not a handyman by any means. So when I see a property, I see certain things. But I always hire a home inspector when I make an offer on a property that’s accepted to make sure I know exactly what I am buying. The home inspector will generally go through every single thing in the house, find out problems, and then you tell that to the seller. Those get either get fixed or you get a credit. That’s very important. In some cases, I have walked away from potential properties because of the home inspection report because I was buying someone else’s problem. Let’s talk briefly about cashflow. I’ll just give you a quick rule of thumb. Try to get the monthly rents as close to 1% of the value as possible. Very hard to do in Southern California. In fact, I would say probably impossible. But get as close as you can. So what does that mean? So that means if your property is $400,000, you want the monthly rent to be $4000. And you’re saying that doesn’t exist. It’s not available. Well, it depends where you live. There are certain markets in the South East that actually do have pretty good cash flow. So it depends upon where you go. This one though is, is important, is you wanna get your cashflow as close to that 1% as possible. Because markets do turn, markets do change and make sure that you have enough cashflow to be able to, to cover what may come up. Here’s another important point, is buy for the cashflow not to flare. So what does that mean? If you’re new to real estate investing, maybe you’ve owned some homes and you like the one that has this kitchen and this view and this bathroom and has a great backyard, I get it. That’s not necessarily the best criteria for a rental property. You’re going for the bread-and-butter homes. They’re not necessarily the homes that you are going to live in, although they could be. But generally these are homes- these are people that go to work every day that need a home to live. They take care of the home generally because they’ve got families, they’ve got jobs. They’re trying to- they’re trying to do the right thing. So it’s not when you walk in looking at the kitchen and saying, I love this place. That’s not the best candidate for a rental property. Look at your cashflow. Cashflow, cashflow. Cashflow, right? So buy something to collect cashflow, and then think of it as an investor, which is what you are, you’re investing in a property that’s an investment. Any kind of investment, you put in a certain amount of dollars and you have an expectation to get back a certain rate of return plus your capital. So you think of it the same exact way. And I think one thing I wanna mention on valuations, properties versus rents. This is kind of- I’m, everything I’m going over is a generalization. You could find exceptions to everything, certainly. But as a generalization, the more expensive the property, the harder it is to be a rental property and have a decent cashflow. Because as property values go up, yes, rents go up, but not at the same rate. Right? So when you’re buying luxury homes, maybe something in Rancho Santa Fe or Delmar or wherever it may be, those kinds of homes generally don’t make the best rentals, just because the valuation is too high relative to the rents that you’re going to pay. All right. Let’s talk briefly about things to consider before you buy. Real estate, it’s like a business, right? And if you want a business, if you’re a business owner, if you like having a business, you probably like real estate. If you don’t want a business and you’ve never invested in real estate, this may not be the best thing for you because there’s a lot to it. So first of all, you gotta pick the right property. You gotta do your own cashflow analysis. Figure out is this the right property in the right area? Then you need to find tenants. And guess what? Tenants don’t always pay, and so you may have to evict them. You gotta collect rent, you gotta be the handyman. Or you’ve gotta hire people to do all this, which is expensive. So, anyway, many people when they first start out, they’re their own property manager. They’re their own maintenance person, which I’ve done as well. I made several mistakes that way. But, anyway, just be aware that. There’s a lot to this and there’s a lot of ways to make mistakes. Be realistic about your skills, your time, your money, your budget, right? Make sure that you can really afford this. And what I would say is when you run your cashflow analysis, which I’m gonna show you how to do this in a second, then make sure that you can weather storms in good markets and bad, because there will be both as we relate to the future. And then finally, is if you’re not gonna do the work yourself, then make sure you get a good team, property manager, maintenance people, and so forth to be able to help you. Okay, so that’s a little bit on picking the right property. Let’s go over cashflow. And so what you want to think about is something called cash-on-cash. I’m gonna show you what that means and why that’s important. There’s also cap rate, I’m not gonna talk about that today. That’s usually used for larger apartment buildings, other kinds of commercial buildings. Cash-on-cash is what most investors use when they buy condos and single-family homes. So here’s what it is, right? Calculate cash-on-cash and you take your net profits, net profits, and you divide that into your equity in the property to figure out, well, what kind of rate of return are you generating? Go through example in a minute. But it’s really important to tell you city by city, county by county, state by state, these are different ratios. So just be aware. Different areas have different cash-on-cash. So let me give you an example. So I got a couple properties here. Okay, so the first example is property number one has rental income at $2000 a month, so that’s $24,000 for the year. And then you add up all the rental expenses, right? So what, what’s that? Well, that would be your property