Richard

If you are like me, I suspect you’ve heard a good number of gurus, or even seasoned, well-meaning investors, give the following advice in some form or fashion:

“Systems and policies are essential. If you want a business that works, you need to have systems and policies. You need to have those systems and policies, and you need to follow those systems and policies because systems and policies are absolutely essential to have and follow. Systems and policies!”

While it is certainly true that systems and policies are extremely important as I will elaborate on further shortly. Of course, just saying that isn’t particularly helpful. The “how” part is often missing, unfortunately. So, in this article, I will at least sketch out an outline of how to approach building systems and policies for real estate investors.  

Why Systems and Policies Are So Important

First and foremost, the reason systems and policies are so important is because it’s a massive waste of time and energy to simply reinvent the wheel over and over again. Indeed, even the simple act of making decisions can be exhausting, and so if there is a solution ready to go for a given problem (i.e. a system or a policy), you can execute that solution with little thought and devote your mental energy to something else. 

Systems also make it easier to delegate tasks, as employees and contractors won’t have to continually ask for directions. They also allow you to maintain quality control and standardize outcomes throughout the various parts of your business. Furthermore, they make it easier to stay on the right side of the law as treating someone (particularly a prospective or actual tenant) differently than another one could amount to a violation of Fair Housing.

But the most important reason for systems and policies, at least in this author’s humble opinion, is that they lay the groundwork to scale your business. It’s important to remember scaling is not growth. Instead, scaling is what facilitates growth. Investopedia defines it as follows,

“Scalability refers to the ability of an organization (or a system, such as a computer network) to perform well under an increased or expanding workload. A system that scales well will be able to maintain or increase its level of performance even as it is tested by larger and larger operational demands.”

Growth for the sake of growth is the philosophy of cancer, which, left unabated, will eventually kill its host (the business). Only through scaling (which relies on systems and policies) can the foundation be laid to “maintain or increase” the “level of performance even as it is tested by larger and larger operational demands.” 

Only through scaling can you truly and sustainably grow a business. And even if you don’t want to grow that much, systems and policies will make your life a whole lot easier, shrink your liability and increase your profits.

The Key Point To Remember

I can’t think of anyone who has actually said this, but I do think there is an underlying assumption that many entrepreneurs believe you build your systems, and then you build your business. Or perhaps, you start off by building your business by going from one whim to the next, and then you realize you need systems, so you add those, and then you go back to building your business.

If I could ensure that this article accomplishes one thing, it would be to permanently remove this idea from your mind. 

Business does not work in such a sequential manner. Instead, you should be building your systems and policies in lockstep with your business. It’s an iterative and never-ending process. As you expand your business, you should be expanding and updating your systems and policies. It never ends. Don’t expect it to.

Learning and Borrowing From Others

Of course, that doesn’t mean you need to start from scratch and feel your way through the dark to only learn from hard-fought (and expensive) experience.

There are plenty of good sources to learn from, including here at BiggerPockets. You should be regularly reading articles (on real estate and business in general), reading books, listening to podcasts like the BiggerPockets Real Estate podcast, and attending meetups and conferences. You should definitely be involved at your local Real Estate Investors Association or BiggerPockets meetup groups and ask seasoned investors about their various systems. Trust me, people love to talk about themselves. They’ll open up.

There are also four books, in particular, I would recommend reading when it comes to systems and policies. Any business owner should read through these:

The E-Myth Revisited by Michael Gerber

This book outlines the importance of thinking of your business like a franchise owner would, creating the policies that could be handed to someone else in another market to replicate. 

The Checklist Manifesto by Atul Gawande

Gawande highlights the incredible improvement all sorts of organizations have made by simply having and following checklists for recurrent tasks. You should definitely start making these. We have developed checklists for creating scopes of work, screening residents, moveouts and deposit disposition, analyzing properties, due diligence, and financing properties, etc. Having these and following them dramatically reduces mistakes and oversights.

Traction by Gino Wickman

Wickman goes over creating an EOS (Entrepreneurial Operating System) that covers every part of your business and then hones and streamlines them as best as possible. 

Scaling Up by Verne Harnish

Harnish might as well take the torch from where Wickman leaves off when it comes to scaling. He particularly highlights the importance of creating key performance indicators (KPIs) to monitor and improve performance throughout your company. 

As a bonus, I would also add Getting Things Done by Gary Allen to systematize your own life. 

Of course, if you are a new investor, you don’t need to read all of these before you get started. But I would definitely get on reading them as soon as possible.

Laying the Groundwork

As soon as you can, you want to start building systems, even if that’s before you get started. (Although you should not use a lack of systems as an excuse to procrastinate, again, building systems is a never-ending process.)

You should start by identifying your core processes. As Gino Wickman notes in Traction,

“It’s surprising how productive this step is. This exercise creates clarity of thought that is then put down in black and white…just by calling your processes by a consistent name, you reduce complexity and increase efficiency in the organization.”

So, for example, in our business, we have the following core processes. Yours will likely be a bit different, but this should make it clear what you are aiming for.

• Acquisition
• Financing (private loans upfront)
• Refinancing (bank loans on the back end)
• Accounting
• Rehab
• Turnover
• Property Management
• Maintenance 
• Human Resources (hiring, firing, etc.)

We have then blocked these into several departments. So, I oversee acquisition and refinancing. My brother oversees human resources and assists in acquisition, and my dad is in charge of finding private lenders (financing). Thus, in our main office, we have four other departments that report to us:

• Property management
• Maintenance
• Rehab and Turnover
• Accounting

I don’t have the space here to go over each component of each department, so we’ll hyperfocus on one aspect to give a general idea. In this case, we’ll look at how a typical turnover is handled through the property management and rehab departments.

Our process is as follows, with the department in charge noted in parenthesis.

1. Visit the property and evaluate condition and damages (Rehab)
2. Create a scope of work for repairs during the same visit (Rehab)
3. Do a deposit disposition based on damages noted (Management)
4. Send that scope of work to one or more contractors (Rehab)
5. Evaluate the bids and make a decision (Rehab)
6. Verify work is completed and take marketing pictures (Rehab)
7. List property (Management)

This process requires several checklists and policies embedded within it. For example, we have a scope of work template in Excel for writing up scopes. We have a bid template in Smartsheet we send out to contractors. We have a deposit disposition template as well as a master availability list that shows everyone in the organization where things are at as the property proceeds from the management department to the rehab department and back.

Some of these templates are available free of charge. BiggerPockets itself has a long list of landlord forms, including applications and leases you can get for free. If you are a real estate agent, your brokerage and the MLS should also have such forms.

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As you standardize your processes, you should also standardize your materials. Use the same paint colors (or just a few), vinyl, countertops, appliances, etc., for your rehabs and turnovers. This will make it simpler to acquire and replace these items and also make it more likely you can simply make repairs or do a touch-up rather than a full replacement.

Now, this probably sounds like a lot. It is. You may be just starting, and the idea of having departments could sound ludicrous to you. That’s completely understandable. It was how I would have felt not too long ago. Remember, building systems is an iterative process. Build your systems for you in the meantime, and soon enough, you will be hiring others who you will want to make sure to follow those very same systems. Trust me, you will need to be continuously building and changing your systems and policies as you grow.

Indeed, we have a whole smorgasbord of old Google sheets and Word documents in what we refer to as the “Google Docs Graveyard” meandering about the cyberspace. There will be plenty of false starts and curveballs no matter how well laid your plans are.

The Iterative Process of Building Systems and Making Policies

Again, there’s only so much you can do upfront. As you go, you will run into all sorts of problems that you hadn’t thought of nor planned for. These unique problems, however, are great opportunities to systematize your business. 

Indeed, with each new decision you make, you should attempt to create a system or policy out of that. Don’t just fly by the seat of your pants as problems get thrown at you. Yes, it takes more time in the beginning to systematize and/or create policies. But this is a Quadrant II activity (important but not urgent), as Stephen Covey discussed in his classic book The Seven Habits of Highly Effective People. These are the tasks that reduce the amount of time you need to spend on such issues going forward. 

These Quadrant II tasks “maintain or increase” the “level of performance even as [your company] is tested by larger and larger operational demands.”

These Quadrant II tasks are the ones you need to prioritize.

To give you an idea of how this works, here are a few examples we have had to deal with and the solution we have come up with:

Problem 1: Cockroach infestation at a house three weeks after a tenant moves in.

Policy Solution: If infestation is within the first month of tenancy, it’s on us (they were likely there when the tenants moved in), afterwards, the cost is on the tenant.

Problem 2: Tenant constantly pays late, clogging up management resources.

Policy: Allow for one payment plan per year. Afterward, an eviction notice will be filed, and the tenant will either need to pay the whole balance or set up a time to leave.

Problem 3: A maintenance order takes way too long, and it was our fault.

Policy: In such cases (when it’s not so egregious, we would consider a rent discount), we offer a gift card to their favorite restaurant (which we ask for when they sign the lease) to smooth things over.

Of course, not everything can be systematized or made into a policy. On a recent portfolio purchase, a tenant gave notice to leave to the seller while we were under contract. Their lease, however, went for another six months. The seller had been soft about enforcing lease terms, so the tenant thought it would be fine. And they just got a house under contract to buy and couldn’t afford both the mortgage and the lease. In this case, we asked the seller to prepay two months of their rent, and we would call it good and let the tenant out of their lease. He agreed.

You can’t really create a policy for such a specific situation, but you can for many. And you can create broad outlines of how to respond to really unique circumstances (i.e. if, while under contract, the seller wants to let a tenant out of their lease, we expect to be compensated for it). So, while it’s impossible to cover every scenario, and you certainly need to leave room for flexibility when it comes to many decisions, you can still systematize and make policies for a lot of ground. 

And that will go a long way to scale your business and facilitate future growth (and continued sanity). 

Key Performance Indicators

As you go, you will want to start developing KPIs for each major area of your business. Broad indicators for your company are pretty simple and should include things like:

• Gross Income
• Net Income (after operating expenses)
• Cash Flow (after debt service)
• Change in Income Year over Year
• Occupancy Rate
• Delinquency Rate
• Units Bought this year

But these indicators are very broad and don’t tell you a lot about why things are the way they are. Thereby, you also want to nail down KPIs for managers, or in the high likelihood that you don’t have managers, departments, or areas of your business.

While it’s true that you may not know whether the number you get with any given KPI is good or bad, you know what’s better and what’s worse. So you know which direction things are going and also have something to aim for, which clarifies your (or your manager’s) goals.

Here are some examples that we track for different departments:

Acquisition

• Properties Acquired
• Units Acquired
• Average All-in Price per Property
• Average ARV
• Rehab Estimate
• Rehab Actual/Rehab Estimate

Turnover

• Total Rolling Days of All Properties in Turnover (at end of the month)
• Average Days from Possession to a Finished Scope (for month)
• Average Days from a Finished Scope to Market Ready (for month)
• Projects Completed that Month
• Average Cost of Turnover

Property Management

• Deposits in Month
• Deposits Minus Moveouts
• Percent of Potential Rent Collected (i.e., delinquency)
• Lease Renewal Percentage
• Occupancy Percentage
• Average Rent Increase
• Total Rolling Days of Properties Available for Lease on Market (at end of the month)

Maintenance

• Closed Work Orders (in month)
• Work Orders Outstanding/Closed Work Orders
• Average Time to Complete Work Order (in that month)
• Number of Work Orders that took Longer than 48 Business Hours to Visit
• Call Back Percentage

Those are, of course, just what we do. Yours don’t have to be the same. But they do give you a good idea of how things are going. And while monthly anomalies shouldn’t be surprising (particularly with things like “Average Cost of Turnover”), these aberrations should work themselves out over the long run and give you a good idea of how things are going.

And if you do have managers, they are a great way to evaluate their job performance without micromanaging or blindly trusting them.

One last note here, in order to track your KPIs effectively, you need to have quality accounting. In addition, in order to sell at top prices and get banks to lend to you or just know whether you’re solvent, it’s critical to have your accounting in order. This is not something to skimp on. Make accounting a priority and either learn accounting or, better yet, outsource or hire someone capable of doing it.

I can’t tell you how many times I’ve seen small investors selling a property with horrible accounting. Such a state of affairs not only reduces the value of their asset but it makes it all but impossible to scale.

Conclusion

Systems and policies are essential for scaling, and scaling is essential for growth. But again, the biggest takeaway here is not just that systems and policies are good and necessary, it’s that building them is an iterative process that never ends. 

Don’t be scared or overwhelmed by the thought of them. Every entrepreneur starts with zero systems in the same way every real estate investor starts with zero properties. But in the same way, you don’t intend to stay at zero properties, you should intend to grow your systems alongside your company. Back forth, around and around, forever and ever.

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.

CNBC’s Diana Olick, joins ‘Squawk on the Street’ to discuss existing home sales numbers slowing, year-over-year price declines in home sales, and the factors weighing on higher-end home buyers.

Ashley:
This is Real Estate Rookie episode 236.

Pace:
People confuse debt and ownership, meaning I can take over payments on a house and people go, “How? Don’t you have to pay off the debt in order for you to become the new owner?” No, I don’t. Think about it this way, if I go into a grocery store and I use a credit card and I buy a bunch of groceries, who’s the owner of those groceries if I use a credit card to buy them? How do you know that? If I use somebody else’s money, how am I the owner of those groceries?

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. And I usually read a review at this point, but I didn’t pull one up. So I’m just going to ask you guys, leave us an honest rating and review on whatever platform it is you’re listening to and we’ll give you a shout out on the show. So Ash, we have an amazing guest, one of my favorite episodes we’ve done recently, we have Pace Morby on the podcast, and this was an encyclopedia of everything subject two.

Ashley:
And we are going to have him back on and do a live workshop. So we’re super excited about that, too. But Pace talks about creative financing, so doing subject two deals, and seller financing, breaks down what the difference is between them, who is the motivated seller to actually want to do these deals with you, how to negotiate, what the steps you take to actually get these deals done.

Tony:
He also talks about how a truck with over 300,000 miles is what prompted his whole journey into creative finance. It was a really great story, so make sure you listen for that as well.

Ashley:
So once again, we are live from BP Con. We are taking every advantage and opportunity of getting to meet people in person and get them into our interview room here that we have set up that is actually sponsored by Pace. So thank you very much for that, Pace. Welcome to the show. Thank you so much for joining us on our morning talk show, or evening talk show.

Pace:
This is amazing. Look at this backdrop you guys have. They made this just for you guys.

Ashley:
No, it’s just for you. All the other guests have come in here, it was nothing. Then they brought this all on when you came in. But for anybody that doesn’t know you, just tell us a little bit about yourself and actually how you got started into real estate.

Pace:
Oh, great question. So I came from a family of 12 kids, so 12 kids in my family, I’m number three, nine kids underneath me, same mom, same dad. And when I was growing up, my parents were in the construction trades. I learned how to work really hard, blue collar background, and my dad could never afford the house, the size of the house, that he needed to house all the kids he had. So he had a job as an accountant and then moonlit as a contractor. And so my whole life growing up, my parents lived in sub two houses, seller finance houses, lease option houses in order to afford those houses. So that was like my background in real estate and creative finance. But when I got older, I became a contractor and I was Opendoor’s main contractor for seven years.
So I opened up their markets and that’s how I got into construction and got into the real estate world. And one day somebody comes up to me and they go, “Pace, why aren’t you in real estate?” I’m like, “What are you talking about? I am in real estate.” And they go, “No, no, no. Opendoor’s in real estate, you’re a service provider.” And I was like, “Oh my gosh,” and it hit me right in the chest. And I knew that I had to make a deviation into doing projects and construction and stuff for myself. And so luckily I met some people at some meetups, a lady named Brittany, and she says, “Here’s how you do it, here’s how you send out postcards, here’s how you do this.” And I got my first deal 10 years ago, roughly, and it was through a postcard, it was a wholesale deal, and that’s how I got into real estate.

Tony:
So we talk all the time, Pace, about the power of networking and building relationships, and we were just talking about this before we started recording as well, and something we tell all of our audience members is that if you want to get started in real estate investing, oftentimes it’s such a scary and lonely path, and the best way to get past that is by networking. And it’s so funny that the person that you met at a meetup was the person that kind of changed your life trajectory because the same thing happened to me. I met a guy at a meetup, we invest mostly in vacation rentals, and I met a guy at a meetup and it was that guy that introduced me to Airbnbs. Now we’ve got a portfolio across multiple states. So it’s like you never know where that one connection might take you.

Pace:
Yeah, it’s empowering. So when you’re looking at this path of real estate, if you look at it like everybody only has one flashlight, I can only light the path in front of me so far and so I’ve got to find other people with other flashlights on the same path. And so I’ve got to just put people on that path in front of me that have a flashlight too, that light it just far enough, and you’ll get far enough down your path, you’ll get your first deal, your second deal, and you turn around, you look back and you go, “I have never made a dollar in real estate by myself.” Have you guys ever made money in real estate by yourself?

Ashley:
Actually, no.

Pace:
So think about that. If you guys are at home, you’re a rookie, you’re a newbie, you’re just starting in here, if you’re consuming content, no matter how much content you take in or any education you take in, you have to apply that with other human beings. So you have to network, it is an absolute requirement. It’s not a suggestion, it’s not a great idea, it is an absolute requirement. Every single deal we’ve all done has had other people involved that you’ve had to network with in order to get those deals done. Unless you guys… have you ever done a deal where you’re like, “I didn’t need anybody else?”

Tony:
No.

Ashley:
No.

Pace:
Isn’t that weird to think about?

Ashley:
It is.

Pace:
Nobody talks about it. But two weeks ago I was like, “Oh my gosh, I’ve never made a dollar in real estate by myself.”

Ashley:
So in the beginning, when you mentioned your parents talking about how they were able to purchase properties, you mentioned a couple terms, subject two, can you talk about those different creative financing deals and explain what those are?

Pace:
So most people look at buying a home, you got to go through a bank. You go down to Chase, Bank of America, Quicken Loans, and you apply, you get a loan and you acquire a house, right? It’s based on your credit, how much cash you have and your credentials, like how long you’ve been at your job, what kind of job do you have, your degree, those types of things are important, credit score, blah, blah, blah. My parents, no matter how good their credit score was, my dad’s income during the day was a… he was a CPA, so he made $60,000 a year, but he had 14 people in his household. So how is my dad going to afford living in a eight bed, five bath house, making $60,000 a year? He’s not.

Ashley:
And paying for all the food, clothes, everything else.

Pace:
Right. And so what my dad did, bless his heart, he would come home from his CPA job and then he would run a painting company, but his painting company was all under the table, so it was non-documented cash. So a bank’s not going to look at that and go, “Okay, you’re approved for a bigger house.” So what my dad did is he went directly to the owners of properties, he goes, “Oh, there’s an eight bed, five bath house, or a seven bed, four bath house, my kids and my wife and I could live in there.” And my dad would go to them and say, “Why don’t we just work out a deal, instead of me going to the bank and applying, you become my bank?”
And I didn’t really truly understand this until later in life, but I realized that creative finance, like the ability to buy anything without your own cash, without any credit and without credentials, applies to everything, even things outside of houses. And it wasn’t until I was a contractor, like I mentioned earlier, that it really hit home with me. My dad didn’t teach me this stuff. I just knew we lived in bigger houses than my dad could qualify for and my dad would stay, say stuff like, “Own or carry, sell or finance,” and because I was a teenager and a knucklehead, I didn’t take the time to learn it. And my dad also didn’t utilize those strategies as an investment strategy, he only used them to get his family into a bigger house.

Ashley:
It was more survival more, really.

Pace:
Survival. So when I became a contractor, I have this story that really hits home of what seller finance is. It’s my F-150 story. Have you guys ever heard this story? It’s cool.

Ashley:
No, I don’t think so.

