The real math on owning real estate

Read The Transcript Below:

Steven (00:08):

Hello everyone, and welcome back to the Retirement Tax Podcast, AKA The Least Boring Tax Podcast. I am one of your hosts, as always, Steven Jarvis, CPA, and with me here to share a personal story about taxes, Benjamin Brandt, welcome to the show.

Ben (00:24):

I’m so happy to be here. I have to say though, I have a bone to pick with just the internet in general because I can’t log on to YouTube or Twitter or any other place without a personal finance guru telling me that all of my troubles are yesterday because all I have to do is buy some real estate and I’ll never pay taxes again, and we can go through the situation, but I bought some real estate and I’m going to sell it and I did not make money and I’m going to pay taxes, and so that’s why I’ve got a bone to pick with the internet because I was told that that was not the case.

Steven (00:57):

Well, not only are you going to pay taxes on that transaction, Ben, I’ve seen your tax returns. You’ve been very patriotic for the last few years, so you have to pay taxes on this transaction. The real estate didn’t magically take care of all your other tax liabilities for the last couple of years. So yeah, that’s a bone to pick for sure.

Ben (01:13):

I’m one of the most patriotic. If we look at the averages, I’m very patriotic. Yeah, so the situation is I bought a piece of land to build a house on three years ago and we decided to not build this house. We’re going to stay in our current house. So we said, all right, let’s sell it. We have a purchase agreement and I’m going to sell it for more money than I bought it for, but I’ve been paying for carrying costs for three years, so property taxes and interest on the mortgage. So I’m actually going to break even when I add all that back, but you and I talked and I had kind of researched this myself, even though I’m breaking even, I’m still probably going to have to pay capital gains taxes. Maybe we could talk about why that is, because again, like I said, if you pay attention to any social media gurus, you don’t pay taxes if you’re involved in real estate. So what gives.

Steven (01:59):

Yeah, so let’s talk about what’s out there on the internet and then we’ll come back to your personal situation because so many things, there can be some truth to some of the headlines you hear about real estate. There certainly are opportunities to use real estate to offset other tax liabilities, but it’s in very specific situations and all too often on the internet, it gets painted as if everyone can do this. But again, there are very specific requirements that you have to be a real estate professional. There’s hours that go into that. There’s certifications, there’s licenses, there’s activities, there’s all these things that’s been, thankfully I do appreciate that you never came to me and said: Hey, Steven, I think I’m a real estate professional. We should just write off all these losses. I’m glad we have that kind of relationship where you don’t bring BS to me. So that’s kind of the general messaging on the internet at times. If you are into real estate and you are a real estate professional and you’re working with a tax professional who’s helped you vet that strategy, I’m not trying to scare you away from it. I know a lot of people who are very committed to real estate and are taking advantage of very valid tax strategies, but for more people, I think in situations like you, Ben, maybe we’re even talking about primary residence, which we’ll come back to. In your case, this was a property you had built with the intention of using it as a primary used property. People end up with vacation homes. There’s all these other situations where that fluff on the internet is not going to be applicable.

Ben (03:13):

So the first place I went, anytime that I am looking at making any decision really financial or otherwise, the first place I go is probably the first place you go, and that’s to the most powerful financial planning software on Earth a spreadsheet. So in this case it was Google Sheets. I made a P&L for my property and I modeled out every month what I’m going to pay in principle and interest and taxes. And so even though I’m going to make, I think let’s say I’m going to make, with finger quotes a profit of I think $60,000, I have paid that in carrying costs. I pay a kid to cut the grass, cut the weeds, really, I pay property taxes and then I’m also paying interest on the mortgage. And so if I add all that back, I’m actually breaking even maybe making a few thousand, maybe losing a few thousand depending on closing costs and actually when this deal happens. So from a net worth perspective, I’m not making any money, but I’m still going to owe taxes because neither of those modify my basis what I paid for the property originally. And that’s for I guess a couple of different reasons, but I’m probably deducting that over the last three years in a place that I’m probably not remembering, right? I’m deducting my property taxes potentially as long as I’m under the $10,000 cap, and then I’m potentially deducting the interest as well. So those aren’t resetting my basis, but they’re accounted for other places maybe is what I’m trying to say.

