Cubert from AbandonedCubicle.com shares his plans for using real estate, including AirBnB and VRBO vacation rentals, on his path to financial independence at the age of 46. Is it worth the risk? Plus, the fellas answer your questions about real estate investing: will it help you minimize taxes in a high tax state? And how can you avoid capital gains when selling rental property?
- (00:52) Will Real Estate Investing Help Minimize Taxes in a High Tax State?
- (07:46) Cubert from AbandonedCubicle.com: Vacation Rental Real Estate – A Passive Income Path to FIRE (Financial Independence / Retire Early)?
- (18:10) The Dangers of Leveraging Rental Real Estate
- (28:33) How Can I Minimize Capital Gains When Selling Rental Property?
Let’s face it, the last thing you want in retirement is to be forced to go back to work, right? Learn how to manage the risks that can derail your retirement on the latest episode of the Your Money, Your Wealth TV show. Watch it online at YourMoneyYourWealth.com, and check out our blogs and videos on risk management while you’re there. Be sure to subscribe, new episodes of the Your Money, Your Wealth TV show post every Sunday!
Now, today on the Your Money, Your Wealth® podcast, Cubert from AbandonedCubicle.com shares his plans for using real estate, including AirBnB and VRBO vacation rentals, on his path to financial independence at the age of 46. Is it worth the risk? We’ll find out. Plus, the fellas answer your questions about real estate investing: how can you avoid capital gains when selling rental property? And will investing in real estate help minimize taxes in a high tax state? Here are Joe Anderson, CFP® and Big Al Clopine, CPA to answer that one right now.
00:52 – Will Real Estate Investing Help Minimize Taxes in a High Tax State?
This is from James. “My wife and I make $900,000 combined. We live in San Diego and pay a lot of taxes. Most of our income comes from our salaries and bonuses. We’d like to minimize the impact of taxes. What might be some good choices for us to consider? Tax-exempt bonds won’t work, and tax loss harvesting has a marginal impact on net income. Is real estate investing a good idea? What ideas should we consider?”
AC: Well James, first of all, congrats, $900,000 a year is fantastic. I’m assuming he says they “make” – I’m assuming that salary
JA: That’s what he said, salaries and bonuses.
AC: OK. So right off the bat, we’ll just go down some categories really quickly. So when it comes to salaries, you want to look at your 401(k)s if you have them, if you’re under 50 it’s $18,500, if you’re over 50 it’s $24,500. I’m assuming maybe you’re already doing that if you can. But that’s dollar for dollar tax savings. When you look at other potential tax deductions, there are a few quick categories I want to review with you. One you brought up, real estate. Real estate can be a great investment, and it can be a great write off, but only if one of the two of you is able to spend at least 750 hours a year and become what’s called a real estate professional, to where you can actually write off your losses.
JA: A lot of times people will come to us and say, “hey, I heard real estate is a really good tax haven,” and it’s not for most.
AC: For most is right. And so probably in your case, the way you said this, it probably doesn’t work either, because if you’re both working and making this kind of income, you’re probably both working full time.
JA: They could both be making 400 some-odd thousand bucks.
AC: Yeah. So “real estate professional” means you have to work at least 750 hours a year doing your real estate investments – management, buying properties, whatever. And it has to be more than half of your professional time. So if you’re working 2,000 hours a year, you’ve got to work 2,001 hours in real estate. That’s a lot of time. Not too many people can pull that off. But if you can, or you’re in a situation where maybe one spouse isn’t working and can do the 750 hours, now all of a sudden you can write off your depreciation losses. I would say it like this: for probably about a million dollars of property, you could probably generate about a $25,000 deduction – maybe a little bit more.
JA: Only if there’s a real estate professional in the household.
AC: Correct. And based upon the actual cash flow, I’m making just a very broad assumption. So if you want a $250,000 write off against income, one of the two you would have to be a real estate professional and probably have to own about 8 or 10 million dollars of property. (laughs) So that may not work for you, but that’s what I wanted to bring up.