Pace:
All right, great. So I have this F-150. I’m a contractor. My guys are driving the truck. The truck hits 320,000 miles. Okay, well now I’ve got some problems. This truck’s starting to have issues. So I go, “Okay, well I’ll take it out of my fleet and I’ll throw it out on Craigslist and I’ll sell this thing and I’ll take that money, go buy a better truck, something with less problems.” So where do we go when we want to find the value of a car?

Ashley:
A Kelley Blue Book.

Pace:
Boom, Kelley Blue book. So it’s like Zillow for cars, right? So I go on Kelley Blue book and the truck says it’s only worth five grand. And I’m like, “Okay, well if I sell my truck for $5,000 on Craigslist, Facebook marketplace, Offer Up whatever, am I going to get $5,000?”

Tony:
Probably not.

Pace:
No. Because somebody’s going to come along and be like $3,500 all cash today, as if like… what else were you going to pay with besides cash? You know what I’m saying? So I decided not to put it up for sale for five grand, I put it up for sale for $10,000 because I’m a belligerent seller. And I go for 10 grand and I’m thinking, “I don’t need all the buyers. I just need one buyer that would pay 10 grand.” Well, three months goes by, I don’t sell the truck. So my wife comes in to me, she goes, “Why don’t… you know how your dad used to buy houses where he would just get the sellers to let him make payments? Why don’t you sell your truck on payments?” And I’m like, “Oh my gosh, that’s so freaking genius.”
So I go back to Craigslist where I had the truck for sale and I changed one thing and it was, “F-150, will take payments.” So did I sell that truck for 10 grand? I sold it for $12,500 and I let the buyer just make monthly payments to me. And I was like, “Oh my gosh, I did this with a truck, why can’t I do this with a house?” Now you might ask yourself the question of, “Well, why did Jose,” the guy who bought the truck from me, “why did he pay $12,500?” I also learned that the value in anything is not based on the purchase price. The value, this is important for people that want to learn creative finance, the value of anything is based on what you can do with the thing you bought.
So he looked at that truck, he made me $350 payment, but he turned around and earned $7,000 a month in a painting business he used for that truck. So did he overpay for that truck? No, he didn’t have to use his credit, he used a thousand dollars down payment to get into a truck he couldn’t otherwise qualify for and I was like, “I need to be doing this in real estate all the time. I can go acquire anything I want this exact way.” So I call my dad and I go, “Is this what you’ve been doing?” He goes, “Yes, every single house I bought.” And so I go, “Well, what about people that have payments on their cars or on their house?” He goes, “Oh, you can just take over the payments.” I’m like, “You’re joking me. I can just take over somebody’s payments on their car?”
And he goes, “Yeah, go to lease trader.com. You can take over somebody’s lease right now. In two minutes, you want a BMW X5, you want a G wagon, you go to lease trader.com right now and you can take over somebody’s G wagon, just take over their payments.” And I was like, “You can do this with houses?” And that’s what subject two is. Subject two is a seller sells their house to you by you just taking over their existing payments. You don’t have to qualify, you don’t have to do anything, just take over their payments. And seller finance means that the seller had the house paid all the way off, and they create an agreement with you that says, “Hey, just make the payments to me.” And I was off to the races and we’ve now, just this year, we bought 600 multifamily deals with seller finance… or with creative finance, and we bought about 70 single family homes all through creative finance, just this year alone.

Ashley:
That’s awesome. Congratulations.

Pace:
It’s pretty cool, pretty cool.

Ashley:
When you had that conversation with your dad, were you already purchasing property, you were investing in that?

Pace:
I was doing some wholesale.

Ashley:
And how did that pivot and change for you?

Pace:
Everything. Because there’s a KPI, if you guys don’t know what the word KPI means, it’s key performance indicator, the number one KPI I looked at in my business at the time as a acquisition person buying deals was cost per contract. So how much money in marketing did I have to spend in billboards, TV, radio, postcards, letters, SEO, PPC, whatever it was, what was my cost per contract? And if you’re a wholesaler or you are somebody out there trying to fix and flip, the average cost per contract when you’re spending money on advertising is about seven to $10,000 depending on what part of the country you’re in.
So you go, “Okay, I want to go out and find my own deals direct to seller.” Well, you’re going to have to spend seven grand in marketing. That’s daunting and scary for somebody that’s brand new. But with creative finance, my cost is zero. And so for me, when I was wholesaling, I go, “Oh my gosh, I can go to other people’s sellers,” like a real estate agent or another wholesaler and go, “When you have a seller that wants too much money, I’ll buy it on seller finance, and when you have a seller that has no equity, I’ll buy it on subject two.” And it changed everything for me. And my cost per contract went to $0.

Tony:
So Pace, you talked about your motivation for selling the truck, seller finance. If I’m a new investor, can I make the assumption that the motivation for homeowners is the same as your truck? What would prompt someone to want to sell their home subject two or a seller finance?

Pace:
Okay, so let’s talk about the difference between subject two and seller finance. So subject to typically, like I’d say 80 to 90%, I haven’t done the math on this, but just my gut experience, 80 to 90% of the time on a sub two deal, the seller’s in some sort of pain, they’re in foreclosure, they’re going through a divorce, they don’t have equity, a lot of times they refinanced their house last year, they pulled all their equity out, now they want to go sell, they don’t have any equity, so they can’t sell without cutting a check. So that’s subject two, that’s typically that pain. So if you guys are looking for a sub two deal, a really great place to go is expired listings, agents. What market you’re in…

Ashley:
Buffalo.

Pace:
Buffalo. You’re doing deals in Buffalo? I don’t know why I thought you were doing deals in Florida.

Ashley:
No, no.

Pace:
Maybe I saw you guys on vacation in Florida.

Ashley:
Probably.

Pace:
That’s what it was.

Ashley:
We’re down there like every month.

Pace:
Okay, there you go. That’s why. See, I follow you and I thought you were doing deals in Florida. So expired listings are a really great way to find sub two deals. Seller finance is not pain, it’s gain. The seller of a seller finance deal wants one thing and one thing alone… now, there’s other benefits than this one thing, but the one thing that they care about anything else is they want to win the negotiation, which means they want the top line price to be as high as possible. So I’ve got a deal in San Angelo, Texas, I just closed 30 days ago, it’s a 43 unit deal, seller’s name is Mario, seller finance, seller gave me $0 down, 4% interest and he gave me 50 year note. Crazy, right?

Tony:
50 years?

Pace:
50 years. I took Eric, my video guy, over there, and it was just like jaw dropping to watch me negotiate this deal. Why would Mario do that? Well, number one, the property, 43 units, is only worth 2.7 million. I paid three million. Did I overpay for the property? I think most people go, “Yeah, you overpaid for the property.” But I go, I didn’t put any money down, it cash flows on day one. I have zero cost of capital. Why would Mario do that? Well, he got $3 million on paper, he’s charging me interest 4%, he avoided going through an agent, so he didn’t have to pay 6% to agents, he didn’t have to pay the closing costs, no appraisal. When you guys are in the commercial world, like multi-family, appraisals are expensive, surveys are expensive, we avoided all of that stuff.
So if you compare him getting three million at 4%, he’ll end up getting about $6 million over the term of the loan. But where do those payments go? They go to his children. So when he passes away, he doesn’t need the three million, he’s like, “I’m worth a hundred million dollars, I don’t need the $3 million right now.” So the biggest reason is sales price. The second biggest reason is that it mitigates their tax liability. So imagine if Mario, who bought that property for a million 20 years ago sells it to me for three million 20 years later, how much in taxes he is going to have to pay?

Tony:
That’s a big tax bill.

Pace:
Massive. He has a $2 million gain. So he’s got a big influx of cash that comes into his bank account, now he’s got hundreds of thousands of dollars of tax. But if we spread that out over 30, 40 years, what he can now do is every year he can offset the money he receives with other tax right offs. So essentially being zero tax liability on that deal.

Ashley:
Okay, so now that everybody listening knows that, they know the advantages, they know what they are for the seller, What happens when you’re actually negotiating with the seller? You’re face to face with them, do you do it on phone, what’s your typical setting? And then how do you actually convince them or pitch this or give them some key points, I guess, or tips?

Pace:
I love that. So here’s the great thing about creative finance, it’s easier than cash by far. People think, “Oh, I’m going to start with wholesale or I’m going to start with fixing and flipping and I’m going to start with BRRRR.” Guys, no offense to any of those, I do all of them, they’re all great, they all work incredibly well, but in order for me to do a wholesale deal, I’ve got to offer 60 cents on the dollar, 50 cents on the dollar. In creative finance, I can pay 80, 90 cents on the dollar and make actually more money than the person who paid 50 cents on the dollar.
The greatest part about it is that creative finance is the only thing that is… it’s not a zero sum game, which means the seller makes more money, it doesn’t take money out of my pocket. In a cash transaction, I have to low ball a seller in order for me to make money on my flip or in order for me to have a good refinance on a BRRRR. In create finance, no banks needed, no credit needed, so I can pay the seller more on paper and when I’m talking to a seller and they go, “Well, why would I do that?” And I go, “Honestly, why would you let somebody pay 60 cents on the dollar? Why wouldn’t you let me pay 90 cents on the dollar of what it’s worth?” What would you rather do, go into appointment and pay 90 cents on the dollar or 50 cents on the dollar?

Ashley:
50 cents.

Pace:
Really?

Ashley:
No.

Pace:
No, I mean in terms of as a salesperson.

Ashley:
Yeah, as a salesperson because-

Pace:
As a sales person.

Ashley:
… you’re going to get the commission.

Pace:
No, no. Let’s say that you’re a wholesaler.

Ashley:
Okay.

Pace:
And your job is to go in and get a contract with a seller directly. There’s no agent, you’re not the agent, you’re just acquiring the deal. You have to convince that homeowner to sell their property to you for 50 cents on the dollar to be a wholesaler. But in creative finance, I can tell them to sell it to me at 90 cents.

Ashley:
So, okay. So yeah, so they’re going to be more willing to make more.

Pace:
They’re making way, way more. The second they see how much more money they’re making, it’s like why would they ever sell on cash?

Ashley:
So, okay to clear it up is you’re saying that you’re able to make the numbers work at 90 cents on the dollar and that’s the advantage?

Pace:
Yeah, all day long.

Ashley:
Okay.

Pace:
So for example, if I go out and if I did that same deal with Mario and I had to buy it cash, I would’ve had to given him $2.4, $2.5 million to make it work and guess what I would’ve had to do? Qualify for a loan and then go raise $700,000 from partners or investors and give that $700,000 worth of ownership to those investors. So now I’m into that deal with a higher interest rate, I had to pull my credit, I had to raise money, give up ownership and the seller actually got less money.

Ashley:
Okay, so let’s break that down even more. How are you figuring out what that purchase price is? So are you working backwards then?

Pace:
We’re always working backwards. So the number one thing I always ask… So when a seller’s… I go, “What are you looking for?” Mario says, “I want $3 million.” I go, “Great. If I was able to come up to $3 million, could you give me terms?” Mario says, “Sure, I’ll give you terms. What are you thinking?” And I go, “Well, here’s the problem, Mario. Most of my deals I buy are $0 down, 0% interest. So I doubt you’ll want to do a deal with me.” He goes, “I’ll do $0 down, but I will not do 0% interest.” I go, “Okay, well what are you thinking?” This is all recorded by the way, I record most of my appointments. “I’ll do 4%.” I go, “Okay, great. Do you want a balloon?” He goes, No. If I do a balloon, I still have the same tax problem. I’d rather just let you make payments to my kids even after I’m passed away. My kids keep bearing the interest, it’s a great investment.” So that’s how… literally was like a four minute conversation.

Tony:
So Pace, are you specifically looking for… you talked about failed listings as one way, you talked about talking with wholesalers or agents that the sellers are maybe asking for too much, but say I don’t have a relationship with an agent, say I don’t have a relationship with the wholesaler, I’m brand new, am I just going on the MLS looking for listings that say seller financing or creative financing? What other ways can I…

Pace:
You could do that. So you could go on the MLS. If you are an agent, you could go on the MLS. If you go on landwatch.com, have you guys ever heard of Land Watch?

Tony:
No.

Ashley:
No.

Pace:
It’s so gangster. It’s a great website. If you go to Land Watch, Land Watch has 11,400 seller finance listings right now on their website. 11,000. That’s nationwide. If you go on your MLS, you’ll average, depending on the market, you’ll average about a hundred seller finance listings per one million population. So there’s a lot of seller finance stuff out there. But let’s say that I’m brand new, I don’t know any of that, what list do I go pull? I would go to listsource.com or wherever you guys… if you guys are using PropStream, they’re a big sponsor of this event, Foreclosures, huge.
Right now, this is what I love doing too and you guys should have me back, I’ll call Foreclosures with you guys. We’ll do it. Tell them in the comments, tell them whatever I will call Foreclosures live. So Foreclosure list is the easiest. We can get a deal in 15 minutes. Hands down, easy done. Foreclosure is really good. Expired Listings is really good. People are going through divorce, people are going through bankruptcy, typically that’s sub two deal. Seller finance is a high equity list, so you can literally pull a list on ListSource that says people have their house paid off. Or you can see people that have owned a property for over 10 years, that typically is a really great seller finance opportunity too.

Tony:
So once I find someone Pace, and I’m like, “Okay, this person’s a good candidate for seller finance or sub two,” how do I structure that in a legal sense that they don’t just run away with the property or try and kick me out after I moved in?

Pace:
Well, he who has the deed is the one that controls the property. So it’s set up the same paperwork that you go to… if you go to Bank of America and you get a loan from them, it’s literally the same paperwork. So it’s no different than anything else. Same paperwork, same documents, same ownership goes to you. It’s not some under the table, weird thing. The deed comes in your name. Nobody can change anything about that. So think about this too, this is something that confuses a lot of people, people confuse debt and ownership. Meaning I can take over payments on a house and people go, “How don’t you have to pay off the debt in order for you to become the new owner?” No, I don’t. Think about it this way, if I go into a grocery store and I use a credit card and I buy a bunch of groceries, who’s the owner of those groceries if I use a credit card to buy them?
How do you know that? If I use somebody else’s money, how am I the owner of those groceries?

Tony:
Cause you bought them.

Ashley:
You take them home.

Pace:
Okay, so great, I love that. So two reasons why. One, I have the ownership physically, but couldn’t somebody just come up and steal those from me? They could, but the second thing I have is I have a receipt and proof of purchase. So in real estate, the receipt of real estate is called the deed. Whoever holds the receipt is the owner of those groceries, so whoever holds the deed is the person who holds that property. So think about this, I go to grocery store, I buy groceries with an American Express and I’m walking out into the parking lot and I walk up to you and I go, “Hey, I see you got those groceries. What’d you pay for them?” You go, “200 bucks.”
I go, “I’ll pay you $225 for those.” And you go, “Okay, I’ll make 25 bucks like that.” And I go, “But one caveat, I’ll just pay your credit card payment for you.” I just subject twoed your grocery bill. So the credit card payment and the ownership are not the same. And so people don’t understand that I can just go and transfer a deed 25,000 times in two days, but the debt just stays in one place. The American Express bill stays in the same place, nothing alters, nothing changes, nobody does anything to it. It’s just whoever is currently holding the deed makes the payment to the mortgage. So a subject two deal is the seller’s name stays on the mortgage, your name stays on the deed, you’re the owner. Nobody can take the deed from you without a legal transfer.

Ashley:
I actually did one subject two deal, and it was actually before I even learned who you were, and we had had a guest on the podcast who had kind of taught us a little bit about it, but I wish I would’ve found you because it would’ve made the process a lot smoother. It took I think over a year to actually close on the property just because my attorney wasn’t familiar with it and get everything… all the ducks in a row. But as I did it, I… it was a farm. So there was lots of pieces moving with it and dealing with this farmer, he didn’t really know a lot and it was answering his question. Cause some of the common questions that he had, and I had, so the first one is how do we know that the mortgage isn’t going to be called because of the change… for the due-on-sale clause?

Pace:
Okay, she’s talking about the due-on-sale clause. So the due-on-sale clause happens about one out of every 5,000 sub two transfer. So it’s going to happen. And if you do a lot of sub two deals, you will run into a due-on-sale clause. There’s very typical reasons why the due-on-sale clause gets called. Number one, improper paperwork. Upfront, you use the wrong paperwork. Number two, you didn’t transfer the insurance properly. And number three, you’re a knucklehead and you stopped making the payment. Those are the only three reasons you’ll ever get the due-on-sale clause called. Then when a due-on-sale clause gets called, which it does happen, it’s happened to me five times. You need to know how to handle it.
So why did the due-on-sale clause get called? It’s because you transferred the… or the farmer, me, I transferred the ownership, the receipt of my farm, over to you, I gave it to you. And the bank sees that we transferred ownership and they go, “Hold on, you just took ownership of this farm, but there’s a loan in that farmer’s name still, you need to pay that off.” Legally you don’t have to pay it off. The bank has the right to call it due, not the obligation, but they have the right to say, “Hey, we want Ashley to pay that now.” So how do you handle it when you run into it? How do you handle the due-on-sale clause? How do you get rid of it so easy?

Ashley:
I don’t know the answer, do you?

Pace:
I don’t know either, yeah, no.
Okay, so the way you get rid of the due-on-sale clause is one, make sure you did your paperwork up front, two, make sure you did your insurance properly and three, make sure you make your payment. But if it does still get called, which is very incredibly rare, what do you do? The deed is what triggered the due-on-sale clause, so what do we have to do?

Tony:
Transfer it back.

Ashley:
[inaudible 00:26:14] deed back.

Pace:
Transfer the deed back to the farmer and repurchase it on a lease option where your option price is the mortgage balance the day of your execution. Does that make sense?

Ashley:
Yeah, it does.

Pace:
So it’s technically a… it’s still a sub two deal, but you haven’t transferred the lease… or you haven’t transferred the deed.

Ashley:
So my second question-

Pace:
I got that from a bank by the way. So I’ll tell you how this happened. So I had a property on Lost Dutchman trail. The seller was in foreclosure and we reinstate the foreclosure, he was behind like $20,000, but we reinstate the foreclosure the day before we transferred the deed. And why is that a problem? Well, because the bank that had the loan, they’re a small bank, Johnston Bank, shout out Johnston Bank. They only had five branches. So the president of all the branches was the person actually handling the foreclosures. So we reinstate the loan, we closed the deal the next day and the following Monday he goes to his stack of manila folders and he goes, “Oh, Lost Dutchman is now no longer in foreclosures.” So he goes to reinstate it. It’s just a slow process for them, they did a couple days after we had already closed on it, and he goes to reinstate the loan and he sees that we transferred the ownership.
So he physically manually saw… nobody’s calling due-on-sale clause unless it’s like a situation like that. So they send out a letter, we get the letter two, three weeks later, I call the guy myself, the branch owner, and I go, “Dude, we caught up the mortgage payments. Why are you calling the due-on-sale clause? We’re making the payments.” He goes, “Oh, it’s just bank policy.” I go, “Okay, well,” and he sounded nonchalant, like he ran into this a hundred times, I go, “Okay, well what do you suggest I do? Because I bought this subject two and I caught up the payments.” And he goes, “Oh yeah, easy. All you do is just deed it back to them and then rebuy it on a lease option and the option price is the mortgage balance the day you execute the option.” I was like, “Done, thanks, have a good day.” Pretty simple.

Ashley:
Yeah, that is.

Pace:
So that’s one of five ways to overcome the due-on-sale clause, we can talk about another day, but that one’s really simple.

Ashley:
So follow Pace if you want to learn more about that.

Pace:
Yeah. If you want to get nitty gritty, this is not rookie stuff, but the reason why don’t I just originally buy on a lease option with the option price being the mortgage balance?

Tony:
Because you want the deed.

Pace:
I want the deed because when I have the deed, I get the tax benefits and the tax benefits allow me to not pay any taxes every year.

