Universally Accepted Lies In Real Estate EXPOSED!

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There’s so much out there in the real estate investing world perceived to be universally understood as ‘known’. Just a few examples might be . . . .

  • “Buy ‘n hold, and never sell.”  
  • “Only fools pay taxes when a tax deferred exchange is an option.”
  • “Leverage is all about down payment. The lower the down, the better the return.”
  • “Flipping is investing.” 

Buy, Hold, and Never, as in Never Ever, Sell.

The good news/bad news joke that’s never funny about this school of thought. First, the good news is that the investor following this Grampa Economics school of thought will most likely end up with a few small income properties free ‘n clear. That will, undeniably, generate the most income possible — for each property — a fact which nobody attempts to argue is bad news.

The bad news? They end up with relatively older properties, usually at least 30 years old, and many times over 50 years old. Why is that bad news? Oh Lord, let me count the ways.

Older properties as a rule end up being at least somewhat functionally obsolescent. Kitchens without garbage disposals and/or dishwashers, wall heaters and the like. Yeah, every woman wants to live there, right?

Tenants prefer more modern units. Duh. Combine older units with subpar amenities, crummy off street parking, and in a badly aging part of town. What would you speculate the percentage of the tenant pie that owner will ‘enjoy’? 

The older the property, the higher the operating expenses, especially maintenance, repairs, and outright replacement. Vacancy rates also tend to be higher.

However, the worst news by far and away, is the amount of capital growth and ultimate retirement income (cash flow) that wasn’t generated. Why? Simple: By never making no-brainer moves that would’ve significantly improved their position — WHEN the market invited them to do so, they purposefully and severely retarded their end game retirement cash flow. This isn’t arguable, as the physics of investing principles are like gravity. Gravity can be our friend or our worst enemy — our choice. 

Never Ever Pay Taxes if They can be Avoided — Period!

Whether it’s long term capital gain taxes on your real estate, or deciding whether or not to ‘gut’ your 401k/IRA in order to generate a better retirement, there are times when paying the taxes, even if they’re relatively high, is the more rewarding choice. The key is found in the phrase, ‘long term’. This is especially true in the two examples given — tax deferred exchanges and qualified retirement plans.

1031 exchanges can and do save investors tons of money, but not anywhere near always. The idea is to compare paying the tax bill vs doin’ the exchange. The downside to tax deferred exchanges is that you’re forced to carry a backpack loaded with the ‘rocks’ of the previous property. That pack can become unbearably heavy over time. This is especially true when there are two or more exchanges stemming from an original property. In retirement your options are often reduced to refinance, or pay horrendously high taxes on a sale. Hitting retirement with an adjusted cost basis of a Happy Meal isn’t recommended. ;)

Related: Tax Deferred Exchanges — 1031s — THE Crucial Question

If you’re one of the VERY small minority of Americans who will end up with a two comma 401k/IRA balance as retirement becomes reality, good for you. But let me pose one of those pesky questions first.

Wall Street advisors tell us we should be way more risk averse in retirement,  which also means the yield on our capital at that point in life will likely be in the range of 3-5% or so. Now you tell me, did you manage all that self-discipline and sacrifice for 25-40 years so you could amass a seven figure balance in your qualified plan that would generate $30-50,000 a year? Before taxes? Yeah, I didn’t think so.

Imagine you have more than a few short years ’til retirement. Imagine you pay a very painful tax bill, PLUS a 10% penalty as a result of withdrawing your plan’s balance over a one or two year period. Ouch and a half! If all you ever did was buy discounted first position notes secured by real estate, you’d surpass the after tax income from that significantly lower amount by double, at least in most cases. In real life my experience is that $500,000 in a Roth ‘envelope’ will produce as much or more TAX FREE income as your 401k/IRA will do with twice as much in BEFORE TAX income. Hhmmmm

See what I mean? Pay the tax now. Today is likely to be the day when the tax liability generated will be the lowest it’ll ever be. You can pay now, or pay later. You’re likely to be unhappy with the results if you remain in your current non-Roth, non self-directed plan. Once folks see the numbers on paper, they grin and bear it while paying the tax guy.

