Welcome back for Part II of Semi-Retired MD’s post on Fast FIRE. If you haven’t yet or would like a refresher, please go back and read last week’s post, How to Fast FIRE Your Way to Generational Wealth – Part I.
Below, you’ll see some eye-popping numbers. As a disclaimer of sorts, I’d like to state that the doctors who wrote the post have seen amazing results with their real estate investments. That does not mean you can expect to repeat their results.
There is risk involved in this plan, including using leverage (debt) to rapidly acquire more and larger properties.
For me, the take-home point is not necessarily the huge discrepancy between the results of in index fund and their hands-on real estate investing example, but rather the incredible amount of earned income that can be offset with paper depreciation losses when one can claim real estate professional status.
How to Fast FIRE Your Way to Generational Wealth – Part II
This is a continuation of a two part series on using Fast FIRE to achieve financial freedom quickly (in less than 5 years) and by financial freedom, we’re not talking Lean FIRE, we’re talking Fat FIRE.
In Part I, we shared our four step system for achieving Fast FIRE. The first two are See the Money and Make the Money. We used an example of a fourplex to illustrate the difference between investing $100,000 in index funds vs. cashflowing rentals, and we showed that after 10 years, the money in index funds would grow to $200,000 and the money in the fourplex would grow to $320,000. And that’s without even including rent and market appreciation, which would make that number even larger.
In Part II, we’re going to show you how to take these returns to up a level. Using these next two steps, it’s not uncommon to generate returns of greater than 200%.
Keep the Money
Keep the Money is all about utilizing the tax-saving strategies offered to those who buy and manage real estate. Although there are many tax saving strategies, for brevity’s sake, let’s just cover the main one that is applicable to our head-to-head comparison: Real Estate Professional Status (REPS).
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What is Real Estate Professional Status?
Real Estate Professional Status is a relatively unknown tax status that allows you to use paper losses from your rental income and shelter W2 or 1099 income.
This is not a small thing. It’s huge.
In fact, we like to call it “the greatest wealth building secret that nobody knows about.”
This is what we’ve been using to pay zero taxes on our clinical income each year for the last four years. Yes you heard right, ZERO taxes.
For those of you pursuing Lean Fire and frugality, imagine eliminating your single biggest expense line item.
We won’t get into the details here but if you want to learn more about REPS status, check out this post. [PoF: In summary, by spending 750 hours a year (about 15 hours a week) on a real estate business, one can claim real estate professional status (REPS) and use depreciation from real estate equity to offset earned income.]
Let’s now apply this to our fourplex example and show you how REPS works in real life.
The first year that you buy the fourplex, you do a cost-segregation study. This allows you to create a $100,000 loss from just this one property.
This results in approximately a $100,000 tax write-off (which you can use against your clinical income, for example), which, at the 25% effective tax rate, would save you $25,000 in taxes (as an aside, if you had four of these properties, you could generate a $400,000 loss to offset $400,000 worth of income!).
Imagine getting $10,000 a year in cashflow, $5,000 a year in equity AND sheltering $100,000 in taxes (giving you a $25,000 tax refund)!
Now, let’s say you reinvest that $25,000 refund into another property yielding 10% cash-on-cash return over 9 years (because you don’t get your refund until year two). The $25,000 grows to $60,000!
When you go back and compare the two investments, and you add in the value of the tax savings, your fourplex has now made you $380,000 vs. $200,000 with index funds (see Table 2).
Now I’ve shown you how you make more money in real estate compared to index funds. But I haven’t shown you how you get to Fast FIRE in 5 years, and I haven’t revealed how you build generational wealth.
Fast FIRE Step 4: Expand the Money
You’ve learned about the cashflow and the equity you build up. You’ve seen some of the tax benefits of REPS. You even have had a taste of all of the other ways you make money besides cashflow, like rent appreciation and market appreciation.
It’s time to show you how you can use real estate to dramatically step-up your wealth.
To do that, let’s trot out our $400,000 fourplex again. But this time, I’m going to give you a little cash to rehab (fix up) the property.
It’s time to rehab!
Let’s say, you put $100,000 into fixing up your fourplex. You do so with an eye toward increasing your cashflow. So after the rehab, instead of 10% cash-on-cash return, you now make 15%.