Ashley:
So my second question for that would be on the seller side is, okay, the mortgage is still in their name. How do they go and get another mortgage? And this is-

Pace:
So DTI coverage.

Ashley:
This is actually how I found you because this was the last piece of the puzzle, the last question I needed and that’s how I found you.

Pace:
Love this. Okay, how does any investor go and get another loan when we go get multiple loans on… and you guys are going and getting Airbnbs and you’re investing, How do you get more loans?

Tony:
You have to show that there’s income on the other properties.

Pace:
There you go. So it’s the same thing. So when I get a seller, so I had one of my favorite deals I ever did, Dave Biarsky. Okay, so here’s what happens. Dave ski driving home one day, he gets a wild hair and he is driving home one day from work and he sees a new home development across the street from his development where he’s lived for 19 years and he turns in there, he goes in, gets suckered into a $20,000 non-refundable deposit on a brand new build, drives back over to his house and his wife’s like, “Hey sweetheart, where you been? I haven’t seen you. You usually home on time.”
He goes, “Babe, I just bought as a brand new house.” And she goes, “Oh my gosh, this is amazing. Can we turn this one into a rental or something?” And he goes, “No. The lender over at the new home build said we have to sell this house in order to qualify for the new house. We can’t have two houses.” She goes, “Okay, no problem. Let me call my friend who’s a real estate agent and let’s have them list the property. It’ll sell in two months and that house will be done in six months. It’ll be perfect. We’ll rent for a couple months, it’ll be perfect timing.” You following me? Okay, so five and a half months later they still haven’t sold the house.

Ashley:
And it’s coming time to close on that new house.

Tony:
Yeah, they got two weeks.

Pace:
It’s coming time to close. They’re going to lose their $20,000 non-refundable and they’re going to sell that house to another person. The agent on that listing calls me up and goes, “Pace, I saw that you do this creative finance stuff, what do we do?”

Tony:
Wait, and had you ever met this agent before? Did you have a relationship with them?

Pace:
I saw her at a meetup and I was like, “Hey, if you ever have-

Ashley:
The power of networking.

Pace:
The power of networking. So I go up to people, I go, “Hey, if you ever have a seller that has a hard time selling their listing because they have lack of equity, come to me.” The seller had lived in the property 19 years, why doesn’t he have equity? Cause he refinanced, pulled out all his equity out of the deal. So he has no equity. Now you’re telling a homeowner that just put $20,000 on a new home build that he’s going to have to write a check to sell this house. Is that the only money he’s going to have to pay to close out on that house?
No, he’s got the rest of his down payment, he’s got furniture, because everybody, when you get a new house, you’re pumped about your furniture. He’s like, “I got a barbecue thing, I got all the stuff I want to do and now she’s telling me I got to cut a check to sell my other one.” I go, “Well what if you didn’t have to write a check? What if you just walked from the property, let me take over the deed?” He goes, “No, I can’t do that.” I go, “Why not, Dave, it solves every problem in the book.” And he goes, “Because my lender on the new house says that I have to sell this house in order to qualify.” I go, “No, she doesn’t know what she’s talking about. I was a loan officer for years. Let me call her and talk to her underwriter.”
So I got on the phone with the underwriter, I’ve done this 400 times by the way, get on the phone with the underwriter, not the loan officer, if you’re talking to loan officer, they don’t know, they’re salespeople. I was a loan officer, we’re salespeople. Talk to the underwriter. So you talk to the underwriter and you say, “Hey underwriter, I’m buying this house subject two, I’m going to be making the payments. What do you need to see from me in order to wipe this off their debt to income ratio to qualify for the other one?” She goes, “Oh, he never told me he was going to do that. No problem.” So we write up our agreement. By the way, you should always use a servicing company when you do sub two and seller finance stuff. West Star is the company-

Tony:
Can you define servicing company?

Pace:
So a servicing company is, let’s say that you and I create a financial arrangement and we want to make sure there’s a non-interested third party watching what we’re doing, making sure you’re receiving it, I’m paying it on time, we would hire her as a servicing company to make sure. So there’s companies like West Star Loan servicing that you pay them $17 a month per house and they are the sheriff of every creative finance deal you’ll ever do. So I worked this out with Dave and Dave goes, “Holy crap, you solved every single problem in the book for me. I thought I was going to be in a world of hurt.” So debt to income ratio needs to be wiped out by the underwriter on the deal.

Tony:
So Pace, I mean first dude, thank you so much man. This has been a crash course on everything subject two.

Pace:
Oh yeah, I could talk about this for 20 hours.

Tony:
So I mean, last question for you, brother. So I just want to know, so given where we’re at with the economy, with inflation, there’s a lot of people feeling the sky’s falling, now is a terrible time to invest in real estate. Does subject two still make sense in this environment?

Pace:
My average deal I’m acquiring is 3.25%. My average BRRRR deal that I do is about seven and a half to eight and a half percent. So I honestly don’t know a market where subject two hasn’t made sense, will not make sense. Subject two is and will always be a strategy that will dominate. Right now it is winning big time. I’m being overwhelmed where people are like, “Oh my gosh, our listings went from 10 days on market to now 70 days on market, please whatever you got to do.”
So here’s a really good example for brand new people. I will randomly do this once a month or I’ll go in my local market in Arizona and go, “Anybody in Arizona come to my office today, We’re going to go… we’re going to do a group activity for seven hours today where I’m going to teach you guys what creative finance is and then we’re going to do a contest at the end of the day for 45 minutes and we’re going to get everybody on the phone and we’re going to see how fast we can get a deal.” So we just did this two weeks ago. First, where you go is you go, listings have been on the market for longer than 90 days, call the agent, say, “Hey agent, if you’re having a hard time with that listing, I’m okay just taking over the payments. Would you pitch that to your seller?” So in 45 minutes a group of a hundred people got six written contracts signed back from the agents done in 45 minutes. This market is incredibly easy. You’ll be pouring in with properties.

Ashley:
So when they’re doing that, are you guys looking up on PropStream or any other software?

Pace:
That’s where we got the list.

Ashley:
What the estimated payment is and mortgage payments?

Pace:
Yeah, so you’ll have the estimated mortgage. Here’s how you know, when you said structure, last thing guys, so sorry. Have them have me come back because I will come back and I’ll talk forever. Here’s how we know if it’s a good deal. I don’t care about purchase price. People send me stuff like, “Pace. I got a four bed, three bath or three car,” I’m like, I don’t care about any of that. What can I bring in on the property? What’s the highest and best value of that amount?
Same thing. I go to AirDNA, if it’s going to be an Airbnb, if it’s a sober living facility, I call a sober living company and I find out what I could bring in on that property and then I reverse engineer with the seller and I go, “Okay, if I can bring in three grand a month, the most I can pay the seller is $2,000 a month because I’ve got blah blah blah blah blah, expenses and whatever else.” So you reverse engineer and a lot of that information before we get to the negotiating part of the conversation, a lot of it we find on PropStream.

Ashley:
Yeah.

Pace:
Yeah.

Ashley:
Cause I think that’s such a… Are you finding that too with the seller, finding their motivation to… or what they want out of the deal? So if purchase price is important to them or interest rate, like they just know they want a high interest rate, but maybe you amortize it over 50 years or things like that. Are you thinking at all variables?

Pace:
Sellers typically don’t want a high interest rate unless they’re already a creative finance guy like me. When somebody goes, “Yeah, I’ll seller finance it to you, I want 20% down and 8% interest. I know he’s already… he’s probably already taken my course, or whatever, or he is been in the game for 20 years. Yeah. But if they go, “Oh yeah, what does that mean?” I go, “Great, you care about purchase price,” it’s kind of like a teeter-totter, “I’ll give you a high purchase price but you got to give me low down payment, low interest.” And they go, “Okay, no problem.” They care about the purchase price more than anything else.

Ashley:
Interesting.

Pace:
We have literally barely touched the surface of this. We could go on for hours.

Ashley:
I know, I feel like I’m going to be laying in bed tonight just like there’s so many more questions.

Pace:
Oh my gosh. The thing is I can’t go out and get a cash deal… I could get a cash deal pretty quickly, but I could guarantee you if you guys had me back, I could show you how we could get a deal under contract within an hour on the Rookie show start to finish, agent sending us a contract signed. It’s that simple.

Ashley:
Yeah, we should definitely do that.

Pace:
Guys, less information, more implementation, I would love to implement some of the stuff and do it live if you guys would have me back.

Ashley:
I think that’s part of the problem with the show is we get a lot of stories and what people are doing and stuff-

Pace:
Let’s freaking do it.

Ashley:
… but like the step by step, like doing a workshop, that would be so fun.

Pace:
I would love to. That’s what I… You get, and I know you guys are the same way, you start talking about these strategies, you’re like, “Okay great, let’s go. Let’s go buy something.” So if you guys have me back, I’d love to do that. It doesn’t have to be in person, but we even do it virtual, it’d be great. We could do the same thing.

Ashley:
Yeah. Cool. Well, one question I do have, because I think this would be for everyone that’s listening, where are you getting the proper steps and the proper documentation? So when I bought the farm, it was… my attorney had no idea where to even start with documentation.

Pace:
So I went and paid an attorney in my local state named Sean St. Clair. I have an attorney, actually brought him here to BP Con, had him on my panel. My attorney who I learned from for years and years actually was on my panel today. So I just go to an attorney that’s been doing creative finance and I had them draft documents and then the documents were great, but really you need somebody when you run into a specific situation, especially with a farm, there’s all sorts of weird things going on with farms, you need to have somebody that knows what they’re doing and the way I found these people was networking at meetups.

Ashley:
And that’s cool, the answer is basically just asking what their experience, if they have experience, in doing subject two.

Pace:
Yeah. Have you ever closed a sub two deal? We have a list actually because my job, or my goal, years ago with creative finance is, I said my overall goal is I want to normalize the conversation around creative finance. That’s my goal. If I accomplish that, I could die, I’d be happy. I want to normalize the conversation. One thing that we’ve done is we’ve found five title companies or title attorneys in every single state across the country and we’ve put them on a Google sheet. So if you guys want, I’ll give that to you guys, you can give it to your audience.

Ashley:
Yeah, we would love that. So we’ll put that into the show notes for you guys.

Pace:
There’s not a single state in the country you can’t do sub two, seller finance, novation agreements, wraps, [inaudible 00:38:51], you can do anything in all 50 states. Not just legal, it’s been getting done for hundreds of years.

Ashley:
Well, thank you so much Pace. This has been awesome.

Pace:
Have me back.

Ashley:
And also thank you for sponsoring this media room. We’ve been really taking advantage of it. This is our third podcast we’ve done today in here, so thank you. Yeah. But where can everyone find out more information about you?

Pace:
Go to BiggerPockts episode whatever I was on. It was the first one I was on in November of 2021.

Ashley:
We will also link that number in the show notes.

Pace:
There you go. Go watch that.

Ashley:
Well, thank you so much for joining us today. I’m Ashley at Wealth Rentals and he’s Tony at Tony J. Robinson on Instagram. Thank you guys so much for listening and we’ll be back on Wednesday with another episode.
(Singing)

Dave:
Hey, what’s going on everyone? Welcome to On The Market. I’m Dave Meyer and today, I am not going to be your host. We have a special host today, Mr. Jamil Damji. What’s going on man?

Jamil:
Hello. I am happy to host On The Market today because of a bet that you lost. For those of you that were at the Bigger Pockets convention, we, James Dainard and I, won a bet where we dominated at a debate. And so, therefore, I am your host today. And because I am your host today, I have chosen a great topic and it is called The Depressing Show.
Yes guys, I plan to depress everybody today but actually, not depressed, because if you look at what we’re going to talk about, we’re going to show you how you can gain, how you can make a tremendous amount of money and find big opportunities in a down market. So don’t get depressed because everything that we’re going to talk about today will be an opportunity for you to gain. But before we get into that, we’re going to take a quick break.
Hey everybody, welcome back. Let’s hear from our panelists first. Henry Washington, how are you today brother?

Henry:
I am doing well sir. Thank you. Thank you for doing this. I wouldn’t say you dominated the debate. I would say you eked out a slight victory on a technicality, but I mean you won, so we’re here. But thanks for having me.

Jamil:
Well, I appreciate the fact that you’re a very sore loser, but we did dominate and it was a fantastic debate. I mean, look, you showed up, you did your best, but it just wasn’t enough. Kathy, so good to hear from you today. How are you?

Kathy:
Well, I think we should have another live debate on On The Market at some point so that we can redeem ourselves.

Jamil:
Well, redemption is always good, but it’s not for you today. The only person that I actually have a tremendous amount of respect for on the panel today, is Mr. James Dainard because he was my partner and helped us win. How are you, James?

James:
I’m doing good. We did dominate then, didn’t we? Did we get a standing ovation, if I remember it?

Jamil:
We absolutely got a standing ovation. In fact…

Henry:
It’s cause you were leaving.

Jamil:
Wow.

Kathy:
I remember there was some cheating, some guessing…

James:
Me and Jamil just have good synergy. It just is what it is. But I happily accept Kathy’s challenge for another live debate on the On The Market.

Jamil:
I’m with it. I’m with it, but you know what? They can’t have a round two for another 12 months because you don’t just get another at bat. You got to earn the at bat. And so for now, we’re going to hold onto that belt. Dave Meyer, how does it feel to be demoted?

Dave:
Honestly, I’m terrified right now because you’re going to find out how easy my job is.

Jamil:
Oh.

Dave:
The ruse is up.

Jamil:
Well Dave, I’m sure that the entire audience is going to be looking forward to you taking control of On The Market again. Everybody loves you, myself included. But today’s topic is really important because this is a down market, guys. We are seeing the market completely shift. Interest rates and the Fed have engineered one of, I would say, the fastest slowdowns that I’ve ever seen in the real estate market. It was the dramatic halt. And for anybody investing in real estate right now, there has to be an opportunity. I’ll tell you guys a little story.
Back in 2010, I reentered the real estate market after losing millions of dollars in the financial crisis of 2008. And I built a fortune in that down market. In fact, most millionaires will tell you that you will find the best opportunities in down markets. So what are they talking about? What strategies can we implement? What things can we do right now, to put ourselves in a position to win when the market is cooled off? Because as you might know, when people are zigging, the rich zag, wouldn’t you all agree?

Dave:
I a 100% agree. This is my favorite time.

James:
Yeah, absolutely.

Jamil:
It’s my favorite time too. So let’s share with the audience some of the strategies that we can put into practice right now, while the market is down. And I have five specific ones that I have been personally using to generate opportunity for me. And I will share those five. And I would love if each of you would speak to your experience with one or some of these strategies so that we can share with the audience how they can participate when the market has cooled off.
The first strategy is buying deeper. The second strategy is getting creative. The third is finding new ways to hold property. The fourth is going after foreclosures because they are up. And the fifth is short sales. Guys, do you find any resemblance to what happened in 2008? I know we have to be careful because we have a completely different market than 2008, but some of these things came back up. What are your thoughts. Henry?

Henry:
Yeah, I totally agree with you. There is tons of opportunity out there. I’m seeing more opportunity on the purchase side than I ever have before. And you’re right, foreclosures, short sales, those are all… You know what, a lot of people don’t know this. I bought my first property, to live in, back in 2007 and so, I paid a pretty decent price and then everything went crashing and I was in a tough financial spot. I had to short sell my property. So, I know the not so fun side, what that’s like, but there is absolutely opportunity out there and I think we’re 100% looking at more of those strategies.
And I think the catch or what a lot of people are going to have to figure out is, yes, the opportunity is there, but how do you find the money or the funding to buy those opportunities? And I think that’s getting a little trickier but not impossible and not hard. And I’d love to be able to expand on places where people can… It’s a double edged sword, right? Opportunities are there, find the financing and then, if you can hold through the downturn, then you make yourself a substantial amount of money as things come back up.

Jamil:
So, what Henry is talking about is buying deep. When the market starts to slow down, sellers still need to sell and real motivation is going to move people. Now because there’s so little money in the market right now, so few people are actually taking action and people are fearful to enter the market. A lot of the retail buyers are standing on the sidelines, just waiting for things to cool off. They’re trying to see, “Are interest rates going to come down? Are prices going to come down? Do we have more of an opportunity? When will the bottom actually hit?”
So buying deep is actually, right now, one of the biggest opportunities that we have. But you have to look at it from the point of view of, “How deep do you buy,” Right? That’s a big question because, what if you don’t buy deep enough? What if the market depreciates even further? Kathy, James, Dave, what do you guys think about buying deep? And I know Kathy, for you specifically, you are an expert at raising capital. Just like Henry had described, where do you find the money? If there’s anybody on this panel that I think has a real insight into where the money is hiding…

James:
It’s hiding in Malibu.

Kathy:
There’s a lot of money out there. There’s still a lot of money out there. Lenders are getting more cautious but that’s mainly because, and this is way off topic and we’ll do another show on it, but it’s because there is a belief that mortgages will come back down. And so, it’s not a great time for lenders to be lending. So it’s a little bit harder to get money right now, from a traditional place, although it’s still out there. Again, topic for another show, I’ve got a great guest for that. But at times like this, this is where doing partnerships, JVs, syndicating, working with people who don’t know what to do with their money. Maybe they have a self-directed IRA and they’re just frozen, they don’t want to lose any money in the stock market. There are people who want to invest and know that there’s opportunity but don’t really know how to take advantage of that opportunity.
They don’t have the experience but they have the money. Maybe they don’t have the time. So, it’s times like this, that private money, talking to people who just want their money secured to something because you could… What are they getting elsewhere? What kind of return are they getting elsewhere? They could lend to you. Be in first lean position at… I mean, what are interest rates today? What seven, 8% return that they could get being secured in first lean position on your deal? I mean, private lending is a wonderful opportunity for people to be able to participate with you. You bring in the experience and they bring the money.
I started syndicating in 2009, before I even knew what that word meant. Which was, basically, collecting money from lots of people. Lots of people invest together. It’s regulated by the Securities Exchange, is the SEC. So it’s different than the Department of Real Estate. There are lots of rules about how to use other people’s money. If you have just one partner, you still have to be very aware of security law because if the person bringing the money isn’t doing any work, then it’s considered a security. So, you need to know the laws and regulations. There’s lots of ways to learn that. We could do a show on it sometime, but this is an opportunity. If you could do that, you can acquire so many great deals.
So that’s why we have a fund started right now. We’re going deep, as you say, we’re getting discounts. Discounts on property that we could not even bid on before, there was a wait list for these properties. Now we’re getting discounts. It’s incredible.

Jamil:
Incredible. That’s the feeding frenzy. And of course, there are a lot of people right now who have taken big hits in the stock market and are looking for alternative opportunities to invest. And real estate is always a great option for folks, especially in times like this when you can get incredible deals. And James, I’ve been following your social medias, been watching you walk properties and you are one of the most talented renovators that I’ve ever seen. But I also know you to be an extremely talented acquisitions person. And so, tell us how are you and your team pivoting right now? Because if there’s anybody who can navigate the waters that we’re in right now with great grace, it’s you Mr. Dainard.

