Building vs. Buying and Avoiding Capital Gains on a Sale

Ashley:
This is Real Estate Rookie, episode 264.

Tony:
But oftentimes if you do a new build in 2023 versus a rehabbed house that was built in 2005, the value of that property, especially if you’re looking at it as a short-term rental, which is what we do, is typically higher. We can rehab a house that was built in 2005 to the nines, but the construction style, the aesthetic of a house built in 2023 is going to be more modern than a house that was built in 2005 even if it was rehabbed really nicely.

Ashley:
My name is Ashley Kehr, and I’m here with my co-host, Tony Robinson.

Tony:
And welcome to the Real Estate Rookie podcast, where every week, twice a week, we bring you the inspiration, motivation, and stories you need to hear to kickstart your investing journey. I want to start today’s episode by shouting out someone by the username of lukster8891. Lukster left us a five star review on Apple podcast that says, “Encouraging podcast. Tony and Ashley, their podcast is extremely informative and encouraging. Thank you for creating a space to give people like me the knowledge and extra nudge to feel confident about investing in real estate.”
I like the way you phrased that, Lukster, “for giving and creating a space to give people like me that space to feel confident.” That’s really what the Real Estate Rookie podcast is about. There’s obviously a ton of information out there about investing in real estate, but sometimes it can feel overwhelming, sometimes it can feel, I don’t know, just too much to try like drinking from a fire hose. The purpose of the Rookie podcast is to give every single listener digestible, usable pieces of information and stories to really help move them along in their journey. So if you all are listening and you haven’t yet left us an honest rating and review, please do. The more reviews we get, more folks we can help, and helping folks is always our goal. Ashley, how’re you doing today?

Ashley:
Good, good. Well, first of all, if we haven’t said it enough, thank you guys so much for those of you that have left reviews. We love reading what you like about the podcast and how it’s benefited you and especially when you guys leave us your wins, what you have accomplished. So when you leave a review, makes sure you share that with us what you have learned from the podcast from one of our guests. Who was your favorite guest? Who do you love, or maybe who do you want to come onto the show too? We’ve been having a lot of production meetings as to who are some of the bus guests we can bring on for you guys that will bring the most value. Believe it or not, it’s just not boring banter, we actually do try and plan things out and really strategic about how we operate the podcast. Yeah, so Tony, what rehab, what are you working on, anything?

Tony:
Yeah, we got some big plans for 2023. I know we had our goal setting episode a few weeks ago, but a big focus for me is I still do want to close on my first big commercial property this year. We’re looking at hotels, boutique motels around the country. We learned a lot last summer with that deal that we had on our contract but didn’t end up being able to close on. And really it was the purchase price. We had raised a couple million bucks, we needed a couple million more. And it’s like, “Well, man, how many deals could I have bought with the two something million that we had already raised?” There’s a lot of properties out there that we could have bought. So I think we’re going to go back and probably just reduce our purchase price a little bit and try and find something that makes a little bit more sense in that price range.
And then another big goal for me is launching our property management company on the short-term rental space as well as our short-term rental cleaning company. So trying to find the right COOs to run point on those ventures for us, but I think those are two big gaps in the short-term rental marketplace. There is no nationally known brand in the cleaning space for short-term rentals. There definitely are property management companies that are big, but I feel like we’re in a unique position where we’ve built a portfolio of our own first. We’re host first and property manager second, so we have a different perspective from a lot of these other companies that have been around for a while.

Ashley:
Are you going to start out with just offering it in the markets that you operate in now? What is your plan to grow and scale it? Will it be more of a franchise model eventually, or is it something that you want to continue to oversee the markets and you’ll select which markets you’re going into and continue to grow yourself?

Tony:
Yeah, that’s a great question. We haven’t really decided yet. The franchise model is something that I think might work, but I also do the idea of really retaining control over certain aspects of the brand. But I think initially we just want proof of concept. We already have the infrastructure, so we have the operations team to do all the guest communication and working with the maintenance crew and the cleaning staff. So really we do feel like we can take that infrastructure into any market, we just need to find the right cleaners and handymen in those markets to support us. I think our biggest focus is just finding the right properties and the right owners to work with and then we’ll let the markets take care of themselves.