The last Two are Much Easier. The Concept of Leverage and what Flipping Really is, are Short Topics for discussion.

Once and for all, leverage is never primarily the size of the down payment as it relates to the price paid for the property acquired. The investor can put 0% down and have disastrous leverage, that can drive them to bankruptcy. I’ve seen it play out too many times to count.

The actual definition of leverage is this:

Positive leverage: When the cost of borrowed money to acquire the asset is lower than the overall yield generated by that asset. Example: The money is borrowed at 5% while the property has an overall yield/return of 9%. The down payment can be 1% or 99%, but if the yield is more the the cost of money, it’s ‘positive’ leverage.

Negative leverage: Reverse the two numbers. ;)

And Finally, Can We all take Step Back and a Big Breath While we Agree that Flipping isn’t Investing?

The IRS treats it no differently than if you were buying used cars and sellin’ them for a short term profit. Short term is defined by our favorite uncle as less than a year. But that’s not even the primary point.

Related: Passive Real Estate Investing: How to Have a True “Four Hour” Real Estate Workweek

The most important point to make about flipping is that while it can be incredibly profitable, often creating huge ‘ordinary incomes’ for flippers, it allows for zip, zero, nada, nothin’ for retirement. Flippers find themselves with a rapidly improved lifestyle for their family, but nothin’ whatsoever for their ultimate retirement. Then they learn that they can’t really quit cuz that new lifestyle is a lot more costly than their pre-flipping days. It’s long term investing that spawns retirement income. Until the flipper makes the conscious effort to begin diverting portions of their profits for the expressed purpose of creating said retirement income, they’ll eventually become a prisoner of their own often times phenomenal success.

Those are just four misconceptions I’ve found to be almost universally believed while simply not being accurate.

Be sure to leave your comments below!

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About Author

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.

29 Comments

  1. Jeff, while I agree with most of what you said, why does “flipping leave nothing for retirement”? The fact is that having a solo 401K attached to your flip business allows reduction of taxable income directly. Seems like a no-brainer way to increase your retirement fund. A profitable flipper can put up to $55k per year into an account and reduce his/her taxable income by that much. Am I missing something here?

    • Jeff Brown

      Hey Walt — If your job is attached to your employer sponsored 401k, is your job an investment, or a job? See what I mean? I can just as easily revert to the used car lot. The key indicator in the real world is how the IRC treats the profit or gain. Also, long term investment isn’t considered a job by the IRC. In fact, when you have your own small business with a Solo 401, the business itself is literally restricted to a certain amount of investment generated revenue. The business must be providing a service to others or selling them widgets, or both.

      That’s why flipping isn’t different from selling stuff for a profit on eBay.

      The W2 employee who ‘invests’ in various assets in their 401k at work, is investing long term in stocks, etc. As I pointed out above, using portions of his job’s paycheck doesn’t make his job an investment.

      On the other hand, your point is well taken, but completely unrelated to the post’s point. The fact that a flipper puts money away in their solo is very wise. But it’s completely unrelated to the fact that flipping is in no way investing. It’s rank speculation, plain and simple. I’m definitely NOT saying flipping isn’t a solid way way to create impressive profits. It’s a proven INCOME generator. I love flipping when it’s conducted by true pros.

      Also, I’d strongly recommend those who can afford to put the maximum contributions into their solo to bite the bullet and put it into the Roth side, NOT the traditional side. But that’s another post altogether.

      Make sense?

      • Jeff, It is not an investment directly, as you said. But it does allow one to build an investment portfolio faster, and if already doing flips that growth is essentially free. And yes, I totally agree about putting as much as possible into the Roth side, when possible. How long does it take for that to pay off? I am 57, so I can begin taking money out in Jan 2017.

