Real Estate Investing Basics

4 Real Estate Myths Many Investors Embrace as “Eternal Truths”

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There are many universally accepted, hard ‘n fast truisms in real estate investments that are quite simply factually inaccurate. Today let's take just a few major examples.

1. Buy and hold forever.

2. Always plan to utilize tax deferral to role over gains without taxation.

3.  Cash flow is ALWAYS king.

4.  Investors should always sell within 2-5 years.

Buy ‘n Hold Forever    

To employ one of my favorite phrases from the nomenclature of the professional, “What a crock!” 🙂

Here’s what you have to look forward to if you buy into this belief system. You’ll retire with the following factors in place, embedded in concrete:

All your properties will be 30-100 years old the day you retire. I'm sure that was your goal, right? 🙂 After all, what's better than being retired reliant on ancient properties with failing systems, obsolete floor plans, operating expenses 20-40% higher than when you first acquired 'em and tenants of deteriorating quality? Yeah, that's the ticket.

Where do I sign up for that retirement Nirvana?!

But wait, it gets worse. Since at retirement you’ve owned pretty much all your units for a very, very long time, you’ve not received your retirement bonus surprise. This special gift is courtesy of your belief in buy ‘n hold forever. You get to have your units all debt-free with massive cash flow relative to when they still had debt. The special gift? None of that massive cash flow is tax sheltered in the least. No, not a penny forever more.

Welcome to the wonderful world of buy and hold! 🙂

Then there's our old friend functional obsolescence. Think of the really old rentals in your market these days. I live in San Diego, so it's much of the inventory. How bad and dysfunctional can a floor plan be? How 'bout having to walk through one bedroom to get to another? Think I'm makin' that up? I've seen it far too many times in older homes and even some multiple unit buildings. See, it wasn't a big deal when Leave It To Beaver was winning the ratings wars. For the record, The Beav was born in 1948. 🙂

Related: 5 Dangerous Real Estate Investing Myths Beginning Investors Believe

Or how ’bout my personal favorites, the wall/floor heater and wall/window air conditioner? Tenants go outta their way to find units sportin’ those amenities. You know, the tenants who can’t afford the modern and totally functional units a block up and two blocks over. There are a lot more examples of function obsolescence, like kitchens without dishwashers, but you get the point I’m sure.

Although, if you’ll indulge me a bit here, another all-time favorite of mine is the so-called ‘”family” unit braggin’ about three bedrooms with one bath. Gotta believe having extra one bedroom units in the same complex available makes long term sense if you have many 3/1 units. The divorce rate must be off the charts with just one bath for a married couple with two kids. One of ’em will surely end up renting that vacant one bedroom. 🙂

Always Tax Defer — ‘Cuz, You Know, Taxes Are Evil

I love 31 Flavors Jamoca Almond Fudge ice cream. But it’s a freakin’ treat, not a staple of my normal diet, for Heaven’s sake. The avoidance of tax liabilities for the sole purpose of being able to say you never pay taxes on your long term real estate gains is beyond bad thinking. Let’s quickly, but succinctly, explore why that’s true.

Tax deferred exchanges — often called “1031 exchanges” due to their origin in the Internal Revenue Code, Section 1031 — are NOT tax free as many describe them. When was the last time the government gave you a tax break and didn’t get it back later, at least in some form or fashion? And didn’t get more than they let you skate on previously?!


Two things happen when we exchange, using the rules provided in Section 1031 of the IRC. First, the potential tax shelter on your newly acquired property(s) will almost always be reduced from what they woulda been had you simply sold and bought. The reason is that your new depreciable basis will only increase by the amount your newly acquired debt exceeds the debt on the property you relinquished.