Ashley:
For me, I’m taking back my property management we’ve used for the past three years, property management company. And now what I’m doing is just building out a property management company again, where last time when I first started, I was self-managing, so I was the property manager, I was the leasing agent, everything. And now this time I’m hiring a property manager. I think she’s actually going to be signing her contract this week, which is super exciting. And then I’m just going to oversee everything and basically just have it done the way that I want it. But we’re not taking on any clients, it’s just my properties and the properties of my business partners. That is one thing, I don’t want to have to deal with owners. Tenants can cause issues and things, but sometimes the owners are worse than the… And I know this because of other owners talking about how they interact with their property management company.
Me as an owner to my property management company, I don’t want to deal with that. I always think of teachers an example, having to deal with the students in their class but then having to deal with the parents and sometimes the parents are worse than. So part of my big vision and goal for 2023 is figuring out what are the things that I don’t want to deal with that feel heavy to me, and one of those things is being responsible to other owners. I’m very confident that I could start this property management company and right away I already know that I have these owners that would come in that I can share overhead with, but I just don’t want that responsibility of there’s something that’s happening and going on, okay, it’s my cash flow, it’s me saying, “To take care of this problem, I’m just going to spend this amount of money to have it taken care of.” Where if it’s an owner, it’s somebody else’s property, I can’t just, say, go and spend this money and take care of it because that’s their cash flow that’s decreasing, that’s their issue.
So I like having control over making the decision that is going to impact me and my properties and not that it’s going to impact an owner and not having to really worry about that I guess.

Tony:
That definitely is a concern for us as well is that as you scale, there’s a lot of personalities that you have to deal with. But I also think that’s why we want to be pretty selective with the owners that we work with. If that person is… I don’t want to say a pain because I think that’s an unfair representation. But if that person maybe is looking for a level of involvement in the day-to-day operation that is not in line with the kind of involvement that we want from our owners that maybe it’s not a good fit. I think that’s what we’re trying to scale up pretty slowly to make sure that… We want people to trust us and that are coming to us for our expertise and not people who feel like, “Hey, I can do a better job than you can,” and trying to teach us how to be short-term rental operator. So there’s a fine line there.

Ashley:
You just described me as an…

Tony:
And that’s a good point-

Ashley:
[inaudible 00:08:29].

Tony:
Because I think you were in a position where you honestly could do a better job than-

Ashley:
Yeah, and I would.

Tony:
… that property manager that you have.

Ashley:
Yeah. And I [inaudible 00:08:36] that experience. I think in your situation you’re vetting the owners too. You’re not just going to grow and scale so fast that you’re taking on anybody just to maximize your client base and maximize your revenue, that you are going to be selective. And that also gives you that exclusivity too, as to you want to be an owner… and not to use the word train, but as you take on new investors, new owners as setting those expectations as to, “This is what we expect of you, and this is what you expect of us. If either of us vary from that, that’s where we have a situation as to how do we work around that.” Or maybe the partnership isn’t working because really it is a partnership. Especially when it’s your investment property, you’re no longer in control of the day-to-day operations of that property and maximizing cash flow and things like that, you’re trusting your partner, the property management company, to oversee all of that and really maximize the performance of your property. And that’s one thing I didn’t understand when I hired a property management company, is I should have asked a lot more questions.
One example is, okay, the water bill. It goes into their billing department, their payables. Somebody’s there scanning in the bills. They go ahead and pay it and then it’s taken care of. Great, I don’t have to pay bills, things like that. But there’s also no one going and saying, “Wait, the water bill was $100 last month. Why is it all of a sudden $250? Is the toilet running? Is there something going on?” Just because it’s going into a general department that doesn’t know your property, things like that. I feel like I’m getting way off on a tangent.

