High Equity Properties and Other CPA Lessons
Nate Hedrick and David Bright discuss the rapid appreciation that some investors are seeing in their markets and some lessons learned from CPAs.
Summary
Nate Hedrick and David Bright sit down together and answer a question that continues to come up in the YFP Real Estate Investing Facebook Group. They discuss the rapid appreciation that some investors see in their current real estate markets and some of the many tax considerations that go hand in hand with taking action (or not taking action) on that appreciation.
Nate and David break down four options for getting that appreciation out of your property, a HELOC, a cash-out refinance, a 1031 exchange, or selling the property and paying taxes. David also mentions a fifth option, holding the property and choosing not to sell. All of the options mentioned have their own set of benefits and drawbacks to consider.
David shares his personal experience and past missteps with investing and why he now consults with his CPA and business advisor before making major real estate decisions that may affect his tax outcomes. One of the best questions David’s CPA and business advisor asked was why he was selling and what he planned to do with the money. David shares that your motivations for choosing to sell or not sell may help guide your decisions, in addition to the advice and guidance from a CPA.
Mentioned on the Show
- YFP Real Estate Investing 18: Tax Strategies for Real Estate Investing
- Join the YFP Real Estate Investing Facebook Group
- The Book on Tax Strategies for the Savvy Real Estate Investor: Powerful techniques anyone can use to deduct more, invest smarter, and pay far less to the IRS! by Amanda Han and Matthew MacFarland
- YFP Real Estate Investing
Episode Transcript
Nate Hedrick: Alright, David, good morning.
David Bright: Hey, how’s it going?
Nate Hedrick: Good. This is new for us. We are in person recording for the first time ever.
David Bright: Yeah. After — what — for Episode 20, we’ve done these all over Zoom like everyone has for everything. We get to finally do one of these in person.
Nate Hedrick: Yeah, we’re actually in YFP headquarters this morning. And David and I came in a little early so we could get a recording done together.
David Bright: So how’s everything else going for you?
Nate Hedrick: It’s good. Market is still crazy hot. I thought it was cooling down a little bit. We had some houses that were actually price dropping and thought there would be some more availability, but it’s still pretty tight and kind of crazy. What about you?
David Bright: Yeah, same kind of thing. Hard to find stuff but thankful when we do find something.
Nate Hedrick: Exactly.
David Bright: Yeah.
Nate Hedrick: And we’ve been talking — you know, we were talking about what we wanted to talk about this morning and trying to figure out what made sense, and we started hearkening back — both of us on the drive down were listening to last week’s episode that just came out with Amanda and Matt about tax strategies. And we were thinking about that episode and thinking about all the things that go into that and thought, a lot of people are dealing with increases in value recently, right? We’ve had a market that’s going up and up, and now you’ve got a property with extra value. And so our thought was, well, maybe we should talk about that. And I think it started in the Facebook group, right?
David Bright: Yeah, there’s been a couple posts in the Your Financial Pharmacist Real Estate Investing Facebook group. If you’re not a member, you should join, if this kind of conversation is interesting to you. And so there’s been people really — and I think it’s kind of a common phenomenon of if you’ve owned a rental property for 5-10 years, in this crazy market, you’ve probably seen some appreciation in value.
Nate Hedrick: Right.
David Bright: And if you’ve seen some appreciation in value, then you probably have some equity in there and trying to figure out what to do. And I think the episode with Amanda and Matt talking about the intentionality behind what to do with that and the tax consequences that can erupt from different things that you might do with trying to leverage that equity. There’s different strategies there that can come out.
Nate Hedrick: Yeah, and I think it’s important to step back too because I see all the time in some of the other Facebook groups that I’m in is that what actually is equity? It just feels like this magic thing that comes up. And so equity really is if you buy a property — let’s say you buy it at $100,000. And over the course of time, you’ve been paying down the mortgage. So part of that equity is in the difference between your original price and the money that you’ve paid that down, right? So there’s value there. There’s equity there. But you also gain equity on the appreciation side. So as that property goes up in value, maybe now it’s worth $120,000, that $20,000 difference between your purchase price and the current value, that’s also built-in equity. And there are multiple ways that you can tap into that. And we’re going to talk through each one of those today.