Example: You traded into a property for which you borrowed $200,000 to acquire. The relinquished property had a balance of just $125,000 at the time of sale. That means that even though you paid almost $300,000 for the new property, your "new" depreciation on it will be based upon a lousy $75,000, the increase in debt. But wait, it gets worse. You can't depreciate the whole amount, as you must first subtract the value of the underlying land first, using its percentage of value. So, if the land is worth 20% of the property, you're left depreciating just $60,000. If you use the same formula 95% of investors use, that amount will be the answer to — $60,000/27.5, which is a mere $2,182/yr. If you'd bought that new rental in a straight sale, eschewing the exchange, your depreciation woulda been somewhere around $8-9,000/yr!

Sure, you're right when you say the relinquished property's old adjusted basis goes with ya in the exchange, including it's, um, less than robust annual depreciation. But even with that added to the new rental's largely restricted depreciation figure, it's not even close to the sell/buy approach in the vast majority of cases. This isn't to say that sometimes the investor should indeed execute an exchange. It does mean that exchanging, tax deferred, shouldn't be the default strategy.

Cash Flow is ALWAYS King

I think it’s possible that belief has turned more investors’ retirement plans into epic disappointments than just about any other. Besides, it’s about the timing. Is cash flow ever a bad thing? ‘Course not. However, emphasizing cash flow over capital growth at the wrong time can horribly retard what coulda, shoulda, woulda been your much more impressive retirement cash flow.

Here’s the Captain Obvious simple reason why:

To the extent we go for cash flow, we hinder capital growth. The reverse is also equally true. Both can be easily seen when doing spreadsheets. It’s much easier to detect when it’s too late, which is what I run into all the time with investors lookin’ for help. Once we buy into the myth that cash flow is king — always and without exception — the die is cast. There are several ways to inflict this on ourselves. Let’s talk about two.

  1. We buy one property with a huge down payment instead of two properties with reasonable down payments. In my world, “reasonable” starts with 20% minimum, just so ya know. 🙂 People do this for a few reasons, most of which is they must have a “bar” for lowest cash flow allowed. In average “plus” to “oh my God” bluechip locations, this means higher down payments. On the one hand, we get blue chip locations, while on the other hand, we’re poisoning our ultimate retirement cash flow to the max. Am I implying we should eschew top notch quality locations? No way. I’m saying there are those level locations not requiring your firstborn as down payment just to get them to pay for themselves.
  2. We buy inferior locations with “high” cap rates. The spreadsheets on these properties are indeed impressive, though most should be nominated for best script in a science fiction short story. Am I spoiling your fantasy that the 15% cap rate you bought is really far less than that? Are the vacancy rates double what you were told? I'm both shocked and chagrined. 🙂 Are the tenants not what you expected?

Here’s a solid piece to read on this narrowly defined topic of cash flow vs capital growth.

Understand that all cash flow, when the smoke clears, is a yield on a pile of gold. The bigger the pile, and/or the more piles you have, the more cash flow you will enjoy — when the cash flow matters, which is (wait for it…) our freakin’ retirement! 🙂

The investor with $3 million makes the same yield, more or less as the guy down the street with $1 million. It’s just that his retirement income is triple what his neighbor’s is. That poor neighbor will forever be trying to figure out how cash flow wasn’t always “king.” 🙂

Real Estate Investors Should Always Sell in 2-5 Years

(Or some other nonsensical time period.)

Man, I’ve heard this rubbish since Nixon was in office, and it’s as dumb now as it was then. Please tell me about your crystal ball’s record, will ya? Besides, with precious few exceptions, one of which I practice often for clients, having a set timetable to sell simply makes no sense whatsoever. Yet I read and hear about it all the time. When folks espousing this gibberish are asked to explain why, the whole ambiguous “maximize” investment yields malarkey we’ve all heard ad nauseum pops up.

Even a well thought out plan like the cost segregation strategy is subject to changes in many factors that could derail the end game, and most of 'em are out of the control of the investor. Let's take a phenomenally rising market like the one we experienced nationwide, especially in markets like San Diego, in the mid-late 1980s. It was crazy cool if you'd just bought income property back then. Prices were increasing double digits annually.