Tony:
No, but that’s such a good point. It’s like how do you set those expectations up correctly at the onset or not even at the onset, before the relationship even really begins? There’s a great book that I just read, and it’s called Never Lose a Customer Again. The book really focuses more so on larger companies, but it’s like, when you are looking for customers, how can you have conversations at the beginning and then how can you structure those first 100 days of that relationship so that, A, your customer has a really amazing experience and they stay a customer for a long time, but, B, that the expectations that you have of them and that they have of you are super clear on both ends, that way both of how to operate effectively within that partnership. So Never Lose a Customer Again, I can’t recall who the author was, but it was a great book that I really enjoyed.

Ashley:
I think that would’ve helped me work with the property management company better, is if we both had expectations of each other and had set that ahead of time. I’m sure they do a great job, they’ve grown and scaled so much over the past couple years that obviously they have a successful business model in place, but it was just different than what I expected, and we should have had those clearer expectations up front.
Okay, so our first question is from Annie Johnson, and this is through the Real Estate Rookie Facebook page. If you haven’t already, make sure you guys join the Facebook group. There are over, I think, 60,000 members in it right now. It’s a great way to ask questions, get information, or to even share your own advice and wisdom. Okay, so Annie’s question is, “Has anyone partnered in an LLC for out-of-state investing? Did you use an attorney in your state or the state you were investing? Does it matter? Any insight on this subject is helpful. This will be our first partnership and LLC. We decided we do not want to do a legally-documented partnership agreement.”
Okay, so I’m wondering why as to that last question because when you create an LLC, you have to create an operating agreement, which is the terms of your partnership anyways. So I think that if you do, no matter what, if you create your LLC, for it to be a legal LLC to function the way you want it, have to do the operating agreement, which is basically a partnership agreement in itself.

Tony:
Really quick, I just want to shout out to Annie who’s asking this question. This is actually Annie Hatch Johnson who was a guest on episode 46. I recognize the face and the name there. Shout out to Annie. I think last we talked to her she was somewhere here, I can’t remember, in the Midwest somewhere, but she actually ended up moving to Alaska. Her and husband were doing some short-term rental stuff out in Alaska, so shout out to Annie.

Ashley:
So Tony, do you want to actually answer this because you’ve done this a lot more? I think you actually do joint ventures, but the only out-of-state investing I did was with James [inaudible 00:13:32], and we did a joint venture agreement where we had our own separate LLCs and they came together in the joint venture agreement. So we had my New York LLC and then his Washington State LLC, and then did the joint venture agreement through that. And we had the whole operating agreement documented as to how the partnership worked for that one deal.

Tony:
Yeah, it’s a great question. The majority of our partnerships are through joint venture agreements, not necessarily new LLCs that we set up either. But Annie, I’ll give you a little bit of insight based on the conversations I’ve had with my attorneys and different SEC attorneys and things like that. Every state is different. The information that I was given, and again, I’m not an attorney so please consult with an attorney to make sure that this information is accurate, but for us, we were looking to purchase property that was in California using a new LLC. Your question around is it in your state or the state where you’re investing, there are some limitations. For example, there’s better tax treatment in states other than California obviously. But say I wanted to create an LLC in Delaware but, say, I was in California, the partners in California, and the property’s in California, I can’t create a Delaware entity to hold title and collect rents on that property in California.
So depending on what state you live in and what state the property’s in, there are some laws you have to follow around where to create that entity. So my first piece of advice, Annie, would be to ask an attorney in your state or in the state where the property is located to get their advice on where you should structure that entity and what state it should be focused in. Have you seen anything different on that front, Ash?

Ashley:
No, no, I really haven’t. I also haven’t looked into it that much though, but that’s kind of what I’ve heard, I guess.

Tony:
I mean, so yeah, that’s the first thing, is talk to your attorney to identify what state it is in. I think the second question, this kind of goes back to Ashley’s piece, is you said, “We decided we do not want to do a partnership agreement.” I’m assuming when you say that, Annie, is that you don’t want to go the route where we went of just having a joint venture agreement, you actually want this entity to be in place. But to Ashley’s point, I think you still want to go through all of the same thought processes or exercises that you would if you’re doing that partnership agreement to make sure that if, for whatever reason, there’s not tension, but every partnership’s going to have its bumps and maybe disagreements, and the more time you spend upfront answering those questions, the better.
There is a fantastic book that I read last year called The Partnership Charter by someone named David Gage, and it was one of the best books I’ve read on partnerships. It’s not specifically geared towards real estate, but it is a business partnership book, and it is just chock-full of questions that you and your partner should be asking one another before you really enter into this partnership to make sure that there’s clarity around how you are going to handle certain problems in that partnership. So read that book, talk to an attorney, I think those are my first two pieces of advice.

