Recently, I was listening to The Motley Fool Podcast by Alison Southwick and Robert Brokamp and was really captivated by their episode "Why Real Estate Investing Might Make You a Mint." It features tax strategist Thomas Castelli with The Real Estate CPA who helps explain the world of real estate investing. If you are looking to invest or just curious about the topic, this is definitely worth a read.
Southwick: Because you listen to this podcast, you probably know a thing or two about investing. I know I certainly know a thing or two about investing...
Brokamp: At least two things.
Southwick: At least two things. One thing I know absolutely nothing about, though, is real estate investing, but all that changes today, because our guest is Thomas Castelli. He's a tax strategist with The Real Estate CPA. Thomas, thank you for joining us!
Thomas Castelli: Thank you guys for having me today!
Southwick: Before we get into some of the different ways that people can invest in real estate and talk about taxes, which everybody loves -- I know Bro can't wait to get that part -- could you tell us a little about yourself? Where are you from? How did you get into this line of work?
Castelli: Absolutely! I was born and raised on Long Island in New York. Currently live in Astoria, Queens right across from Manhattan. I moved out there because I got a job in Manhattan before eventually going virtual with The Real Estate CPA.
The way I got into the real estate space and real estate investing was when I was in college I started reading some books -- The Rich Dad Poor Dad books. I'm sure some people are familiar with those. Real estate was a big theme in there and from there the rabbit hole just went pretty deep and I was like, "Oh wow, real estate's what I need to get into."
I went to school to be an accountant and I became an auditor. I looked around at people 10 years older than me and realized that that wasn't what I really wanted to do in 10 or 20 years, so I started investing in real estate. I started doing deals and stuff like that. That culminated in me finding The Real Estate CPA on LinkedIn and seeing, "Oh wow, that's a perfect mix of my accounting background and my passion for real estate. I could help real estate investors save money on taxes. Help them build their wealth." That's how I got involved in this space.
Southwick: Why should someone consider investing in real estate? It was very compelling to you.
Castelli: There's a bunch of reasons. We could discuss three or four of them. The main one, especially for your listeners who may be interested in stocks, is "access and control." When you're investing in the stock market, per se, you're investing in a company. You're relying on their management team to really drive the returns for you and you really don't have that much control over those returns. You can go to their proxy meeting, but you're not really going to get any real influence over that company.
When you're investing in real estate, in many cases you're doing it directly yourself -- if you're going to buy your own single-family house or your own apartment building -- and you're going to have direct control over the entire asset and the way you want to run it. And for some people that's comforting. The control is in their hands. And in other instances, like when you're investing in small partnerships, you may not be the managing partner of that entity, per se, but you might have a relationship or can develop a relationship quite easily where you can have the influence and control. That access to the managers. For some people that's a good reason to do it. There's an entire sect out there that believes that you should control it, so some people like that aspect of it.
Another reason is it's a "proven asset class." The core business model of real estate is you're going to buy a plot of land. You're going to develop it and sell it at a profit, or you're going to hold it and rent it, or you're going to acquire an already existing building and hold it for rent. The fact is, shelter is a basic human need. It's been that way for thousands of years and it's going to continue to be that way hopefully for thousands of years. I don't see that business model going anywhere anytime soon and neither do a lot of people.
The supply and demand factor is built in inherently. In 1990 I think the population was around 6 billion. Fast forward to 2019, around 30 years, and it's over 7.5 billion. That's 1.5 billion people added in 30 years, but guess how much land was developed in the last 30 years? Basically none, unless you count the dredging of islands. But the reality is that land's going to continue to increase in value, especially in those areas that are desirable and people want to live. That's one reason.
Another reason is "tech isn't going to change." You see tech changing all these industries and revolutionizing industries in ways that people can't foresee, but at the end of the day you can't live in the internet, so the internet and tech isn't going to replace real estate. It's going to be there.
The third reason is "multiple profit centers." Real estate has appreciation as the first profit center. You buy it, you hold it, and eventually the price rises and you're going to have a return on that. There's something called "principal paydown." Most of the time when you buy real estate you're not buying it in all cash. You're buying it with leverage. You're buying it with debt on it. Your tenants will end up paying down a part of your principal every month increasing your equity in the building. That gives you another form of return.
There's, of course, the rental cash flow from it, and then there's the tax benefits, which in and of itself is a profit center. I think we're going to get to that a little later.