James:
I appreciate that. I always try to be graceful. I think this is a great topic. Like, buying deep, what does that mean, right? Everyone’s like, “Oh, the market’s getting unsteady. What do you need to do to get into a safe deal?” And everybody’s answer should be different, right? And going into what Kathy was just talking about, cost of money.
The first thing you got to figure out if you want to define how you want to buy is, what is your cost of money? You have to know what that financing debt’s going to be, what the worst case scenario is and then you put that into your performa at that point. So for us buying deep right now, we bought hundreds of homes in 2008 and nine, when the market was crashing down rapidly and we were flipping properties on the regular. So it’s a business model that works, but you have to be really good at implementing the right plan and knowing what your buy box is, based on your own costs.
So buying deep for us, based on that is… What we’re doing is, we’re packing our performa. Is where we’re taking right now because we see that the treasury yield’s higher, the economy’s not loosening up and the Fed’s going to keep increasing rates. And so, we think that the market is going to keep coming backwards a little bit. And that’s okay, as long as we build that into our metrics. So buying deep for us, we’re using our ARV values at comps that are only 30 to 45 day sold and pendings, at this point. So it’s very current, recent data. In addition to, because we think rates are going to increase, we’re knocking 5% off that number because if we think that there’s an annual 6% slide coming, if we are in and out of our flips in six to seven months, we’re going to knock 5% off that value at that point.
In addition to cost of money, we’re running this with extension fees already built into our performa because it could take longer to sell these things. We’re adding two months of debt cost, of whatever our debt cost is going to be. And that’s why it’s so important for you to understand what the actual expense is. If it’s 12% money, that’s fine. In 2008 we were borrowing 18% money from a loan shark, essentially. And that was okay. I always talk about this guy because he really did…

Henry:
Was it Jamil?

Jamil:
It wasn’t me.

Kathy:
It was me.

James:
Yeah, Kathy. Should have known. Well, speaking of sharks, Jamil, I still have our Snuggie shark outfits, by the way. So, those have to come out. But it doesn’t matter what your interest rate is, as long as you build it into the deal. Even when it was 18%, I wasn’t sweating the 18%, I just had to put it in my performa. And then, as we think the market’s going to slide down, we’re adding two months to our whole times and we’re adding in extension fees because usually, we’re getting a six month term. And we’re just accounting for that upfront. So that goes into our deep buying process. In addition to, we’ve increased our margin expectations by 10% than what we were buying nine months ago. So if we were targeting to make 30 to 40% with leverage on a deal, we’re now targeting 50 to 55%. So we’ve increased our margin expectation, we’ve taken the juice out of our ARBs with actual logical information to us, that we think there could be another 5% slide.
And then we’re over budgeting for a financing and debt cost, because it could go longer right now. As the market slows down, transaction slow down. And lastly, we’re putting 10 to 20% contingencies on our construction, just to pad that deal a little bit more. Even though we have seen a sudden drop in construction costs over the last 30 days, I’ve already clipped down my budgets by 10%. And so for me, defining what buying deep is, yes, buying deep is buying cheap, but you really want to think about what are all your expenses, pack those expenses and then that will give you the defined buy box of what you should pull the trigger on.
And that’s really what we’re focusing on, is just putting the metrics in, padding it and as long as it clicks out that way, we’ll buy that deal. We just bought three homes in the last two weeks. There is good buys out there but you really need to define it. They just don’t gut check them anymore. The last couple years, you could kind of gut check a deal, buy it and make some money.

Jamil:
Yeah.

James:
Not going to happen anymore.

Jamil:
I love what you’re saying right now. In fact, you gave me insights that I haven’t been using either. Like baking in the extension fee, that’s something that I completely missed on all of the flips that we’ve been purchasing recently. Now, I feel like I need to be texting my team and letting them know, “Hey guys, bake in an extension fee as well.” I think what you just said right now was magical. Everybody needs to be taking notes. He is baking in added construction costs, he is increasing his profit margins, he is baking in a slide of 5%. He’s only using data that’s 90 days or newer and checking pendings.
All of the things that James is saying to you right now, are as good as of a crystal ball as you could possibly get. The data is the crystal ball, guys. And if there’s anybody on this panel and a panelist used to be a host, but a panelist that is tied to data and understands data better than anybody else that I’ve ever met in my life, Dave, what the heck is happening out there and what do the numbers say is going to happen?
I mean, if there’s anyone that I know is studying the trends, I feel you have an insight beyond any of us on this entire episode. So, what do you see as going to be coming around the corner Dave?

Dave:
Well, I was going to just sit here and not talk because this is kind of my day off but you flattered me enough so I’ll respond to this.

Jamil:
I love it.

Dave:
Thank you. I think this point about buying deep is excellent and it’s kind of just returning to being what an investor is. When I started investing back in 2010, you never paid what people were asking for. That’s just what investing is. You try and get a deal every single time. And so, I think that there is a lot of downside risk in the market that property prices are going to drop in a lot of markets. And my advice and what I’m trying to do is to head that off by basically saying, “Okay, my market might decline five to 10%. So that’s what I would offer, under the asking price so that if it does go down five to 10%, that you are protected.
You’re not going to get it exactly. And honestly if you’re off by a few percentage points and it goes down on paper, if you’re a buy and hold investor, it’s not a huge deal. So the question is, how much is your market going to go down and no one really knows. I think the best way I’ve heard it described is, we had John Burns on the show recently, and he said that he expects all of 2021’s appreciation to be wiped off the board.

James:
That’s what I been saying for the last year. I think we’re going back 2020 pricing.

Dave:
Which is still up from pre-pandemic. So I think that’s still important for people to know, depending on how you define a crash. But you look at markets that popped 20% last year, they’re probably going down 10 to 20%. But if it went up five to 7%, that’s probably the ballpark, at least, you should be considering for how much below current values they might go. But I mean, again, Kathy mentioned this, so this is a whole different story, but if mortgage rates do come down and a lot of people are forecasting that, the downside might not be as bad as I think a lot of the more bearish forecasters are calling for right now.

Jamil:
So, that’s really great news because that means that if you essentially, just for back of the napkin math, if we erase the insane appreciation that happened for that little short period of time, if we take that off the table and we get back to fundamentals of underwriting and really get out there and use the negotiation techniques and leverage what’s happening in the market right now, if things don’t turn out as bad as we might think they might get, we’ll be actually doing really well.
And so, guys, there’s an opportunity here for you to continue to participate by being hopeful and knowing that the market could rebound or could come back to a normality here, sooner than later. But even if it doesn’t and we lose the gains of 2022, there’s still a massive opportunity for you to take advantage of motivation. Guys, when people need to sell, they need to sell.
I’m in a deal right now, where an appraised value on a property was 1.7 million and I’m under contract at 1 million dollars. The seller needs to sell, there’s nothing that they can do. I’m the only person that’s willing to come in and take the deal. And so, this is the opportunity that I get to take advantage of and I’m seeing this day after day after day. Guys, the next strategy that I want to dive into is being more creative. When we find ourselves in situations like the market now, where rates are seven, maybe even 8%, we want to take advantage of the cheap money that trailed into this market. And again, there are so many people that have motivation, that are ready to trade their property and have incredible financing attached.
So for those of you that are not familiar with creative financing or subject to, that’s when we are leveraging existing financing. Where we are having a seller provide us their existing financing on a property and we take over that property or control of that property, with the existing financing in place. Now, if we look at the rates that trailed into the current market, we had rates at 2%, 3%. So there’s thousands of homes out there right now, that have incredible financing attached to it and we can leverage that financing as an asset. Henry, are you taking advantage of any creative solutions right now? Are you buying any properties subject to? And how can people participate with that strategy?

Henry:
Yeah, man. Creative finance is super fun. I’ve actually been spending a lot of time educating and re-educating myself on different creative financing strategies just to have that additional tool in my tool belt, to not only use it to make money, but you use it to provide your sellers another solution to their problem. You’re right. People still need to sell and the problem or the opportunity is that, there’s less people that are willing to buy these deals that need to sell. And there’s less real estate agents who are willing to take on tough listings because it’s harder to sell properties right now. And so, if they’re going to spend their time, they want to spend their time on the deals that they feel like are going to be easier to get over the finish line. So that creates this opportunity. Yes, we’re absolutely looking at creative finance, I am looking at any deals that I am offering on.
I’m also looking at what would the terms be on an owner finance and offering an owner finance solution as well, because if that deal needs to sell, I can typically pay a little more on an owner finance and it creates this win-win situation cause I don’t have to go get expensive money from a bank or a hard money lender.
Also, we are taking a look at deals that we looked at 3, 4, 5 months ago. Specifically, commercial deals that we’ve looked at 3, 4, 5 months ago and maybe the numbers didn’t work, maybe the seller wasn’t quite ready to work a deal yet. And what we’ve done is, we’re looking at who’s got the debt on these deals, we’re calling those banks and asking them, “Are you good with us assuming the loan, or taking on the loan with the current debt in place? And then, what would you need from us to bring to the table additionally, for us to do that?” And we’re reworking the numbers on deals that have still been sitting there and the sellers are now a little more desperate, a little more willing to negotiate and now, we can work a deal because we’re taking over a loan at a lower interest rate, we’re getting the deal done or sold and we know there’s some motivation because these are things we’ve looked at several months ago.
So, that’s two of the strategies we’re using to look at creative financing.

Jamil:
Guys, to highlight something here that Henry just said. A lot of people have this irrational fear of the due on sale clause being evoked when somebody takes over a subject to property, and Henry is running in front of that situation, by calling the institution and getting permission. Understand that you will never get what you don’t ask for. And there are lots of institutions out there who do not want to lose the loans if it can be a performing note, and if they can find somebody to come in and take control of the property and do better with the asset than the current seller, they would love to have that person.
Now, that might mean that you have to re-qualify or add additional security or something, for that institution, in order for them to allow that assumption to take place but guys, that money is so cheap, we’re talking low, low, low. One, 2%, 3% loans. You guys could really get and take advantage of those opportunities. Dave, what are you seeing there?

Dave:
Jamil, I’ve seen, in the last week, two deals for commercial, like 12 to 20 plus units in Colorado, where the seller has arranged that with their financier. Because they’re motivated to sell, and they know how difficult it is for you to find a loan, they are going to the banks and advertising that the loans are assumable by the buyer, which is just incredible. One of them I was looking at was at 3.2%. So they’re going and doing the work for you right now because they know how hard it is and they’re offering these incredible financing deals that… I mean, this is just unheard of over the last couple of years.

Jamil:
So people would actually be crazy not to take advantage of this, right? I mean, when would you ever be able to… Again, I don’t see rates coming down to 3%. I don’t. Even with the market rebounding and turning around again, I do not think we’ll find ourselves in money that cheap again. So these opportunities guys, if you look at an amortization table and you see how much you spend in interest, how much you pay in interest. If you can take advantage of this cheap financing, it doesn’t matter if you’re paying a little bit more for the building. Over time, you are going to win. And I see that smile Kathy, and I know that that just tickles your fancy. How are you guys taking advantage of creative opportunities right now, in your business model?

Kathy:
Well, it really is important to have banking relationships because there are a lot of commercial properties that are in trouble right now. I don’t see that so much with residential, but we’re obviously seeing an uptick there. But with commercial, a lot of people got into bridge loans or they didn’t do proper underwriting and having those banking relationships, I have banks contacting me all the time saying, “Hey, do you like this deal? Do you want this deal? Will you look at this one,” Because banks are not real estate investors. That was how we did our first syndication.
We were able to just take over the bank loan. It was 26 town homes, riverfront, waterfront in Portland, that were 70% complete but not finished, and the bank failed. There was a 3 million dollar loan on it, the value was about 20 million. We just took over the note. And we were able to finish out those properties because a bank’s not going to do that. They’re not going to finish out a 70%, almost finished, product. So banking relationships are a great way. And I mean, mostly with the portfolio lenders, the private lenders because they’re maybe stuck with some stuff they want to get rid of and don’t know what to do with. So that’s one way, for sure. It’s a good time for that.

Jamil:
I couldn’t agree more. Relationships are incredibly important. And when we’re talking about getting stuck with and holding property, I mean, holding and being creative and expanding our thought process on how we can hold property if we end up having to wait out a market cycle.
And James, I’m fixing and flipping right now and I’m holding some of these luxury flips that I have to be creative on how I can refinance these properties and cash flow to hold them until the market takes some kind of rebound. I know you to be one of the most incredible fix and flippers in the entire country. How are you holding property that you got stuck with? And are there any creative solutions? Like possibly, corporate rentals or nursing homes or sober living? Are there any things that you are doing to hold property more creatively, to generate increased cash flow for some of the stuff that you might get stuck with?

James:
A lot of people aren’t going to like what I’m going to say, but I’m a firm believer, if I bought that inventory to sell it, it’s getting sold. And I’m not afraid to lose money if I need to lose money because one thing I don’t like to do is force an investment into something that it’s not supposed to be in. I would rather take a clip. I just lost 300 grand on a house and it was just, the deal went sideways every different… It just went wrong on all avenues and breaking even in a good market would’ve been okay. And that happens. If you buy a lot of property, you’re going to get clipped on a minimum one out of 10 properties. That’s just the way it goes. You can’t hit every stock, you can’t hit every investment.
There is no magic crystal ball where you’re a hundred percent accurate. So, there is going to be those times you get clipped. So for me, a lot of times, I’m looking at how much am I going to bleed on it or how much can I break even on it, is there the equity position. I’m looking at the core metrics. I’m okay to keep some properties and take a little bit of a hit every month and ride out a bad market, and I can look at doing things like short term rentals. We can do corporate housing, we can just do a straight traditional rental or we can add a kitchen in the basement and maybe just add a couple more units in the building to kind of subsidize down the cost. But majority of the time, when we’re doing luxury stuff, it’s not going to pencil well.
I’m going to have to put that up at a high end Airbnb. Like where you got to [inaudible 00:29:25] two flips that we’re listing that are going to be four and four and a half million dollars in the next 60 days. Those are expensive properties, we’re into them for 2 million. My debt cost on that’s going to be 15 to 16,000 a month on a traditional rate, if I refinance that deal in. That’s not healthy. That is not good to do. I would rather sell that money, get the cash back out and I could rent those out probably, for four to five grand a week, actually more than that. I could probably get seven to 8,000 a week for these properties, but that’s not what I’m doing. And if there’s a vacancy and if we’re going into a recession, people are spending less disposable income. Those pricing could come down, and at the end of the day, I have a substantial amount of cash in each one of these deals.
Seven to $800,000, sometimes a million bucks. I would rather get 400 grand back and lose the four, and go buy a smart investment with a big kicker down the road. That’s just short term paying, long term game. If I got to take the clip, I want to get my cash back and then go buy something better because the buys out there now, are unbelievable. We are ripping deals right now. Large multis, small multis, single family, development sites, we are getting really good buys. So I’d rather just take the loss now and reload, and keep to my same basic principles. I don’t like to force a plan. And if it needs to be sold, it needs to be sold. And I know that’s a hard thing for a lot of people to hear because on these luxury flips, when the market compresses 15%, it hurts. No matter what you do, it’s going to hurt.

Jamil:
A hundred percent.

James:
And so, I’d rather just take one in the teeth and move on to the next one.

Jamil:
Well, I mean James, that is very astute and I agree with you. There’s going to be some deals that we’re going to have to just lose money and write a check on. And forcing a business model that’s not your core competency, is also problematic, right? Because you take your eyes off of what you do, to generate capital. When you do that, when you pivot and you do other things, you take your focus away. But I still believe that there’s a way that we can, at least not lose the entire bank. We don’t all have your jaw line, so we can’t all take it on the chin. Henry, what would you do creatively, to hold any of the stuff that you get stuck with?

Henry:
I run a much smaller operation than James, right? And so, that means I need to manage my risk a little differently. Partially, I do that by, I’m not in million dollar flips because A, my market doesn’t have a ton of them. I’m in a whole different area of the country, and B, my margins are slimmer. And so, what I am doing when I need to pivot is, I am planning in my underwriting, for buying it at a price point that I know I can cashflow as a long term rental, if I have to pivot. So my strategy typically and still is, I market heavily direct to seller. I buy everything that’s a deal. I sell the singles, I keep the multis. But I am also a believer in, you know, “You take what the defense gives you.” And in 2020 and 2021, 2022, the market was saying, “Hey, you can take a lot of your cash flow in the form of a sale right now and then reinvest that money into better cash flowing assets.”
And now the market’s telling you, “Hey, it makes a lot of sense to buy some of these properties that you’re getting great deals on, and just sit on them and hold them.” And so now, when I’m making offers on my single families, I’m writing in to my underwriting.
In other words, I’m not going to offer at a price point that’s only going to work if I flip it, I’m offering at a price point that’s going to cash flow very well, and will make me a good amount of money if I sell it, so that when, and if, I have to pivot, I’m totally okay with it because the numbers say I’m going to cash flow well. So it’s just a matter of understanding where your properties are, what they’re going to be able to rent for, and then what you’re going to have to put into it. And I won’t buy a property that doesn’t have one exit strategy right now.

Jamil:
Smart. And that takes a substantial amount of confidence and level of sophistication to pivot exit strategies. But guys, what Henry’s saying is really important. Look at every deal before you get into it and see what are the different exit strategies that I could put into place here, if things go wrong. And Kathy, I seen you do that at a project in Park City. Tell us a little bit about what happened there.

Kathy:
Well, first I wanted to make a comment on what James was saying because I see a lot of the comments that people make and people do DM me and tell me that they’re really struggling with trying to sell a property. And I think knowing that you can take a loss on one property but take all the knowledge you learned and go make more money on the next, is really what makes you a professional investor.
You just have to be able to cut the ties and walk away if it’s not going to work. So I think that’s just really, really important advice. I know there’s a lot of pain out there. I know that we hear talk about how exciting it is to be investing right now because there’s deals out there, but it is not good if you’re trying to sell. This is a hard time to sell and you’re just going to have to either find a creative way to hold and wait, or you’re just going to have to take a cut, in most cases. I know there’s pain out there and I just wanted to address that and let you know, you’re not alone. It’s just part of being an investor. You’re going to be the one who gets the great deal on the next deal if you have to take a loss this time around.
So, with discovery, with our properties in Park City, I’m actually going there this weekend. We’ve had to pivot in so many ways because this is 20, well was a hundred homes that we’re building and selling. We’re down to 20. And the 20, are the ones we’re supposed to make all the profit on. So this is a painful time to be a builder because all your costs are usually upfront, all the infrastructure, the roads, the utilities, and you make your money at the end and if you don’t time it well, it stinks. It means you might have just spent the last five years not making money when the profit’s supposed to be there.
So we’re just working to hold, not build spec homes. Banks don’t even want to build spec anymore. So we’re just holding tight. And I have a very different perspective than a lot of people. I really believe that mortgage rates follow inflation and we’re going to start to see it go in a better direction because we’re just simply comparing year over year and the average of the year. So we know that inflation was really low in the summer of last year. So when we’re comparing, it’s terrible numbers and we knew that, we knew it was going to look bad. But starting in October, that’s going to change but we’re not going to get the results of that till November or even December.
So there’s still going to be pain but right around the corner, unless we have major problems with diesel and energy and gas and that [inaudible 00:36:38], that’s another issue, we’re we’re going to see inflation go down, most likely, and that would bring mortgage rates down and I just think that there’s going to be another housing boom. I know I might be alone here on the panel thinking this, but spring summer of next year, when we’re down to like 5% rates, there’s just not inventory and there’s demand and when we get down to a five or a low six, it’s going to be a boom again. So I don’t think this opportunity’s going to last very long, honestly. So if you can just hold for a bit, that’s great.
Or create a financing. And answer to your question, some of the ways that we’re selling what we will build or that people want to build, is shared vacation rentals. There’s technology that’s bringing in more options. I know people who are using technology to just rent by the room. That’s really cool. The medium term rentals, there’s options to just be able to hold a little bit and not buy into the fear.

Jamil:
I love that.

Kathy:
That’s my [inaudible 00:37:43]

Jamil:
No, that’s a great perspective Kathy. And I think anytime that we allow ourselves to succumb to fear, the result is just more fear. So I think your perspective is astute. I think it’s really good for everybody listening. You’ve got to be able to take the pain. And you spoke about pain and I want to take these last two topics and kind of put them together because they address the pain.
And Dave, I’m looking at foreclosures, I’m looking at short sales and I’m seeing that there is definitely increases in both of those. Have you done any studying to find out how much they have been increasing and where they might be leading or what indicators they’re showing us the market to do or where the market is going in the coming 90 days, with respect to the pain that we’re feeling as sellers?