Steven (04:27):

Yeah. there are going to be situations where a secondary property might, some of those expenses might be deductible, but you’re still out of pocket for those expenses and they’re still going to come back because in general, and a lot of our listeners probably already know this, but when we talk about an asset, something like land or property, the simplest version of what we’re going to pay taxes on is how much did we buy it for and how much do we sell it for, and what’s the difference. Now, Ben, part of what you’re talking about is that if you were a real estate professional, if this was a rental property, this is an investment property, it’s possible that you could be doing things over those years that would increase the basis that would make it so we don’t have to pay quite so much of a gain. But the things that you’re talking about aren’t going to do that. So you’re already out of pocket 50, 60, $70,000 over the last couple of years just maintaining this property and now you’re going to get to pay taxes on that growth and you’re going to be out a bit more. So if we did that P&L over the whole life of owning that property, you’re probably right. You probably came out behind from a cashflow standpoint, but we’re not doing this episode to criticize your decision-making. Really, there’s several important takeaways here and some good things to learn. One is that there is always more to a money decision than just what was the cash out the door or the cash in the door. We got to think about taxes, we got to think about these maintenance costs, these cash flows at different times. Then was we were getting ready for this episode. You mentioned opportunity costs, what we could have been doing with these funds otherwise. But I like to take a big huge step backwards and start with we got to make good life decisions and then figure out the tax impacts of the financial impacts. And when you bought this property, it was this thing that you and your family were excited about potentially moving and living on a river. There was a clearly thought out goal for this that was not, Hey, let me get rid of my taxes. And then those goals changed over time, right?

Ben (06:10):

Yeah. Something that I learned from actually learned from Robert Kiyosaki, which don’t Google him because his advice has gone significantly downhill in the last 40 years since I’ve read this book, but Rich dad, poor dad, he would talk about and cashflow quadrant, he would talk about how real estate is an asset, but your personal house is not an asset. That’s a liability because assets make you money and liabilities cost you money. Now, don’t carry that logic over to your children. You’d be in for a rude awakening assets versus liabilities, but he said your personal residence is a liability because it costs you money, you pay upkeep and you pay up. So when we were thinking about building a new house, I didn’t think at all about the investment aspect of it because this is just going to be our house for the next 30, 50 years, whatever it is, and it’s a liability. It’s its purpose is to have a place for your family to live, not necessarily make you money. If it makes you money, and we’re going to talk about that. I think coming up here, if it makes you money, that’s a good secondary effect. But we want our real estate as I’m not a real estate investor. We want a real estate to house our family and make memories. So we’re really not looking to make money, but if we do, that’s good and we’ll pay taxes. But it maybe seems a little bit ham-handed that the situation that I’ve been buying and selling a property three years later, but life changes and we just roll with the punches.

Steven (07:21):

Which Ben, as you were telling me a little bit about just kind of the evolution over those couple of years. Again, it’s a good reminder. A concept we probably haven’t talked about on this show but comes up in accounting and taxes a lot is the idea of sunk costs or costs that we’ve already incurred that we get emotionally tied to that make it harder for us to make good decisions going forward. So it could be really easy for a person in your situation to say, well, I already bought this land. The plan was to build this house. We’re going to build this house. We’re all going to be happy about it. That was the plan. Not only have we bought the property, I’ve already been paying upkeep for the last three years, but some of that is sunk cost. We can sell the land and get some of the money back. Thankfully in your case, the value of it up, you’re going to be able to get that money back, but we’ve got to be able to remove the emotions from it and just allow ourselves the grace that life changes our priorities might change, our goals might change, and we can adjust our decisions without just flogging ourselves about how dumb we were in the past because this isn’t about you made a bad decision and now you have to correct it. You made a decision based on your goals and expectations, and now those have changed.

