Ask Paula: Escaping a $100K Tax Nightmare

28:10Now, all of that said, you could skip the short-term hassle and go with medium-term rentals. And a medium-term rental is something that has a duration that's longer than 30 days, but less than a year. That would circumvent the need to get a short-term rental permit. Yeah, much, much easier, the medium-term rentals. And I think that that also, doesn't that vary municipality by municipality, what the definition of short-term is, like when they're - Generally speaking, it's 30 days or less. It's 30, yeah. 30 days. Yeah, that's more or less standard. There might be one or two municipalities that have some variance in it, but I would say 98 % of the time, you're going to see 30 days as the barometer.

28:54I think there are a lot of people that aren't in this market that I think will still find it fascinating, Paula, why there are so many restrictions on Airbnb. I mean, we could kind of guess, but it's actually cases of things that happened, municipalities being behind. I know that one of the early cities to embrace Airbnbs, Lisbon, Portugal, ended up with a horrifying circumstance where literally nobody, nobody lived downtown. And Lisbon officials were horrified because they inadvertently stripped the culture of people living in a place from the place. Right. And so Lisbon had to do a lot of backtracking.

29:35And I think other cities then very quickly went, oh, we've got a problem here. Yeah. But it was much more a case of backtracking than it was forward thinking, of looking at what had happened at the time, forward thinking, oh, cool, we can just put more tourists downtown. And oops, we filled downtown completely with tourists, which is also why we're getting backlash in some places like Barcelona now, as an example. Right. There were protests in both Barcelona and Marseille around tourism. And in Las Vegas, In the building that I lived in, I lived there for five years, we had the problem where in the morning there would be parents getting their kindergartners ready to go to school and you'd have drunk people coming home from the casinos.

30:23Oh. Right? This is a residential building where we're all taking our kids to school and putting on our dry cleaned suits to go to work and just trying to live our lives. And you've got people vomiting in the hallways. So you can only have so much of that before the residents just start to rebel. Oh, I thought you were going to say, we just got to teach the kids what reality is. Not at all the right lesson. The other thing, Saul, that I want to address is that you mentioned that your rental property in Virginia breaks even when it comes to cash flow, but is not cash flow positive. That does not give me any information as to whether or not it is a good rental.

31:04And by good, I mean has a strong cap rate relative to its risk profile. So the wealth that you are gaining currently through the rental property that you hold comes from principal payoff, which those tenants are paying down the principal on that mortgage. It comes from property appreciation. It comes from tax advantages. There is a lot of wealth accumulation that happens from a rental property outside of cash flow. And in fact, many rental property investors will aim for a cash flow of$100 per door. So if you're breaking even and there are other people whose goal is to be positive$100 per month, realistically, we're talking about a difference of$100 a month.

31:51That's one trip to a restaurant per month. We're not really talking about a big number. But why do rental property investors shoot for$100 per door in positive cash flow? We know that particularly in the beginning, positive cash flow is not how you make money on a rental. That comes later. In the beginning, the wealth accumulation that comes from a rental comes from these other mechanisms. And so the way to assess whether or not a rental is performing is not based on monthly cash flow, especially in the early days, but rather based on the cap rate of the property. And so that's what I would want to know before you sell that property.

32:29What is the cap rate? How good is that cap rate? Because the cap rate is functionally the unleveraged dividend that you are earning from the property. And once we know what that unleveraged dividend is, we add that to the rate of appreciation. And now you know the unleveraged total return. And you can then compare that to alternative investments. And for those of us in the audience, Paula, that don't do a lot of real estate investing, just for them, what does cap rate mean? So cap rate, as I said, it's unleveraged dividend. And what I mean by that is that any asset makes money in two ways. There's the asset going up in value, and then there's the dividend or the income stream that it pays out.

33:12So a share of Coca-Cola stock ideally rises in value. And that same share of Coca-Cola stock also pays a dividend. Those are the two ways that that share of Coca-Cola stock makes money. A house does the same thing. A house makes money in two ways. It ideally goes up in value and it also pays a dividend. Now that dividend is measured as a percentage of what you paid for it. Percentage of the purchase price. Yeah. Exactly. A percentage of the purchase price of the property. And so what you do to calculate cap rate is you take your gross rent, you subtract out your operating expenses, repairs, maintenance, management fees, vacancy, things like that.