Related: Money Myths and the Biggest Mistakes I’ve Made Raising Capital

So many times back then, I’d hear someone suggest we buy and sell every couple years. It was a very reliable and profitable “formula” for the first two moves. Notwithstanding all their predictions of massive wealth creation, the S&L Crisis hit like a red hot sledge hammer to the back of the head. Vacancy rates vaulted to double digits from virtually 0%. Rents tumbled 10-25% simultaneously.

See, most formulas work perfectly ’til the day they don’t.

From around 1976 through May of 2003, when I left my hometown market of San Diego permanently, the holding periods were all over the map. From ’76 through fall of ’79 some local investors bought and cashed out or exchanged three different times, using the same investment “lineage” of the original investment property! From the fall of ’79 to around the end of 1983, ’84 there wasn’t much goin’ on at all. As in, a whole buncha nothin’. We were back to the races in full stride by the end of 1985. From then ’til around the middle of 1990, it was game on in a huge way. If you’d managed to acquire property in my neck of the woods sometime in early ’85, you were trading into bigger stuff no later than late ’86, early ’87 — and doin’ pretty well. As likely as not, you did it again in ’89 with the same or even better results.

After that, though? From the last of 1990 to the beginning/middle of 1997, you either held or got clobbered. If you traded in 1989, that’s a holding period of eight years, planned or not. Thing is, we hold ’til it makes Captain Obvious sense to stop holding. Simple principle, isn’t it?

BawldGuy Axiom: We don’t decide the holding period, the market does. Period. End of sentence. Regardless of what some may think, we DO NOT control the market. 

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The same type scenario played out at the turn of the century. I personally know many, many investors who had no choice but to make use of tax deferred exchanges three separate times in the five year period spanning 2001-2005. They made tons of money.

The principle in a nutshell is to take what the market gives us. Take it the way it gives it to us. Take it WHEN it gives it to us. Then smile. 🙂

There are many more of these “known truths” that are nothin’ but wishful thinking. In the end, what we must always do is look at the picture as it is, in real time, with a complete analysis. Objectivity is our friend. Always has been, and always will be.

Investors: Do you agree with this assessment? What would you add to the list?

Leave a comment, and let’s have a conversation!