Dave:
Yeah, so it does. You will see a lot of dramatic headlines about foreclosures right now, because they’re going up on a relative basis, at a very high rate. So you might see, “Hey, foreclosures went up 200% since last year,” And that is true, but it’s going from one to three. The relative amount of foreclosures compared to even a normal year, not even 2008 to 2018, is still relatively low. And we actually had Rick Sargon on the show recently, who was explaining to us that a lot of the foreclosures we’re seeing now, are actually people who were just defaulting back in 2018 and they just got into the forbearance program. They sort of caught a break with COVID, were able to defer their foreclosure for several years. But I do think it will tick up.
A lot of what Kathy was saying about rates going down, that theory that rates are going to go down is predicated on a recession, right? Because if there’s a recession, bond yields will go down. So, if that happens, there probably will be a slight uptick in foreclosure but I don’t think it’s the point where we’re going to see anything like what was going on in 2018. Generally speaking, Americans are in one of the strongest cash positions they’ve ever been in, and are very well positioned to service their debt. If you just look at credit scores, you look at foreclosure rates, default rates, they’re really low. And that one I’m talking about here, is mostly residential. I think James actually had a really interesting point about defaults in a recent show, in a commercial space.
I don’t really know that much about that data wise, but I think there will be an uptick, but I don’t think it’s going to be this feeding frenzy. And I think one of the things that we talked about, I forget who the other guest was who said this but, someone was saying that they don’t expect the foreclosures to really even reach the auctions because banks are much smarter and they learn to hold onto these assets or not to sell them at such a steep discount as they did last time. I think there will be slightly more opportunity, but it’s not the strategy I would count on.

Jamil:
I love that. But I also really want to highlight that one position where there could be some opportunities in the commercial space. And James, I know that if there’s anybody on this panel that would be able to deploy the capital to take advantage of a possible foreclosure or a short sale situation in commercial real estate, you’d be the man to do it. What are you seeing and are you making any purchases in that realm right now, with what you’ve been seeing in the market? Commercial wise?

James:
Yeah, we come from… I mean, that’s where I grew up when real estate was banging on foreclosure doors and working short sales back in 2006, seven and eight and nine. And I will say about short sales, it’s a miserable process for me. We used to do 300 short sales at a time for servicing. I will never do that business again. It was just not enjoyable. It was very much a pain. But where I do, do short sales is, I like negotiating and targeting foreclosures and short sales with paper that wants to move things. This is not traditional Fannie, Freddie Mac paper. That’s a slow process. It goes into a box, you can’t negotiate, is fluidly with them. And so what we have been doing is, I’ve been calling over the last 30 days and my phone is ringing off the hook. Construction lenders, hard money lenders, private lenders and people that were underwriting deals very… These hard money lenders were asking for so little down on these investments, they were asking for 10% down, funding a hundred percent of rehab.
And now the market has came down 20% in some of these sectors and their paper is overvalued at that point. And they are bankers, they are not rehabers, right? We actually own a lending business in Seattle and we are actually rehabers. So if someone goes wrong, we’re going to come in, fix it, stabilize it, get rid of it. The most operators are not in the lending space and what they want to do is, they want to move paper. That’s how they make money. What they don’t make money on, is sitting on assets that are just compounding and dilapidating as it goes. A lot of these things are half built, they’re not moving forward and they’re going down in value as it speaks. And so, a lot of times, I’m actually targeting more of the business sector… Like a B2B foreclosure situation rather than the homeowner. The homeowners, I do think there is going to be some opportunity there in people that overpaid, that did very little money down, they’re going to walk away.
I think that does happen. I also do think we are going into a recession and I think people, yes, locked in great rates, they worked on their DTI in the now, but I think people’s income are going down right now. People’s income is going to be the [inaudible 00:43:19] over the next two years, or at least that’s what I think. If they were stretched to a 50% DTI, and their income goes down 20%, that’s a problem. I don’t care what your rate is. And so, those are the sectors that I do think there’s some opportunity. And actually, that’s where I think the sub two financing’s going to come into play. If it’s a nice cookie cutter house and they’re at default and you can take it, assume their loan, pay it current and then take over, that’s a great rental for you down the road.
But the short sales and foreclosure, we are targeting B2B opportunities. People moved a lot of money over the last 12 to 24 months. They want to get the paper off their books. A lot of these lenders have… I call them daddy lenders. They’re not the people financing the deals. Their daddy is going to call their notes due and they’re going to have to pay off these lenders that they sold notes to. And I want to step in the middle of that and buy those deals. And for me, it’s a great opportunity. There’s going to be half-built things, a lot of the stuff’s already going to be permitted, which is nine to 10, 12 months of hold times that I can cut right through, and I can go directly to the source, take over the project and usually buy that paper. That was where we were buying our best deals in 2008.
Wasn’t buying property, it was buying paper in distress. They were selling it to us at like 20 cents on the dollar back then. And if you could buy that paper that cheap… It was like, we would buy the paper, take it to foreclosure and a lot of times, it would get bit up to 40 cents on the dollar and we would rack a hundred percent return in a very short amount of time, or we got it back and we got to stabilize it and we would rip those deals. So working with people that don’t want to deal with assets, bankers will get rid of a property a lot quicker than a homeowner will. So that’s actually what we’re targeting right now. Foreclosures in the business and commercial space.

Jamil:
Incredible. Guys, I brought to the table five ways that I believe we could all benefit or at least pivot in this down market, but just listening to you guys talk for the last 40 minutes, I can tell that I’m definitely not the smartest guy in the room. So I’d love to turn it over to you guys and ask, where you are personally making changes. Henry, I know that you’ve got a lot of great opportunities for you up there in northwest Arkansas. What do you got going on?

Henry:
Yeah, I think a great thing for people to be doing in this down market is, working your network hard. Shooters shoot, right? Investors invest, it doesn’t matter the market, they find opportunity. So there are people that are buying, we’re all actively buying. There are investors in every single market right now, that are actively buying. I think there’s a great opportunity to find really, really good deals and sell those deals or assign those contracts to the shooters, the buyers.
I think your competition is going to be less because as things get more difficult, economic times get harder, I think you’re going to see less wholesalers active, less deal finders active. Especially the ones who haven’t developed a strong buyers list, because that’s the part that’s going to be hard to find. Now the deals are going to be out there, but if you don’t have a strong buyer’s list or a strong way to dispo your deals, you’re going to be stuck with telling people you’re going to put their property under contract and know where to take it.
So, if you can develop that strong list of buyers, I mean, you can make money hand over fist right now because the buyers are still buying. If you find that right network… I think it was Kathy who alluded to it earlier, about finding private money, talking to your network, find the people who are still investing regardless of what’s happening. Let them know, “I’ve got deals coming for you.” And then you can take advantage of buying deep and then assigning those contracts to the buyers who are out there, active in these markets, looking for those deals.

Jamil:
Great. Great advice. Kathy, what do you got going on that’s different?

Kathy:
Ooh, I mean it’s not different, it’s what we’ve been talking about. We’re syndicating. We’re back into syndicating heavily and that means, again, raising money to raise cash to go be a cash buyer without competition and not having to pay high interest rates to a bank. I’d rather just give that to an investor and part of the profits.
So it’s where we’ve got a 20 million dollar, single family rental fund. It’s actually one to four units and we’re doing exactly what James just said, finding builders who couldn’t complete. My partner has operations in Dallas, so she’s got property management, she’s got all the repair teams, she’s got the acquisition people. So we’re able to just go in where somebody just got a little too aggressive, didn’t understand how to build or how to do a reno and we’re able to pick it up for cheap, finish it off, but we’re keeping it, we’re not selling because this to me, is not a seller’s market.
I mean, yeah, it’s just a time to be buying and holding, in my opinion. When it’s time to sell, we’ll sell. But these cash flow. So it’s a little bit different than what James is doing because he is actually cash flow really well. So we’re just going to hold. We’re sharing the cash flow with the investors and sharing the profits with the investors.

Jamil:
That’s great. Relationships win all the time. James, what do you have going on?

James:
It’s all about restructuring deals for us right now. As the market, one thing I’ve learned is… We’ve been through five different little market cycles since I’ve been doing this in… We started in 2005 and we’ve seen all sorts of things go on. And one thing I have learned is, you have to pivot and change your whole… Structure your business and how you operate with every market change. And one thing that I like to do in transitionary market is, we’re actually engaging… We can find the deals right now. Finding the deals isn’t a problem. I have lots of properties coming in, they’re large multis. We’ve done a couple syndication deals recently. Small multis for development [inaudible 00:49:07], we’re looking at fix and flip, we’re still buying development, we’re buying with only permitted sites now, to cut the cost down. So we kind of know that strategy.
But how we reduce risk and what we’re doing right now is, we’re actually meeting with our strategic partners that we’ve known for a long time. And a lot of these people, we’re looking at different ways to joint venture deals. Because half it is, we know that time is a killer right now. There’s two things that are killer on deals, time and debt cost. And so what we’re trying to do is address those two items. The first thing is time, is we started engaging. We know that our contractors are actually low on work right now and pricing’s coming down, they need work and they need a better kickers on them. So we’ve actually met our best three contractors and we have proposed joint venture deals with them to where I can operate, focus on my business, focus on getting the deal flow and then we are giving them 30% of each deal but they are getting these projects done 25% below budget and it’s moving extremely quick and that’s going to reduce my exposure to a bad market.
I’m happy to give money away to make sure that I’m staying in and out and fluid in the market. That’s the first thing is they’re doing. Finding joint venture deals with operators that can reduce our risk through professionalism and good strategies. The second thing we’re doing is, instead of looking at the same way that we always look at it, “Hey, find a deal, get whatever debt cost we can get,” Right now, short term bridge cost has gone up three to four points in the last 90 to 120 days. You used to be able to get money at seven, 8%, now it’s 11 to 12. And that is going to consistently keep going up for a little bit. So what we’ve done now is, how do we reduce that risk? Well, we can go find bigger money partners that are not great operators because what we’ve seen over the last two years is, a lot of people bought assets, they made a bunch of money but they didn’t really have the right plan but they still made money anyways.
And these people know that they went a hundred percent over budget. They got a little bit lucky but they’re cash liquid at that point. So what we’re doing is, we’re proposing and looking at deals and bringing in JV partners, where we’re giving them a pref return and an equity split because it reduces our carry cost. No matter what, it mitigates the risk down. So we’re focusing more on the strategic partnerships and how can we operate and mitigate risk during transitionary time, rather than just trying to buy cheaper and do those things.
And so, really lean into your partners, figure out where the synergies are, figure out what everybody’s good at, and then put the puzzle together. And then we’re buying based on what puzzle pieces we put together. It’s all about the resources and the bench. And by doing this, by having this, it gives us like… I can go still do luxury flips if we’re very liquid on cash because, what kills us on a luxury flip is, our payments 10 to 15 grand a month to carry that house, it’s expensive. And if we can reduce that, wipe that off, we can still get in those deals and we’re buying them for substantially cheaper, mitigate the risk and still rack the good returns. So we’re just looking at deals differently.

Jamil:
That’s mind blowing, James. I had not renegotiated with my contractors yet, either. So again, another insight that I’m going to take back to my team and implement immediately. Dave, what are you doing differently out in Amsterdam right now, to help your investing over here stateside?

Dave:
Well actually, this is the first time since I’ve moved to Europe that I’ve actually been pretty seriously considering buying individual properties. I’ve been just doing syndications and funds over the last couple years because I couldn’t play the game when you had to bid and respond to a seller in like four hours, because I’m asleep when you guys are all doing that stuff.
But now, since things are sitting on the market and you have time to actually consider some deals, I’ve actually been… In addition, I’m still doing syndication investing, but actually looking at buying in Colorado again, it’s starting to make sense for the first time in two or three years for me. So I’m super excited about that.

Jamil:
That extra time also just gives the seller a little bit more anxiety because you’re sleeping and there’s…

Dave:
Like, “What is he doing? Why isn’t he signed yet?”

Jamil:
“Why is he taking so long? How aloof.”

Dave:
Yeah.

Jamil:
Guys, this was really fun. Dave, thank you so much for letting me win that bet. I know it happened guys. You guys felt sorry for me and you wanted to give me a win, so you’re like, “Hey, let’s just let Jamil win the debate and let him have a takeover show.” I know it was all a conspiracy behind the scenes to love on me a little bit, but thank you so much for giving me the chance to take over the On The Market show today. Dave, how did I do?

Dave:
Oh, you did great, man. Now I get to go on vacation. I’m going to call you and you can do all the planning and research too. This would be great.

Jamil:
This is a lot of fun. Guys, again, if you have not yet subscribed to this channel, please like and subscribe and leave us a review on whatever platform you’re listening to this podcast on. It’s really important and it helps our numbers. And from myself and the rest of the panelists here and our old host, Dave Meyer, we will see you On The Market on the next show.

Dave:
On The Market is created by me, Dave Meyer and Kailyn Bennett. Produced by Kailyn Bennett, editing by Joel Esparza and Onyx Media. Research by Pooja Jindal and a big thanks to the entire Bigger Pockets team.
The content on the show, On The Market are opinions only. All listeners should independently verify data points, opinions, and investment strategies.

CNBC’s Diana Olick joins ‘Power Lunch’ to discuss the impact of rising intrest rates on home affordability, the causes of buyer pullback in the housing market and the compound effect of high home prices and high mortgage rates.

Earlier in November, new Consumer Price Index (CPI) data was released, revealing that inflation had dropped on a year-over-year basis from 8.2% in September to 7.7% in October. This is welcomed news. Don’t get me wrong, 7.7% inflation is still unacceptably high, and no one should be cheering yet. But the fact that the year-over-year inflation rate has fallen four months in a row is a good sign, and I believe it will fall even further. I ran some numbers and believe it’s very likely that inflation has peaked and will decline (albeit slowly) throughout 2023. 

There are several reasons for why inflation has likely peaked: Fed action, supply-side fixes, and the “base effect.” I’ll quickly touch on the first two, but I am excited to share my research on the base effect, so make sure to check that out. 

Fed Action

As we all know, the Federal Reserve has been raising its Federal Funds Rate for most of 2022 in an effort to reduce inflation. Inflation is often described as “too much money chasing too few goods,” and by raising interest rates, the Fed targets the “too much money” part of the equation. 

Raising interest rates makes it more expensive to borrow money. When borrowing is more expensive, people tend to spend less (otherwise known as lowering demand). Less demand removes money from circulation in the economy and helps to tamp down inflation. 

The thing is—this takes time. It’s not as if the Fed raises rates and suddenly, people stop buying things. The reduction in demand takes time, and interest rate hikes are not fully felt in the economy for several months. So it’s very likely that we’re only now beginning to feel the impact of interest rate hikes. And since the Fed has indicated they intend to keep raising rates, we’ll likely feel the impact of lower demand in the economy for the foreseeable future, helping to tame inflation. 

It’s also worth mentioning that the rapid increases in money printing have stopped. Below is a graph that shows the year-over-year change in M2 monetary supply in the U.S. As you can see, after a wild ride the last few years, annual increases in money supply are back to normal rates and the lowest they’ve been in 10 years.

Supply-Side Fixes 

While the Fed is attacking the “too much money” part of the inflation problem, there has also been a more silent contributor to inflation: supply-side shock. This is the “too few goods” part of the “too much money chasing too few goods” equation. When there’s not enough stuff to buy, prices go up. 

Supply-side issues arose from Covid when manufacturing was limited across the globe. There were just fewer products made, and that causes inflation. The U.S. and most of the world resumed manufacturing gradually throughout 2021, but China, which manufactures a ton of goods for the U.S., has been much slower to ramp back up. This has constrained supply and helped inflation stay stubbornly high. This is starting to change, though, and manufacturing is ramping up now, which should help curve the supply-side issues. 

The second main issue that caused supply-side issues was the Russian invasion of Ukraine. Russia is a major exporter of food and energy, and western sanctions have cut those goods off from most of the world. Furthermore, Ukrainian exports, particularly wheat and grain, are having a hard time hitting the market. This has further constrained global supply chains and pushed up inflation. 

While the war in Ukraine is unfortunately still raging and sanctions still exist, the world is adapting to the new reality. This means other suppliers of goods normally supplied by Russia will step up production and help stabilize the marketplace. This could help inflation cool as well.

The Base Effect

While the Fed’s actions and supply-side fixes should help cool inflation, there’s another reason why you should expect to see inflation numbers come down in the coming year: the base effect. Check this out. 

We talk about inflation in the United States on a year-over-year (YoY) basis. When the recent data said inflation was at 7.7%, what it’s really saying is prices went up in the U.S. by 7.7% between October 2021 and October 2022. 

Because of this, it doesn’t just matter what prices are today. It also matters what prices were a year ago because we’re comparing the two. When we compare high prices this year to low prices last year, the difference looks huge, and that’s what’s been happening for most of 2022. When we compare high prices this year to low prices last year, the difference looks smaller, which is what is starting to happen. This is known as the base effect. It matters what data you’re comparing today’s numbers to. 

Just check out this chart. Remember, during the beginning of the pandemic, inflation was pretty normal. In fact, we had deflation for a few months! Things didn’t really start to go crazy until the middle of 2021. So for the first half of this year, we’ve been comparing high 2022 prices to relatively lower 2021 prices, which makes the difference (YoY change) look really high. In the second half of 2022, we’re comparing high 2022 prices to already-high 2021 prices, which makes the difference look smaller. 

For this reason, inflation on a YoY basis (which is what the Fed cares about and how we generally evaluate inflation in the U.S.) peaked back in June and has fallen for four straight months.

This is likely to continue, and I expect YoY inflation to decline slowly but considerably in 2023. Why? Because I did the math! 

In the most recent CPI report, prices rose 0.44% month-over-month from September 2022 to October 2022. That’s pretty high, yet YoY inflation still fell. That’s the base effect in action! 

If we continue to see prices go at a similar monthly rate for the next year, we will see inflation fall to somewhere around 5.5% next year. Again, the same monthly increases, but year-over-year inflation goes down. And if prices start to increase at a slower rate, we could see inflation come down even more. 

Check out this colorful chart I made. Across the top, you see potential scenarios for monthly price increases from 0% to 0.7%. Each row represents a forecast for YoY inflation by month for the next year. As you can see, the only way inflation starts to go back up YoY is if monthly price increases accelerate to 0.7% (remember, we are at 0.44% now).

Conclusion

Personally, I think it’s unlikely that we see monthly inflation increase unless there is some big, unforeseen geopolitical shock again. Instead, I think it’s pretty likely we will see monthly inflation rates decrease, perhaps to somewhere between 0.2% and 0.4%. If that happens, we can expect the inflation rate to be between 2.5-4% in 2023. Still not where the Fed wants us to be (around 2%), but way better than where we are today! As long as the monthly rate of price increases stays close to where it’s been the last four months, inflation should come down.

None of this is to say that the Fed will stop raising rates soon (they’re not). But it should offer some relief to Americans who are struggling to keep up with inflation. If this trend continues, it should also give us a clearer picture of when we can expect normal inflation, which will help us forecast when rate hikes might stop and when economic conditions become more predictable. 

Of course, something unforeseen could change this trajection. But if the status quo continues, we should see inflation come down. Let’s all hope that’s true. It’s the best thing that could happen to the U.S. economy. 

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.

David:
This is the BiggerPockets Podcast, show 689.

Matt:
I can buy a $50,000 car, put no money down, and if, let’s say, it’s over 6,000 pounds and all of that, I can get a $50,000 deduction for not putting any money down. So that’s why depreciation is so powerful because you get so much more. You get so much bang for your buck, we’ll say.

David:
What’s going on, everyone? This is David Greene, your host of the BiggerPockets Real Estate Podcast here today with my co-host, Rob Abasolo, who brought in one of his friends and people that work with him, Matt Bontrager, who is a managing partner at TrueBooks CPA and does Rob’s tax planning. So we got into a great conversation with Matt, which I think was maybe one of the most fruitful and simplistic explanations of how to save money in taxes that I’ve ever had. Rob, what did you think?