33:58You do not subtract out your debt servicing because that's financing. So that's a different ballgame. So you don't subtract out the principal and interest payments that you make on the mortgage, but you do subtract out the property taxes and the homeowner's insurance because those are all part of the operating costs. So you take that gross rent, you subtract out the operating costs, and you are left with a number that's referred to as the net operating income. Now that net operating income divided by the purchase price is your cap rate. And that cap rate is your dividend. So then you take that dividend, add it to the rate of appreciation on the property.

34:36And that is your unleveraged, meaning without a loan, that is your unleveraged total return on the property. So once you see what that number is, you can then compare it to, let's say, a share of Coca-Cola stock or a share of VTSAX, because then you'll know, hey, what kind of total return without taking lending into consideration, because you're not borrowing to buy VTSAX, right? So let's just leave that off the table for now so that we can compare apples to apples, leave the lending off the table. How does this total return compare to just buying a share of VTSAX? There are two things I'm thinking.

35:11The first one is I would imagine what most new real estate investors don't think about, Paula, is the vacancy part. Like you said, vacancy, but then we kind of washed it. I think a new person doesn't think about the fact this might be vacant for two, three, four months, and I need to make sure that that's a piece of the puzzle. On a long-term rental, typically, that's less of an issue. On a short-term rental, which is what he's talking about, vacancy is a much bigger issue. And so that's another concern, Saul, that I would have for you if you decided to go the short-term rental route. Not only would you need to be in a neighborhood that has permitting for short-term rentals, you would also want a really good assessment of what the vacancy rates on other short-term rentals in the area are.

35:57And then the second thing that I think about is, do you think that owning a single property, if I'm comparing it to owning the total stock market index, like you said, or a share of Coca-Cola, I think of a single property ownership as being risky in a few more ways. I have to be personally involved. I've got just a tiny neighborhood where Coke on its own is distributed globally, there's a ton of people working on Coke versus me and maybe one or two other people. Is there what we call a risk premium on that where I need to see that I'm making more money on this? So if I compare it with VTSAX, let's say a VTSAX 10 % versus this returning 10%, I would think I should go with VTSAX because heck, I could just put my money over there, sit back with my hands behind my head and not do anything.

36:50Hmm. What's interesting about Saul's specific predicament is that he is comparing a rental property in Virginia that would be held purely for the purpose of its function as an investment. Right. With a hypothetical new property in Texas or Nevada. Yeah. Which would serve the hybrid purpose of providing him and his wife with a place to live for ideally 184 days a year. He's just comparing new place to old place. Well, it's not an apt comparison of new place to old place because new place serves hybrid modality, while old place has one specific usage, right? new place must be that Venn diagram intersection of personal consumption and viable investment, at least minimum viable to cover the holding costs during the six months of the year when he's not there versus old place is being held purely for the sake of an investment.

37:52So it is apt to compare the Virginia property to VTSAX because both the Virginia property and VTSAX would be held purely for the sake of holding an investment. But by contrast, the Nevada, Texas property would be held for a hybrid reason in which personal use is 51 % of that reason. It's funny because, and this is maybe getting a little nerdy, I still love the comparison game because while it's not a risk premium, now it's like a usage premium. You know what I mean? I'm going to accept a discount on my rate of return on the Houston property? And is that a fair amount of discount based on how I'm going to - Yeah.

38:38So it's not a usage premium. It's a usage discount, essentially. Yeah. Still fascinating. I think it's still a great measure to have to think, is this worthwhile or not? Right. But all of this, Saul, hinges on whether or not you and your spouse are willing to live in this property for 184 days per year. I don't know about Houston, but Texarkana, yeah. probably. Las Vegas is a great place. It does get brutally hot in the summer. Do not go there in the summer, but the winters are nice. January can get a little bit cold, like right around the holidays, New Year's, it gets a little bit cold, but February is spectacular.