The final reason some people like it is because it's "a hard asset." You can touch it. You can feel it. It has intrinsic value. It's not a piece of paper. It's physical. You could break down the components of a building and sell it and still cover your costs.
Southwick: So when most people think about investing in real estate -- at least here in the D.C. area for a little person like me who doesn't have some massive real estate empire or come from a world like that -- when you think about investing in real estate you think about investing in a house and maybe flipping it like a single property. Or investing in a property and then renting it out. And it is very active, because you have to go and physically either pound nails into the wall, yourself, and paint the place. Let's talk a little bit about that form of real estate investing, because it's broken up into "active" and "passive", correct?
Castelli: Correct. When you're flipping a house, it's not really a form of investing, necessarily. You're considered a dealer, in most cases, so you're actually in the business of buying and selling houses. It's really no different than buying and selling cars. No different than buying and selling shoes in a shoe store. It just happens to be that the asset is very expensive that you're buying and selling. That's more of an active business. It just gets misclassified as investing by real estate investors.
Really the active form of investing would be you're building a rental portfolio, buy-and-hold real estate. That would mean you're identifying a market that has favorable fundamentals. The population is going to be growing. Job growth is there. A diversified economy. There's other factors that may make that area desirable.
You're going to identify properties. Most of the time people want to identify properties you can get at a discount. Maybe the buyer has a motivation to sell. Maybe they're getting divorced. Maybe they can't afford it. Maybe they're facing foreclosure. Or in other cases the property has deferred maintenance and needs a lot of work, so you buy it, fix it up, raise the value of the property, rent it out, and then later on sell it down the line.
That's the active side of it and you're going to be responsible at the end of the day for finding that market, finding that property, putting down the down payment, getting that financing, and then managing the property after the fact. Are you going to hire a property manager or are you going to manage it yourself?
All that comes into play when you're on the active side of the business. In the beginning, especially when you're first starting out, that's going to be quite hefty. It's going to be quite a hefty load for you to carry to get your first one or two properties. And then after that it might be easier for you to scale going forward. That's kind of the active side for most individual investors. You'll be buying single-family homes. Maybe two to four units. Maybe smaller apartment buildings. That's the type of thing you'd expect.
Southwick: Now let's talk about passive investing. We're going to talk about two different kinds -- "turnkey" and "syndication." Let's start with turnkey. What is that?
Castelli: Turnkey investing is when a lot of that work that I just mentioned is done for you. A turnkey company will find a property that has deferred maintenance or buy from a motivated seller. They will go in and fix that property up, put a tenant in that property, and then sell you that end product. You, as the investor, will buy a property. It's already fixed up, it already has a tenant in it, and generally the turnkey company will remain on as the property manager. You still own the property, but it becomes very passive for you, and that's why they call it turnkey, because it's almost like you're just buying the property and letting it go.
However, when it comes to turnkey you are still, at the end of the day, going to be responsible. If a boiler breaks, you're going to be the one paying for it, not the turnkey company. That's something to keep in mind. But at the same time you still have that access and control. You still own the property so unless there's some kind of contractual obligation, you can fire the property manager and manage it yourself or hire someone else. So for people who are looking to get in on a passive side on more scale and still have that access and control, turnkey is an option for them.
Southwick: Then the next one we're going to talk about is syndicate investing in real estate. If I understand it correctly, this is something that's really taken off recently because of the Jobs Act. Is that correct?
Castelli: Syndication has been around for a long time. People were doing syndicates back in the 1980s. It's been around, but it became more popular with crowdfunding. Then with the Tax Cuts and Jobs Act with the introduction of opportunity funds, we're definitely going to see a rise in that type of business model on the syndication side.
Southwick: I know a bit about the Jobs Act and how it has opened up investing like this for more people because of the Motley Fool Ventures Fund. Like before the Jobs Act, it probably would not have been possible for The Motley Fool to open up a venture fund and have 800 limited partners. In a similar way, the Jobs Act opened it up so that accredited investors have more opportunity to invest in commercial real estate?
Castelli: The Jobs Act definitely opened it up to more people -- allowing more people to invest -- and you don't necessarily have to be an accredited investor.
Southwick: To be an accredited investor, you have to...