Rob:
Yeah, man. So this specific episode really came out of one of the more common questions that we get, but a very specific YouTube comment. Is it okay if I read it really fast?

David:
Yeah. Let’s hear it.

Rob:
Okay. So it says, “Hey, Dave and Rob. I’m a big fan and think you guys are great.” So let’s just take a minute to marinate on that. We’re great, David. Don’t forget that. “I think it would be awesome if you guys could go deep into the short-term rental loophole, go deep on the tax savings of bonus depreciation through cost segregation, which you touched on a little in this episode. Thanks, and keep the great information coming.” So, yeah. I think the cost segregation, the short-term rental loophole or hoophole, whatever you want to call it, it’s a really big topic right now. I’m seeing it all over Instagram, all over TikTok, and we bring in a pro to actually come in, and lay it down, and just give us all we need to know. So I’m excited because I think a lot of people after today’s episode are all of a sudden going to be like, “Hmm, how do I buy an Airbnb to cancel out my taxes?” So, yeah. I’m excited.

David:
Yeah, and if we’re being completely transparent about this, this is something that a tax preparer would probably charge you thousands of dollars to teach you. You’re literally getting that, and this is not a sales pitch, for free in this episode. This is what Matt would charge people to tell them. This is what my CPA charges me to talk about it. In fact, I think they even charge me sometimes to go look up the information that they are then going to go charge me to tell me about. Right? So if you like getting free information that will save you tens of thousands of dollars or more, would you please do us a favor and leave us a rating or review on Apple Podcasts, Spotify, wherever you’re listening to this? That’s all that we ask for. We’re never going to charge you for information. We just need to make sure we stay at the top of the charts.

Rob:
With that, let’s get into today’s… Are you going to throw it to me, or can I? Sorry, I was feeling froggy. Did I steal your thunder?

David:
I like that you just grabbed it, and took it, and ran with it. Yeah. If you’re feeling froggy, leap.

Rob:
All right. Okay. For today’s quick, quick, quick tip, whenever you’re trying to plan out your taxes, it’s best to really have a good understanding of your accounting and your bookkeeping at least by October so that you have roughly about a quarter of the year worth of time to figure out how you can get rid of some of that tax bill, slice and dice that tax bill to hopefully zero if you’re using all the right tax strategies and tricks out there. Otherwise, if you’re waiting until December to get all of your bookkeeping in order and you’re trying to figure all this stuff out, you’re not going to have enough time, especially if you want to buy more real estate. If you want to buy more houses, that takes time. It takes two, three, four months sometimes. So the faster you can start planning, the more time you give yourself, the more likely you are able to cut your tax bill pretty significantly. How did I do, Dave?

David:
Amen to that. In fact, that was only one take, which I don’t know that I’ve ever seen you do.

Rob:
No.

David:
You’re clearly developing very nicely.

Rob:
Thank you. I’ve learned from the best.

David:
Now, if you listen all the way to the end of today’s show, you will actually hear us give you some examples of how to take all of the tax strategy we’ve given you with other strategies like house hacking, and borrowing money, and leveraging. It all comes together for some very, very simple ways that you could shield your W-2 income with very little money down. That’s the beautiful thing about real estate is as you’re putting in your time listening to these podcasts and you’re developing your tool belt here with all these different tools, you put them all together, you can create something beautiful. So you’ll see at the end this culmination, this climax of how you can take all this information, put it together, shelter your income, and then take that tax savings, and put it right back into real estate investing. Let’s bring in Matt.

Rob:
It’s going to be a good one. All right. Matt Bontrager, welcome to the BiggerPockets Podcast. How you doing, buddy?

Matt:
Doing great. Super pumped to be here. This is a huge thing for me.

Rob:
Well, awesome, man. Well, I want to throw you right into the fire here if you’re cool with it because we actually get a lot of tax questions, and you are my tax guy. You are my personal CPA, and I was like, “I want to put you to the test in front of everyone at home.” Are you up for the challenge?

Matt:
I am. Hit me.

Rob:
Okay. First question, fellow house hacker. “I have my first house hack, and I’m wondering how to best list it on my taxes. Do you get a difference between claiming the property as a rental versus a personal residence? If so, which would be better to do? I know this varies state by state, but I’m sure there’s some sort of commonalities. I’m in DC, by the way, in case you have firsthand experience.” Matt, what you got?

Matt:
Okay. So, first, house hacking is a great way to build wealth starting out. Right? So when it comes to house hacking, part of the property is going to be used as a rental, part of the property is used as your primary. It’s going to be more advantageous to, one, take the expenses like your property taxes, your mortgage interests, utilities, and things like that against the rental income that you’re receiving because you’re going to have to report the rental income from the tenants you have in the property with you. So you’re going to want to lower that income with those expenses, and it’s basically going to be pro rata. So if half of the home is listed for rent and used for rent, you would write off half of those utilities, half of that mortgage interest, and things like that. So, yes, better to take against the rental income.

Rob:
Okay. Okay. Very good. Very good. Very concise and very clear. Good job, man. We didn’t even feed you this question beforehand. Question number two, “At what point did you decide to get an accountant? I typically do my own taxes. I just started my investment property portfolio last year, and I have less than five doors. I’m on track to have 10 total by the end of the year. Also, I have an LLC, but I go back and forth on whether it’s really necessary, right? At least until I reach 10 more doors.” So I guess they’re asking, at what point shall someone consider an accountant?

Matt:
Really good question because we’re also going to segue into when you should hire an advisor versus a tax preparer or an accountant. My answer here would be I’m a fan of hiring a professional when you either become a landlord or when you have a small business. At that time, you need somebody that knows what they’re doing. But when it comes to hiring an advisor versus just like a tax accountant to prepare your tax returns, at this pace, for what you’re on, I would hire a CPA or an advisor that can help you tax strategize, not just prepare your tax returns.

Rob:
All right. All right. Take a deep breath. We don’t ever do this, but how do you feel after? Just giving you a couple of, I don’t know, softballs, curveballs? I don’t know which one these would be classified for you. Probably softballs.

Matt:
Both were pretty high-level softballs, but the first one was good because that does get a little bit nuanced with, “Hey, I’m living in this property, but also renting it.” So there’s some complexity there with separating the expenses, but no, those were good.

Rob:
Okay. Well, awesome. Well, now that we’ve proven your credibility to everyone at home, tell us a little bit about yourself, man. What do you do? Give us some background here.

Matt:
Yeah. So I’m 30 years old. I’m a dad of three hooligan kids. I have really young kids. I got a three-year-old and twin one-year-olds, and I’m a CPA. I love money. I love finance. I went to school for accounting. Luckily enough, it was one of those degrees that I got where I use it every day, and I’ve always been in accounting.

Rob:
Yeah, yeah, because I text you every day. I’m like, “Hey, can I write this off?”

Matt:
I got to stay sharp, so that’s what keeps us sharp. No, it’s great, and so I’ve been in accounting since I left school. I’ve stayed in public accounting, which is pretty important to recognize because I service a multitude of clients. Right? I’m not working at an accounting firm, just servicing one client, or I’m not working at one client’s in their backend accounting office. Yeah. So, 30. I got a family going, growing the CPA firm that I’m a part of, I’m the managing partner here at TrueBooks, and just staying sharp, helping people with their taxes, strategizing to bring it to zero if we can.

Rob:
Yeah.

Matt:
Right? So, that.

Rob:
Yeah.

Matt:
Yeah.

Rob:
That’s the goal.

Matt:
Yeah, always the goal.

Rob:
I’m very jealous because David, I think David is… He bought a commercial property that wiped out some of his tax bill there for a couple years. Right, David?

David:
Yeah. Two years, basically, I got covered.

Matt:
Nice.

Rob:
So, Matt, you touched on a couple points here, but can you walk us through the difference between being a tax preparer and a tax advisor because I know that they’re two very different functions? Is that right?

Matt:
They are. So most people that are using a tax accountant, the old school style is they’re going to prepare your taxes. So I’ve always made the joke that it’s awesome because anybody I shake hands with, I can do business with because they need to file a tax return. But when it comes to you running a business or becoming a landlord, growing a portfolio, you need more than somebody that just understands the forms that you’re sending them and preparing your return. All they’re doing is really filling out the report card for what happened in the previous year, and so what’s important now is you need that next level of advisory, somebody that’s going to help you forward plan to, “Hey, buy this building. If you do, it’s going to lower your tax liability by this many dollars,” or, “If you do this, within a couple years, you will be at this stage.”
So somebody that’s helping you plan and look at things in the future is more of that advisory role, and most people now, they either do their taxes themselves like we just saw in that question, which is fine. I used to do my taxes myself as an accountant before I started to do tax. But now, once things get a little bit more complex, I would at least hire a professional to prepare your returns. You’ll get a couple questions with them and things like that, but when you’re starting to grow and run a business or grow a portfolio, you need to sit down with somebody and look at everything holistically, which is where an advisor comes in. So, for example, at our firm, those are two different services. We have a tax preparation team, we have an advisory team, and it’s because those roles are completely different. So, two components to this game, for sure.

Rob:
Yeah. I miss the good old days where… Basically, from the ages of 18 to 26, I could log onto TurboTax and put a couple thing. Maybe I would even get a return. Maybe get $2,000 and $2,000 then.

Matt:
Yeah, refund.

Rob:
Then, I became self-employed, and I’ve really understood the importance here of proper strategy really early on in the year. So what is it exactly that you do? What’s your particular specialty?

Matt:
So we specialize in three things. Accounting, which we’ll also go over. So doing the books and the bean counting. We do tax preparation, and then we do tax advisory. I specifically am focused on the advisory side and in real estate. So 99% of our clients have a touch point in real estate, whether they’re agents, landlords, developers, whatever it may be, but we specialize in tax, and then in a sub-sector of real estate. The most tax-advantageous moves you can make are in real estate.

Rob:
Well, I can speak to your advisory skills, my friend, because you saved me… I don’t know. I would say at least $150,000 in taxes, but probably more than that, and hopefully, more than that this year too. So I know we have a lot to cover here, so I want to get into some questions and just understand and help people understand, really, everything that they should be thinking about as they start planning for taxes and everything that goes into it. Is that cool?

Matt:
Yeah, for sure.

Rob:
So why is your accounting so important for anybody in the real estate world, or if you’re self-employed or if you’re really trying to strategize with the whole tax side of things, what makes accounting particularly important?

Matt:
So there’s a few reasons of just why it is the core backbone to every business. One, if you’re looking to get a loan, your loan officer is going to ask for tax returns, and year-to-date P&Ls, and balance sheets. So if you don’t have your accounting, you will be scrambling. If you’re going to sell your business, they’re going to want to see the profitability, the balance sheet, what your numbers look like. If you’re looking to JV with a partner, they’re going to want to see how your business is doing, see the KPIs. Last, what hits us closest to home is people see us, and they’re like, “Great. I’m in this situation to where I can use an advisor.” The problem is if you come to us, and we go to sit down and tax plan, and you don’t know what your year-to-date numbers are or any numbers, we can’t even start.
So while accounting is boring and it’s like, again, bean counting the green visor in the back room, it is literally the backbone to everything business related. So that’s why I tell people. I just got off a call earlier, and they were saying, “Hey, I’m just starting out. I’m about to buy my first flip. I have one rental. What would you do before year end?” I posed the question of, “Could you pull your financial statements right now through at least September?” That answer was no. My answer to him was, “I would scramble to get your accounting caught up to at least October before doing anything else because again, it’s the first step to anything else that you want to do.” Again, it can be costly, but it’s such a requirement, which I think you both now could attest to. Rob, we’ve had a lot of conversations about accounting.

Rob:
Yeah.

Matt:
So, again, I can’t emphasize enough. No matter what talk I do, if I’ll get to do a speaking engagement, it always ends with and comes back to the importance of accounting.

Rob:
Yeah, and just to clarify for people, punching in on that, that’s bookkeeping. Right?

Matt:
Exactly.

Rob:
Properly understanding how much cash flow is going into your business, how much cash flow is leaving. Are you profitable? There are months where I… Really, when you just look at your bank transactions, for example, it shows you two numbers: money going in, money going out. If you’re looking at that, it’s a very, in my experience, inaccurate way of really understanding the profitability of your business just because money comes in and out at different points in a month, but it doesn’t necessarily reflect… I don’t know. It could have implications for many months down the road and stuff like that.
So, for 2021, I was having a VA do a lot of my bookkeeping, but my business exploded. Then, I gave you my books, and you were basically like, “Yes. Thank you for these. For 2022, would you mind putting them in a garbage can, and pouring gasoline on it, and lighting it on fire?” So, now, we’re having to scramble to get back, and I know that one of the main questions we get in the forms a lot is, “Should you wait until you’re established to dial in your bookkeeping?” Really, it’s the first thing that you need to do. Right?

Matt:
The very first thing, and that’s where I tell people, “If you’re comfortable using a spreadsheet,” I mean, I’m in spreadsheets hours a day, “Cool. If you can use a spreadsheet and track your money in and out, your expenses, your income, great.” But I’m a fan, and I’m not affiliated with them, but QuickBooks online. They make it so easy. You sync your bank accounts directly with it. The money comes in and out. You just classify what it is, you’re done. But when you have the cash flow, and it makes sense, and you’re a flipper, you need to hire a bookkeeper.
If you care about your finances, and your tax strategy, and all of that, you’re going to need your accounting because that’s the other thing. It blows my mind. Accountants are very risk-adverse, but I’ve seen so many people make a ton of money, and they have no clue where it’s at, how many bank accounts they have, what their P&L looks like. All they’re worried about is the day-to-day. So that’s when I say, “The first thing you can do when starting a business, buying a rental, whatever, getting your accounting squared away. Either you’re going to do it or you’re going to hire somebody to do it.”

Rob:
Yeah. So, really, a follow-up on here is, because you did talk about it, if you know how to work a spreadsheet… I do remember when we were doing taxes this year. I mean, when my bookkeeping was still getting caught up, that was a big back and forth, “Hey, do you have this?” “No,” and I’m reporting back to the bookkeeper. But then, I brought you a surprise set of taxes. I was like, “Hey, my other CPA dropped the ball. Can you do my taxes?” “Yeah.” I gave you a spreadsheet that had all of those listed, and you were able to really crank out the return super fast. So, the spreadsheet method, that’s a totally viable way of at least tracking expenses when you’re starting out. At what point should you convert over to something a little bit more robust like a QuickBooks Online account?

Matt:
I’m honestly a fan of… I don’t care if it’s a lemonade stand. If you’re willing to pay the 20, 30 bucks a month for QuickBooks, I would come out of the gate with an accounting software because you’re not in business to just start up and fail in six months. So if you plan to be in business, you might as well come out of the gate with what you need that will sustain you when you’re doing $5, $10, $20 million in revenue. But if you wanted to do the spreadsheet, I would say to break… If you have more than a hundred transactions a month, I would go to an accounting software because then, if you care about your time, you will get so much of your time back using an accounting software.

Rob:
Well, a fun fact. In college, I took Fundamentals of Accounting, and legitimately, for the first 15 minutes of every class, we played Lemonade Stand, which was a new app back in the day on the iPhone, and everyone was always like, “Okay. We get it,” because I guess it was a good illustration of accounting in some capacity, but the professor was obsessed with it. Sometimes we would spend the whole class playing it. We’d be like, “Teacher, the test is next week, and we still haven’t actually learned what you’re trying to teach us, so.”

Matt:
Yeah.

Rob:
So, yeah. I get a little PTSD there, but moving on, man. One question that we get… I mean, this is one of the hottest topics right now. We’re going to actually get into a lot of hot topics here. Hot topics. What is a cost segregation, and when can this be performed? I think there’s a lot of confusion here, a lot of people that don’t really know all the ins and outs. I’d love to dive into this, if you don’t mind, just imparting some wisdom on the greatness that is cost segregation.

Matt:
So when you purchase a property, you are buying the land that it sits on. You’re buying the actual structure of the building, the roof, the plants outside, the windows, the carpets, the paint, all of that. All a cost segregation study is doing is you are telling… Let’s assume you hire a firm to do it because you can go one of two ways. You can DIY it online and use a software where you’re telling them what you paid for it, you’re submitting pictures, and things like that. Let’s assume you hire a firm to do it. All they are doing is going in, and evaluating this property, and saying, “Okay. We know that you bought this asset, including the land,” and they’re going to break out the cost of that into certain buckets. Why does that even matter?
Bonus depreciation and depreciation alone is the holy grail for people in real estate. It is basically you getting the expense for likely sometimes money that you never even paid. So if you put $10,000 down on a house, you can get a way larger depreciation expense just because it’s based on the purchase price, not based on how much money you put down. So, at the end of the day, a cost segregation study is literally taking what you paid for something, the cost, and segregating it into these smaller buckets so that when they’re done, you literally take that PDF report, stash it away, give a copy to your accountant so that they can do your tax return correctly, but you honestly hope to never use the report other than what your accountant needed it for because… Why do you need the report?
Let’s assume you buy a rental, you do a cost segregation, you get this huge depreciation number, and then you later get audited, and the IRS goes, “Hey, how did you come to that? What do you have in your back pocket?” The cost segregation study from a reputable firm, an engineering-based firm that now you can use to defend that audit, but that’s all it is. It’s really an evaluation and a cost segregate report of this piece of property you just purchased. I mean, we can dive into when I would do one and stuff like that, which… I mean, it’s fairly quick.
If you’re a landlord of long-term/short-term or you’re in real estate full-time, it’s very likely you should do a cost segregation study. To the point of when, we’re about to close out 2022. Let’s say I bought a rental right now. I get it up and running by December 1st. It’s rented for those 30 days, and we’re in March of next year, and I want to cost segregate it. I totally can. I can go hire a firm, they can go do that report for me. I just wouldn’t get my tax return done, obviously, until that report is back, and I can compile all my records, but you can do them after the fact too. Quick tip there. I’m always a fan of doing the study, the cost segregation study after you spend your rehab money. So I would buy the property, rehab it, then go in for the study so that they can look at everything as a whole.

Rob:
Oh, okay. Yeah. That’s a good tip. So, I guess let me punch in on this because there are a few intricacies, I think, with how this works. So, typically, if I’m not mistaken, you’re my CPA, so I’ll let you take all the liability here. Typically, when you’re depreciating a long-term rental, for example, that is depreciated over 29… No. Sorry. 27 and a half years. Then, if it’s a short-term rental, it’s over 39 years. Is that right?

Matt:
39 years. Yep.

Rob:
Okay. Cool. So, basically, every single year, when you’re running your taxes on these properties, you get a small portion of that depreciation that you can write off?

Matt:
Mm-hmm.

Rob:
Right? Okay. So if you run a cost segregation report, basically, what this allows you to do is instead of breaking up that depreciation over 27 and a half or 39 years, you can now actually just… and taking a small portion of it every year, you can take a very large chunk of that depreciation and write it off in the first year?

Matt:
Exactly. Yeah. Do you want me to hit you with a numbers example? I’ll try to keep it as…

Rob:
Yes, please.

Matt:
Okay.

Rob:
Yeah, yeah.

Matt:
Okay. So if an accountant is listening to this, they’re going to grill me, but that’s where I want to preface this with. This is an example, a drastic example. If I bought a property for $400,000, I just paid… and we’re not going to rehab it. We’re assuming it’s rent-ready.

Rob:
Turnkey.

Matt:
Let’s say of that $400,000, $100,000 of that value is to the land. The IRS says, which is safe to assume, you cannot depreciate land. It is not going anywhere that we know of.

David:
Do you mind if I stop you real fast, Matt? I’m sorry.

Matt:
Yeah. For sure.