JA: Or you could give like a million dollars to charity… that will save you a little bit. Let’s look on the schedule A, because that’s where you have to figure this out. Well now, state taxes, property tax, you got 10 grand. Maybe if you get really sick, that’s some ways to save some money in taxes. You got medical expenses, if you want to get the hip replacement, you could do it in a year where you have high income. Charity.
AC: Yeah and I want to talk about charity.
JA: That’s probably the only thing besides your real estate.
AC: Unless you’ve got a business. And I’m assuming this is salary.
JA: Salaries and bonuses – but if it’s his own business, you can set up different types of retirement accounts.
AC: Exactly. But with regards to charity, think about this: so $900,000 is a great salary and it doesn’t say how old you are, but let’s just say you’re making the salary towards the end of your career – salary and bonuses. Maybe you’re going to retire next year or the year after. And if your plan is to give to charities throughout your retirement, why not give today, get the deduction today for future year contributions while you’re in the highest tax bracket. You set up a vehicle called a donor-advised fund, and you could set it up at usually pretty much any brokerage firm, like T.D. Ameritrade or Fidelity. There’s a couple there. Schwab would be another one. You set up this account. You put the money in the account. The year that you put the money in the account it becomes a tax deduction. And now you’ve got this account that you can invest and manage as you see fit, and then you give to charities of your choice over time. And this can be over the rest of your lifetime or whatever you want to do. And better than giving cash is maybe you take some of your stock that’s gone up in value and you donate your stock to the fund. And now, whatever the stock is worth on the day of the donation becomes a charitable deduction, and you don’t have to pay the capital gains tax. So that’s the best way to do this, apart from having real estate and owning your own business, and taking advantage of your employer’s 401(k), charity is kind of about the only thing that’s available.
JA: Not necessarily. What about oil and gas? (laughs)
AC: Well, the only thing I’d recommend. (laughs) And I actually just had a chat with a client about that on Tuesday.
JA: There was some wildcatting! Dig some oil wells! That’ll give you some tax credits.
AC: And the reason I brought it up was because…
JA: How about low-income housing?
AC: Yeah, that’s even worse. (laughs) There’s no investment value there, but… so, oil and gas. So you invest $100,000 in an entity, usually an LLC that tries to drill for oil – intangible drilling. And so you generally can write off the majority of your investment in year one, and then after that, hopefully, it starts paying off. The problem is, they generally don’t pay very well, so usually, it’s like throwing money away for a tax deduction.
JA: Well it’s like striking oil. That means it doesn’t happen every day.
AC: Yeah and in the past decade when it has happened, the payouts have not been that great.
JA: Fracking. Will I get tax credits for fracking? (laughs)
AC: Well (laughs) I dunno how those work. These are intangible oil drilling wells. And actually, fracking is the reason why these have not been pretty good over the last decade because the price of oil has gone way down because the supply is up. And so people that have done this have been pretty sorry – they got a tax write off and that was about it.
JA: Yeah. Remember the tax credits – I don’t remember, but you do – but like in the 80s and everything else. It’s like, “well here, I’ve got this great tax reduction, or tax benefit, but the investment is absolutely worth nothing.”
AC: Yeah. Remember the windmill farms? You were just in elementary school, but…
JA: I have no idea what you’re talking about.
If you own real estate, have a high salary, own a business, have capital gains, or generate a lot of income from inherited assets, there are ways for you to pay less income tax – find links to learn more in the show notes for this episode at YourMoneyYourWealth.com
07:46 – Cubert from AbandonedCubicle.com: Vacation Rental Real Estate – A Passive Income Path to FIRE (Financial Independence / Retire Early)?
JA: Alan Clopine, It’s that time of the show.
AC: That it is, Joe. We’ve got another great guest.
JA: Cubert. Just like one name.
AC: Like Madonna. (laughs)
JA: (laughs) I knew that was coming. Or Prince.
AC: Or… Joe. (laughs)
C: So for anyone who grew up in late 70s early 80s that loved the coin-op video games, you might remember Q-bert. So I figured let’s just combine the cubicle life with a video game from my childhood, and that’s that’s how we landed on Cubert.
JA: Cubert writes a blog, it’s called AbandonedCubicle.com. Tell us a little bit about your story. He’s part of the FIRE movement.