Castelli: To be an accredited investor as a single individual, you have to make $200,000 or more for the last two years with the anticipation of making that same amount or more in the third year. If you're married, that's going to be $300,000. Or you have to have a net worth of $1 million or more excluding the value of your primary residence. That's whether you're married or single. Those are the two different ways you can qualify as an accredited investor. There's certain offerings that are made to "sophisticated investors."
Southwick: I love that! Everyone thinks they're a good driver, has a great sense of humor, and are also a sophisticated investor.
Castelli: There's definitely different levels of sophistication, but basically there's something called a 506(b) rule. It's a regulation under Regulation D that allows sponsors, or people who are going to raise the money for a deal, to allow up to 35 non-accredited investors into the deal as long as they're "sophisticated."
That's really going to be determined by the sponsors, themselves, and how much risk they're willing to take on. They have to understand this person's sophistication, so they have to measure that in some way. Maybe this person works in real estate. Maybe they have a finance or accounting background, or a business background. They might not be accredited, but they're still sophisticated enough to understand what they're investing in.
Southwick: Let's get into it. How does it work?
Castelli: Syndication is when multiple people pool their money together to buy an asset that they wouldn't maybe be able to buy individually. There's two parts of the syndicate. There's going to be the "general partnership" side, also called the sponsors, and there's going to be the "limited partners" or the passive investors.
The sponsors are responsible for everything in the deal. Making sure that it happens. Making sure that they're identifying the market. Identifying the property. Identifying the business plan. There's something called value-add -- a strategy -- where they go into a property that has that deferred maintenance or is otherwise undervalued. They're going to renovate that property over a few years and rate that property's value and then later on sell it.
They're responsible for identifying the asset, making sure it's in a good market, coming up with a business plan to renovate that property. They're going to be responsible for raising the financing, both from the debt side, whether that be from a bank or another institutional lender, and then the equity side is going to be usually from passive investors to be used for the down payment and renovation budget of the property.
Then they're going to usually use third-party property management to manage the property and make sure that renovation goes as planned, ultimately selling the property. These things usually happen anywhere from three to seven years. It's the traditional time frame of a syndication from purchase to end. It just depends on a number of factors. Market conditions. How long it takes to get the renovation done. That's how that works.
Southwick: And does it end when they determine they're going to sell the property to someone else? What determines the end? I assume your money is locked up there.
Southwick: How do you get paid?
Castelli: It depends on the structure of the deal. There's all different types of structures on how it can be done. Sometimes there's cash flow that comes out. During ownership of the property you get distributions. Then there is also the capital gain at the end of the sale. So when the property is sold it's usually when the syndication will end. That's two profit models -- two different ways to make money on the syndication.
Depending on who you're investing with and how they structure it, usually you'll see anywhere from a 6%-10% pref, preferred return, which means that the investors will get paid out anywhere from that 6%-10% annually before the sponsors get to touch any of the money, before they get any profits.
Then usually there's a target of 15%-20% or more internal rate of return. This is the kind of returns you expect on these deals. Now, depending on what type of asset class you're investing in it can vary and these days a lot of people are investing in multifamily. We're starting to see those kinds of rates decrease, slightly, because there's a lot of money chasing a little bit, amount, of assets. Supply and demand is going to push the price of those assets up, and when you have to purchase that asset for a higher price, the return, the yield is going to be, of course, lower.
So returns vary, and I'd have to say that if you're going to be investing in one of these things, the biggest part, as a passive investor to look at, is the sponsor themselves. What track record do they have? Do they have a track record of success in that asset class -- for instance, multifamily or self-storage? What do other investors say about them? Who are their partners? Who are they using as their lender? Their attorney? Their accountants? All this comes into play when you're determining whether or not you want to put your money with it, and it really comes down to, like Warren Buffett always says, the management team. You invest in a company with good management. It's no different here.
Southwick: I'm going to lean back now, while we shift to talk about taxes. I always struggle when we talk about taxes because I want to know why the tax code is the way it is, and I need to remind myself that taxes are just this bear of a thing, like a Frankenstein monster that's created, and influenced by tons of different people and interests. And you love talking about taxes.
Brokamp: I wouldn't say I love talking about it.
Southwick: No, you love it! You love talking about taxes, so I am going to lean back a little bit and let Bro lean in a bit more to talk about some of the tax benefits of investing in real estate. Some of them just make my head spin. I'm like, "Really? Really?"