taxes, your mortgage payment, right? It would be your property manager if you have one. It would be maintenance, it would be insurance, it would be cleaning fees, on and on and on. Those are your expenses. So you take the net of those two, $24,000 minus $19,000 of expenses gives you $5000 of net cash flows. You compare that to your equity, right, in this case, your equity is $100,000. Again, equity is total value of the property minus the loan balance. So equity $100,000, cash-on-cash made $5000, have $100,000 invested. That’s a 5% rate of return. Cash-on-cash. That’s pretty good. In Southern California, that’s very difficult to find. In fact, almost impossible. But there are places in the country where you can. Property number two, this might be a little bit more typical of Southern California. Rental income $30,000, rental expenses $28,000. So now your $2000 of net cash flows. $200,000 is your equity. $2000 into $200,000. That’s 1%, Cash-on-cash. So that’s not near as good. But again, it depends upon the area. And if you are going for appreciation, like let’s just say, which is often the strategy, when you’re in a high-cost area, then that’s okay. Just understand that’s what you’re doing. You’re going more for appreciation than cashflow, right? But as long as you have enough cashflow to be able to weather storms, then that’s what you wanna have. And I’ll give you another tip. So these amounts, the property rental amounts, that’s an annual amount. So let’s divide that by 12. What’s the monthly amount? $2000, $2500 per month. I want you to have 3 months rent in the bank. Just sitting there for every single property that you have as a safety net. This is over and above your emergency cash. Okay? $2000 a month times 3 months. That’s $6000. I want that to be sitting in an emergency account for this property. Here, $2500 times 3, that’s $7500, right? I want you to have that set aside. You may wanna do more. I’m giving you a minimum. But in this way, if you have that kind of cushion, you might be- you might be able to weather storms a lot better. Okay. Now, now that we’ve kind of gone through this, let’s sort of put it all together as to why do people invest in real estate in the first place? What are the numbers? What’s the benefit? Okay, so this is property number one again. Okay. So in this particular case, let’s say it was purchased for $400,000, and don’t get hung up on these numbers. These are just examples. It’s gonna be different in your area, of course. So home value, $400,000, loan amount, $300,000. Equity is $100,000 like we saw on the last slide. Okay. So what kind of rate of return are you actually getting on this property? Well, the first thing is annual appreciation. Let’s just say the property goes up 5%. 5% of $400,000 is $20,000. You are the owner. You get all of that, right? So that’s pretty good. This is one of the huge benefits of owning real estate. Secondly, your cashflow. We already saw that you had a $5000 cashflow for the year and in that cash flow, you’re paying some principal payments on your loan. So let’s say that was $2000. So we add those 3 together, you get $27,000 is your total return. Now we take your total return divided by your home equity. That’s a- that’s 27%. So can I make money in real estate? The answer is yes. A resounding yes. Now, if this went down 5%, Okay, what, what, what kind of rate of return? Now we’re negative 20 plus 7, so now we’re negative $13,000, right? So now we basically lost 13% on our money. So just- that’s why I talk about leverage. Leverage works both ways. It really helps you when properties are going up. It really can hurt you when properties go are going down. And here’s what happens, happened to me too. I read all the books, I still made the mistake. Which is you have these properties, they’re going up, you’ve got more and more equity, you refinance, you pull out cash, you buy more properties with them. That works great as long as properties keep going up. But when it turns, you get stuck in this, where you end up in some cases with negative equity. I had several properties in 2008, 2009, with negative equity. I thought I did my homework. They had good cash flows. They had, they had, you know, some cushion. But what I didn’t really fully anticipate was the Great Recession, as big as it was, as great as it was. So now, not only were my properties negative in terms of negative equity, but the rents. The rents I had to lower drastically because people didn’t have the money to pay the rent they were paying. So I actually, I’ll just be real honest, I lost 3 properties in a short sale in 2008, 2009. This, this is real life, this happened. So be aware of going too quickly. Make sure you have enough reserves to be able to handle it. So with that, we talked about some of the basics. We talked about finding the right property, how to compute your opportunity, cash-on-cash. Andi, let’s open it up for a few, few questions before we go to the next section.
Andi: All right. Well first I wanna mention the fact that we did get more people asking whether or not today’s webinar is being recorded. The answer is yes. You will receive an email when it’s available for replays so that you can watch it on demand. But now we’re answering your questions. If you have any questions about anything that Alan has just spoken about, go ahead and type them into the Q&A right now. This is your opportunity to have him answer those questions live. We do have a number of questions that relate to things that you’re about to talk about. We have some advanced real estate investors here, but I will ask one that’s a little bit off topic. I don’t think it’s gonna fit in anywhere else, so I’ll ask these now. Okay. From Tim, “How can a parent help an adult child purchase a house or condo in the expensive San Diego area. For example, loan them say $300,000 out of a total $500,000 mortgage. Gift them the money? And how should title be held, parent and child, or child’s name only?”