AC: Financial independence / retire early.
JA: Look at you, Big Al.
C: So you put 20 years into the corporate scene, and you look out in front of you and you say to yourself, “holy smokes, I’ve got another 20 years of this.” And three or four years ago. had a project from Hades. It was rough, it was a year and a half of doing the weekend thing, doing the evenings, and the worst part was that was right around the time that our kids were born. We have boy-girl twins. I’ll never forget. Instead of being able to celebrate the first Mother’s Day, my lovely wife and kids, they kind of hung out while I was on work calls and I’m like, “oh my gosh, this is not what I had envisioned for us.” So that prompted me to go out onto Google and look up Mr. Money Mustache, I sort of stumbled upon his blog. And I’ll tell you, after you’ve gone through those posts, I’m like, “man, this is going to be a life-changer.” And that’s really what sort of set me on my journey.
AC: And I know you started buying some rental properties, and I think your most recent one you bought, it’s a vacation rental. I think you’re using AirBnB and VRBO, and I think our listeners would kind of like to know some of the ins and outs there.
C: So this is probably a good time to say careful what you walk into. Yes, they can be rewarding. They can be profitable. But it takes work, and there will be surprises. So just today, I get a call from my property manager, he’s like, “I need you to turn on the fan, because your condensate line in the air conditioning was plugged in you had about six inches of standing water in your furnace that I had to drain out and now that’s in your return air duct.” And here I am 600 miles away, and about the only thing I could do was go to my Nest app on the phone. And I control my thermostat remotely and at least turned the fan on to get the air moving in the place. So you just never know when things are going to come up. And of course, I’ve got a guest checking in later this afternoon.
AC: So 600 miles away. So how do you manage that with property managers, repair people, things that need to be done to the unit?
C: If you are going to get into this, I would just make sure that you’ve got a friend nearby. We had it quite easy. We were hanging with my folks and there happened to be a unit available for sale where they live. So my folks, when they’re there in the summer, can keep an eye on things. They have made good friends with the property manager. So he’s a friend of mine and he also looks after the place. So having those contacts is key. If you’re hundreds or thousands of miles away and you haven’t established those relationships, I would have a lot more sleepless nights.
JA: You’re looking to get financially independent at age 46, which is a pretty aggressive goal. So it sounds to me is that you’re building up a portfolio to get passive income to provide yourself with a lifestyle from now until the rest of your life. And the strategy that you’re using is real estate, and then now you’re trying to expand that portfolio a little bit by doing a little bit more AirBnB, VRBO, versus just having standard rentals?
C: That’s right. And this is intended to sort of boost that passive income. But…
JA: What you say is more risky? I could buy a single-family residence, I could have 2 or 3 units and things like that, depending on my cash flow, should I look and say, “I’m going to turn all my rentals into VRBO or AirBnB” or do you want a little bit of mix to be diversified?
C: You know, a mix is good, and I’ll tell you why. I think there’s some risk-reward. I think that the reward is greater with vacation rentals. We expect to yield a little bit more income off of this one unit, as opposed to our single family’s. But, the tradeoff is you’ve got to put work into it. I’m constantly on my phone managing guests. You’re constantly on. It’s not passive. The other thing is this: it seems like you turn the page in any local rag where tourism is part of the base and there are new regulations. And in fact one of the gotchas that has emerged this year for us is I’ve heard from the board of our homeowner’s association that they are not too thrilled with all the coming and going with the vacation rentals at our condo complex, so I might be on borrowed time with my ability to rent out for 1, 2, 3 night stays. I might be penned into weeklong stays, and that could really cut into things.
JA: Looking at VRBO or AirBnB, are you looking in areas specifically… It would have to be a desirable place to go. If I live in… Cincinnati – nothing against Cincinnati, I love Cincinnati (laughs) we live in San Diego. I think maybe I could get away with that if I had a nice place close to the beach. But if I’m living in suburbia, I don’t know, does VRBO or whatever we’re talking about, or AirBnB, does that even make sense?