        • You may very well be in better position than you thought, Walt. Contact me via email, and I’ll quickly go over your status quo. You’re preachin’ to the choir about combining short and long term ventures to gain better overall results.

  2. Jeff,

    I’m a new buy and hold investor and I seem to have purchased a property that fits the mold you outline in your article saying to avoid that prototype. What is your criteria for a buy and hold? How long do you hold for?

    • Jeff Brown

      Hey Chris — That question deserves more time than it would take me to answer here, and in writing. The short answers might be helpful though. With rare exceptions the so-called formulas professing to answer your questions, are completely reliable ’til the day they aren’t. :)

      Seriously though, If you’d like to get a better answer, email me and we’ll make it happen.

  3. Travis Fisher on

    Jeff that’s about the best definition of leverage that I’ve seen. Too many people look for the 0% down deal without putting enough focus on real leverage. One quick question. As a rule of thumb, if it cashflows would it be considered positive leverage?

  4. Justin Maynard on

    If i flip a property and its not an investment how can i do a roi on it? Return on what? Stupid argument, but i have seen people put money in a 401k cd account earning less than inflation. If i take proceeds from my flips and invest in rental properties it is the same as reinvesting dividends. So yes all forms of making money in real estate is investing, granted, the smart play is to use it to invest in longer term diversified investments. When one takes money to make more money they are investing time, effort, and risk which are the core things that make an investment. Look at dave ramsey millionaire lost everything including rentals due to banks calling his notes. When risk is involved it is an investment, eliminate risk and it is a money machine.
    Sorry to blab on but i just see no point to this argument. Its all a means to an end and no matter how u invest u better know ur stuff or u will loose ur ass… and investments

    • Jeff Brown

      If I get your point, Justin, a person going from a $10/hr job to at the local 7/11 to a $50/hr job at Apple, they went from a CD to flipping. A questionable comparison, but I get it.

      I guess if somebody calls it investing and not a business, and enough folks buy it, that works.

      Different strokes, right? Have a good one.

      • Justin Maynard on

        Definition of INVESTMENT
        : the outlay of money usually for income or profit : capital outlay; also : the sum invested or the property purchased
        My point was that just because people invest in a 401k or rentals doesn’t mean it is a profitable investment or smart. Ex. CD = in most cases dumb
        I agree with your point that longer term cash flow positive or equity based gains must be considered, but I just disagree that flipping is not an investment if you have money in the deal. My money into any deal must make money unless something goes wrong, because I evaluate it based on ROI, time, effort, and other opportunities lost.
        I can understand if you said flippers or wholesalers that have $0 in a deal is not an investment (besides time and effort). I think your overall goal was to say “hey guys use your profits to invest in longer term assets that produce cash flow and/or have equity, so when you hit retirement age you will have a means to stop the short term investing of flipping or wholesaling.” I just don’t see the point of telling many users that when they throw money into deals they are not investing. And I do agree they should run the short term investment business as a business. Good business sense says to diversify, plan for the future, and invest in long term assets.
        Thanks

        • Jeff Brown

          It’s a fine point, Justin, but a good one. My point was in a different context. However, what you say is not something with which I’d wanna argue. :)

  5. Hey, Jeff. You know we agree with most things real estate investing related so I’m not going to bother arguing over minutiae. But I literally laughed out loud at the headline of this post. I thought I was going to go to News of the World or The National Enquirer. :)

  6. @Jeff Brown

    Flipping is short-term investing but it is investing. You said so yourself ”long term investing spawns retirement income” as the opposition to flipping. Thats correct yet there would have to be dozens of SFRs in your portfolio if you don’t have a 100+ unit MFR to be able to sit pretty when retirement came around. For tax purposes flipping is short-term capital gain in the eyes of the IRS. Which can immensely increase the tax bracket of the investor. However with the right expenses being deductible its not all frowns.The opposite which is residual income investing is long-term capital gain which yields better tax breaks. For the most part I agree with your blog, though.