Al: That’s a great question. Well, first of all, yeah, all of the above, any of the above, there’s pros and cons on each. Certainly you can loan money to your kids. You have to have a bonafide loan agreement. They need to pay interest back to you and so forth. And in that scenario, they probably are the owner, right? So they own it. But you have a loan. On the other hand, you can jointly buy it with them. Maybe you co-sign on the note. In a lot of cases people don’t want to co-sign and I understand that, but that is a way to go. You can gift money, you can gift the $300,000, you have to file a gift tax return. I can’t go too deep into it right now. But anyway, there are a lot, a lot of considerations. But anyway, with that, let’s go on cuz maybe we have more advanced questions, which is awesome. Okay, let’s talk about income taxes. Okay. So when it comes to income taxes, you gotta understand how to calculate your income to know what you’re paying tax on. So, we’ll kind of go over that. Okay. Understanding depreciation, what does that mean? When you do an improvement on the property? Is it repair? Is it capital repair? You get to deduct right away. If it’s a capital expense, you have to depreciate it and then you create a tax loss. But can you take it? Can you take the deduction? Not always. So, we’ll go over that. So right off the bat, let’s talk about calculating your income. Okay, so we kind of went through that one example at property number one, right? Let’s see if I can get there quickly. Yeah. $24,000 of net income. $19,000 of rental expenses. Okay, great. $5000 of profit. And remember I said expenses would be things like interest on your mortgage, property taxes, insurance, property management fee, repairs, cleaning, pest control, on and on and on, things like that. You end up with this net number and hopefully it’s a positive number. That’s a positive cash flow. If it’s negative, like let’s say it’s negative $2000, now you’ve got a negative number. You actually lost $2000 on a cash-on-cash basis. I have invested in properties that have negative cash flow. And I’m okay doing that as long as the negative is not that bad and I feel really good on the prospects of growth. But in this case, $5000 is positive. But remember we said this property costs $400,000, right? So now you get to depreciate it. So $400,000, you’ve gotta allocate between land and building. So land- you don’t get to depreciate. Building, you do get to depreciate. So let’s just say, accountant says 75%’s the building. So you get to depreciate $300,000 in a residential property. You get to depreciate it over 27 years. 27 and a half years actually. So you take the $300,000, you divide it by 27 and a half. That works out to be, I don’t know, around $11,000, give or take. So that’s a deduction for you. So now on paper, on your tax return, you don’t have a $5000 gain. You get to subtract that depreciation against it, $11,000. So now you’ve got a $6000 loss. So this is one of the huge benefits of real estate is that you can take your income and you can depreciate it. And in most cases what I’ve seen is, is hopefully got a little positive cash flow, but on the tax return it looks like you’re losing money. Best of all worlds, you’re making money. While on the tax return it looks like you’re losing money. Right. And when it comes to depreciation, if you have other commercial property, non-residential like a business park or industrial, that’s 39 years. Right, not 27 and a half years, you have to take your building part, divide it by 39 years. There’s something called a cost segregation study. Now I’m getting a little advanced, but if you got a property that’s big enough, has enough value, you’re gonna wanna hire an engineering firm to come in and analyze what you bought. It’s not just land and building, it’s personal property and land improvements, and you can get a lot more depreciation upfront. So just be aware of that. But that’s depreciation. Repair versus capitalization, some things are obvious, right? So there’s something that needs to be fixed, right? Or maybe you need to touch up paint. Well, that’s a repair. Well, if you add on a bedroom, well that’s a capital item, right? That needs to be capitalized and depreciated over 27 and a half years on residential. Right? And then there’s a whole myriad of things in between, which I don’t have enough time to go into all of this, but just be aware. If you’re a real estate investor, make sure you get kind of clear on what’s a repair versus capital. Your accountant can do this, but generally a repair is something that go ahead and fixes something that you already have. Right. In some cases, accountants call replacements repairs. It just depends upon your accountant. In other cases where you’ve added something, right, you’ve added a bathroom or you’ve added- you’ve substantially improved a kitchen that might be a capital improvement as opposed to repairing what you already had there, right? So think about that. And then qualifying for that tax deduction. So if we think of our example, I had a $6000 tax deduction. Can I take it? Maybe. So let’s talk about that. So, to qualify for a tax deduction, I either have to have income that’s low enough or I have to qualify as a real estate professional. Okay? If I don’t qualify for either of these two things, that $6000 loss, it doesn’t vanish. It’s on the tax return. It gets captured as what’s called a passive loss carryover. So I will be able to use it later when I have positive income, or I’ll be able to use it when I sell the property, but to take it currently on your tax return. Okay, so the first rule is if your income is below $150,000 modified adjusted gross income, which is basically your tax return adjusted gross income without regard to the real estate. Okay? So that’s- you gotta see what that is. If it’s below $150,000, you’ll at least be able to deduct some of it. If it’s below $100,000, you can deduct up to $25,000. Okay? So in this example, I had a $6000 loss. My income is below $100,000. I will be able to deduct all $6000 of loss because it’s below $25,000. If my income is between $100,000 and $150,000, there’s a phase out where I can either