C: I think you do need to understand the market. I experimented with this earlier this summer by putting our own house up on AirBnB. Didn’t get a single bite. And this is Minneapolis, we’re in a pretty nice part of the city with accessibility to the airport, quick drive to the Mall of America, parks, you name it. But not a bite. Doesn’t mean it can’t happen. But compare that to our rental in northwest Michigan, outside Traverse City and Charlevoix, we had no problem at all drumming up bookings. Yeah, I think the market certainly is a big factor.
JA: So with your journey to financial freedom, tell me a little bit about the planning that you did. Did you just kind of work back your living expenses, or are you one of the types that can live off of $1,500 a month?
C: Well it doesn’t hurt to be cheap. For most of my adult life, I’ve played it pretty tight in terms of where I put my money. I had a roommate for a number of years, we’ve kept a small house all these years, the kids share a bedroom. We’ve got two cars that are paid off. Nothing fancy. They get good mileage. And our kids are going to the public schools right here. A few things have helped along the way. The real estate venture that we started up in 2013 with the single-family houses – couldn’t have picked a better time. We got in when the rates were just so low, and I think our average interest rate on our rentals is like 4.5%, and the value of those houses was still pretty depressed since the housing bubble burst. So we got in at the right time, and I think timing is a lot of it as well.
AC: So let’s talk about that just briefly. So you bought the first rental, and then did you have extra money for the down payment for the next rental, or did you refinance the first one to buy the second one, or how did you do this mechanically?
C: So, probably wasn’t the smartest thing in the world, but for the first one, it was using our own HELOC. We had a home equity line of credit on our primary residence. We dipped into that. The next one, not more than six months later, said, “you know, we should really go for number two, because this market, it could heat up in a heartbeat.” In that case I used a 401(k) loan and we paid it off, like, straight away. But it didn’t sit well with me that we had to do it that way. But back then, I think it was worth it to use the HELOC and that 401(k) loan to make those first two rentals happen.
JA: So if I were to look at your portfolio, is it mostly real estate? How are you putting all those assets together to get you to financial independence at such a young age?
C: Well this is what makes it less scary for us, I think, is that it’s about 50/50. Half of our net worth is sitting in index funds in a 401(k). And then the other half is comprised of our real estate. And that’s where the passive income comes into play. We won’t tap into the 401(k) dollars until right around age 60.
JA: How much leverage do you have on your properties.
C: It’s quite a bit. On the rentals, we’re big believers in other people’s money. So the bank is holding the houses while we take advantage of the income, but we are working to aggressively pay off the mortgage on our primary house. One less expense to cover in early retirement. So we expect to have that paid off right around this time next year as well.
AC: I do think you’re right. Other people’s money makes a lot of sense when you’re building, growing, if you hit the market right. If you hit the market wrong, it actually can work very much against you, because now all the sudden, your mortgages are greater than your valuation. And usually when that happens, people can’t pay the same kind of rent. And so now you’re not covering your cash flow as well. So for our listeners, it’s a caution. Leverage is definitely a way to build wealth, but you have to be a bit careful with it.
JA: Yeah, you need time and you need cash flow.
AC: Yes you do. And that cash flow can change when market conditions change. As I experienced in 2006, ’07, ’08, ’09. (laughs)
C: We all have some horror stories don’t we?
AC: Of course.
JA: Well you gotta check Cubert out, he writes at a blog, it’s called AbandonedCubicle.com. Cubert, we really appreciate you hanging out with us today.
C: It was my pleasure. Guys thanks very much for having me.
For more on using AirBnB and VRBO to generate income, find a link to Cubert’s Comprehensive Guide to Profitable Vacation Rentals in the show notes for this episode at YourMoneyYourWealth.com. Next week on the Your Money, Your Wealth podcast, Joe and Big Al will get into the basics of individual retirement accounts, also known as IRAs. Learn everything you need to know about contributing to an IRA, IRAs for small business owners, self-directed IRAs, IRA mistakes to avoid, and we’ll answer your questions – like what’s the return on an IRA? Subscribe to the podcast for free at YourMoneyYourWealth.com so you can listen on demand, and if you have IRA questions – or, for that matter, any other money questions, comments, suggestions, or guests you’d like to hear Joe and Big Al interview, email firstname.lastname@example.org
18:10 – The Dangers of Leveraging Rental Real Estate
JA: We just got off the phone with Cupert.