Ben (08:22):

 Yeah, some costs is a powerful thing. We see that in stocks all the time. It’s like, well, I bought it at a hundred and it went up to 150 and now it’s worth 80, but I’m going to hang on to it because I think I don’t want to sell at a loss, and I think it might go back to 150 someday, and that’s the sunk cost in that. The loss is the loss. We’ve got to look at opportunity costs. Where else could we put this $80 a share that we could sell it for now, kind of the same thing with this lot. I could potentially hold it forever and hope that it goes up in value or hope that maybe we’ll build a house on it someday, but I’ve got this monthly cost that’s coming up. I could use that money elsewhere, since it’s not a revenue. So even if there’s a big loss, I still would’ve sold the property just because I want my life to be more simple and the down payment that’s tied up in that I could have it invested somewhere else, even though there are some costs that I, I’m thinking about and it’s keeping me kind of mentally tied to this property in a way that’s not positive from a behavioral finance standpoint, I could invest that money elsewhere. So that’s what I’m choosing to focus on, even though I’m probably going to lose money, especially after paying capital gains on this property.

Steven (09:24):

Yeah. So Ben, let’s circle back and talk about the capital gains because you talked about these upkeep costs and how they won’t increase your basis to reduce the gain that you’re going to calculate, which inherent in there is an implication that there are other things that would increase your basis, and this is true whether we’re talking about an investment property or a secondary property like this or your primary home, a rental property accounting tax rules have two different buckets of costs when it comes to property, and so maintenance and upkeep type things, things that we have to do on a recurring basis just for the property to exist, those don’t add to our basis. So they aren’t going to reduce our capital gain if we’re using the property to generate revenue. If it’s a rental property, those are things we can use to offset the income being generated by the property, but we don’t get to deduct the payments you’re making to keep the weeds down. Those are things that since it’s not a revenue generating property, that’s just not part of the deal. So if in the time you own that land, you had built a dock on the property, if you had started doing things to develop the property in anticipation of building a house, it’s possible that we’d be able to add to the basis and reduce the capital gains that you would pay. So in really broad terms, this is something you’d want to look into specific to your situation. If we are increasing the life of the property or the usability of the property, those are things we look at to potentially increase our basis. So again, this isn’t I cut the grass or even a lot of times redoing the landscaping or more serious maintenance. It’s really things that dramatically change the usability or life of the property.

Ben (11:02):

And this comes up with clients too. If you’ve lived somewhere a very long time or if you’re in a high growth area, we’ve got clients in California, parts of Texas, I mean there’s a lot of actually hot areas right now, but when you sell a property and it’s like 250,000 for a single person, 500,000 for a married person, if you break through that number, we’ll talk about what are some areas where we could increase our basis. And so people would think, well, we did put in new carpeting and we put in new cabinets and we replaced the driveway and we added on a second story or something. There’s no shortage of things that cost you money as a homeowner, but not all of those are necessarily going to change your basis and help you essentially increase the $500,000 of tax-free growth that we have allocated to us as long as you’ve lived there, what is it, three of the last five years or something like that. But is there an easy place to look or we can help figure out if the new blinds that we bought or the new couch that we bought versus putting in a pool would change our basis.