And that’s 15% on your now $200,000 investment ($100,000 down and $100,000 for rehab), which is $30,000 a year. This might seem like a big increase in cashflow but we’ve regularly achieved these types of numbers whenever we rehab our small multifamily properties.
So what does doing a $100,000 rehab and increasing your cashflow to 15% do for your net worth? One small thing and one really big thing.
First the small one.
That $100,000 that you just put into your rehab is a write-off. It’s a loss on your tax return. It’s equivalent to the government paying for a portion of your rehab for you. So, even though you put $100,000 into the rehab, in the end you actually only pay for about $75,000 (assuming a 25% effective tax rate).
Assuming you do the rehab in the year you bought the property, you’ll get the $25,000 refund in the following year. And like before, if you reinvest the $25,000 refund into another property yielding 10% cash-on-cash return over 9 years, the $25,000 grows to $65,000. Add that to the other tax savings you got from doing cost segregation, and the total value of this tax savings reinvested totals $130,000.
Now let’s move on to the really big thing.
As some of you may know, the market value of multifamily rentals is primarily determined by their income. We’re not going to get into the nitty gritty details of this but with the increased income, your $400,000 property would now be worth double, or $800,000.
That’s right. You put in the equivalent of only $75,000 of your own money (since you wrote off the cost of the rehab as a tax loss) to fix up the property and as a result it appreciated $400,000. And the renovation took less than 6 months.
That’s what we call one giant step-up. And that is the power of forced appreciation.
Let’s now circle back and look at the head-to-head comparison of putting your money into index funds vs an investment property and tapping into forced appreciation (see Table 3).
In the case of the index funds, we are going to assume you invest $200,000 and at 7% growth to make it a fair comparison to the rehab-fourplex case (where you put in $100,000 as a down payment and $100,000 to rehab the property). Over ten years your index fund investment would compound to $393,000.
Now let’s look at the fourplex.
- The $100,000 you initially invested is now growing at 15%, so this expands to $405,000 over 10 years.
- The equity build up (from renters paying down your mortgage) ends up being the same as we saw in the example above because your mortgage hasn’t changed, so that’s $60,000 at the end of 10 years.
- We add in an additional tax savings of $25,000 that you get in year two from your cost-segregation study (which results in a $100,000 phantom loss). This grows to $60,000 by year 10.
- The last component of return that we’re adding in is the $400,000 of forced appreciation from the renovation.
- The $100,000 you put into the rehab is spent money, but $25,000 of it comes back to you in the form of a tax refund year two. If you immediately reinvest that into a property making 10% cash-on-cash, you end up with $60,000 by year 10.
So what do you do now?
One option is just to sit back and collect the cashflow. After all, this property is now cashflowing $30,000 a year. Not too shabby.
But what if you took that $500,000 in equity ($100,000 down payment plus the $400,000 it appreciated after renovation) you now have and reinvested it to make you even more money?
Are you starting to see your net worth growing exponentially? And what if there was a way to do all of this tax deferred just like a 401(k) (but way better)?
I think I’ve heard of a 1031 exchange…
You may have heard the term 1031 exchange thrown around in passing. Or.. maybe you haven’t.
I mean, who really goes around talking about 1031 exchanges with passion and excitement except real estate investors!?!
A 1031 exchange is a tax incentive created by the government named after the section of the IRS code where the rules are described in detail.
The ruling allows you to sell a property and take all of the proceeds from the sale and buy another property. The taxes on this transaction are deferred to a later date (or maybe you never pay them at all – which I’ll cover next!).
Because 1031 exchanges allow you to move from investment property to property, leveraging your appreciation tax-free with each move, the 1031 exchange enables you to grow your portfolio very quickly by making “steps up.”
In this case, one option is that you could hold your property for a year and then trade it in for a bigger property. You would sell your fourplex, valued at $800,000 with a loan of $300,000, and roll the funds into a $2 million property (if you put down 25%) tax-deferred using a 1031 exchange. At 10% cash-on-cash this new property would yield you $50,000 a year in cashflow plus the equity paydown, rent appreciation and market appreciation.
Plus you also get to cost segregate and do 100% bonus depreciation on this next property purchase too! There’s another $500,000 write off (or $125,000 in tax savings) assuming you are sheltering $500,000 of your W2 or 1099 income.
Yep, this is getting real isn’t it. Do you see why we’re willing to put in the time and effort needed to invest in cashflowing rentals?