Ashley:
Okay, so onto our next question, and this one is from Sia, “Has anybody bought a land and built a house instead of a rehab? Really having a hard time finding a deal because people are overpaying. How is it getting a refi on a newly built house?” I think maybe the market might be changing a little bit where you’re not going to see so many people overpaying, so hopefully you can have a better chance at finding deals. But I’m in this real estate text message thread, and one of the investors sent on a message that quarter four of 2022, he’s a house flipper and he was having property sit for sale for over 60 days. Soon as January 1st hit, he saw a huge increase in showings. I think he said they tripled, the amount of showings he was getting tripled, and he had four go under contract just in the first two weeks in January that he’s seeing just this huge uptick since the first of the year. So maybe people are going to start overpaying and overbuying again.
So with doing this building a house, I’ve built my personal residence, but I’ve never went and bought an investment property or built an investment property doing it from the ground up. The first thing I think that you should really do is your research on what that property is going to appraise for when you are done doing the build of it. Is it going to appraise for what you put into it or even more so you can pull all of your cash back out? The second thing is how are you going to fund that? Are you going to do cash? Are you going to get a construction loan? So if you’re paying cash, one thing you’ll have to do is you’ll have to look and talk to banks, and we answered this on another rookie reply, I think it was the one that aired last week as to the seasoning period. Because if you’re paying cash to have this house built and then you’re going to the bank to refinance it, they may say, “You know what? You haven’t owned this house for a year, and we’re not going to refinance you for a year to do that cash-out refinance.” So those are some of the things you should definitely look into before you actually go through the build process.

Tony:
A couple of points from my side. Just like Ashley, I’ve never done new construction myself on the investment side. We have purchased quite a bit of new construction, but it was from the builder who did the work to identify the parcel, they got all the permits, they managed the ground of construction, and we were essentially purchasing a finished product from that builder. I just want to talk about the pros and cons of that approach and why we decided to go that route. The first pro that we saw was that we were able to get a superior product. Oftentimes, and it depends on the level of the rehab, but oftentimes if you do a new build in 2023 versus a rehabbed house that was built in 2005, the value of that property, especially if you’re looking at it as a short-term rental, which is what we do, is typically higher.
We can rehab a house that was built in 2005 to the nines, but the construction style, the aesthetic of a house built in 2023 is going to be more modern than a house that was built in 2005 even if it was rehabbed really nicely. And that’s what we’ve seen a lot, is that our new constructions tend to do better than our rehabbed homes even though the quality is just as nice, but it’s just that frame of the home is a little bit more dated with that older stuff. That was one big pro for us.
The second reason why we went with a lot of the new construction from this builder was that he had already identified and permitted multiple parcels in this city that we were looking to invest in. So for us, it allowed us to scale exceptionally quickly because he had already done the hard work of… The permits take almost longer than building the house in California. So the fact that he had already done that hard work on multiple parcels meant that we could build this machine to just start acquiring these properties as soon as he was done. And for us, we were in a really strong growth phase, that was a big goal of ours, was to scale quickly, and having that relationship allowed us to do just that. So those were the two big pros: we got a really superior product and we were able to acquire those units relatively quickly, much faster than if we had tried to do it ourselves.
The cons to that approach is that we were definitely paying more for the finished product than if we had done the work ourselves of identifying the land, pulling the permits, and building that property out ourselves. There’s no question about it. He wouldn’t be selling us those homes if he was selling it at a loss every single time. He was selling it to us because he was making a healthy profit. We knew that we were, not overpaying because it was still market value, but we know that we were spending more than had we done it ourselves. I think those are the two things you have to weigh. Do you have the skillset to do ground-up construction, because it is definitely different than doing a rehab. Those are similar skillsets but still different. And then the second piece is do you have the time to really manage something like that as well? So the ability and the time are two things to look at.