AC: Cubert. You’re calling him Cupert. It’s Cubert. (laughs I think it’s a “bert.” Cu and bert.
JA: So, AbandonedCubicle.com. So we get a lot of these FIRE people on, financial independence / retire early, and some of them have interesting strategies.
AC: Sure they do. And so I guess in this particular case… So the thing I like about Cubert is he’s got a lot of passion about getting into real estate. He’s relatively new to it, he’s got five properties. As we just heard, they’re pretty well levered up.
JA: He got in in 2012.
AC: Yeah right. At a good time.
JA: How long have you been a real estate investor? 30 years?
AC: Yeah. Since 1985. 30 plus years.
JA: So you’ve got a little bit of gray hair. Is that from real estate, I would imagine?
AC: Yeah. And it’s funny. So one of the suggestions by Cubert was to use other people’s money. Which does make sense. In other words, if you use all cash, then if the property goes up 5% or 4% in value, then you made 4 or 5%. But if you put 10% down and it goes up 4%, now it’s like you made 40%, because you’ve got less invested. Because you’re the equity owner. The problem is, if it goes down 10%, now you’ve lost 100% of your investment, so that’s where you have to be a little careful on leverage. And when I first got interested in real estate investing, and this was in the mid-’80s, I started reading books about it. I went to a couple seminars. And I was a little bit surprised to find out that almost every speaker had basically lost everything at least once in their career from real estate and had gone bankrupt. And I thought well if this is so easy, how does this work?? (laughs) And then, actually, someone that lives here locally, Robert Allen, he wrote the book called “Nothing Down,” in I think 1990 or the late 80s, and it was, I thought, a really good book on how to buy property using other people’s money. But he had gone through an experience where he had a bunch of properties, and he basically lost virtually all of them. And I was trying to figure out why he and others had lost so much money, and then over time, I did figure it out. And I experienced some of that myself. (laughs) Because what happens is, when you buy properties with high leverage, it means a high loan. So a simple example, a $100,000 property, you put 10% down, $10,000, you borrow $90,000. In the Great Recession, that $100,000 property, which I had in Las Vegas, it was a condo. It was little more than that, but easy math, right? So $100,000 other property that I had an $85,000 loan on, all of a sudden is now worth $50,000 is what it was. It went down 50%.
JA: And you have an $85,000 loan on a property that’s $50,000.
AC: I got an $85,000 loan on that property, and then the rents that I was receiving to cover the mortgage, I couldn’t charge the same rents anymore because it was the Great Recession. No one could afford it. So now I gotta lower the rents. I can’t sell the property, because I’m $35,000 negative, and I can’t hold the property because I can’t afford it. (laughs) It’s like if my business was going really well – but it was the Great Recession! My business was not going well at that point. And it’s like, “oh man, now I get how all this works.” And so leverage can definitely work for you, but it can work against you in poor markets.
JA: You know, the financial industry, I was listening to some podcast and it’s like, with everything it’s the seven sins, and I’m like man, our industry is full of them. You got the greed factor when things are good. And it’s like, “wow this is pretty easy. Look at the cash flow that I’m making, you know what, why don’t we do another one?” Couple of months later, “hey, I pull a 401(k) loan, I’ve got a bunch of money in the 401(k), let’s do that, boom” and then, “hey you know what, maybe we just take a distribution from the overall plan, because look how much more money we’re making on the other side?” Until it doesn’t happen anymore.
AC: Until it doesn’t work.
JA: Until it doesn’t work. And Alan, you’ve always said, if you want to get into the real estate game, you need to have time. You need to have time to weather through bad markets. And you need to have cash flow.
AC: You need to have resources.
JA: Yes, you need to have cash flow or resources to make sure that you can weather through those bad times.