39:20I think February is the best month of the year to be in Las Vegas. People think of the casinos, but it's a beautiful area. Really, you're living in Southern Nevada. You're living in canyons and mountains and camping and hiking, gorgeous desert. And knowing a few people who live in that region, frankly, when you live there, you're never at the Strip. No, not unless you work there. Yeah. Yeah, never. And what's cool is that city, for people that haven't been there, been there only briefly to go to the Strip, that city truly is built around the Strip to isolate it. Right. You know, New Yorkers never go to Times Square.

40:00It's the same thing. Yeah. Just as New Yorkers don't go to Times Square, people in Las Vegas don't go to the Strip, unless you work there. Or unless you want a buffet. So thank you, Saul, for the question. And congratulations on having a fully paid off home in Mexico and on being five to seven years from retirement. Great work. High five. Yeah, absolutely. And I do encourage you to spend 184 days a year in Las Vegas. or in Southern Nevada because it is a beautiful place. The mountains, go to Lake Mead, go to Mount Charleston. Those mountains are spectacular. And Saul, by Las Vegas, Paula means Texarkana.

40:43That's what she means. She can read between the lines. TXK. All right, we will take one final break to hear from the sponsors who allow us to bring you this show at no cost to you. And when we return, we will hear from Nina, who loves the neighborhood that she lives in, doesn't think that she can afford to buy there. What should she do? The Burlington Coat Event is back. Buy a coat now through November 29th and get$5 off your merchandise purchase of$25 or more from December 6th through December 24th. Plus, Burlington is donating 50 ,000 new coats to help those in need nationwide through our partnership with Delivering Good.

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42:14Our final question today comes from Nina. Hi Paula and Joe, this is Nina. I'm a relatively new listener of Afford Anything and I'm just setting off on my personal finance learning journey. Your podcast has been hugely helpful for me. My partner and I live in San Francisco, an obviously very high cost city. About four years ago, at the age of 29 and 30, we pulled the trigger and bought a small home here with a 10 % down jumbo loan. As soon as we were able, we refinanced with a 15 % down loan with fixed interest of 3.25%, and we've just passed the 20 % down mark. We love our home and especially our community and couldn't imagine living anywhere else, but with one child already in hopes of at least one more in the near future, our two-bed, one-bath, very outdated home is quickly feeling small and cumbersome.

43:03We plan to build an upwards addition to add two beds and one bath, in which case I think we would happily live here at least 10 more years. That said, building and renovating it will cost a whopping$500 ,000, inclusive of a buffer for unforeseen needs. We bought our home for$1.36 million, and it has appreciated in value a couple hundred thousand. It would cost more than an additional$500 ,000 to purchase a new four-bedroom home in the neighborhood, and we likely wouldn't get a 3.25 % interest rate for a long time, so we still feel it makes most sense to build versus buy. So my question is, are there any financial programs or loans we should tap into as we begin this addition?

43:48We plan to take out a HELOC in case of emergency, but I have the $500 ,000 in cash ready. That said, we will need to wait three plus more annual bonus cycles to get there, and I would love to begin this process as soon as possible. Are there any building resources that we don't know of? For additional context, we currently have about$150 ,000 in investments in a diversified portfolio. We also have about$60 ,000 in rainy day funds, mostly in high yield savings account, which wouldn't be included towards the$500 ,000. My husband has$200 ,000 in retirement. I have$180 ,000 and we have a$20 ,000, about$20 ,000 and a$529 ,000 for our toddler so far.

44:30I make an annual salary of$200 ,000 with a possible 10 % bonus and my husband makes$210 ,000 with 50 % bonus. We're fortunate to live to make an amazing living but given the high living costs here of our mortgage, property taxes, daycare, an IVF journey, etc. The majority of our savings are coming from our annual bonuses which have just increased significantly this past year. Would love any advice you have on how to wisely build and renovate as soon as possible or if you think this is a bad idea would love to hear that as well. Thank you so much. It's funny, Paula. The second that she said a whopping$500 ,000, my very first thought was, you live in San Francisco.