Ashley:
Yeah, that price that you’re paying extra is really the project management fee, is like the general contractor fee is like them taking the administrative role, the management of the whole project is what you’re paying. So even if you were not to go with the builder and you did it yourself, you still may be paying a general contractor a little buffer percentage because they’re going to be the one getting the subs in and things like that to actually take care of the project too. But if you’re going to act as the general contractor and you’re going to manage the whole project and you’re going to hire individually each contractor that needs to come in, then, yeah, that’s where you’re going to save a lot of money. But like Tony said, do you have the time and the knowledge of doing that too? If you are going to try it and you don’t have the knowledge or experience and you just want to learn, it may end up costing you more than it would’ve to actually build it.

Tony:
Just buy it from them.

Ashley:
Yeah, just to buy it from the builder. So that’s definitely something to consider.

Tony:
I just want to share some of the headaches that come along with trying to do the ground-up construction yourself. We’re good friends with this builder now because we’ve purchased I think 13 houses from him at this point. We were out of the site one day and I was just asking about the permitting process. Typically what he does is he’ll submit plans for multiple parcels at the same time, same exact floor plan, same exact floor plan, just different parcels, and he’ll submit them to the county. Each plan, remember they’re identical plans, get submitted to four different… Gosh, who are the people review the plans in the county?

Ashley:
The code enforcement officer?

Tony:
Yeah, I can’t remember the name of the folks that are looking at the plans or whatever it is, it escapes me right now. But anyway, it goes to four different people, all the same job, just four different individuals. Each person will look at the same exact set of plans and come back with different notes. Person A will say, “Hey, you need to fix this thing.” The second person won’t see what the first person saw, but they’ll call out something different. So it is the same exact thing, but four different people have a different interpretation of what needs to be fixed. So he’ll get those plans back and then he has to make four separate sets of changes, some of them back to four different sets of people, so it is definitely a very arduous and sometimes frustrating process to go through the whole new construction thing on your own.

Ashley:
Or you can just live out in the country in rural areas where you get to know the one code enforcement officer, the one building inspector, and yeah, that’s it, that’s all you have to deal with is one person. And then the planning board, I guess.

Tony:
What’s even crazier, Ash, is we were looking at some places in Arkansas, and there are certain counties in Arkansas where there is no approval process. It’s like you can pretty much just build whatever you want to build. So depending on what city or county you’re going into, the ability to build something new is probably easier in some places.

Ashley:
Yeah, we definitely got remote areas like that. I haven’t invested in one yet, but it’s like you can put up whatever. There’s no approval process or anything like that, no permits to put in.

Tony:
Your land, you do what you want with it, right?

Ashley:
Here’s a story that’s going to frustrate some people is, on the building that my liquor store is in, it needed a new roof. So Daryl went out and he got somebody who’s going to do the roof, we got the bid, everything, and he is like, “I can start tomorrow.” And so I said to Daryl, I was like, “Well, we don’t have a building permit. Did he get in?” He texted the guy and the guy’s like, “No, I didn’t get one, but I can start tomorrow.” So we drive… It’s 15 minutes away drive to the town hall and like, “We need to get a building permit, we want to get this done.” She was like, “Okay, fill out this form,” and it was a hundred dollars and did it. She’s like, “Okay, we’ll have it ready for you tomorrow. Just come and have the contractor pick it up and we’ll put it in the window.”

Tony:
Wow. Let me tell you a story on the opposite end of the spectrum. We have hot tubs we began installing at most of our short-term rentals in Joshua Tree. It was a very similar process where you have to submit plans for the hot tub like where’s it located in respect to the house. You have to get an electrical permit inspection done to make sure that it’s all done the right way. And then there’s certain safety features you have to add to the hot tub. It was a very similar process where they would send out a different inspector every time.
So the first inspector goes out, he gives us a list of things we need to fix, and we fix 1, 2, 3, and four. The second inspector comes out to validate that the first four things were done, but then he calls out other things that the first inspector missed. Then a third inspector comes out and he calls out something totally… So it was just like this game of musical chairs trying to fill all these boxes for these different inspectors, and it took months for us to get some of these hot tubs permits, so it’s definitely frustrating.