David Bright: One of the things we do too for the math is if different people throw out different examples when they ask questions in the Facebook group and things like that, so we thought we’d put together just some really simple math on some recent webinars, some other things that we’ve done. We’ve used like the $100,000 rental property, which in some markets probably feels like a unicorn. Other markets, it’s reasonable. But yeah, if we just go for a minute with a $100,000 rental property because if in your market that’s $500,000, just multiply all this by 5. It’s simple math we go on. So $100,000 rental property. Let’s assume just for sake of discussion you bought that by putting 25% down. So $25,000 down. You took a $75,000 mortgage. And over this say five-year period, it appreciates to $150,000 value where if you were going to sell it today or get it appraised today, it would sell or appraise for $150,000. So $150,000 minus the mortgage of $75,000, there is roughly $75,000 of equity in that property. And since you bought it — we’re assuming we’ve talked about the 1% Rule before. If the property rents for 1% of the purchase price, if we go with that and it rents for $1,000 a month because you bought it for $100,000, then it’s trying to figure out what do we do with this property that’s renting for $1,000 a month and has $75,000 of equity?
Nate Hedrick: And something we should mention too is that that appreciation example is nice, clean numbers. And some people may have seen that in their markets where you’re actually seeing a house go from $100,000 to $150,000. That is atypical. This market the last couple of years has been ramped up pretty quickly. I mean, usual appreciation is probably closer between 3-5% per year. But we are seeing very rapid increases across the market and across the country. So that number is probably not far off for some of you that maybe have purchased a property five years ago for $100,000.
David Bright: But if you’re looking to purchase a property today, I would not expect that over the next five.
Nate Hedrick: Right.
David Bright: It’s like this is just kind of an anomaly, which is why we have this interesting scenario of what do you do with this rapidly acquired equity in a rental property just because of really favorable market conditions to an owner and unfavorable market conditions in other situations.
Nate Hedrick: And we posed this question kind of in the Facebook group to talk about some of these things. And really, what we’ve decided on is there’s really four options at this point, right? If you’re asking this question and trying to figure out how to tap that equity, there are four ways to do that. So the first is a HELOC or a Home Equity Line of Credit. No. 2 is a cash-out refinance. Three is a 1031 exchange. And four is you can simply sell it and pay taxes on it. And so we’ll walk through each one of those examples to kind of talk about the upsides and the downsides of each one. So I guess let’s start with HELOC. So the HELOC is something that I’ve done personally. I’ve done one on my own personal residence and I’ve also done one on a rental property before. But what a Home Equity Line of Credit is effectively the bank looks at a property and says, “Let’s see how much equity you’ve got in the home. And then we can give you a credit card, for lack of a better term, to basically tap into that. And it really is a — there’s no physical card in most cases, but you have a bank account with a certain amount of credit attached to it and you can tap into that. So again, if we look back at our example of our $150,000 value house with $75,000 that we currently have in it, right, we’ve got $75,000 in potential tappable equity. Now, most cases, the bank will not let you tap all of that, right? They have a limit on what you can tap into. In most cases, it’s between 75-80% loan-to-value. And so what the bank will do is they’ll actually send out an appraiser. They will appraise that property. And they’ll say, “OK, it came in at $150,000, as we were expecting. And so we will give you a line of credit for the difference between the 80% number and what you owe on it today.” And that actual amount is something that is sitting in a line of credit account and then you can tap into it to pay off whatever you want to. And one of the common questions I get when this comes up is well, what can I use that on, Nate? Are there restrictions? Can I only buy other properties with it? The reality is it’s a line of credit. You can spend it just like a credit card in most cases and use it for whatever you would like. Now of course, there’s — just like a credit card — an interest rate associated with tapping that moneys. But there is a way for you to basically pull out some of that equity and utilize it right away.
