Real Estate Investing (Part 1)

By Jason Watson, CPA - WCG, Inc

This will be a two-part series on real estate investing opportunities. Sure, I know what you are saying, interest rates are nutty right now so why would you want to invest into real estate? Simple – people still need to sell, and people still need places to live.

Understandably, a 3% increase in interest rates reduces your purchasing power by well over $100,000 and blows up your internal rate of return (IRR). But, if you consider what goes up must come down, 2023 might be a wonderful time to snag some real estate before everyone else does. Then in 2026 you refinance back to 3.5% range for a short-term hit, long-term win.

Buy And Holds

This is your common strategy of buying a single-family home, or something similar, and renting it out long term. Easy, right? Well, the acquisition is the toughest part for two reasons. First, you understand the objective and easily detach yourself from falling in love with the kitchen or the yard or the neighborhood. However, you are competing with the slightly irrational couple who must have the house for the kids or for some other heart string. In other words, your competition is not necessarily playing the same game as you.

Second, financing can be challenging since some lenders want larger down payments for rentals. Interestingly, a second or even third home can have a lower interest rate than rental properties.

Fix And Flips

Buying a fixer-upper is another path to your real estate investment portfolio. Everyone will tell you that the money made on a fix and flip is done on the buy side. In other words, the effort to find the right buy… the right price… is where the money is made. Sure, that’s a great sound bite at the seminar or cocktail party, but in our experience, the fix is also where the money is made (or severely lost).

If you consider what goes up must come down, 2023 might be a wonderful time to snag some real estate before everyone else does.

Do you know which people make the best fix and flippers? Realtors? No. Contractors? Maybe. The answer is interior designers… huh? Interior designers take a house, spritz it up with new paint and floor coverings on the cheap, and make it into a lovely home. And they don’t have to remind themselves that they are doing it for others…that is already a part of their DNA. Said differently – rookie fix and flippers make one mistake with real estate investments; they fall in love with the property as if they were moving in and raising a family. They compete with the heart strings above on the buy, and then project their tastes onto the property when they fix it up. Detach. Be practical. Be smart. Don’t fall in love. Maybe saying be smart and don’t fall in love is saying the same thing but you get the idea.

Also, fix and flip activities are usually reported on Schedule C of your Form 1040 tax return and are subject to self-employment taxes. What makes things worse is that the houses you are flipping are considered inventory, and all the fixes – all the improvements and dollars spent – are capitalized into inventory and are only recognized when the property is sold (as cost of goods sold). This is where an S Corp election might be handy in reducing the self-employment taxes.

There are some exceptions when you buy something as an investment, and then later determine that you need to fix it up. For example, you buy a house. Try renting it with no luck, and then decide that you need to renovate to get a better rent. You do that, and later determine that selling the money pit is preferred. This is not a fix and flip situation – this is an investment activity, and is not reported on Schedule C nor does it pick up self-employment taxes.

Fix And Hold

Nothing too exciting here in terms of real estate investing. You buy, you fix and you turn it into a rental, either shortterm or long-term. The improvements are going to be capitalized which is a fancy way of saying added to your fixed asset listing and depreciated over time. There might be a cost segregation benefit (see previous NORTH issues), but generally that big kitchen renovation or basement finish will be depreciated over 27.5 years. There is an acronym called BAR; if the cash outlay makes the property better (new kitchen), adapts it to new use (basement finish) or restores it to the original condition (new roof), it is an improvement and not an expense. And as such, it is depreciated over time.

VACATION/SHORT-TERM RENTALS

Vacation rentals add a lot of variety to your real estate investing activities. A lot of people rent out their ski condo or beach house primarily to help offset some of the costs. Today, with the help of VRBO and AirBNB, people are not just offsetting some costs, they are running a business. Additionally, these activities are routinely mishandled on tax returns, even by the most seasoned tax professional.

I won’t bore you with the rules on which tax schedule (C versus E) to use or vacation rules. Yuck! Let’s fast-forward to the short-term rental (STR) loophole. Yay!

If your rental property is considered a short-term rental where the average stay is 7 days or less, then your activity will be considered non-passive. Why is this a big deal? Typical rental activities are considered passive; passive losses are limited, and your rental losses might not be deductible. However, an STR that is considered non-passive generally does not have a limit on rental losses. This is especially helpful when a cost segregation study is used to accelerate depreciation.

Subleasing Vacation Rentals

This is an interesting real estate investing strategy, and it requires relatively low cash. It goes like this – you find a house or something similar in or next to a vacation hotspot, or at least something with a ton of activity. You enter into a five-year lease with a sublet clause allowing you to sublease to others. Don’t be surprised if your landlord adds a premium to the rent; then again, you are also committing to a multiyear arrangement so it might cancel out.

Next, you spend $30,000 to $50,000 furnishing the property complete with dishes, artwork, linens, etc. There might be accelerated depreciation such as Section 179 or bonus depreciation available on some of these expenditures, depending on your situation.

Next, you stage the place and hire a professional photographer for your VRBO or AirBNB listing. You collect short-term rent, you pay long-term rent, and pocket the difference. WCG has a client who clears over $400,000 with this type of arrangement. Sure, it is a full-time job but not too shabby, right?

Jason Watson, CPA, is a Senior Partner for WCG, Inc. a progressive boutique tax and accounting firm located in northern Colorado Springs.

You may contact him at 719-428-3261 or jason@wcginc.com.

Summary

Good stuff above. In the next issue, we will discuss NNN leases to Starbucks or AutoZone, the Real Estate Professional designation as defined by the IRS (spoiler, real estate agents don’t instantly qualify, much to their chagrin), and holding companies. We will briefly mention cost segregation and like-kind exchanges since those were covered in previous NORTH issues.

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