Brokamp: It is different than if you go out and buy shares of Amazon. Let's start with depreciation, first of all.
Castelli: A lot of people consider real estate as what they call "tax-advantaged" income and that really comes from depreciation. When you buy a property you buy a building and you rent it out to someone. You have cash flow. It's going to be considered rental income. And you're going to have your operating expenses; things like advertising, mortgage payments, property management fees, anything like that. And there's one of those operating expenses called depreciation, which is not a cash expense, so there's no cash that actually goes out of your pocket when you take depreciation, but it can be usually increased through various strategies so that you actually show a loss for tax purposes despite actually generating positive cash flow.
For example, you have $10,000 of rental income, $4,000 of actual cash operating expenses that left your pocket, and say you have a $7,000 depreciation expense. Now you have a net loss of $1,000, so you're paying nothing on that income, but you really pulled in $6,000 that you put into your pocket. That's kind of what the power of depreciation is and you can use cost surrogation studies to increase your depreciation.
With the Tax Cuts and Jobs Act, they actually came out with something called 100% bonus depreciation. That allows you to depreciate property with a class of less than 20 years and generally, on real estate, anywhere from 20%-30% of a property can be classified as five, seven, and 15-year property, so you can depreciate 20%-30% of that property and take that expenses depreciation in the first year you buy it. That has a major impact on the amount of money and tax you're going to pay over the time you own the property.
Brokamp: It's kind of funny, because you're saying, "I own this asset that I want to increase in value, but I get to take this charge that assumes it's actually depreciating," but it's usually not.
Castelli: It's usually not. For the most part, real estate tends to increase in value. There is a dark side to depreciation. It's not all love. There's something called "depreciation recapture", which when you sell the property you have to recapture the amount of depreciation you took, assuming you have a gain, of course, up to 25%. It's taxed up to 25%, but generally the thought process behind that is the time value of money. You'd rather take the depreciation today, have the tax-free cash flow so you can reinvest it, put it back into your business, and then pay the taxes later on.
And by the way, you can't not take depreciation and avoid that. Some people will say, "What if I just don't take depreciation? Do I have to pay that tax?" The IRS will assume that you did take the depreciation and charge you that tax anyway, so you're better off taking it. There's no way to avoid it. There are ways to avoid that depreciation recapture tax and I think we'll talk about that in a little bit, as well.
Brokamp: That's basically getting a tax break along the way, but then there's the tax break you can get when you sell the property, otherwise known as 1031 exchanges. Why don't you talk a little bit about that?
Castelli: When you sell a property you're going to have a capital gain...
Castelli: Assuming you're investing in the right way, you're going to have a capital gain. And part of that capital gain is going to be depreciation recapture. Now what a 1031 exchange allows you to do is defer that capital gain and the depreciation recapture by purchasing another property. What you have is 180 days from the day you sell your original property to roll over the entire sales proceed , so both the capital gain and your original principal, into another deal. This is normally called "trading up."
Let's say you have a property you bought for $100,000. Ten years passes, and now it's worth $150,000. You have a $50,000 capital gain. Break it up in between capital gain and depreciation recapture however you want. You're still going to have to pay tax on that 50 grand. So when you pay tax on that 50 grand of capital gains, you're going to have less money you can reinvest. What a 1031 allows you to do is invest that entire amount so you're not paying the taxes today, and you can purchase a larger property.
You could continually purchase larger and larger properties and continue to use the 1031 exchange pretty much forever. And if you really wanted to -- I'm just going to be honest as it's easier said than done -- you can eventually leave the property to your heirs and they'll receive that property at the fair market value on the date of your death, eliminating all of this capital gains depreciation recapture that you should have paid during your lifetime. In theory, you can just keep purchasing larger and larger properties, making more and more cash flow, but never actually paying any taxes on that property.
Southwick: This is crazy to me! This is one of the reminders of how it's easier to get richer when you're already rich. If you're already wealthy then there's all these ways for you to easily make more.
Castelli: I'll say something on that, too. These days I feel like the internet, Google, a podcast like this; there's a lot of ways to access information, and as long as you're willing to put in the work and do the research and pull things together... My motto is "figure it out." As long as you're willing to figure it out, you're going to be able to put a lot of things together, and you can use these same strategies that the "rich" are using. There's no one stopping you from using it. It's just in the past there wasn't as much access to this information.
Southwick: You'd have to join a country club. You'd have to be on the links to learn about real estate deals.