    Its always good to diversify and that’s not just a stock tip its for real estate investments too, imho.

    • Jeff Brown

      Hey Mary — Excellent points, except for diversification. I’ve followed Buffet’s take on that strategy. He said:

      “Diversification is for those investors who don’t know what they’re doing.”

      Pretty harsh, I agree. Yet, the returns on investments via the employer sponsored 401k has proved this beyond debate. The vast majority of employees have averaged under 4% return while invoking the principle of diversification.

      On the other hand, you clearly know what’s what. Thanks so much for chiming in.

  7. Hi Jeff, I’ve been trying to parse that sentence, but just can’t wrap my head around it: ” If all you ever did was buy discounted first position notes secured by real estate, you’d surpass the after tax income from that significantly lower amount by double, at least in most cases.”
    Can you elaborate a little bit more?

    • Jeff Brown

      Hey Steffen — That is shamefully tortured syntax, and that’s being kind. In fact, I’m gonna write next week’s post on that topic, so as to answer you question in the clearest possible way.

  8. I agree with almost everything you said except you classifying older homes as having more problems. It depends how they’re built. I have 6 SFH and the 1960s homes have far less problems than the 1985 home I bought a year ago. My point is that if you buy a well-built home and work hard to maintain it, wouldn’t you rather hold on to it if it’s making your numbers?

  9. Hey Jeff,

    That may be Mr. Buffetts point of view in the stock market. Yet from an real estate investor’s standpoint; if one’s preference is to secure rental property as their primary investment, it wouldn’t hurt to do a fix and flip every now and then. Maybe a lease/option here and there would be another great addition as well. That’s a great way to sell it off ‘before it gets too old’. :-) Thanks again.

  10. Great article, but I wonder if it would be better to convert your 401K to IRA after you leave your job then borrow against it. The loan terms are usually quite good and you can expense the interest. You can usually borrow up to 50% of the account value which is what you would be left with after paying penalties and taxes anyways. That way you can get cash today and still own a bunch of paper stocks with may or may not be worth anything when you retire.

    • Jeff Brown

      I hear that suggested a lot, Ronald, but hears the problem from where I sit.

      If, as in the example used in the post, the investor has 17 years ’til that happens, how many hundreds of thousands of dollars did they lose during that wait?

      • Jeff Brown

        Forgot something, Ronald. Borrowing a lousy $50k, which is the maximum allowed, from a balance of $700k is hardly worth the pains of execution. :) Also, the mandated payback terms are over just 5 years. That’s over $800/mo not counting interest. Hardly seems worth it to me.

        You?

        Then there’s the whole traditional vs Roth discussion, right? In the end, we can’t escape the reality of taxation if the money’s in something other than a Roth envelope. Assuming today’s traditional work sponsored 401k will be more in 17 years, why would somebody plan to pay even more taxes then, than paying far less taxes now? This is especially true when we understand that once that initial and admittedly horrific tax/penalty is paid, that’s the end of taxation of that account forever.

        • I would tend to agree with you. Although I think I am in a similar situation as most people. My employer does some sort of matching which it seems to make quite a bit of sense buying into it. However, at the end of that employment, it would be very psychologically difficult to give half away to uncle Sam. This is the situation I am grappling with.

          Perhaps, its spreadsheet time for me.

        • Travis Fisher on

          One other thing to remember about 401k loans is that they are due in full if you ever leave your job. It would suck to instantly owe $50K right after being fired or laid off. Or what if you just got your dream job offer and had to turn it down because you didn’t have enough to cover the loan.

  11. Jeff great article The one point about 1031 exchange seems like people always talk about the pros and good about defering the taxes but I am glad to read articles like yours to analyze to know pros and cons of 1031 exchange. The point about leverage is great also great things to think about and analyze keep writing great content like that sir.

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