Steven (12:01):

Before we get to the specific list, there’s one other concept I want to make sure we reinforce here, and it’s similar to so many other things we do with taxes. This only counts if we can back it up, right? This isn’t an exercise and let me sit down and think about what I might have done and guesstimate what the values might have been. If we’re going to put it on a tax return that opens us up to the IRS coming back and asking questions and asking for proof. The other thing that I get questions on a lot related to this that absolutely will not increase your basis is sweat equity. So the amount that you in theory could have paid someone else to do it, but you did the work yourself, the IRS isn’t going to give you credit for that, and so these are actual costs that we’ve incurred that we have purchase orders for that we have receipts for that we have contracts for things like that. Unfortunately, there’s not one, at least that I have found, there isn’t a comprehensive list that in every situation this counts as maintenance and in every situation this counts as an upgrade. That would increase our basis. It really comes back to these kind of core concepts of is it increasing the life of the property? Is it increasing how long we’re going to be able to use this property or is it increasing the usability? So adding a second story, adding a pool, full remodels, things like this as opposed to you mentioned blinds or furniture, those are not things that are going to change how we use the property or increase how long we can use it.

Ben (13:20):

Yeah, so would you say, I mean, it’s hard to have rules of thumb, but things that have depreciating life like carpeting that only lasts for so long, wall treatments only lasts for so long, but something like a pool or some significant landscape would last forever. We put in a retaining wall, something like that in my mind that says, yes, we can increase our basis. We can prove it. We got the paperwork to back it up. Is it something that that’s got a usable life or something that’s more permanent?

Steven (13:47):

This gets really tricky with how the IRS uses words versus how the rest of us use words, because according to the IRS, all those things have a depreciable life. Sure. If we were a business or we were a real estate professional, a lot of those things we could depreciate over just a couple of years. And so I like that you brought up the primary home exclusion on a sale. We kind of have an order of operations here of, Hey, are we going to have a capital gain? And then if we are, that’s going to be over this exclusion, then I would start with that brainstorming session of what might be out there that would be worth considering, and then what do we have documentation for, and then who can we ask to verify that these really are upgrades to the house versus maintenance along the way? So kind of like we talk about how everyone should be doing a Roth analysis every year, not necessarily Roth conversion. If you go to sell a house, you absolutely go through this thought process, but just know that the rules are more slanted towards you not being able to upgrade your basis when it’s a personal residence

Ben (14:40):

Is kind the logic for that because we get such a generous, I mean, for a married couple, $500,000 of free growth in your primary residence is pretty generous. Sort of along the same level of generosity that, I dunno, generosity is a funny word, letting you keep your own money, but with the doubling of the standard deduction is that to give us just a little bit more leeway so that we’re not trying to force every nickel when it comes to improvements, we’re getting a very generous amount of freebies.

Steven (15:07):

Well, so now you’re trying to find the logic in the tax code, and that’s true.

Ben (15:09):

I do that. I tend to do that. I try to find the logic where it doesn’t exist.

Steven (15:12):

I’m with you, Ben. I’ll be guilty of that at times too, of, Hey, there’s this new tax rule. What’s the thought process behind it? I do that with, we’ve talked about the Augusta rule before, and I try to go back what was the original kind of logic behind it, but at the end of the day, we got to understand what the rules are and when we have choices available to us.

Ben (15:28):

Excellent. Excellent. Well, Steven, thank you for this guidance on my attempt to be a tax-free real estate investor. I don’t think it’s going to work out for me this time, but I appreciate your thoughtful guidance as always.

Steven (15:40):

Yeah, Ben, these are such great discussions to be able to have for a long time. Listeners, go back and listen to the last episode if you didn’t catch it, because we had a couple of things in our last episode that we were going to circle back to. This was one of ’em. The other one we still haven’t gotten an answer on yet with some IRS correspondence, but we’ll keep you posted as that comes along. But yeah, Ben, always love having these conversations.

Ben (15:58):

Yeah, stay tuned. No big cliffhangers or teasers for next episode, but we always have a fun time sharing these ideas with you, and if you found value from this, feel free to share this podcast with a friend. Until next time, don’t let the tax man hit you or the good Lord split you.

Steven (16:12):

Hi everyone. Quick reminder before you go. While Ben and I feel very strongly about the information we’re sharing on this podcast, it is for educational purposes only and should not be taken as specific tax, investment or legal advice. You need to make sure that you are working with a professional to evaluate how these concepts apply to your specific situation before you take action.