David Bright: And it creates a really nice strategy when you need that cash. Like I know there are some folks that will use this as an emergency fund because it creates really easy-to-access money, the interest rate is generally relatively low, and depending on the bank that you work with on a HELOC, there’s like a thousand different flavors of HELOC out there, right? But depending on the bank that you work with, some of these are interest only as well. So the payment is relatively low. So if you’re thinking about I need some funds to do rehab or something, check with a bank and make sure that’s alright, but that’s oftentimes a way that you can get working capital, essentially, for your real estate investing.
Nate Hedrick: And then similar to that is a cash-out refinance. And so it’s effectively the same first couple of steps, right? You’re tapping into a bank, you’re figuring out the equity you have in the property, that bank is coming out and they’re doing an appraisal. But instead of giving you a line of credit, they’re actually sending you a check. And this is much more common or much more commonly done when you own a property free-and-clear, for example. So you don’t have this outstanding mortgage already. But that doesn’t have to be the case. That way, instead of having this big, large line of credit, you actually get a check from the bank in the form of a cash-out refinance. And so I’ve done this before using the BRRRR strategy, which we talked about in the past and I know David has as well, where you buy a property in cash, you fix it up to improve the amount of equity you have in that home, go to the bank, ask for an appraisal. They will, again, assess that property and then give you 75% or 80% loan-to-value on that property’s equity and let you tack that on as a cash-out. Basically, it creates a mortgage. They give you the cash to create that. And so again, in our example, with $150,000 as the potential value, you’re looking at $112,500 if it’s a 75% loan-to-value. So in theory, right, if you own that house free-and-clear and you’ve got it to the point where it was worth $150,000, the bank will absolutely cut you a check for $112,500 and then you’ll start a mortgage on it at 4% or whatever the mortgage comes out to. So both of them are a little bit similar. One is more of a the bank holds onto things but you can tap into it when you need to. The other is you actually get a check and you can really get off and running with that. One of the interesting things about the cash-out refinance that I think people often miss is that there’s an assumption that it’s similar to selling a property and that you have to pay taxes on the gains. But the reality is you are obtaining a mortgage. It’s an asset that’s being tapped into. You do not pay taxes on that cash-out refinance. So that $112,000 check, that is yours to keep. There is no Uncle Sam involved at all. So there’s certainly advantages to both those options. But the cash-out refinance certainly feels a bit more fun when that check actually comes available.
David Bright: Yeah, and in that example, if you’re doing that on a property that had that existing $75,000 mortgage and you do the 75% loan-to-value cash-out where you’re getting $112,500 in a mortgage, at the closing table, the point of the cash-out, that original mortgage gets paid off. So they won’t give you another $112,000. They’ll give you the difference, right?
Nate Hedrick: Exactly.
David Bright: Which is reasonable. So they’ll give me the $37,500 difference, which again, you can use that if you’re looking to grow your investing and use that as a down payment on another property or whatever that would be. That’s one strategy that some people use to kind of grow their investing faster. And again, there’s nothing really wrong with keeping equity in a property. Like there’s nothing that says you have to do any of this, but there are a lot of people out there on the Facebook group that have leveraged both of these strategies to get additional money to grow their investing, go further faster.
Nate Hedrick: Yeah, obviously like you said, keep in mind that this will adjust your cash flow, right? If you’re pulling all that money out and you’re increasing your mortgage or you’re starting a mortgage, that’s obviously going to hurt your cash flow in some capacity. And so recalculating those numbers with that refi is super important. It can — you don’t want this to all of a sudden become a negative asset. That’s not the goal here.