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.
    David Krulac from Mechanicsburg, Pennsylvania
    Replied about 5 years ago
    Jeff, Very insightful. 1.Buy and hold forever. In my BP Podcast #82, I talked about selling (actually exchanging) building built in 1890 for buildings built in 1994 and 1996, trading up a century. I had extensively remodeled the older buildings and there wasn’t much more that I could do that was economically feasible. The 1994 & 1996 buildings had: Lead free paint modern open floor plans central air conditioning attached garages fireplaces sliding glass doors modern kitchens outdoor patios and space All of which the 1890 buildings did not have. The 1890 buildings were good investments, the buildings 100 years newer were a better investment. I like buy and hold, after 800+ deals I still own the second property that I bought. but I also go through a process every year where I “thin the herd”, jettisoning some properties and replacing them with better properties. Always Tax Exchange & Do an IRS Section 1031 I’ve done a bunch of 1031s, and also talked about then in my BP Podcast. But the overwhelming percentage of my sales were NOT tax free exchanges. There are about 4 favorable tax IRS treatments that I like including stepped up basis, depreciation, self directed Roth IRAs, and tax free exchanges. But not every deal works with any of those. A good friend of mine recently had a 7 figure long term capital gain and was looking into doing a 1031. He asked me to be the custodian. I refused and directed him to somebody in the 1031 business that we all know. The requirements for a 1031 are strict and unforgiving. My friend couldn’t qualify and meet all the requirements and therefore was able to do a 1031. His 6 figure tax bill was money that could not be applied to his acquiring purchase, as that money went to Washington DC. I’ve seen people rush to meet the 1031 time frames and end up buying a property that is less than stellar. I’ve seen this more than once. And there is accost to doing a 1031 so small gains aren’t worth the time, money and headaches that result. 1031s are not for everyone and not for every situation, but in the case of that second property that I ever bought which is depreciated to zero, I will be giving strong consideration to a 1031 tax free exchange. In combination with Section 121, $500,000 tax free capital gains and the stepped up basis, the 1031 could truly be tax free instead of only tax deferred. And there is a proposal to eliminate the 1031 in congress, so the merits may only be debatable for a little longer. Cash Flow is King When I Started I Had Nothing, its not just a book title. The first 11 properties that I bought were all essentially 100% financed in one form or another. Many of the succeeding properties were also heavily financed. I would borrow as much as I could for as long as I could. therefore I had tons of debt. Obviously the biggest expense every month was paying mortgages to banks and lenders. Cash flow was not the king. The lenders were king. More money went into the lender’s pocket every month, than went into my pocket. I never financed less than 80% or more, what ever I could get. I never put extra down to increase cash flow, and still don’t do that or recommend that. But to buy as many deals as I have, I could not have done it starting with nothing without heavy financing. so I personally sacrificed cash flow to gain in number of properties bought and to amp up the growth. Always sell in 2-5 years That’s about the stupidest real estate concept that I ever heard. what if you bought in 2008 at the peak prices would you sell in 2010 to 2013 at the bottom prices. I sold a property in 2008 at the peak, then sold the identical property next door in 2014 for 60% LESS. There are many reasons to sell, a 2-5 year “rule” is not one of them. David Krulac
    Christopher Moran from Pueblo, Colorado
    Replied about 5 years ago
    Your comment is right on. I can tell that you are wise, knowledgeable, and successful just by this comment. Also, the folks I know that I would consider role modes, did things the same way you did. I love your idea about “thinning the herd”. This way you gradually upgrade over time, get rid of your headaches, and constantly improve. In the future, I look forward to culling my 100+ year old properties too!! Although I will miss their craftsmanship and history, the decision will be unemotional and based on the numbers.
    Tom Phelan
    Replied about 5 years ago
    The author states: “Tax deferred exchanges — often called “1031 exchanges” due to their origin in the Internal Revenue Code, Section 1031 — are NOT tax free as many describe them. When was the last time the government gave you a tax break and didn’t get it back later, at least in some form or fashion? And didn’t get more than they let you skate on previously?!” Contrary to what the Author states there is one way you can beat Uncle Sam (IRS) and NEVER pay taxes and it is something you will eventually do anyway-die. Your heirs will inherit on a stepped up basis and you will have outsmarted the IRS. This could be significant if you had 1031 exchanged multiple times over a period of years. I know of someone who started with four-plexes and 1031 exchanged his way into towering office buildings, his goal is to never pay capital gains taxes and to leave the properties to his heirs tax free.