Or you can do a cash-out refinance
If you want to access your cash tax-free, your second option in this scenario is to keep your property, but do a cash-out-refinance. This allows you to keep your cashflowing fourplex while also using some of the lazy equity in it to continue to grow your portfolio by buying additional properties.
As with the 1031 exchange, this option gets the power of compounding working for you early, so your net worth grows exponentially.
Let’s do the final tally (see table 4)
First, we have our money earned from our first property, the fourplex. As you saw above, this totaled $985,000 at the end of 10 years.
Now, let’s factor in property number two.
Let’s assume you do the cash-out refinance and pull $300,000 out of the fourplex. This could be used to buy a $1.2 million apartment building. Let’s assume this new property cashflows 10% per year (30,000 a year in cashflow). After nine years (because you bought it at year two), your $300,000 down payment compounds to $707,000.
Note: when you remove the $300,000 in equity from your fourplex, your cashflow would likely drop. Since this makes this model even more complicated, I will avoid tackling that issue here.
Now let’s add in the taxes saved from cost segregating property number two. You can safely assume that this property, your $1.2 million apartment complex, will give you at least a $300,000 tax write off the first year (a $75,000 tax savings at a 25% effective tax rate). If you reinvest this $75,000 in another building at 10% cash-on-cash, it will grow to $161,000 (invested x eight years).
For the sake of keeping things simple, we’ll assume that you don’t do any rehab on your second property (even though you normally would since it increases the value of the property so significantly through forced appreciation). We’re also going to assume you don’t sell or do a cash-out-refinance of either of your properties in the subsequent eight years.
So what’s the final outcome?
In that same amount of time that your index funds grow to $393,000, the money invested in cashflowing rentals would grow to $1.563 million.
As mentioned above, the $1.8 million you’ve now earned off of your $200,000 initial investment over ten years, doesn’t include all of the rehab you would normally do to increase the annual cashflow and the value of the second property and beyond.
However, you could imagine how quickly your wealth would grow if you did this year after year and with multiple properties at once instead of starting with a single fourplex and only harvesting your lazy equity once!
And then there’s passing down generational wealth to your children…
Some of you may plan on passing your stock onto your heirs. But what’s going to happen when they go to sell it?
Taxes. That’s right: death and taxes!
But, what happens if you end up keeping your portfolio of rental properties until your death (while living off their cashflow!) and passing them to your heirs?
At the time of your death, there is a step-up in the basis. What that means is that your properties’ basis adjusts to their market value at that point in time.
If your $400,000 fourplex is now worth $1.5 million, well then, your heirs get a property worth $1.5 million with a basis of $1.5 million, which they promptly sell, and pocket the money.
No taxes to be paid on that lifetime of tax-deferred appreciation. Just one more way that real estate is tax-advantaged.
And now, you’ve created generational wealth.
I know that was a lot of data and a very intense model. So, if you’ve stuck with me thus far, let’s conclude with a little summary of Fast FIRE through cashflowing rentals, so you we can hit the highlights again.
- You can apply the Fast FIRE System to build a cashflowing real estate portfolio that pays you tax-free income each year and adds to your wealth through debt paydown, rent appreciation and market appreciation.
- You can take advantage of significant tax loopholes only available to those who actively invest in real estate and completely shelter your W2 or 1099 income.
- You can achieve huge step-ups in wealth by rehabbing your properties and increasing the value of the property disproportionately to the cost of rehab through forced appreciation.
- And then you can harvest market and forced appreciation through 1031 exchanges and cash-out refinances to grow your net worth quickly.
When you invest in cashflowing rentals, you achieve financial freedom years earlier than you would with traditional passive investments like index funds.
So, what do you think?
And, more importantly, what are you going to do?
The duo behind today’s post, Drs. Kenji Asakura and Leti Alto offer a popular course, Financial Freedom through Cashflowing Rentals.
If you’re interested in learning more about how two hospitalists got on the fast track to financial independence with rental properties, this course is for you. It’s the most expensive course I’ve featured, but past students are clearly happy with the value.
Like any course I choose to feature, they offer a full money-back guarantee with no questions asked. You’ll have three weeks from the start of the course to decide whether or not to keep lifetime access to the training. The course is not currently available, but you can join the waitlist for more information.