David:
Can you just define what depreciation is so it makes sense why you can’t depreciate land, but you can improvements?

Matt:
Yes, it’s because… Think of it as the deterioration of the asset. The best example is cars. How they’re always like, “Ugh, don’t buy that new car. It’s going to depreciate the second you drive it off the lot.” Sure, it will, but it’s basically the wear and tear of an asset over time.

David:
There you go.

Matt:
Right? So the reason there is why it’s so powerful to that extent is think of the car. I can buy a $50,000 car, put no money down, and if, let’s say, it’s over 6,000 pounds and all of that, I can get a $50,000 deduction for not putting any money down. So that’s why depreciation is so powerful because you get so much more. You get so much bang for your buck, we’ll say.

David:
Now, the problem with cars, the reason we don’t do this is often, it’s very difficult to make a car cash flow.

Matt:
Yeah.

David:
So even if you borrowed 50 grand, you’d be losing that money plus the interest every year. But with real estate, it will cash flow. So it pays for itself. Yet, the IRS still gives you that deduction because technically, it’s losing value as it falls apart. So thank you for that.

Matt:
Exactly.

David:
I just know everyone gets confused when they hear depreciation and no one ever wants to admit they don’t know what it is. They don’t want to be the one person who says it.

Matt:
Yeah. No. For sure, and so right? So to that question that you just mentioned is that’s why land… Land is land. You can kick it. You can dig it.

David:
It doesn’t go away.

Matt:
You can do whatever, but you own that piece of land. It’s not going anywhere, but now there’s a difference between land improvements, which you can’t depreciate. So if you lay concrete and all of that, you can do that, but…

David:
Mm-hmm.

Matt:
Okay. So we got a $400,000 house we just bought. We’re going to say $100,000 is land. So we’re left with $300,000 of this pie. For ease of numbers, let’s say the building structure itself, so the roof, the framing, the actual structure and foundation is, of the $300,000, $200,000 worth. Okay? So, now, we’re left with $100,000 of this pie. $400,000. $100,000 was land. $200,000 was the building itself. Now, we’re left with that other bucket of $100,000, and let’s say that that cost segregation study report shows you that the windows that are in that property, the paint, the carpet, the desks, the furnishings, the lights, the fans, the sinks, the cabinets, all of that equates to $100,000 of value.
Now, I’m sitting with that, and I can bonus appreciate that because the rules say every asset that you buy is given a life. If it’s a 20-year or less life, the IRS allows you to bonus appreciate it in the first year. So, normal cabinets, if I spent $20,000 on cabinets, I’d have to take it over five years. But because the bonus depreciation rules allow me to bonus anything less than 20 years, I can bonus that, so that’s where… In that example, if the cost seg firm evaluates this house, and they say, “Yeah, $100,000 is your small assets inside that are five and seven years,” you can bonus depreciate that.
Why that is so important is because if you didn’t do that study, your normal accountant is going to look at, “Oh, cool. You just bought a $400,000 house. We’ll say $100,000 is land,” and they’re just going to take the $300,000, divide it by 27.5 which… Let me run this. Would only give you an $11,000 deduction. But if you went to a cost seg firm, and they say, “Wait. We’re going to say only $200,000 is the building, but then $100,000 is small assets inside of it,” you would get a little over $100,000 deduction. So that right there would swing you from probably having to pay tax because you would cash flow and have income profit on paper versus now showing this huge depreciation expense which would drag you to a loss, which is what everybody aims for.

David:
So to illustrate this point even further, are you saying if I buy a short-term rental, and let’s say it grosses me $100,000… or let’s say my profit is $100,000. If I take $100,000 deduction, is my tax bill then zero?

Matt:
If that was all you did, exactly, your tax bill would be zero because now you’re looking at… Your P&L for that property is zero. You have no taxable income when it comes to that property.

David:
Normally, you would not be able to depreciate $100,000 of losses because it would be spread out over 27 and a half years or five years for the cabinets. But with bonus depreciation, you’re able to take that long period of time, crunch it up into a short period of time, and take it all upfront.

Matt:
Exactly. So that’s all you’re doing. All a cost seg report does is, “Hey, what in this property that I just bought…” I don’t care if the property is $20 million or $200,000. It’s, “Tell me what the 5 and 7-year and 15-year property is so that I can identify the value.” So if I paid a million bucks, what if the value of that property is $300,000? I get to take $300,000 immediately as an expense, and I still get to take the building just over 27 and a half or 39 years. So that’s why they’re so important is because you get a huge depreciation expense deduction, which is likely going to swing you to a net negative or a loss.

Rob:
Okay. So, man, there’s just so much. Okay. Cool, cool. So let’s say that you do a cost segregation and you take all your depreciation in that first year, you can still depreciate for the next 39 years, right? Isn’t there still some leftover at 27 and a half?

Matt:
Exactly. So let’s take that example of the $400,000. $400,000. $100,000 is land. $200,000 is the building. $100,000 is the five and seven-year property. If you depreciate the five and seven-year property in year one, that’s gone. Think of it as you’re not going to get to depreciate any of that hundred grand anymore, but what are you left with? The $200,000 building that you just have to depreciate over 27 and a half. So let’s say instead of 11 grand, if your accountant did it the wrong way, you’d get $200,000, and you’d still get 7,200 bucks as a deduction because that $200,000 for the building value, you’re just taking it over a longer period of time. So remember the rule. Bonus depreciation is 20-year life or less. The building in a residential long-term is 27 and a half. Commercial, 39. So neither of those are you going to get to bonus, but the goal is to identify the small stuff, the electrical, paint, carpet, windows, all that.

Rob:
That’s crazy. So, really, you still get depreciation every year after. So is there any reason to not run a cost segregation report on your property?

Matt:
Time, value of money, and all that would tell you no. That’s what I’m saying. If you’re a landlord, short-term or long-term, or you’re in the nature in the game of real estate, I would cost seg it because worst case scenario, you make a $50,000 W-2, you kick up two long-term rentals that you cost seg and somehow drive $100,000 loss. Even if you don’t meet the rules to where like, hey, you have this W-2 for 50 grand and this $100,000 loss, and you can’t net them and say, “Hey, IRS. I made no money on paper,” you can still roll that loss forward, or you can sell rental property number two, and you take this huge loss you just got from year one, and net that against it. So there’s still so many other ways. Just think of it as delayed gratification if you just can’t use it that year.

Rob:
Dang it.

Matt:
So that’s why I would still cost seg, and sorry, this is the last year to do a 100% bonus. When Trump passed that Tax Act, we got a 100% bonus depreciation. It was just a heyday for real estate investors. Now, this is the last year that we get a 100%, and it will phase down to 80% next year and continue to phase out 20% each year.

Rob:
Yeah, yeah. Okay. So just so I’m clear, and I want to make sure we understand the concept because then we’re going to get into another thing here, but let’s say I have a short-term rental, and let’s say I’d take $100,000 deduction from the cost segregation you talked about. Let’s say that I have any rental I guess, and let’s say I’m making a $25,000 profit. Then, let’s say that I have another business that’s self-employment like of a 1099 employee of myself, right, and that’s a $75,000 profit or gain. Would my deduction count towards both of those?

Matt:
So think of it as the rentals could offset. So if you have a rental making 50 and a rental losing 50, it’s likely there are circumstance that you can net them out and pay no tax on your rental income. If you want to start involving your business and saying, “Hey, I’m going to buy real estate, and I’m going to take these huge losses against my business income,” that’s where we’re going to get into that because there’s a few ways to do it, but there’s a lot more check boxes to go that route, but for sure on the rental side where rental making money, rental losing money, and you can net those out.

Rob:
Okay. Cool, cool. So I guess that gets us into another really big hot topic here in real estate in the forums, which is real estate pro status, and what are some of the qualifications here, and what are the benefits of being a real estate pro?

Matt:
Yeah. Okay. So that’s exactly what we’ll go over. One thing I want people to think of real estate professional status as being as a designation or a badge that you get from the IRS. There are two rules that you have to follow to be a real estate professional, and they’re not this or that. It’s this and that. You have to meet both of them. The first test is 750 hours, personal service hours in a real property trader business, real estate.
There’s nine of them, I’ll read them quickly. Development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operations, management, leasing, and brokerage. Those are the types of businesses which if you’re a realtor, if you’re a flipper, a wholesaler, landlord, you will pass, but you have to have 750 hours in this business. Quick note there. If you’re an employee, you have to own at least 5% of the business for those hours to count, but the first test, 750 hours.
We have a lot of clients that are like, “Great, I’m a real estate pro. I’ve hit 750,” but they forget about test number two, which is more than one half of your total work time has to be in a real property trader business or in real estate, and that is where most people fail. They’ll be a manager at a department store. They’ll be a doctor, a dentist, whatever. That’s why what we see is one spouse will… Let’s say they’re a money-maker. They’re a dentist. They’re making a ton of money.
Their spouse will now go out, maybe be a realtor, start flipping, run their portfolio, and they will earn this real estate professional status because let me tell you now, from my understanding, there’s been one court case where somebody argued that they were a full-time employee somewhere, yet still a real estate pro, and it’s because it’s very hard. If you’re working full-time, how are you going to argue to the IRS that you work 4,000 hours a year and more than one half in real estate while you maintain a W-2 job? So those are the two rules, 750 hours, and then more than one half of your total work time to be a real estate pro.
So the reason why real estate professional status even matters. We have to look at rental real estate and business income of what you do day to day. They’re separate. Rental real estate is considered passive, and business income is non-passive. There are a lot of rules with the IRS to merge the two. Being a real estate professional is one of those carve-outs where the IRS says, “Hey, if you have a lot of losses from real estate, rental real estate, and you are a real estate professional, you have the ability to take those losses. If you’re not a real estate pro, basically, kiss it goodbye. Your only other option is the short-term rental loophole, which we’ll go over after. So what we need to segue next into is being a real estate pro is great, and that gives you the ability to take these losses. But if you don’t materially participate, being a real estate pro doesn’t even matter.

Rob:
Okay. So you mentioned something when you’re breaking down real estate professional status, which is material participation. That’s pretty important too. I know that there’s a lot that goes into it, so can you quickly just break… Well, as quickly and whatever you need to do to get the point across, but what is material participation?

Matt:
So, at the end of the day, the IRS wants to see if you’re taking these losses from real estate. They want you involved. They want skin in the game. They want to see that you’re managing or assisting managing the property. So material participation basically is… There are seven tests. In this case, you only have to meet one of them. There are three that most clients will meet, and so we’ll cover those. So if you have a long-term rental, and you are a real estate pro, and now you need to meet material participation, this is how you would do it. The gold standard is 500 hours. If you spend 500 hours on that rental, they call it an activity, but a rental, then you would qualify as materially participating. That’s hard. If you have one long-term rental, it’s very unlikely you’re going to hit 500 hours.
Test number two is a little bit easier where you have to hit 100 hours and more than anybody else. So you notice how if I hire a landscaper, a cleaner, or anybody like that, I now have to manage their time and see how much time they’re spending because I have to hit at least 100 hours and more than them. Again, showing the IRS that I have skin in the game. I’m doing the work. Test number three is a catchall, but it’s a little bit sketchier, and it is basically substantially all. You’re saying you did substantially all the work. The problem with that test is notice that the second you hire somebody to assist with the property, you’re now held back to that test number two because now you have to track their time and make sure you’re doing more than them.
So I say this as you have to think of real estate pro as the first hurdle jump over, and then materially participating as the second. You have to be a real estate pro. You have to materially participate to take that loss that you just got from that big cost segregation study. That’s why I was saying even if you don’t get to take the loss because, let’s say, you’re not a real estate pro or you failed material participation, it’s okay. You’ll get the loss later. But for you to maximize this and take these big losses that cost segs are giving you, you have to be a real estate pro, and you have to materially participate if you’re going long-term.
We’ll get into the next piece, which is short-term rentals, which is… There’s a bit of a loophole there around this entire section that we just talked about, but everybody, every TikToker, every Instagrammer forgets or leaves out that piece, and that’s the piece that I want people to remember is not only do I have to be a real estate pro, but I have to materially participate in these properties, or else the real estate professional means nothing.

Rob:
Okay, and so if you materially participate and you’re a real estate pro, at that point, you are able to take your depreciation losses against W-2 income or no?

Matt:
Exactly. The best example. You have a spouse making $50,000 as a manager somewhere. You have the other spouse being a real estate agent, and you buy a property. They’re a real estate pro because their day-to-day work is in real estate. You buy this property, you self-manage it, you do a cost segregation study, you get a little bit of rental income, you write off your mortgage interest, and you’re basically at zero on your profit and loss. Then, you come in with this whopper depreciation expense of… Let’s say it’s 60 grand. You now would be able to take your W-2 of $50,000, take the $60,000 loss, and on paper, look like you lost $10,000. You’re getting your entire refund back, and you’re sitting pretty. You’re going into year two with a $10,000 loss, but notice they had to be a real estate pro. They had to materially participate. But when they did, huge tax savings because now you basically made no money on paper when in reality, you took home at least 50 grand, and the property probably cash flowed.

Rob:
Man. Okay. So, all right. Again, every time I talk to you, my mind melts, but this is where… This short-term rental loophole, this is a really popular thing. This is, really, a groundbreaking thing for people in the Airbnb space, short-term rental space. So tell us about that because this is where things start changing a little bit, right?

Matt:
This is a wild one, and let me preface this with too. People don’t like the term “loophole.” Don’t care because this is truly a loophole. I don’t think this is the IRS’s intent with this. I do think this will go away, and here’s why. Real estate professional status, and material participation, and basically, back to that example of you earning rental real estate, and taking losses, and trying to net them with your business income. You’re held back by doing this because of Section 469 rules and the STR loophole. You are simply skirting the rules because in the definition of Section 469, it says these things are not rental activities with respect to these rules. So you think, “Okay. Well, if I don’t have something that’s a rental activity, I don’t have to abide by those rules,” and how you’re avoiding it is two main rules.
If you have a property where the average rental period is seven days or less, you are considered transient use property, not rental property. So, therefore, I get to avoid those rules. The next rule is I have a… so a client out here in Vegas. They just bought a high-rise condo, and they’re held to doing mid-term rental. So they have to do 30 days. The rule for that is… so another one of those exceptions to this whole code section is if you have a property where it’s equal to or less than 30 days on average being rented, that’s okay too. That’s not a rental property. But in that case, you have to have substantial services, which in that case is like daily turnover service, private chef, a vehicle for them to use. Something more along the lines of a bed and breakfast. This is not just a normal short-term rental now. This is a business.
So if you can meet those two, you’ve now skirted the rules of 469, which was disallowing you to merge these things, your day-to-day business and your rental real estate, and now you’re able to do that. The only kicker is what do you still have to do? You still have to materially participate. So, perfect example. Couple, they buy a short-term rental. It doesn’t matter what they do for their day-to-day job because I don’t need to be a real estate professional here. They get an Airbnb. The average rental period is six days. That’s the average stay for a tenant. They manage the bookings. Right?
So, let’s be honest. Back to those three tests of material participation, you’re not going to want to clean it yourself. You’re going to hire a cleaner. What happens if you hire somebody? You’re held to doing 100 hours and more than everybody else. So what’s going to happen? You’re going to manage the bookings. You’re going to walk it. You’re going to post it online. You’re going to do everything else, but clean the property. You’re going to hit your 100 hours. You’re going to let somebody else clean it. You’re going to do a cost segregation study. You’re going to drive a huge loss, and you’re going to net it against your day-to-day income. That, at the end of the day, is what everybody in real estate should aim for because that’s the holy grail. That’s the Trumps, the Kiyosakis, the Grant Cardones, all of that of how you’re netting these losses from your business against this or with this rental income. So the STR loophole is a great way to do it and like you said, is really catching a lot of attention now because it’s so powerful.

Rob:
So if I’m understanding this correctly, just to break it down, let me make sure that I’m picking up what you’re putting down. So you can basically buy a short-term rental or an Airbnb of sorts. I guess in some instances, a mid-term rental, but I’m just going to go with the short-term rental side of it. You can materially participate in that. You’re working at least 100 hours on it and more than anyone else who’s working on that property. If you do that, when you take a loss with the cost segregation, you can count that loss towards W-2 income as well, and the loophole is that in other scenarios like long-term rentals, you would have to be a real estate professional on top of materially participate. In this instance, you just have to materially participate. Is that right?

Matt:
Exactly. I can avoid, right? So me as an accountant and a CPA, I can do this. I don’t need to be a real estate professional. Prior to that, it was cool. Real estate is great. It appreciates. You cash flow. But if you want to really realize the tax benefits, you got to be a real estate pro. Now, this is simply a way to skirt those rules if you can still meet these new rules and still maximize your losses from real estate.

David:
Matt, what are some other things people can do that would qualify for working on the property? So if you’re doing research on other properties and what they’re doing to generate revenue or stay booked, or if you’re looking up information about how you could generate more per stay, or you’re shopping for furniture for a couple hours, does all of that… Can those hours be counted towards the time you spent on the property?

Matt:
That time does count. What I want people to watch out for is, is if you went to battle with the IRS, and they look at your time log. There’s operational hours, we’ll call it, which are the good stuff, like you said. Furnishing it, dealing with tenants, drafting the contracts, walking the property, those kind of things. Very managerial day-to-day ops. But then, there’s like you mentioned researching other properties, “I’m checking the financials,” “I’m collecting the rent,” “I’m reconciling the bank account.” Those are investor level hours or what could be considered education and research hours. If you sent a time log to the IRS, you wouldn’t want the majority of those hours to look like educational or investor level hours. You want it to be property related. So there’s no for sure answer of what allocation can be those hours, but I wouldn’t have the bulk of them be that. But just as you said, there’s a lot of different things you can do to earn those hours.

Rob:
Yeah. So, David, I was going to ask you. You bought 15 short-term rentals this year. Is that just going to slice your tax bill for life?

Matt:
That’s nice.

David:
No. Now, I’m actually wondering because I wasn’t thinking about this before. I had that property that covered last year’s taxes and this year’s taxes, but I’m wondering if these ones could cover next year’s taxes. So is there a way that I can build up depreciation in 2022 that is unused and could be applied towards 2023, Matt?

Matt:
For sure. We just had a conversation with a client this morning that it’s still rolling over depreciation. This will be his third year into 2023. So if you have a net operating loss, which is what you likely generated last year, that rolls forward with you, and if you generate another one in 2022, you will continue on with that. For sure. That’s the game. That’s the name of the game.

David:
This depreciation is just like a superpower, right? When we’re trying to figure out how to shield our income from real estate, this is almost exclusively. We’re just looking for creative ways to take advantage of it. We call it a loophole. I hate that phrase.

Matt:
I know.

David:
I know what we mean when we say it, but it sounds shady. It’s not shady.

Matt:
Yeah.

Rob:
Yeah.

David:
The reality is if you owned a restaurant and bought a dishwasher, that dishwasher is going to break down. It’s not going to run forever. You get to ride off the period of time because you got to buy new equipment for it. Right?

Matt:
Mm-hmm.

David:
Your rental property, even though it’s a house or whatever, it does fall apart, and you got to spend money to paint it, and fix it, and the foundation will go out over time. The roof will go out over time. The cabinets will wear down. It is slowly falling apart. It’s just got two things that nothing else has. One is you can leverage buying it much easier. You can borrow a bunch of money against it. Two, it tends to appreciate in value where your car doesn’t. The dishwasher doesn’t. Everything else you buy becomes worth less once you own it, but real estate, because of inflation, goes up, and you can borrow. You get this trifecta of leverage and appreciating value through inflation mixed with this depreciation factor, and bam, it’s how the Trumps and the Kiyosakis, like you said, say they don’t pay taxes. Now, it irritates me personally when they go up there and say, “I don’t pay taxes. I’m not that dumb,” because then it incites everyone to go want to get on this political rampage like, “Let’s get rid of depreciation so these greedy investors stop doing that.” Right?