    Jeff Brown from San Diego, CA
    Replied about 5 years ago
    Very true, Tom. That would make the dead investor a martyr on the ‘altar’ of 1031 for his kids, right? 🙂
    David Krulac from Mechanicsburg, Pennsylvania
    Replied about 5 years ago
    Jeff, Btw, the Tax Free Exchange has been part of the IRS code since 1924, so it is one of the longest surviving provisions of the US tax code.
    Jeff Brown from San Diego, CA
    Replied about 5 years ago
    Anything that’s become such a proven money maker for the government/IRS tends to hang around, right? It’s much akin to ‘temporary’ taxes that ‘tend’ to become permanent.
    David Krulac from Mechanicsburg, Pennsylvania
    Replied about 5 years ago
    Jeff, I’m not sure that is the reason. 1. Few people take advantage of the 1031, so it is relatively unknown and under utilized. 2. Except for the combination with section 121 or stepped up basis, the IRS will eventually get the money. 3. Its misnamed as a tax free exchanged, its really a tax deferred exchange. 4. IRS doesn’t make the law, its up to Congress, and so far there hasn’t been a public outcry to eliminate the 1031.
    Christopher Moran from Pueblo, Colorado
    Replied about 5 years ago
    Jeff, Regarding your Point #2, regarding §1031 exchanges, rather than guess at if you will be economically better off with a sale and purchase, or with a like-kind exchange, you can use the formula found on page 60 of the following tax policy research paper: This formula accounts for the time value of money, and the §1250 depreciation recapture tax, which are both huge hits to the sale and purchase strategy you mentioned. When tax-policy analysts studied the effect of repealing §1031 of the tax code, the conclusion was that repealing §1031 would increase tax revenue by $318 billion from 2011-2061, and increase tax revenue $98 billion from 2011-2021. A net increase in tax revenue to the United States Treasury means that, on balance, taxpayers would pay more in taxes, if §1031 was repealed. This means that, in aggregate, if real estate investors voluntarily did not use like-kind exchanges, as you suggest, they would pay billions in additional taxes over their lifetimes, with all else held constant. More importantly, when you sell a property, rather than exchange it, this usually reduces your available investment capital, because a large chunk of the proceeds will usually go to taxes currently, instead of continuing to have that money invested. For a good compounder, this is the kiss of death. Although, in aggregate, taxpayers are better off with exchanges, each situation is unique. So, to be certain for each specific circumstance, you must plug your numbers into the equation referenced in the paper above. Then, the taxpayer should exchange into the replacement property if the present value of the exchange strategy, exceeds the present value of the sale-purchase strategy.
    Dawn A. Rental Property Investor from Milwaukee, WI
    Replied about 5 years ago
    This article is funny in many ways. Most of the properties I invest in are built in the 1950s now. So my properties are already around 65 years old. Most of them only have 1 bathroom, even with 4 bedrooms. And most don’t have central air or dishwashers. And yet, I put up an ad and get 20 people to come to one showing. So even these “obsolete” type places can be in high demand in some markets. Then you add some of these amenities and people stay forever.
    Christopher Moran from Pueblo, Colorado
    Replied about 5 years ago
    Amen to that!! Same here. I have properties that were built in the 1890’s, and are extremely “functionally obsolete”. Yet I am always overwhelmed with interest when they come up for rent. One of them is a 5 bedroom / 1 bath. 1 bath!!!! Sounds crazy, but when it comes up for rent (at ridiculously high rents that I keep raising), I am overwhelmed with responses on the first day. I had to start figuring out ways to eliminate most folks, so I don’t have to tell fifty people “no” (I use Cozy as one way to prescreen and automate rent collection, by the way). I keep waiting for the day to come when I have difficulty renting them, and then I will add a bathroom, dishwasher, central air, open up the floorplans, etc. After a decade, I get the feeling that remodel time is a long way off, since demand for them seems to keep increasing every year. In fact, my functionally obsolete properties get much more demand than my newer ones!
    Katie Rogers from Santa Barbara, California
    Replied about 5 years ago