45:13That does not sound whopping to me. Don't get me wrong, in Texarkana, that is a big, big house. But knowing a lot about San Francisco prices, $500 ,000 is frankly... And then when she said the value of the entire house, like$500 ,000 seems spot on or even inexpensive, frankly, if you're adding that much more living space. Right. To answer her question directly, because she asked about construction resources, there are construction loans that, Nina, that you could tap. And with construction loans, typically you need 20 % down. Many people mistakenly only think about construction loans when they're dealing with new construction.

45:52But fun fact, you can also use construction loans to finance a new addition. They are for what are known as stick-built houses, meaning that you, If you wanted to do something like build a straw bale home, you might not qualify. But if you want just a conventional stick built house that has all of the proper permitting, that has an architect, that has engineers, if you're going through all of the proper mechanisms and building a conventional home, that is what construction loans are for. And that sounds like exactly what you're aiming for. Banks do these all the time. They're 100 % competent, comfortable with it.

46:30you'll very easily go through the process. They will want to check a bunch of boxes that make sure that your house is what you say it's going to be, that the additions could be what you say it's going to be, but it is not a big deal. Yeah. So a couple of distinctions between construction loans versus mortgage loans or home equity loans. So if you take out a mortgage or if you take out a home equity loan, that loan is made as an upfront lump sum payment. But if you take out a construction loan, that construction loan is paid in phases as work is completed. So once you hit certain milestones in the construction, that is when a phased payment will be made.

47:14And you can pay then your contractors in a timely manner. Everybody gets paid and you avoid unnecessary interest on a huge amount of money all at once that's just sitting there that you're losing money on every month. Yeah, exactly. So the interest rate is a little bit higher on a construction loan, but it's not too out of the woods. It's going to be like maybe a percentage point or so higher than the prevailing traditional mortgage interest rate on a 30-year fixed. What I love most about this, Paula, she already knows how they're going to pay it off. I mean, her goal would be to pay cash, but she knows that three more bonus cycles, she has the 500 ,000 ready and she knows it's devoted to that.

47:57I'm not at all opposed of starting it now like she wants to. Yeah. I think that's a great idea because the value of any given home is a combination of the value of the underlying land and then the value of the structure that sits on top of the land. And when you are in a high cost of living area, as Nina, you are, the value of the underlying land is where most of that home value comes from. The structure itself, some cement and some lumber. I'm being a little flippant. Obviously, there's more that goes into a home than just that. Love, love. Some drywall and some copper, some gutters and downspouts, asphalt shingles and flashing, right?

48:42Yeah, you know, there are materials and they depreciate and they're worth something, but the value of the underlying land is worth so much more. Why is there such a distinction between the cost of a home in San Francisco versus Texarkana? It's not because the cost of lumber is wildly different between the two locations. Sure, there's going to be some minor variation in the cost of lumber or copper or cement between Texarkana and San Francisco, but that does not even begin to account for the distinction in home values. It's the underlying land. So the sooner that you can capitalize on any underlying land that you have, the better, because the structure is the cheap part.

49:24One thing I found from our old real estate podcast that Crystal Hammond and I did is that there are, she asked about programs and what's available. that is going to be city by city specific. And I do know that if you're in some sort of historic district, historic area, the city of San Francisco may have some programs that could be beneficial to look into. And often they prefer it to be for the same reason we talked to Saul about Airbnb. If you are going to be a primary resident living in this house, they may want to help you improve the neighborhood. So we don't know enough about your neighborhood.

50:03I don't know enough about San Francisco specifically, but different municipalities have, every municipality has a program. Texarkana has programs for people, even in my small city, for houses that they're going to live in. It might be worth your time to see if there is a program that could help because as my partner on the Stacking Deed Show, now Stacking Adventures, Talking Travel, but then Talking Real Estate, Crystal found out surprisingly, Paula, she was able to score some great deals. just by looking into what the city of Chicago offered. Right, exactly. So no promises, but I think it's worth looking into, don't you?

50:40Oh, absolutely, absolutely. And I agree with you, Joe. A lot of incentive programs come from municipalities. They happen at the local level. Because what type of program is a bank or any major financial institution going to offer? It'll have various loan packages. But it'll make sure that they get to cha-ching. Right, yeah, exactly. So sure, you can talk to a lender about different types of loan packages. You can talk to a mortgage banker or a broker about some of those options that are available to you. But fundamentally, it isn't the major financial institutions that are going to be offering incentive programs.