Matt:
Mm-hmm.

David:
If people hear everyone say, “Oh, there’s a short-term rental loophole,” it’s very easy to say, “Loophole? That’s bad and not in my backyard.” The next thing you know, you’ve got a political wave of people that are going after short-term rental owners.

Matt:
Yeah.

David:
This is more of a way of qualifying as a real estate professional because they are recognizing this ish is hard work. Owning a short-term rental is not just buying an apartment complex, having someone manage it, and swimming in the dough. It’s frustrating. Rob could sit here and tell you. He wears the same black shirt every day because he has no mental energy when he wakes up trying to deal with the complaints and the headaches of managing what accounts to be a very small hotel by yourself. Right? There’s a reason why the tax code is written to benefit you. The key is, in my opinion at least, it stops you from looking at real estate like, “Should I buy real estate, or should I make money at my job?”

Matt:
Oh, yeah.

David:
It lets you do both. I can make money at my job that I can save if I buy real estate. Right? It creates this holistic approach to wealth building, which is what I think our industry needs. There’s too much of this, “Take a $100,000 course of mine, and I will teach you how to quit your job and just buy real estate.” Right? It never works. There isn’t a person I know… I know, Matt, you work with Ryan, I believe, and a lot of us know people that own real estate. All of them work a lot. We don’t know people that are sitting on the beach doing nothing that bought real estate. Right?

Matt:
Mm-hmm. Yeah, not really. No.

David:
We’re still lurking to earn money in different ways, but we’re sheltering it in the real estate. Right? Let’s not forget. There’s a risk associated with buying estate. This is part of why you’re compensated for these things because you could lose money in it. It’s not like a W-2 job where you go to work, and you do a bad job, and your boss charges you 900 bucks for sitting in their office or at their desk all day. There’s no downside to a W-2 job. There is to real estate. Now, we haven’t seen much of a downside because the last 10 years, we’ve been printing money like crazy. So everyone has done well, but it’s not always like that. Right? You do hit circumstances where you can lose in real estate, and this is a form of shelter against some of those losses.

Matt:
Yeah. For sure. Right. It’s to the point of… So I get a lot of flack because, again, to that loophole method, and it’s like you’re still following the rules. When people like to talk about, “Oh, well, you’re sort of one with the government, and you get these incentives because they’re written by the government.” What do they want you to do? Spur economic development. What are you doing by being an STR landlord? You’re spurring economic development. Right? You’re likely rehabbing a property and making it nicer for the area. You’re generating income that will likely be taxed. So it’s just like that’s the benefit that they’re giving you.

David:
You’re also ruining neighborhoods, driving up housing prices in my backyard. If you really, really go deep on this… I love your point, Matt. Let’s take the property Rob and I bought in Scottsdale as example. Okay?

Matt:
Mm.

David:
We are employing house cleaners to go in there and make money that are going to have their income tax and provide revenue to the government. We are employing landscapers who have to go in there, and they have to do work, and we’re generating revenue for them that will be taxed and will go to the government. We are paying money for utilities, for water, for energy, a lot of stuff. We have a pool service person that has to go in there. We’re constantly buying new products like a $25,000 water heater that Rob really wants for this property that’s going to be taxed, that’s going to make money for some business that employs people that all pay money on that.
We have a handyman that have to go fix stuff all the time. Right? A person had to build that house in the first place that made money from it. The airlines that people fly in from to visit our property are making money and being taxed. The car that you rent at the airport or the Uber driver you take to get to there are all generating revenue, and they’re all being taxed. So it’s easy to say the real estate investor isn’t having to pay tax, but like you said, they’re generating more revenue for the government than what they are keeping and not having to pay the tax from the property.

Matt:
Exactly. It’s why you get the benefit for doing it is because you’re spurring all of that development, and then just like you said, how many did you buy this year? Look at what you’re doing across the board. I almost wish you could mind map that out and see how many other people and how much other income and tax you’re generating by those assets even though you may not pay tax. Yeah.

David:
Let’s talk about the neighbors that don’t like it for a second. Okay?

Matt:
The Karens.

David:
The Karens, right?

Matt:
Yeah.

David:
They all complain, “I don’t like that person making money with that house.” All right. I bet you don’t mind the value of your Scottsdale property quadrupling in the last six years, and there’s a reason why. Those properties are worth more to an investor who runs it as a short-term rental, so they pay much more for the house, which now takes the comps and bumps it up for every house in the neighborhood. You know what happens when a house sells for more. The Scottsdale city and the state of Arizona get more money in property taxes because the basis doubles, and property taxes go up. Now, they have more money to fix roads, and put on events, and do all the stuff that everyone loves.
It’s super shortsighted to just get angry at somebody who’s making moves and to get upset. It makes that entire area worth so much more. Every one of those homeowners has six figures minimum to all of them with what their house is worth, and the same happens in a lot of different environments. A lot of different areas where short-term rentals have moved into there, you do get your stereotypical loud parties and crap, but in general, they make the area worth so much more. They increase the tax revenue for the area. The basis of all the properties goes up. The homeowners make more money. Now, they get equity lines of credit on that, and they go spend it on new stuff which now creates revenue for all the people that are selling them this stuff, which now pay income taxes on their W-2 income. When you look at the big picture, it makes so much more sense. It’s often when we focus in on the one little thing that you get that negative Karen energy. Is there a name for that? NKE?

Matt:
Bad vibe.

Rob:
I think it’s NKE.

Matt:
Yeah.

Rob:
I will say, dude, make sure that you have an editor cut that last one to two minutes and put that on TikTok, and you’re going to go viral, man. That’s all very true. This short-term rental loophole, whatever you want to call it. I mean, this is one of those things that I’m a lot more unapologetic than I used to be, a younger, not as wise self. It’s like people are always like, “How can you not pay taxes? What about the roads?” And, “How dare you.” I’m like, “Look, first of all, all the millionaires and billionaires are out there. They’re using the tax code. I’m not going to just be…” What is it? What is it? I’m not going to be the guy that’s like nice and being like, “You know what? It’s wrong that they did that. Thus, I’m going to mail in a check to the government because I’m a nice guy.” It’s like, “No. I don’t want to do that. I’m going to use the tax code as it was written,” and the tax code was written for real estate.

Matt:
That’s exactly it, and that’s what always gets me, and I love to clap back at these people in the comments is I would love to sit across from an auditor and show them your tax returns, show them any of our clients’ tax returns is because we are following the rules. We’re not exploiting any rules, or I guess you could say exploiting if that’s the word, but whatever. We are following the rules that they’re writing. To your point too, when you look out at the macro, it’s either you pay the tax, let’s say, as an employee, and the money goes to the government. The government depends on where it spends the money.
The government is terrible at spending money. I would much rather have somebody go in and like you said, hire the cleaners. Maybe you buy a lot off somewhere else in the desert, and you got to build roads to get to it, bring utilities to it. So you spending that money your own way is likely still better than having the money go directly to the Fed, and then them spend it that way. So it’s like you’re going to get the economic development somewhere. I’d rather have it go from the investor who’s going to want to grow it into more. You know?

Rob:
Yep, yep.

Matt:
Any day, so.

David:
Which is the same principle behind the 1031, right?

Matt:
Yeah.

David:
It’s the same idea. You’re not avoiding taxes. You are taking your gain and putting it into a bigger property that the government is going to get more money from later because you’re better at using the money efficiently than any… the government isn’t going to do and stuff. I’m not trying to be negative, but look at your experience with the TSA versus if you go to Clear. Okay? Do you ever go to the DMV and walk out like, “I’m going on Yelp and give it a great review because this DMV experience, they were so good?” It’s just that’s the way it works. They’re not incentivized. It’s not a capitalistic endeavor. So anytime you can take people that are good at doing something and put the power in their hands, it’s going to be better for everybody than when you rely on the government. It’s like opportunity zones. Same idea, right?

Matt:
Mm-hmm.

David:
Investors do a much better job developing an area that’s been hurting by pouring money into it in a prudent way than the government going in and building public housing, and then ignoring it, and it turns into a crime-ridden area that’s been ignored, and none of them know how to fix it. I like painting the tax code in the appropriate light, which is they’re wanting to incentivize this behavior. They want the brightest and the best minds in business that are good to develop real estate because people need housing, and the more that houses are worth, the more taxes it makes for the area. All those people that are not real estate investors benefit when their area generates more property taxes, and it can get poured back into the schools and everything else that’s benefited. Don’t take the shortsighted approach that you’re going to see in YouTube comments or Instagram hate where they’re like, “Greedy landlords are ruining this for everyone.” It’s usually the opposite.

Matt:
Think about it. They want you to grow as an individual. You could be a W-2 employee, right? When I say they, the IRS or the government in this case for the tax code. You could sit on the couch, be a W-2 employee, and you’re going to pay tax on your W-2. You go stand outside, and hold a sign, and start selling lemonade for a dollar, you’re a business owner and can take deductions. Why? Because now you’re in the pursuit of income, and you’re going to now start spending money in other ways that are going to drive economic development. If you’re going to just be an employee, and retain money, and spend it on goods and services that you’re going to use personally, great. There’s room for that. We need that. But if you’re going to go out there and spur development, you’re incentivized, and so you get to take those deductions.

David:
What happens if you buy a primary residence, you live in it for a period of time, you move out, you turn it into a short-term rental?

Matt:
You can cost seg it. You can take the loss. You can do all of that, and potentially, when you end up selling it, because we all know if you sell your primary residence and you’ve lived in it two out of the last five years, you get huge tax advantages. So even if you, let’s say, lived in it for 10 years, you have it be a short-term rental for a year or two, you don’t like it, you sell it, you still may get to bite off a piece of that tax benefit just not as much, but totally fine. It’s a great strategy.

David:
So you live in it for two years, then you rent it out for three or so as a short-term rental, you get all the tax benefits of the short-term rental, then you sell it at the end of that, and some of that gain would be sheltered by the two years that you lived in it as a primary residence? Totally legal, totally intelligent. You don’t have to go put a massive amount down to get into the short-term rental game. You can go put an FHA loan on a primary residence, live in it for a period of time, rent it out. You can take advantage of everything we’re talking about without needing to be a multimillionaire with 400 grand to go drop on a Scottsdale property.

Rob:
Mm-hmm, like 500, but that’s neither here nor there. Plus, another 200. Ah, that’s not the fucking price.

David:
[inaudible 00:56:57]?

Rob:
We’re going to make it. We’re going to make it back. Okay. I do actually want to say before we wrap up today that one thing for people to keep in mind… There’s already some angry man or angry lady that’s already left a comment in the comment saying, “Oh, how dare you not talking about recapture tax.” So all of this obviously is riding on the fact that you don’t sell the property because if you cost seg and you take the loss on your taxes, you can’t… don’t think you’re going to get smart, and then sell the property, and then use that money to go buy another one, and do it again. You’ll have to pay back a recapture tax, right, Matt? Can you explain that briefly, or did I do it? Did I do a good job?

Matt:
Yeah. Basically, yeah. So if you take depreciation, the government is giving you the expense now, and so later, when you sell that asset, you will have to pay some recapture. But for those of you that are like, “Well, why would I even take it then?” One, you have to because if you end up selling the asset, the IRS is going to make you calculate it as if you took depreciation even if you didn’t. So you’re still going to have to pay recapture. So that’s where, always upfront, you’re going to take the depreciation when you can, but you nailed it. You’re going to have to pay some recapture.

Rob:
Yeah. Is the recapture just proportional to basically the years that you owned it?

Matt:
Kind of. So it goes back to those buckets of property because there’s different recapture rates. So, for example, on the building, that’s a 25% recapture. So if you took $100,000 in depreciation, $25,000 is going to be depreciation recapture. On the smaller assets like the windows, carpet, all that, five and seven-year property, that’s ordinary recapture. So whatever your tax rate is, wherever you fall in the bracket, but…

Rob:
Okay. Cool.

Matt:
You will have to pay recapture, but that’s where, to what David was saying, if you continuously purchase real estate, you shouldn’t have to worry about it. The example I like to use is Grant Cardone and the jet. He buys a $90 million jet, sells it, has a huge gain because of this recapture. What does he do? Go buy another jet. What are you going to do if you’re a landlord? Buy another property or 1031.

David:
That is an important point to highlight because it’s not… Like I was saying, it’s not a free loophole. There’s risk associated with buying real estate, and the other thing, when you get into the strategy, like we are, it hits you, “Oh, I can never stop.” You’ve heard the phrase “to grab a wolf by the ears?” You familiar with that, Matt?

Matt:
I’ve heard that, but now I want to see exactly how that…

David:
No one knows what it means, but we have all heard it. Right?

Matt:
No, I’ve heard that though, but yeah.

Rob:
Good. Can I take a guess really fast?

David:
I’d love this.

Rob:
Okay. So it’s like you grab a wolf by the ear before it bites you, and then you’ve got to… It can no longer bite you because you’re holding it by the ears. But if you let go, it’s going to bite you.

David:
Yeah. You could never let go, but it can never hurt you. It’s a stalemate that you’re locked in and by the ears. You’ve got both ears, so he can’t bite you, but you can’t let go. Right?

Matt:
Yeah. That’s a good one.

Rob:
Well, to be fair, I didn’t get that. As I explained it, I was like, “I think I’m getting it. I think I’m getting it.”

Matt:
He’s formulating it as he…

David:
That’s so funny.

Matt:
I was like, “He’s so smart.” Yeah. That’s good though. That’s good.

Rob:
You’re right. I totally see the correlation here. For sure.

David:
It’s that Michael Scott quote, “Sometimes I just start a sentence and hope I find my way as I go.” That’s what Rob did. Yeah. You got to understand. As you’re making money, because you’re taking all the depreciation that’s normally over 27 and a half years or I believe 38 years for a property…

Matt:
39.

David:
39? Okay.

Matt:
Yeah.

David:
You’re crunching it into the beginning, so it’s not free. Right? At some point now, that income is very difficult to shelter because you’ve used it all up. So if you stopped buying more real estate, then you would be taxed higher on the revenue that’s coming in because you took it upfront. It’s not free, and if I keep making money, but I stop buying real estate, I’m getting taxed on it. So what I like about the strategy frankly is it forces me to always be buying real estate.
If I ever got cocky and was like, “You know what? I just want to buy a couple Lamborghinis. I want to get my Andrew Tate on. I want everyone to call me The Top Greene, The Top G, and I want to look like a big shot,” I would be getting taxed terribly on the income that’s coming in. It forces me to keep and delay gratification. I got to keep buying real estate. I got to keep delaying gratification. I have to keep running my finances from a more wise position of living off of the cash flow that the assets produce as opposed to the temptation to live off the cash flow that my business may produce.
I think it’s smart. It’s one of the reasons I recommend this to everybody because it’s… The biggest fear with getting in shape is you’re going to fall out of shape. It’s very hard to stay constantly eating good and constantly working out. This is a way that you stay in financial shape. You can’t get off the treadmill ever. You are committing for as long as you make money to investing in real estate and managing that, and you’re going to have to ride some of the down times too. So what you often find, at least what I’ve found, is the money I’m putting down on the property is very close to the money I’m saving in taxes. It almost ends up being the same. Okay?

Matt:
Yeah.

David:
So I don’t really ever have a ton of money left over to go spend. The majority of my income has to get reinvested into the real estate. So it’s like this perfect… In so many ways, it’s just a better way to live, and that’s why we’re here to talk about it.

Rob:
Boom.

Matt:
What you would think too, at that point, the government probably thought that through, like you had mentioned, where they’re forcing you to do it over and over is because these benefits that you’re getting are temporary. It’s not a one-and-done. You got to keep doing this stuff, so.

David:
That’s why it’s not a loophole. It’s why, and we all understand that, but that’s why it’s not fair to classify it that way because it’s like saying working out is a loophole.

Matt:
I’m coming from the… which is really good because you’re right. It’s not a loophole because I think if you’re following the tax code, it’s legal, and it’s purely not a loophole. I think loophole is you’re skirting some rule and not following it.

David:
That’s how it sounds. Yes.

Matt:
Yeah, and so my context of it being a loophole is I think that there will be new rules that will not allow this because they see, “Oh, crap. Our rules didn’t cover this. So now, we need new rules.”

David:
That’s why we’re telling people to take advantage now.

Rob:
For the sake of the clickbait title and the thumbnail, we’re going to call it the short-term rental loophole. But if you listened all the way through to the end, you know it’s just a tax rule, and that’s all.

Matt:
Yeah.

Rob:
We did it, guys. This was fun. This was a good deep dive. Both educational, little spicy at the end, and then a good, just little like, “Here’s good perspective for you moving on.”

David:
Matt’s got the CPA thing going on that are typically the most difficult people ever to communicate with. I know everyone listening to this is like, “You got to ask your CPA the same question seven times to finally try to get some idea of what they’re trying to explain because they use big CPA words,” but you can communicate with everybody. You’re like that perfect hybrid that’s meant to bring the two worlds together.

Rob:
Dude, I’ve been telling you this, David. I’m like, “You got to get with my guy, Matt Bontrager.” I talk about you all the time, Matt, because, I’m telling you, there are very little CPAs that can talk passionately and be charismatic at this tax stuff, so thank you.

Matt:
I’ll never forget. I was at a bowling event after school just about to graduate with my accounting degree, and I met this guy, and he was like, “You’re going to be a CPA?” I was like, “Yeah.” He’s like, “You don’t seem like an accountant.” I was like, “Well, that must be pretty good,” because that’s it though, and that’s why I was saying advisors and tax preparers are way different. Preparers are a little more nerdy in the background. An advisor has to be really smart and know their stuff, but be able to communicate.

David:
Yes.

Matt:
So that’s where, in a tax world, that’s so hard to find.

Rob:
Well, geez, pat yourself on the back more, Matt. Dang. No, I’m just kidding. Well, awesome.

Matt:
For now, I’ll do that. Thank you so much.

Rob:
Well, Matt, if people want to find out more about what you do and where they can learn more about your services, where can people find you on the internet?

Matt:
Yeah. So, the best way, I’m even still… I’m not big. I’m in my DM. So I respond on Instagram, @mattbontrager. I got my handle, just my name. Then, if you want to work with us, our website is the best way. Submit your info there. We’ll reach out because that’s where…

Rob:
Which is?

Matt:
Oh, yeah. Sorry. That would help truebookscpa.com.

Rob:
Okay. Cool.

Matt:
Yeah. So through the website or through Instagram. Both ways.

Rob:
Or you could buy truebooks.com. I looked it up for you. It was like a million dollars.

Matt:
Oh, definitely. Yeah.

Rob:
Yeah.

Matt:
They’re trying to get us there.

Rob:
David, what about you, man? Where can people find out more about you on the interweb?

David:
Check me out, @davidgreene24, on LinkedIn, Instagram, pretty much everywhere. Now, it’s a YouTube handle, so you can follow me there, and let me know what you think about what I’m posting. How about you, Rob?

Rob:
You can find me, @robuilt, on Instagram, Robuilt on YouTube. YouTube is the main one, and then Robuilt on TikTok. Also, if you like this, if you learned something in the tax world, and this has got you fired up, pay it forward to the BiggerPockets Network by leaving us a five-star review on the Apple Podcasts platform. It really means the world to us. It helps us in the algorithm. It helps us get served to so many new people, and hopefully, help change lives and help people get started in this real estate thing. Final plug here, Matt. Just go follow Matt on Instagram, @mattbontrager. You’ve been posting a lot of good reels. You’ve been blowing up on Instagram. You make taxes very approachable on Instagram, so go give him a follow, and that’s it. That’s it. Mic drop over here. I’m done.

David:
All right. Thanks for your time, Matt.

Matt:
Thank you, guys. That was awesome. Thank you so much.

David:
This is David Greene for Rob, the sworn enemy of negative care and energy, Abasolo signing off.