    What is the vacancy rate in your town? Has it ever occurred to you that maybe people are renting that house because they NEED a place to live? You admit it is a horrible place at “ridiculously high rent.” Are you newer places even more expensive to rent? That would explain why there is more demand for your obsolete places. Did it ever occur to you that people need to be able to afford the rent, or are you one of those landlords who consoles himself with the thought that if the tenant signed the lease, he actively chose the place. Maybe it was only the least bad choice out of a whole lot of bad choices in your town. I have been a tenant forced to rent crummy places at ridiculously high rent. As a landlord, I use the Golden Rule to drive my decisions with only a nod to demand. Demand alone is not a good reason to charge “ridiculously high rents” for an obsolete place. I would go ahead and add at least one bathroom anyway and hopefully a laundry room if it doesn’t already have one. I would make sure I offer my tenants HOMES that I myself would be willing to live in because I have a great deal of respect for that fact that my tenants’ wages are lining my pockets. So I charge rent well below the ridiculous high rents in my town (you sound like your property is in my town and you sound like a lot of landlords in my town) and offer a nice place to live. I screen carefully using my own system (no credit reports needed), have great, loyal, long-term tenants because the Golden Rule really works.
    Katie Rogers from Santa Barbara, California
    Replied about 5 years ago
    You don’t actually need central air or a dishwasher. Personally I prefer places that do not have a dishwasher, and have avoided the fads of stainless steel appliances, all electric heat and cooking, side-by-side refrigerators, mirrored doors on closets, and clear glass showers. And one of the bathrooms should always have a tub. If there is only one bathroom it needs to have a tub. A remodel should be high quality, durable and neutral. Too often I see overwrought remodels.
    Christopher Moran from Pueblo, Colorado
    Replied about 5 years ago
    I am about to try to rent out a home that does not have a tub, only a shower. Wish me luck! P.S. If it doesn’t rent, I’ll go add a tub.
    Katie Rogers from Santa Barbara, California
    Replied about 5 years ago
    You probably will not need luck. People need a place to live, so they will do without a tub. In my town the vacancy rate is so low (1%) that many landlords do not even need to consider your approach “If it doesn’t rent….” People need a place to live, so landlords here offer truly crummy places to live (lack of tub is the least of problems) for outrageous rent. There is no supply and demand competition to motivate them to offer decent housing at a reasonable rent relative to the typical tenant’s wage. If I were you, I would add the tub anyway. Why not put yourself a cut above the rest of landlords for what? less than $1000. I also make sure my tenants have access to a washing machine and dryer, since laundromats are few and far between in my town. You see, I think our business practices should be governed by the Golden Rule. I know how I wished to be treated when I was tenant, so I am determined to treat my tenants as I wanted to be treated (but rarely was).
    Replied about 5 years ago
    To continue: year 2006-7 lots of people ( me too ) got into TIC Tenants In Common in 1031 X. It was easy to buy say 750 units student housing with 25 investors. Now most of them are giving them back to lender or sponsors ( me too). Crook in industry cooked books, 10 yr loan coming due, can’t refinance, may be tax consequences. Hear, if you do not gain, no taxes, only CPA can confirm that. Other issue, homeowners got equity line, used it, now principal payment coming due. So tons of short sale, foreclosure in next 2-3 yrs coming. Have STNL single tenant net lease plan to keep for heir to enjoy ,enjoying cash flow for 20 yrs, stepped up basis for them, no taxes!!! Property will have land value, and will be paid up by than.
    Jerry W. Investor from Thermopolis, Wyoming
    Replied about 5 years ago
    Jeff, as I read your article my understanding is you are saying never say never. Make your decisions based on the economy not an absolute rule. I have never used a 1031 transfer but would like to. I rarely sell a property off but it happens. I would love to defer the taxes rather than pay them. I plan to pass more than a few rentals to my children and hope to have zero tax paid when they sale them with the free stepped up bases. I get cash flow to live on, they get properties to sell or whatever. I have bought some pretty poor cash flow places, in fact slightly negative, because I got a much newer property that will have a fraction of the problems as my older properties in 20 years. They will be keepers later, the lower maintenance and easier to rent properties. I would love to move up a few properties and need to think that over a bit. DAVID KRULAC WOW nice post. Your reply is as good and many blog articles I see. Very insightful and educational for me. Thanks for posting.
    Dan Schwartz Real Estate Investor from Tempe, AZ
    Replied about 5 years ago
    @Jeff Brown and others: I’m interested in reactions to an analysis of a 1031 that I posted in the forum after reading this article. I’ve read in a number of your outlets the pointed advice to avoid tax-deferred exchanges in nearly every situation, and you have caused me to re-think one I have in process (my first).—calculations-of-depreciation-and-various-bases-with-and-without-the-exchange Without your challenging comments, I wouldn’t have dug so deeply into the ins and outs of the post-exchange rules pertaining to depreciation and deferred gains. Thanks!