AC: Because here’s the tendency, Joe, is, you buy a rental property and it works well. And so you refinance it and you buy another one. And then refinance it and buy another one. And all the while it’s like, “well why do I need cash? If I have cash I’m gonna invest it, because cash, I make nothing. And the real estate, I’m making 20% per year.” And you can with leverage. And the way that that works is because you have a down payment, and your appreciation – you get all the nation on your smaller down payment. That’s how you can make good, big money in real estate.
JA: Yeah, because going back to your example, if I have a $100,000 property and the property value goes up 5%, that property is now worth $105,00 for simple math. But let’s say if I have only 10% down…
AC: So I invested $10,000 and I got a $5,000 return. So I made a 50% return. Now it’s not that simple, because there are cash flows and maybe I’m losing money because I have such a low down payment. But that’s the idea. You use other people’s money to make money. And if you hit the market right, it definitely works. And there’s been, at least, in my real estate investing career, there have been two really tough markets. One was in the early 90s, that was the Savings and Loan crisis, where properties in San Diego went down roughly 15 to 20%. And then we had the Great Recession, where properties in San Diego – depends upon where you’re located – some areas only went down 15%, others went down a lot more. I happened to have property in Arizona and Las Vegas at that time.
JA: Not Florida? (laughs)
AC: Not Florida. That would have been even worse.
JA: The trifecta? (laughs)
AC: All three, right? My brother had Florida. So between our family, we made great decisions. (laughs) Phoenix went down, I’m going to say about 50-60% in the Great Recession. The two homes that I bought for $150,000, which went up to about $225,000 in about three years, were down to about $70,000-$80,000 each. That was what they were worth. Now, at this point years later, now they’re back up to the $230,000, $240,000 range. But that’s the thing is leverage can really work against you, and you need to have resources to be able to cover those lean times.
JA: And I think the mind plays tricks on you too a little bit. And so, going back to the example, “I have a property I spent $100,000 for. And then all of a sudden I see the thing go up to about $175,000. I’m feeling really good, I’m feeling confident. So then I’m going to buy another one, lever up, lever up. And then the market tanks, and then now that $175,000 goes back to $100,000, but oh, now wait a minute, maybe it goes down to $85,000. So the property value is less than my loan. And then all of a sudden I’m like, “I’m out of this thing.”
AC: Right, because I can’t afford it. And even though the cash flow worked out on paper…
JA: Even if I had the cash flow – people walked away from that crap.
AC: They did. That was the short sales and the real estate collapse.
JA: Right. It’s like well, you know what, I’ll just walk away. My neighbor is walking away, they’re not paying the rent and this and that. And it’s less worth it. That’s what really kind of bugged me. People would be on, or we would talk to clients. You’ve got millions of dollars and you’re walking away? What the hell are you doing? (laughs) So, I digress. Never mind.
AC: Anyway so I’ll do a little quick summary. By borrowing money, by getting a loan on your rental properties, it increases your potential for growth. And if you know anyone that’s made money in real estate, that’s how they’ve done it. What tends to happen is, you tend to do this when you’re younger, when you’re able to handle the risk. And then as you get older, assuming you hit the right market timing, what you tend to do is you kind of pay down your debt, and then now you’ve got this really good cash flow that lasts for a long time. Now on the other hand, if you’ve levered up too much, you bought too many properties too quickly, and you get a market hiccup, that’s when there are big problems and that’s exactly what happened 2007 through about 2010.
JA: So I’m gonna have a little close watch here on Cubert.
AC: Yeah. See how he does.
JA: Hopefully he continues to blog.
AC: Now he’s in a little different area. He’s in Minnesota, where you can buy a property for $150,000 or $200,000. In California, no way. Forget about it. If you could find a property for $500,000 or $600,000 you probably don’t want it. So then you’re looking at $700,000, $800,0000…
JA: That’s why it makes no sense to try to have a rental property in Southern California.
AC: The old rule, you read all the real estate books, they tell you, “OK, whatever you pay for it, your rent should be 1% of that.” So I’m going to buy a $700,000 kind of basic home in San Diego. Can I rent it for $7,000 a month?? No, not even close. (laughs) Maybe $2,500, maybe. So the math just in some areas doesn’t work very well. So it gets even trickier when you’re in a high-cost area like California because now there’s little margin for error – so you better have a lot of resources.