Castelli: You'd have to be paying attorneys and tax accountants a ton of money to figure this stuff out, but today it's all there. It's all there for you.
Brokamp: You mentioned opportunity funds. This is a very new thing. I'm not going to even try to describe it. I'm going to leave it to you because it is so new, but it is another way to defer and maybe even eliminate some of your capital gains. And it doesn't have to start with real estate. It could be you want to sell some shares of your Amazon. You have a capital gain. Here's a way to at least defer some of that.
Southwick: Can you define for us what an "opportunity fund" is?
Castelli: Absolutely! Before we talk about opportunity funds, you have to understand what an "opportunity zone" is. There's 87,000 opportunity zones across the United States, and they are low-income communities that were designated by the state governors as opportunity zones and then approved by Treasury. An opportunity fund is the investment vehicle that you can invest in an opportunity zone. And for investing in these opportunity zones through this opportunity fund you have these tax incentives.
The way the opportunity funds work is you can defer the capital gains tax on any capital asset. That's usually stocks, bonds, mutual funds, real estate, and things like that. If you're not sure, you could always ask your CPA. They could let you know. Basically what you can do is roll it into an opportunity fund within 180 days of sale -- very similar to a 1031 exchange there -- but the difference there is you only have to roll over the capital gain. You could take the principal back that you invested and put it in your pocket and do whatever you want with it.
Then if you hold that capital gain in the fund for five years, you're going to receive a 10% stepped-up basis in that gain. Let's just say you have a $100,000 capital gain and in five years you receive the 10% step-up; you're only going to pay tax on $90,000 of that capital gain. If you hold it for another two years for a total of seven years, it's going to step up another 5% for a total of 15% and you only pay tax on $85,000 of that gain.
Now, if you hold that investment in the fund for 10 years, your investment in the actual fund, itself, will be tax-exempt. Just say that $100,000 you put into the fund; 10 years from now it's now worth $150,000. That $50,000 capital gain is completely exempt from tax. Now, this is a little longer-term play. You have to keep your money in there for at least five years to see any benefit from it. I think there's over $7 trillion or some crazy number of appreciated gains in the United States. So all of those appreciated gains are technically eligible for opportunity funds and I think the background behind this is they want to take those appreciated assets and move them into low-income communities that need renovation and raise the status of those communities and opportunity zones. Opportunity funds are the way to do that.
Brokamp: So this isn't a situation like a mutual fund. You don't go to Fidelity and say, "I want your version of the opportunity fund."
Castelli: No. I think you're going to see, because of the requirements to have an opportunity fund, that you have to substantially improve these assets, which means doubling the property's basis. Essentially it's the building's basis, but just think about it, I guess for this purpose, as the purchase price. You have to add as much as the purchase price basically in capital improvements, so it's substantial. Or you have to develop the property from the ground up and you have to hold it for 10 years.
So for individuals this might be a hurdle, but I think you're going to see more institutional-level people doing it. You're going to see more of the crowdfunding sites doing it. Will somebody like a Fidelity do it? I don't know. I wouldn't think so. I think Goldman Sachs announced something, but you're going to see more of the professional side probably on a crowdfunding.
Southwick: We have covered a lot here, so for our listeners who want to learn more, you've got a couple of options. They can go to your website, TheRealEstateCPA.com. What are they going to get from that website?
Castelli: On our website you'll find a blog with a ton of accounting and tax tips related to real estate. We also have a podcast where we bring on successful real estate investors. They describe their journeys and how they got to where they are or a specific strategy they use. Then we also discuss how they handle their accounting and taxes, and what tax strategies they use. That's a great resource. A lot of people will love that.
On there you'll also find videos. We're starting to put out accounting and tax tip videos; kind of bite-sized clips for you to learn stuff. We also have information on our services on there, but really the education portion is probably what you'd want to check out and familiarize yourself with the tax benefits of real estate specifically.
Southwick: And also for our listeners, if this interview has you interested in learning more about real estate investing, guess what? The Motley Fool is also launching its first service to help people invest in real estate. It's called Mogul and it will recommend investments in REITs, equities, and commercially crowdfunded deals, as well as provide a range of tools, calculators, research, and curated tax advice to help you enhance your return. So if you want to learn more about what The Motley Fool is doing in real estate, you can go to Fool.com/mogul.