deduct all or part, but eventually by the time I get to $150,000, I can’t take any. So that’s the one way that people get to take their deductions. The second way, a little more complicated, real estate professional. I think probably some of you know about this, but as a review. To be a real estate professional in the eyes of the IRS. It’s not an IRS agent, although it could be, but no, it’s someone that works at least 750 hours a year on real estate investments. So if you have a number of properties, you could qualify for that, and it has to be over half of your professional time. So let’s just say you’ve got a full-time job. You work 2000 hours, you would have to work 2001 hours to be able to qualify as a real estate professional, right? So you have to work more in another profession than you do in real estate. And finally, the one that is missed all the time is you need to materially participate, which means you have to be active in the property. It can’t just be a passive investor. This one’s tricky. Talk to your accountant. There’s a couple- there’s a few ways that you can- you can pass this test. Generally if you’re self-managing or even if you have a lot of properties and you have a property manager, you can probably qualify for material participation. But just be aware that these are the hurdles you have to get past. Now, if you get past all 3 of these, then you can deduct your real estate losses dollar-for-dollar no matter what they are. So let’s take our $6000 of loss. Let’s add a zero to it, $60,000. Add two zeros to it, $600,000. These things are possible, particularly when you have a large property and you do a cost segregation study. You can generate some giant losses potentially on your tax return, but in most cases, you’d have to qualify as a real estate professional to take those kinds of losses. Right, so real estate professional, 750 hours a year, more than half of your time, and you have to materially participate. Be aware that not all states go along with the real estate professional. For example, California does not recognize it. So if you are a resident of California, you’re not gonna be able to take the real estate professional against California. Maybe you get to deduct it on the federal. But on the state, it gets captured. Again, it doesn’t vanish, it just gets captured, carried forward to when you can actually use it later. And my next topic is selling. So, okay, pause-
Andi: We’ve got a number of questions that have ramped up here.
Al: I’m gonna pause there because I went through a lot quickly.
Andi: Yeah. Raul asked, “Is there any tax advantage when you have losses in investment properties?”
Al: Yes, as long as you qualify as a real estate professional, right? Or your income is below $100,000, you can take that $25,000 deduction. Like let’s say your real estate losses are $40,000, for example, and you can qualify for that $25,000. So the first $25,000, you get to deduct dollar-for-dollar against any other income. The extra $15,000 gets carried over as passive loss into the following year, right? So that’s how that works.
Andi: Kelly would like- Oh yeah, we’ve got several. Kelly would like to know, “Is income that you discussed on qualifying for tax deductions based on rental income or your regular job income?”
Al: Oh, okay. Good question. That’s- it’s all- everything I’m talking about right now is related to your property only. Except for how you compute your total income to figure out what’s your modified adjusted gross income to whether you can take that $25,000 deduction. But everything I’m talking about, rental income, rental expenses relating to the property, that’s how we come up with the property income minus depreciation. That’s how we got the $6000 loss. Now you’ve gotta add up all your income. Maybe that’s the question. All your income from all sources to figure out what your, you know, modified adjusted gross income is to see- if you’re below $100,000, you get the full $25,000 deduction, potentially. Over $150,000, you don’t get anything. Or maybe you’re somewhere halfway between and you get partial.
Andi: We also have another question. “Would adding solar to a rental home be capitalization or repair?”
Al: Great question. Solar. Solar would be capitalized. You could get solar tax credits, which could be a benefit. Those rules keep changing in terms of how much you can deduct, but it’s still- it’s still available. So yeah, that’s a capital expense.
Andi: Ian says, “When you sell a property, don’t you get taxed on the amount that you have depreciated throughout the years? And if so, then what’s the benefit of depreciating?”
Al: Oh, great question. I’m gonna hold on that one cuz we’re gonna get to that, but that’s called depreciation recapture. And I’m gonna give you some strategies there. The answer’s yes, yes. You have to pay taxes on that.
Andi: All right. And then, we’ll keep this one for later as well. Charles wants to know “What about using depreciation at the full disposition of an asset?” Okay. And then another one. “What do you think about purchasing a house intended for personal use as a vacation property, and then when it’s vacant to have it as an Airbnb?”
Al: Okay. I like that. I’ve done that. So what I’ve done is, I have done a 1031 exchange from one property into a rental property in Hawaii that ultimately became a vacation rental property. Right. So in terms of how you go about doing that, honestly, it depends upon your accountant. I mean, the best thing to tell you is you sell your rental. You buy a rental, it’s a straight rental, right? For a year or two, and then you turn it into a vacation rental. Does everyone do that? No, absolutely not. And in some cases vacation rentals are highly profitable, right? So it hardly looks like it’s a vacation rental. And the truth is, as long as you use it for 14 days or less, it’s still treated as a regular rental, right? Once you use it more than 14 days, now you’ve got all kinds of different rules and the vacation rental rules and all that sort of thing. But I guess the point is, when you do the exchange from one property to the other, it needs to be rental property to rental property, not a vacation rental.