JA: All right. We’re talking real estate. We’re talking debt. We’re talking retiring early. I think I’m going to change my name. I don’t know what it’s gonna be yet. (laughs)
AC: He did Cubert, why don’t you be Cupert?
JA: That’s what his whole schtick was, the little orange thing with a giant whatever that thing was.
AC: I think you should be Joe-bert.
JA: J- No. Let’s change the subject and get out of here.
Ah, so much for a clever nickname for Joe. Learn more about real estate investing – including 7 mistakes that new real estate investors make and how to avoid them, and 3 tips on how to start investing in real estate, from the experience of the one and only Big Al Clopine. You’ll find links to these free resources in the show notes for this episode at YourMoneyYourWealth.com Now let’s get back to answering your emails about rental real estate. If you’ve got a money question of any kind, call (888) 994-6257, or email email@example.com
28:33 – How Can I Minimize Capital Gains When Selling Rental Property?
JA: This is my favorite part of the show. I really enjoy this. Helping the people.
AC: And you especially like it when I not only have not seen the questions, I can’t even read them. So this is definitely off the cuff.
JA: OK here’s one. This is right up your alley for Big Al. “If my wife and I sold a rental property for $150,000 and purchased a new property for $300,000, how would we avoid capital gains tax?” He’s aware of the 1031 exchange option, “but we want the new property to be our primary residence. Could we rent it out for a period of time before living in it? Any help would be appreciated.”
AC: Okay. That is a great question, and I’m going to walk through it with you. So first of all, a 1031 exchange is when you sell an investment property, a rental property, and buy another rental property – and there are certain timeframes. So when you sell the property, first of all, your money has to go to a qualified intermediary or exchange accommodator, or those are a couple of words. So you cannot actually get your hands on the money, it’s a third party. And then after the escrow closes, you have 45 days to identify up to three properties that you might want to buy, and then you have six months from the close of escrow to actually buy one of those three properties. So as long as you do all of those things, and the rental property that you purchase is more expensive than the property that you sell, then you defer the gain. So you don’t eliminate the gain. You just defer it.
JA: So it has to be more expensive or the same price. It cannot be lower or else there is “boot.”
AC: Correct. That’s right. And boot just means there’s a tax event on the difference. So if you walk away from a transaction with cash in your pocket or less debt, either those things are considered boot and it’s taxable.
JA; So not the whole enchilada, just whatever that differential is, correct?
AC: Yeah but it’s not pro-rata. And I know you’ll know what that means, but basically, it means that if you have gain of $100,000 and you get boot, in other words, cash of $80,000, the entire $80,000 is gain. You still have another deferred gain of $20,000 that goes into that property. And then when you sell that property you’ll pay the tax on that $20,000 dollar gain in the future. So in this case, what I said is you have to sell a rental property and buy a rental property, so this wouldn’t necessarily work. But here’s how you do it. So your thinking is right. The property that you buy for $300,000, that does need to be a rental property. And most accountants would say you probably should rent it for a year, maybe two.
JA: Two tax returns at least?
AC: At least two tax returns. There’s really no hard and fast rule on how long to do it. The longer the better. Really, the rule is this: if your intent is it’s a rental, for rental, there’s no problem. Then you can turn around later, kick the tenant out and move into it as your primary residence because your intent at the point of purchase was that it was rental for rental. Now if your intent really was you want to live in this property, and you have a rental for like a day or a week or even a few months…
JA: You put it on Craigslist and no one ever rents it.
AC: That’s suspicious, right? And so that’s why accountants will say maybe you ought to rent it for a couple of years just to show that this was really your intent, to have it be a rental. But people do this all the time. And so it’s not necessarily a bad strategy, but just remember, it has to be a rental for a period of time, and then later on when you decide, “you know what, I don’t want a rental anymore, circumstances change, I’d actually like to live in this property,” then you can kick the tenant out, move into it, and you don’t have to pay the tax at that point. You pay the tax when you sell the property down the road.
JA: So let’s get into that. So now I 1031 exchanged a property that has low basis. I avoided the gain, and that’s why you do a 1031 exchange – you don’t want to pay the capital gains tax.