David Bright: So we’ve then discussed — Nate mentioned the four options: the Home Equity Line of Credit, the HELOC; the cash-out refinance; and then the next two being the 1031 Exchange or to sell the property and pay taxes. So the second two are kind of back to why we started talking about this a lot. It was the podcast episode with Amanda and Matt, Episode 018, as CPAs talking about all the tax implications of selling. So maybe we can even take those in reverse order there. If we talk about selling a property that has appreciated in value, you’re going to have a big tax hit because you have capital gains. That asset has increased in value, you sell, you pay tax on that difference. Not a lot of people like that, so if you are looking for a way to avoid or essentially in this case delay paying taxes, Amanda and Matt talked through the concept of a 1031 Exchange. And so we’ll go through it kind of quickly today. If you’re looking for more detail, again, go back to Episode 018. They do a great job of going into detail there. But a 1031 Exchange is a way that you can delay that tax by rolling it into the next property. You’re doing a like-kind exchange and essentially selling one house and buying another one. And it’s far more complicated than that. You have to dot your i’s, cross your t’s, have a qualified intermediary, all of the things. And it sounds complicated, but it also can be done. Just like with everything real estate, if you have the right people around you — when I did that at one point, talking with the title company, with a CPA, they were able to set that up, and it ended up being much simpler than this like boogeyman thing I had imagine. But there’s definitely pros and cons to that, one of them being that you are investing into that new property. And so there may or may not be a way to pull much, if any, cash out of that. So if your goal is cash or access to cash, that may not be the best approach for you. Again, talk with your CPA, talk with the folks around you that are helping you through that, being really clear with your goals. But that may not end up being as helpful. And then of course, you can sell the property and pay tax on the profit of that sale, which on one hand, not a lot of people dream of paying tax bills, right, but on the other hand, if you’ve had a property that went from $100,000 to $150,000 in value, that’s also a huge win for that to happen over a five-year period. And so kind of be thankful for the profits. If you have to pay taxes, you have to pay taxes, right? That’s not the end of the world either. And so we had people on the Facebook group talk about the first two, not as much about the second two. But this was reminding me of even earlier this summer had a similar example like that where I had years ago, done some of this without consulting a CPA in advance, paid for it. Like I learned my lesson there. Then I read Amanda and Matt’s book, and I was like, oh yeah, I should talk with smart people before I do things like this. So did that this time and had a lot of those conversations with a CPA and business advisor who helped me kind of work through that. One of the things that I loved out of that conversation is that he started off with this question of why are you doing this? And what are you going to do with the money? Before getting into the minutia and weeds of taxes, like the why and the what are you going to do with this money, which I think was really helpful for me to kind of process through why I was thinking about selling this property. I think there’s probably a lot of people if you go on Zillow — I know Zillow Zestimates are your favorite, right?
Nate Hedrick: Don’t talk about it.
David Bright: But I think a lot of people go on Zillow, and they say, ‘Oh, my house is worth so much more. I should do something with this. And they think about selling, but selling just to sell, right, like that may not be your best option. What are you going to do with that money? What’s going to be the value?
Nate Hedrick: It reminds me of the Warren Buffet quote, like you ask him about when’s the best time to sell a stock and he said, “Well, what’s it going to do next week?” That’s your answer. It’s not, what is it doing today and how much money can I make? It’s, what is the purpose of the investment and is it still in line with the goals? Is it still what you want to be doing in the next week and the next year? And if it is, follow that path. Don’t just follow the fact that well, it’s gone up in value, I need to tap into it.
David Bright: Right. So that was super helpful to me. And for me too, as we see many, many months now into the pandemic, just looking at eviction moratoriums and rental assistance on these things, I was just thinking, you know what? A little bit bigger emergency fund would be a nice thing so that we can just not sweat whatever is coming in the next week or month or 12 months or whatever like that. And so for us, it was we wanted access to cash, which really ruled out the 1031 Exchange. We didn’t really want to scale up from there. We’d probably have to cash into that. We wanted to go the other way. We wanted either the HELOC, the cash-out refinance or just to sell and pay taxes. So for us then, we talked through each of those options and particularly because my business advisor is very much the like buy it and keep it for forever mentality, which I love because that’s — there’s nothing with equity either. We all hope the property appreciates in value. It’s one of the benefits of real estate from a buy-and-hold standpoint, so saying that that’s not a bad thing. But we ended up looking at the cash-out refinance and Nate, just like you mentioned, when you get a bigger mortgage on a property, it increases the mortgage payment.
Nate Hedrick: Right.
David Bright: And if the mortgage payment goes up, it decreases your cash flow by that amount. So for the property we were looking at specifically, it was going to take it to a cash flow negative property. And I didn’t really want to make a monthly payment so that someone else could live in the house.
Nate Hedrick: Right.