Ashley:
Oh my gosh.

Tony:
Anyway, we got off topic, but hopefully see that that was helpful for you. I think long story short is think about the pros and cons and your own skillset in terms of rehabbing a home versus the new construction phase. And then to Ashley’s point on the refinance, just make sure you’re talking to banks on the front end so that way you have a good idea of what the seasoning period is and what other maybe hoops you might have to jump through if you do go the new construction route to get that refinance done and complete it on the back end.

Ashley:
Yeah, one last thing I’ll add to that as an example. Not in my market, a different market, but this friend that I have, they built patio homes, like small apartment complex, just one story. They paid cash for the whole thing, built it ground up, did all this site work, everything. And when they were done, they rented it out, and it actually didn’t appraise for even what they put into the deal. I think they had to leave in maybe 40% of what they paid for it because the bank was only going to lend them 70% of the appraised value. Actually, it was more than that, it was more than 40% that they left in it. I don’t know the exact numbers, but that’s something to be very cautious about, is making sure that it’s going to appraise for what you want because you could be stuck with leaving hundreds of thousands of dollars into a deal that you didn’t expect to do especially if you were are borrowing money from a private money-lender, a hard money-lender to fund that deal and then it doesn’t go and appraise for what you want.
With this investor, fortunately, he was in this situation where he set up a contract with the builder where he was making payments to the builder for some of that gap. So he was able to mitigate that and then just use the cash flow. And it all worked out where it’s still a cash flowing property even after having these two loan payments. So make sure you have multiple exit strategies and different ways to fund a deal.
Okay, so our next question is from Joey Stout, “How does rental income get taxed as opposed to a W-2 salary? Thanks, Joe S.” Well, Joe, your W-2 income is going to be earned income, and it’s going to be based off of what tax bracket you are in, so how much money you have made. Let’s go ahead and let’s pull up the tax brackets for 2022. Okay, so if you are… Let’s look at here. If you make zero to $10,000, you’re paying 10% taxable income, and then 12% for 10,000 to 41,000. 22% is going to be what your income is taxed at from 41,000 to 89,000. Your tax rate is going to be 24% from 89,000 to 170,000, and so on. So the more you make of earned income, your W-2 income, the higher your tax rate gets. So you jump up to over half a million, you’re going to be paying 37% in income taxes.
You look at that and be like, “So I want to stay under 539,000 because then I’m going to pay 2% more in taxes,” and really having to figure out where’s that threshold where it makes more sense. So if you’re right on the border of one, so let’s say 24% to 32%, okay, that’s quite a big jump, that’s 8%. And if you make $170,050, you’re at 24%. But say you go and you make 180,000, you’re getting pushed up to the 32% tax bracket. Is it even worth taking that extra 10 grand because now that whole chunk of money is going to be taxed at 32%? So something everybody should be cautious of with their income.
Those are just some examples of the brackets and they go up. When you’re in a bracket, so say 170,000 that’s taxed at 24%, that 170,000 is going to be taxed at that 24%. But then if you make another 10 grand more, that 10 grand is going to be at the next tax bracket, that 32%.

Tony:
So it’s just your income that falls into that bracket that’s taxed at that percentage, right? So if you make $500,000, that entire 500,000 won’t be taxed at 37%. The first 10,275 will be at 10% and then up to 41,000 you’ll be at 12%. And then each one of those different falls into those different buckets. That’s why taxes are so confusing, which is why everyone should definitely get a really good CPA to help you navigate all those different nuances.
But you made the statement earlier, Ash, that your W-2 salary is earned income, and earned income gets the worst tax treatment out of all income. You’re going to be taxed the highest based on your earned income. Rental income gets one of the more preferential tax treatments. We actually had Amanda Han back on episode 255, and right at the end of that episode, she even within the world of real estate investing categorized which strategies get the best tax treatment, which strategies get the worst tax treatment. Flipping was at the bottom of that tax preference treatment because that is still active earned income. And then things like short-term rentals and long-term rentals were at the top because that’s more considered passive income.