Andi: Jeff says “Are condos or town homes a bad investment? What’s a reasonable HOA to consider?”
Al: Ah, great question. No, condos can be great investments. It just depends, right. HOAs, I’ve seen $50. I’ve seen $2000. So I own one of, I own both of those properties. My home, my residence has a $50 HOA, it’s just for some shared lawns and stuff. My Kauai property has a $2000 a month homeowners. Is that excessive? Yeah. Seems like it. But is that the most profitable property I’ve ever had? Yes. Right. So it depends. Everything is relative, right? It depends upon your rental income versus your expenses, and whether this is really gonna pencil out. Great. Great question though. I love condos. They can be a fantastic investment. A condo can generally allow you to get a property that maybe is a little bit nicer, maybe than a single family home. All things being equal, right? As a general rule.
Andi: Victor says, “What are your thoughts on the approach differences in paying off one rental at a time before buying another versus leveraging up and buying properties more frequently?”
Al: Oh, well, it’s a great question. So the leveraging and buying more properties, you will grow your wealth quicker. It’s just more risky, and I got caught in that trap myself with the Great Recession. Safer, safer to pay those properties down or at least have a lot of equity before you start doing that. It’s up to you, it’s personalized. And I would say it this way for- I mean maybe think about it this way. If you’re younger, right, and you wanna grow your net worth, you might be willing to take more chances. If you’ve already got a nest egg, you’re close to retirement or in retirement, I wouldn’t be doing a lot of leverage. I would probably be doing some because that does increase your rate of return. But I’d just be careful on that.
Andi: Kelly says, “My son is the one that’s getting into buying and renting properties. Should he have an accountant at this time? He only has one rental right now.”
Al: Good question. The answer is probably yes. Although if your son is savvy and knows how to use TurboTax. That can be fine. But I gotta tell you, the passive loss rules that I sort of alluded to are pretty complicated. So you might wanna get some help there. Plus your son, may be missing some deductions that he might otherwise be entitled to. So yeah, I would say probably yes.
Andi: Okay. Vivek has a number of questions, which I know that you’ll be able to answer after the webinar, but one that he asked, is “What, if any, tax planning opportunities or efficiencies exist for setting up a multi-member LLC with your spouse?
Al: Multi-member, LLC with your spouse. So multi-member LLC, with only your spouse is still considered to be a single member LLC. Husband and wife are one in terms of LLCs. So, the reason why you do an LLC, whether it’s lots of people or one person or husband and wife, is for liability protection. It does not do a thing for saving taxes, but it does give you liability protection and I’m not an attorney. This is my understanding, and this is what I’ve done, is you buy an LLC, you put the property in the LLC, something goes wrong with that property where you’re negligent, you’ve done something wrong, you get sued, you’re limited to- the person suing you is limited to the value in that LLC, not all of your assets. I probably oversimplified it cuz there’s worse ways to pierce that. But that’s the idea behind LLC is, is you isolate a property against your other properties or you isolate a property or two, you can put multiple properties in LLC ,against other assets that you have.
Andi: Tom would like to know “What is the best way to tap into the equity of an investment property in order to invest in another investment property?”
Al: Great question. So, refinance, which we’ve already talked about. So refinance is you get a higher loan than what you had before. It’s a little tricky right now cuz interest rates are higher than what we had been used to paying. But for a number of years you could just refinance in some cases, get a lower rate, take a big pile of cash out, buy another property with it. That’s a surefire way to make money in real estate. As long as properties go up, which they don’t always. So just be aware of that. I’m gonna get into- maybe that’s a good segue into the next segment, which is what happens when you sell, right? When you sell, you’re ready to cash out, right? You wanna, you’re tired of the real estate, and there’s 4 main choices I would say. One is you can do an outright sale, and most people that own real estate already get that, what an outright sale is, right? So an outright sale is you put the property on the market, you sell it, you end up paying taxes on the gain. Simple as that. And how much tax do you pay? Well, you gotta figure out what the gain is. So the sales price, I’ll go $1,000,000. Let’s go into the $1,000,000 range. Sell property for $1,000,000. Let’s say the closing costs are 10%. I’m going high. Just to make this a simple example. 10% closing costs, $100,000. So you net $900,000, that’s what we call the net sales proceeds. So that’s your starting point from the sale side. From the cost side, what did you pay for the property? Okay, well, I paid $400,000 for it. Okay, so $900,000 minus $400,000. That sounds like a $500,000 gain, except you depreciated a $100,000, right? So that depreciation has to be recaptured. So that $100,000, so now it’s not a $500,000 gain, it’s a $600,000 gain. $100,000 is depreciation recapture, and $500,000 is the gain itself. Right? So that’s, so you can do that. You can sell a property, just pay those taxes. Depreciation recapture is generally 25%. That’s the rate. The capital gain rate could be zero. Right. It could be 15%, could be 20% depending upon your bracket, and you may be subject to the net investment income tax, which is another 3.8%, something like that. For those that are just trying to do a quick back of the envelope calculation, what if I sell this property? How much tax do I pay? Well, try to calculate the net sales proceeds minus your basis. And at least in California, about a third of that is going to the government between the federal taxes and the state taxes. Now that’s not exact. It just gives you an idea. If you’ve got $1,000,000 of gain, you can probably expect to pay $330,000 plus or minus federal and state. Now, you may live in a different state, maybe different, but that’s