AC: Right. And if there’s no gain when you sell a property, don’t do a 1031. Just sell it.
JA: Yes. And the gain has to be, probably, I don’t know, a taxable gain of probably more than $100,000 for just to be worthwhile?
AC: Well, it depends on the person.
JA: What is the intermediary cost to do all of this stuff?
AC: Well it probably costs $500, $1,000. It’s not the end of the world, but a lot of people don’t necessarily want to buy real estate. Some people do 1031 exchanges to avoid paying taxes of $5,000 and it’s like, “did you want another rental?” “No, I hate rentals.” Well then just pay the tax and move on.
JA: OK, so I avoided the capital gains tax, I’m flipping homes, I’m doing well, I’m just trading up. That’s what a lot of people do, they start with one and then that one was good, let’s trade up, let’s buy a little bit bigger house. Oh, I got some money there, let’s trade up. So you’re continuing to trade up on this real estate cycle. But your basis now is really low.
AC: It’s low because you’ve never paid gains.
JA: You never pay tax, so that that basis just carries through from each exchange that you do.
AC: Yeah. And the way this works Joe is let’s say he buys this property for $300,000 and he avoided a $50,000 gain, for example. So then it’s as if he bought this new property for $250,000, not $300,000. So that’s how this works.
JA: So if he sold it, he would have paid the $50,000 tax. However, now he lives in the home. And let’s say he lives in that home for two out of the last five years. So it was a rental. Does he get the full 250 500? So I can exclude that gain… let’s say if he’s married, up to $500,000 of gain. But he would have to pay tax on whatever depreciation?
AC: Yes, you’re on the right path, it’s a little more complicated than that because it was a rental originally. So first of all, you’re right. So there’s a 121 exclusion if you live in the home 2 out of the last five years, you’re married, you get a $500,000 gain exclusion. Single, $250,000. So that’s true. But if it was a rental property first, what happens is, you have to go back to 2009 and look at the number of years that it was a rental versus today. And so right now it’s 2018, and let’s say he rents it for another couple of years, and then he moves into it, lives there a couple of years. So now you’ve got to look at roughly 12 years. You lived in it two out of 12 years. So two-twelfths of the exclusion is available. It’s actually a little bit more complicated than that because before 2009 counts as a residence even though it was a rental, so… (laughs) If this is your situation, get some help. But the point is, if you bought a rental property and then turned it into a residence, you’re not going to necessarily get the full exclusion.
JA: And this law just changed.
AC: Yeah, well it was “just” 2009.
JA: It feels like yesterday! (laughs)
AC: Well see, that’s what happens when you get older. Sometimes I say 85 and I meant 2015, it just doesn’t seem like it was that long ago. For you that’s forever.
JA: 2009. What year is it? (laughs)
AC: (laughs) We’re nine years later. But the reason…
JA: Nine years, when did we start this firm?! 2007? (laughs) Oh my god.
AC: Yeah. The reason they did this, Joe, is because investors were just simply moving to rental after rental, live there two years, sell it, exclusion. Live there two years, exclusion. Even if you get exclusion you have to pay tax on depreciation and recapture.
JA: And that’s 25%.
JA: So that’s it for us today, hopefully, enjoyed the show. I want to thank Andi Last for producing such a wonderful show. All right. We’ll see you next week. The show is called Your Money, Your Wealth.
Special thanks to today’s guest, Cubert from AbandonedCubicle.com. Find a link to his Comprehensive Guide on Vacation Rentals in the show notes at YourMoneyYourWealth.com, or visit AbandonedCubicle.com to read more about Cubert’s plans for FIRE. Clearly, this real estate investing stuff is complicated, and as Big Al said, it’s a good idea to get some help. You can email firstname.lastname@example.org or call (888) 994-6257 to get some insight on your specific situation, and you can sign up for a free financial assessment at PureFinancial.com
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Pure Financial Advisors is a registered investment advisor. This show does not intend to provide personalized investment advice through this broadcast and does not represent that the securities or services discussed are suitable for any investor. Investors are advised not to rely on any information contained in the broadcast in the process of making a full and informed investment decision.