Ashley:
One thing to note I think with earned income is that like, okay, you’re going to work so much hours, but if you’re right on the edge of one of those brackets, is it worth working those extra hours and then now you’re going to have those hours tax at 37%? And so $37 of that $100 you’re going to work extra for is gone. But you guys can pull up if you actually want to look at what tax bracket you’re in. Some of the examples we use for first single filer, but they changed for married filing jointly, filing separately, head of household. So go and take a look at those, and you can actually figure out what your income is going to be. It’ll show, like, okay, if you made $95,376, your taxable income is going to be $16,290 on that. Then anything over that would be that 24%. So it’s like the sliding scale I think is the best way to put it. As you move up to each bracket, that income going higher is going to be taxed at those different rates.
I think there’s a huge advantage to passive income because of that and then also being able to do a 1031 exchange where you can actually defer the income from your rental property if you do go ahead and sell it.

Tony:
So long story short, Joey, you want most of your income to be passive from your rentals and the smallest amount to be active and earned income if you want to be able to really maximize your taxes. Now, there’s so many different strategies out there, Joey, to help reduce your tax liability even from your W-2 job. Again, I’ll mention episode 255 again because Amanda talks about this, but there are ways that you can use passive losses from your real estate portfolio to offset your W-2 income. Most people achieve this by using short-term rentals. It’s significantly harder to do it with long-term rentals, but there are ways to say, “Hey, I have a $100,000 paper loss on my rentals, and I’m going to apply that to my $100,000 salary in my W-2 job since you have zero tax liabilities.” And I have friends that are paying zero on taxes using that exact same strategy.

Ashley:
I am not one of those friends.

Tony:
I haven’t matched with that yet either. I definitely had a tax bill last couple of years, but when you get a good CPA, hopefully you can start putting those pieces in place. We had a mad scramble at the end of 2022, the year that just ended, to purchase a property to try and get to more cost aggregation benefits as well.

Ashley:
Yeah, you know what’s also something that’s pretty good tax advantage is a farm too, is getting good tax advantages on that. Farmers don’t have to pay estimated taxes, they can wait until your tax return is due and pay your estimated taxes April 15th because when you’re making those estimated tax payments and having to prepay basically every quarter you’re paying as you go along, that’s money the government is getting interest free. So that’s a huge advantage. You get to keep that money until the actual tax time and pay it at the last minute. But yeah, there’s just a lot of write-offs you can do. And even property taxes, you can get an exemption on your property taxes to have them decreased if it used for agricultural uses and things like that too.

Tony:
There’s some weird things about farms. I have a buddy, his name’s Kai Andrew, he bought a farm, a lavender farm, and he bought it because of what you mentioned there, some tax benefits. But also, the zoning requirements, the zoning restrictions on farms are significantly lower or less restrictive than what you see on residential properties or even some other commercial properties. He was able to build multiple short-term rentals on this farm because of what the zoning allowed for in that market. There are so many little nuances to try and really get creative with it. But yeah, I think long story short, look for opportunities to really reduce your taxable income, and usually that happens by going the passive route versus the earned route.

Ashley:
One more thing to add too is a lot of farmers are tax-exempt too. So buying a truck for your farm tax-exempt, that’s huge sales tax that you’re saving on purchasing a vehicle. So lots of different little things like that.

Tony:
And so, buy a dairy farm is the more of the story. Before we move off of this question, so I mentioned Kay Andrew, but if you want to go back to listen to his episode, it was episode 107. We talked about land hacking, so 10 different ways to create income streams with one property. And Kai’s the master at that strategy and the whole buying a lavender farm was just one of the ways that he land hacked his way to success. So episode 1 0 7, if you want to hear more from Kai.