kind of how I think about it. But realize it’s not just what you sold it for on a net base on your cost. You also got a factor in that depreciation recapture. Do you still wanna depreciate? Well, first of all, you have to depreciate, so it’s not a choice. If you don’t depreciate it, the IRS says, we’re gonna pretend that you did and still tax you on it. So that’s not an option. But secondly, you always want a tax deduction early before, right? Cuz time, value, money, a tax deduction is more important today than it is tomorrow. So you get a tax deduction now, right? And then you may pay it back later or you may not right? You may not pay it back later. Because maybe you’re gonna do a 1031 exchange or a charitable remainder trust. And you know what? If you pass away with an asset like real estate, it gets a full step-up in basis for the next generation, even your spouse, right? So you own that $1,000,000 property, it’s got that $600,000 gain in it. You pass away, your spouse. Now it’s if they bought it for $1,000,000. So if you can take the depreciation now and never have to pay it back, that’s the best of all worlds. I’m not suggesting that dying is a great strategy, but I want you to know what the rules are cuz I get this question all the time. You know, my mom is 85, she’s got all these properties. She wants to simplify before assets go to the kids. The answer is no. Manage ’em yourself, cuz you’re gonna get a step-up in basis, right? Anyway, that’s outright sale. Installment sale is, it’s the same idea, except you’re spreading it over time. So installment sale generally means I have a free and clear property, and instead of getting all my money at one time, I’m gonna pretend like I’m the bank, right? My $1,000,000 property I’m gonna sell. Why don’t you give me, $200,000 or $300,000 cash and I will loan you the rest at an interest rate, blah, blah, blah. So I’m only gonna pay taxes on the $300,000 that I actually got. Okay. Not the whole tax. Right? So that’s an installment sale. That’s tricky though. Installment sale, if you pass away with an installment note, there’s no step-up in basis, number one. And number two is you have very little control over it because if the person refinances with a bank for a better interest rate and they pay you. It’s all taxable in that year. So you don’t see a lot of people doing that, but that is, it is an option. 1031 exchange, this is much more common. 1031 exchange is when you sell a property and you defer the gain into the next property. Right? Purchasing a replacement property. Okay, so you have to find a like-kind property. You sell one property. You buy another one. Okay. Like-kind is pretty generous. I can sell a condo and buy a house. I can sell a house and buy an apartment. I can sell an apartment and buy 3 single family homes, right? As long as it’s a rental property. Rental property for rental property, income property for income property. That’s what like-kind is. So I sell the property. Great. And then I’ve got- that starts the clock. As soon as the close of escrow starts the clock, I’ve got 45 days to identify the property that I wanna buy. And the IRS actually allows you to pick 3 properties in the identification process. So you actually have to go to your exchange intermediary and tell them what 3 properties you’ve selected. An exchange intermediary is a middle man/ middle woman/middle person, right? That basically is holding your money until you buy the replacement property. And I’m not gonna go any deeper than that. It’s more complicated than I wanna get into right now. But it’s a third party that holds your money. You have to tell them what 3 properties that you want to potentially buy, and then you have 6 months from close of escrow to actually buy one of those 3 properties. Okay? So one of those 3 properties you need to buy. If you don’t- if all those 3 properties fall through, you have a blown exchange, you’re gonna pay the full tax on that. So I’ve done 3 or 4 exchanges, I guess in my career. All of them were successful. One was to the wire. So, but at any rate, it’s very doable. But you just have to be aware of the timeframes. And Andi, before we get to our questions, I got one more strategy and that is, what do I have here? Yeah, this would be a charitable remainder trust. We also call it a tax-exempt trust. So this is where- this is more complicated. I’m just gonna give you a little flavor here, right? You set up a charitable remainder trust, you put your property into the trust. So it’s a contribution into the trust. The trust sells it. So this is- you only do this when you wanna sell a property. The trust sells it and pays no tax whatsoever because, it’s a tax-exempt trust and you get a lifetime earning stream from this trust. And the way it’s designed is not only do you get the income, but you get 90% of the principle over your expected life, or if you’re married, expected joint life. So you get 90% of the money back while you didn’t pay any taxes upfront. So you have higher investments to- higher level investments- to be able to invest to where you get money back yourself. And the balance of whatever’s in that trust when you pass away goes to charity. Okay, so in other words, it’s ultimately for charity, that’s why it’s tax-exempt, but you’re getting most of the assets back yourself. You’re not paying an upfront tax, and because it’s expected that 10% of the assets go to charity, you get a 10% tax deduction in the year you do this. So that $1,000,000 property, you get $100,000 dollars tax deduction on your return in that year. So this can be a great strategy. A little bit more complicated. I couldn’t dive too far into that. One more quick thing. When you sell your home, I think most of you know this- 121 exclusion, you get $250,000 exclusion per person. If you’re married, $500,000. That means that you have gain that you don’t have to pay tax on, but you must live there and own for 24 months, and so does your spouse to get the full $500,000. Right. I’ve had people say, you know what? Should I get married to get the full $500,000? Well, is if, if you’re- if the person you wanna marry has owned with you and lived in for two years, you’re fine. But just the fact of marrying doesn’t really do much of anything. If you move or unforeseen circumstance happens, you might be able to get a partial exclusion. Okay. So I think I got a lot in, in 44 minutes. So, what other questions do we have, Andi?