David Bright: That just felt counterintuitive. I know there are people who do it, I know that there’s strategy behind that, I know that it can work for some. It wasn’t a super exciting thing for us.
Nate Hedrick: No.
David Bright: So we ended up — the similar kind of thing we would see about the HELOC, so we thought, you know, maybe the best approach for us would just be to sell it, even if that meant some tax consequences there.
Nate Hedrick: And just to clarify, I think something that comes up a lot at this point too is that this is not — this is only for investment properties, right? This is not personal residence. Matt and Amanda mentioned this, again, on Episode 018, which I thought was great. But if you are talking about your personal residence or even a residence that you’ve lived in for two out of the last five years, there are capital gains exemptions. So if you are a single individual, you can sell a property in which you’ve made up to $250,000 in gained equity, in basically in appreciation, and you don’t pay any taxes on that $250,000. If you are married, up to $500,000. So again, in an extreme case, let’s say you have a house that you bought at $100,000 and instead of going up to $150,000, it went up to $559,000. Right? You have all this extra room that you can write off that difference. And so that’s on a personal residence. And it becomes really interesting if you take a personal residence and convert it into a rental for a couple of years because if you lived there for two years, rent it out for two years, you can sell it at the end of that two years and pay no capital gains on any appreciation there because, again, you were there for two of the last five. So there are some ways that you can — and again, I think Amanda and Matt alluded to this on Episode 018 — but there are ways you can kind of combine the two to your advantage to really find ways to mitigate that risk.
David Bright: Absolutely. And that’s going full circle to the point of it’s so, so, so helpful to have these conversations in advance with a CPA with your own goals in mind, with your own property list and all of the details and all of the numbers that someone can wrestle through that and tell you more specifically what the tax consequences would be of different options because when you’re talking about a $50,000 gain, that’s a pretty significant tax.
Nate Hedrick: Yeah.
David Bright: And so you need to be prepared for that.
Nate Hedrick: Yeah.
David Bright: You need to know that going in rather than have that be a gigantic surprise.
Nate Hedrick: You’d hate to sell that and then spend all that $50,000 but then oh, there’s a $10,000-12,000 tax bill in six months that you weren’t ready for. And that can be a huge, huge hit. So definitely important. And the other thing, I see this sometimes as well. I’ve had investor prospects reach out to me and say, “Nate, I just sold a property. I have x amount of days left before my 1031 Exchange is no good. Can you help me find something really fast?” It’s like, hold on. We needed to prep this well in advance. And so having those conversations before you do that, super, super important. Involving that CPA before that sale takes place so that you can plan ahead for that 1031 Exchange. It’s — if that’s the route you’re going to go, it’s super, super important. Again, I think this has been a great discussion, David. I think there are a lot of options out there, a lot of people that are dealing with this good problem, and so there’s no wrong way to approach it. I think you have to go back and figure out what your why is and like you said, figuring out OK, well, if it’s time to sell, why are we deciding that it’s time to sell? And then attacking it from that. And then, again, involving that team, involving the CPA, your real estate agent, your financial planner. Whoever you need to get involved, your lawyer, so that you can make sure that that process goes the right way and that you’re getting the most bang for your buck.
David Bright: Yeah, and I think it’s probably important to also say that just because your property increased in value doesn’t mean you have to do anything.
Nate Hedrick: Right.
David Bright: That’s OK if it appraised higher today. It might appraise lower tomorrow, higher tomorrow. And to some extent, one of the beauties of just long-term buy-and-hold rental property is that those price fluctuations can happen. And hopefully it just keeps making money every month, and hopefully you wake up 30 years from now on a 30-year mortgage and it’s completely paid off. And there’s all those benefits too. So kind of tinkering with this stuff along the way can be a good thing, but there’s nothing wrong with just set it, forget it.
Nate Hedrick: That’s why real estate is definitely a long game, not a get-rich-quick thing.
David Bright: Yeah.
Nate Hedrick: Perfect. Well, David, it was nice having a conversation in person.
David Bright: For sure.
Nate Hedrick: Looking forward to more from in the future I’m sure.
David Bright: Definitely.
Nate Hedrick: Thanks, everybody.
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