Ashley:
Okay. Today’s last question is from Hayes Holland, “If you sell your primary home after one year of residency, am I excluded from the capital gains exemption rule requiring two years, or is there any way around that?” Okay, so first of all, I think there’s a little misconception here is that you are only exempt from the capital gains rule if it is your primary residence. If it is an investment property, you have to pay capital gains on it unless you do a 1031 exchange. That’s the only exemption there. But if you’re just going out and selling, you’re keeping the money, you’re not doing that 10 31 exchange, you’re going to be taxed on that capital gain for an investment property no matter how long you hold the property. But if it’s your primary residence, you have to live there for two years, but it can be two of the last five years. So it could be any two years during that five year period. So it’s not just that you have to live in the property for two years and then sell it. You can hold onto it for another three as an investment property and then sell it at the fifth year and you’ll still be able to have that as tax-free income.
There’s an investor friend who has done this multiple times, I don’t even know how many times, but every two years he buys a new primary residence and takes this money tax-free. I think the rule is you can only take up to half a million tax-free off of it. I’m not sure exactly what that rule is, but there is a max amount. You can’t go and sell your house for $5 million more and get $5 million tax-free. It might even be a million if you’re a married couple, but you guys will have to look that up. Use Google because I don’t know it offhand.
So every two years he buys a property that needs rehab, him and his family live in it and slowly do the renovations over the two years, and then they go ahead and sell it and move to a new property. So yeah, definitely a good way to make income that is tax-free by doing that, as long as your family doesn’t mind up and moving every two years. But if you were to make half a million dollars in two years and all you have to do is move-

Tony:
Move.

Ashley:
… you’re not too bad. So it really depends on what market you’re in. Where I live, it’s hard enough to find a house for half a million dollars let alone to sell one that’s going to appreciate to half a million in two years.

Tony:
Same for me. In the neighborhood that I live in, it’s all a brand new neighborhood. Everything was built 2017 at the latest, so trying to go in and really find a lot of those opportunities are probably scarce as well. But the question does, and we talked about it a little bit already, but we should maybe elaborate on it, but on the investment side, you can defer your capital gains taxes by using what’s called the 1031 exchange. We did our first 1031 not last summer, but the summer before. We were able to tap into equity from one of our homes, and we took that and we used the proceeds tax-free to buy two different properties.
I have a friend who sold multiple of his single family residences in the Midwest and used that to buy… I think he’s at seven short-term rentals right now that he purchased with that. The 1031 exchange is a fantastic way to defer paying taxes, use all of your gains from a sale towards a purchase of another property. There are some restrictions around what you can do and there’s some pretty strict timelines around when you need to identify and close in that property, but this one strategy, some people call it swap till you drop, is what a lot of real estate investors do to continue to scale their portfolio up without paying any capital gains taxes during their lifetime.

Ashley:
So while Tony was talking, I went ahead and did the work for you, guys, for those of you that were driving and you couldn’t Google immediately, the rule is that a single homeowner, single filers can get up to 250,000 tax rate for the sale of their primary and then couples filing together up to 500,000. So that’s the profit based on it. I mean, not too bad over two years, half a million dollars tax-free.

Tony:
Yeah.

Ashley:
I mean you could do that as a full-time job.

Tony:
Totally, right? And you do that a couple of times a year. It also reminds me, we had the one guest, gosh, I wish I could remember what episode that was, but he was purchasing new construction. I think he was in Texas somewhere. He would buy phase one of the new construction and then two years later it’d be like phase 18 or whatever, and all of those floor plans had appreciated significantly and he was just selling those properties once they got to the last phase and he was just recycling that capital into the next one. So you buy a new construction, live there for two years, sell it, buy another new construction, live there for two years, sell it. I think he had done it like three times for the time he came on the podcast.

Ashley:
I think he was doing it in Austin, maybe Austin, Texas.

Tony:
Yeah, it was definitely somewhere in Texas.

Ashley:
Yeah, I do remember that. Yeah. Well, thank you, guys, so much for joining us on this week’s rookie reply. If you guys have a question that you want answered on the show, you can call us at 188-5ROOKIE and leave us a voicemail. Or you can leave a question in the Real Estate Rookie Facebook group where you will most likely get multiple responses and answers from everybody in the group, but also we may play it on the show and you can hear our response to it.
Thank you, guys, so much for joining us. I’m Ashley at Wealth from Rentals, and he’s Tony at Tony J. Robinson, and we will see you guys on Wednesday with a guest.
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