Andi: Actually, I wanted to mention, first of all, before we get to those questions that you are- if you are already a client of Pure Financial Advisors and if you have any questions about today’s presentation, please reach out to your advisor to talk about those. I know many people that are watching today still have a number of questions. Now is the time to schedule a free financial assessment with Pure Financial Advisors right now to see how real estate income might fit into your plans for retirement. I’ve just put a link into the chat so that you can click that link and schedule it for the time and date that works for you. Let an experienced financial professional on Big Al’s team at Pure take a deep dive into your entire financial picture. You’ll not only learn what part real estate can play in your retirement income plan. But also how to choose a retirement distribution plan that’s right for you, how to legally reduce taxes now and in the future, minimize your risk, maximize your return, legally reduce taxes now and in retirement. Maximize your social security, and you’ll also learn how to protect yourself against market volatility, rising inflation, rising healthcare costs. There’s no cost and there’s no obligation. It’s a one-on-one comprehensive financial assessment that’s tailored specifically to you. Pure Financial is a fee-only financial planning firm. We don’t sell any investment products or earn commissions, and Pure Financial is a fiduciary, meaning that we are required by law to act in the best interests of our clients. Pure Financial Advisors has 4 offices in Southern California as well as offices in Denver, Seattle, Chicago. But you can meet with any of our experienced financial professionals online via Zoom, just like this no matter where you are. Just click the link in the chat, schedule your free financial assessment for the day and time that works best for you. Go ahead and click that link and schedule now.
Now let’s get back to those questions. We did have a few on 1031 Exchange. Christie said, and I think you’ve already answered this, “Is there a time limit in reinvesting your 1031 exchange? For example, if I decide to sell and reinvest in a year, is that allowed?”
Al: Yeah, your timeframe is 6 months. Unfortunately, this is set in stone. If you miss it by a day, you’re done, right? So you have 45 days to identify. So in other words, the 3 properties. Now there are exceptions to that. I just said there’s no exception. Here’s one. I guess there’s exceptions to everything. In some cases, you wanna buy more than 3 properties with the property you sold, and there are ways to go ahead and name more than 3 properties. But for practical purposes, almost everyone uses the 3-property rule, which means you identify 3 properties. And then within the 45 days, and you have to make sure that escrow closed within 6 months of the close of your other escrow. Very, very important. I’ve done this, like I said, 3 or 4 times. My best experience, and this is what I recommend, when you sell your property, put another property in contract right away, right? So you have plenty of time if something goes wrong with that property, you’ve got 3 more properties that you can name, the 45 days. So that’s- that would be my strong suggestion. Here’s another suggestion is maybe you name two properties. Maybe the third one you do like a DST, Delaware Statutory Trust, which qualifies for 1031 exchange status. And there there’s more flexibility. Like if the other two properties don’t pan out, maybe you could at least do that. Maybe it’d be long-term investment, maybe short-term, but at least you’ve done your exchange. You can always exchange out of that later, depending upon what the timeframes are for that Delaware Statutory Trust.
Andi: Another 1031 exchange question. People are excited about this concept. “For a 1031 exchange can a person sell the first property owned by me and use funds to partner with someone on a new rental purchase?”
Al: Yes. So in other words, remember I said like-kind needs to be like-kind, but you can sell one property and go into a fractional interest on another property, which I think is what you’re asking because you want a partner to come in. Bring their money. You’ve got your money, as long as your money- it can’t be in your hands. Here’s another thing, you can’t touch it. Like if it comes to your bank account, it’s already a blown exchange. It has to go to a qualified intermediary so that you don’t have access to it, and then the qualified intermediary sends it to your escrow. You don’t have to buy the whole property. You could buy a fractional interest with your- with your friend. So just be aware of that. And I guess it almost goes without saying, but I’ll say it anyway. Your qualified intermediary, make sure they’re bonded, because they’re holding your money for up to 6 months. So make sure that you can get your money back if need be, not just the guy or gal down the street that just opened up a shop. Don’t do that.
Andi: Here’s another one for 1031 exchanges. “Sell a condo. Buy raw land for investment purpose to build a home and rent it out. Does that qualify for a 1031 exchange?”
Al: Sell rental, buy land for investment purposes that can work. And in fact, there’s different rules on construction, which I won’t get into now, but it can work. It’s- what can blow this thing though is like for example, if, and people try to do this, it’s like they sell a property. And then they buy another property and they build their own home on it. So it, in that particular scenario, sell a rental property, buy a land, build a structure on it, rent it out, rent it out for a couple years before you move in. I don’t care what you do after two years, you can kick out the tenant and move in yourself. And by the way, this is what a lot of people do that have an expensive residence. It’s a hassle. I shouldn’t say a lot of people do. Some people do it. They sell their expensive home. They buy something that was $500,000 cheaper than what they sold. So $500,000 is the blown exchange if they’re married, but they get that for free, right? The section 121 exclusion, you can take that, but the rest of the proceeds they do in a 1031 exchange, it almost may bogle your mind, but you can do the $500,000 residence exclusion and a 1031 exchange on the same property, but the exchange part, that may be your future residence. But I don’t want you living in that for two years. You’re gonna have to have a tenant cuz I want you to sell a rental for a rental. Right.
Andi: We have a number of questions left and I know that we’re not gonna have time to get to all of them. So please, if your question does not get answered today, go ahead and click that link that’s in the chat and schedule a free financial assessment so that you can get all your questions answered one-on-one. So I think we’re just gonna do about 3 more questions to wrap this up. Sylvia would like to know, and I already know where this is gonna go, “What do you think of holding properties in an IRA, Big Al?”
Al: Not a fan. In fact, that was something I was thinking about when I was much younger. Well, this is where I have the money. Why not do it there? And it’s like, well, when you think about it, I just took a- I just took a piece of property that’s highly tax advantage and I threw away every single tax advantage there is in an IRA. So number one, I can’t- there’s no depreciation, right? Number two, there’s no capital gain, right? So anything I get outta the IRA is taxed at ordinary income. Number 3, I pass away. The kids get it. There’s no step-up in basis, right? And furthermore, I won’t go into the reasons why, but you can’t really have debt inside of an IRA. There are some exceptions, but in most cases you can’t have debt in an IRA, so it kind of blows the ability to use other people’s money, so don’t do it. Roth IRA, I’m okay with that. Regular IRA, I do not recommend it.
Andi: All right. These, both of these questions are very similarly related, so I’ll ask ’em both at once. Jordan says, “I’m a first-time real estate investor. Where do you suggest that I go from here to expand on what was shared today?” And Kelly says, “Are there any books out there that delve into real estate investing that you would recommend?”
Al: Great question. I would say yes, there are great books out there. I’m probably a little behind in the books that I’ve read. I would just Google it or talk to friends of yours that are more recent real estate investors and find out what books they like. Focus on residential. Don’t worry about commercial or apartments. You may graduate to that someday, but focus on residential and depending upon where you, where you live, think about those neighborhoods that are kind of starter homes, that are working class neighborhoods. That’s kind of where you want to focus on. I’m not talking about neighborhoods where you don’t really want to go at night. Right. You don’t have to, you don’t have to do that. There is a, there is a great market for that if you’re willing to, but no, I’m, I’m just talking about the bread-and-butter homes. Hardworking people that have families, that’s the kind of neighborhoods that you wanna focus on.
Andi: All right. Vivek, Steve, Charles, everybody else that who has- who has put in questions, we’re not gonna have time to answer those today. Thank you all so much for joining us. If you do have more questions, go ahead and hit that link in the chat for your free assessment. I’ve also put in the contact information so that you can call or email. If you would like to have Big Al answer your questions via email, you can go ahead and send them to info@purefinancial.com. That is in the chat as well. Big Al, thank you so much for taking the time today to walk us through. We didn’t get a chance to hear this story about somebody fixing their motorcycle in the living room of your apartment. I was really looking forward to that one.
Al: Yeah. Well, quick, quick, quick story. When I was first a landlord and couldn’t afford having a property manager and I didn’t do the proper checks, I rented to this person, turned out to be a complete dud. I tried to evict them. I didn’t even understand the process. They knew more than I did. But when I finally did evict them, the new carpet that I’d bought, they had parked their motorcycle in the living room. I had grease spots everywhere. I learned a lot. I would say you probably learn more on your mistakes than you do your successes.
Andi: Thank you so much everybody for joining us, and we will see you again next time. Have a great day.
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