51:18I would just make that extra stop. I would go to your municipality, see if there are any programs for homeowners, quickly go through those programs. I would say there's a 85 to 95 % chance that there won't be. That doesn't mean I wouldn't look there first. And then I would head to the bank and do the construction loan that Paula, you're talking about. Yeah. I do have a question. This popped up in my mind when I heard Nina's question. What is the plan B if she were to lose her job prior to the next three annual bonus cycles? That's a great question. You know, because so much of the plan hinges on the next three annual bonus cycles that what happens if either she loses her job or if the company goes out of business or if they change their annual bonus structure?

52:07You know, what happens if this thing that we are banking on does not come to fruition? And that doesn't mean, Nina, that we wouldn't do it. But certainly the plan B might be, well, then we still have this loan. It's long term. And without the bonus and on one income, we can still make the payment. So we'll just have a payment for longer. And we're OK with that. That's OK. But I love the idea of what if something goes wrong? Because you know what, Paula? You've done some construction before. Stuff goes wrong. Oh, yeah, absolutely. Well, and not just that, but what I have learned the hard way in my financial life is whatever Whatever your most bedrock assumptions are, those are the things that are going to be your downfall.

52:48They really are. And I'm laughing not because it's funny, but because it's so damn true. It's so true. Yeah, exactly. In the words of Homer Simpson, it's funny because it's true. Whatever are your bedrock assumptions, those will be the downfall because those will be the things that you don't protect against. I worked with someone who was an engineer for the highway department in the Michigan Department of Transportation, was an engineer. They're always building new highways. And as they're looking at expanding a road or highway, she told me that before they start building, the first thing these engineers will do is make a list on a whiteboard, Paula, of all the things that could go wrong before they build.

53:33What are all the things that could go wrong? And then once they know what their plans are around everything that might go wrong, then they start building. Yeah. And I think that's the case here. It's a great exercise. The issue with it is the thing that's not on the whiteboard. Well, that's what you got to be paranoid about, right? Right. Yeah. And this is why if you have people that aren't in your immediate family are emotional about it, because while you're emotional about it, everything's going to go great. And you bring up a few things. your brain brings up a few things, but your brain is so excited about it.

54:03And so to bring in somebody who's not emotional, man, we said that about the accountant earlier for Jenny. Jenny. Yes. I think that applies here too. Having non-emotional people help you with that whiteboard. Good idea. Absolutely. You have to be, I've learned this throughout my life. You have to be optimistic to make money and paranoid to keep it. Well, and I like being pessimistic in your planning so that whenever anything goes right, you high five yourself, right? And then you have more gratitude when things go right versus, man, we eked out the plan because we were so optimistic in our financial plan.

54:39Yeah. So in Nina's question, she asked, hey, if you think that this is not a good idea, I'd like to hear that too. So Nina, what we're saying is we both think that this is a good idea. We both like the idea of building, but we encourage paranoia. We encourage a heavy think on plan B. What happens if you get sick in the next three years? What happens if your company goes under in the next three years? What happens if the annual bonus structure shifts? What happens if the home burns down and you end up in an insurance quagmire where they are delaying and dragging their feet on making the insurance payout?

55:18I mean, we encourage sitting and thinking through what's my plan B, my plan C, my plan D. But the reason we encourage that is because we like plan A. It's only when you like plan A that you think about the contingency B, C, D, E, F. But Nina, it sounds exciting. Yeah, absolutely. Congratulations on the growing family. Yeah, on the great position that you're in, the wonderful job in the wonderful city and now this dream home. Finding a neighborhood you want to live in is so important. Exactly. You know, Paula, part of why we moved back to Texarkana is because we love our friends here. You know, some of my friends here.

55:56I do. Your friends, your friends are fun. We love the people here, which is great. It's so cool because I've lived and you've lived in places where your neighbors aren't that fun and they can make or break your life experience. So being able to stay in that for a cool half million dollars. Exactly. It is a weird day when I get to say 500 ,000 ain't that much, but it's San Francisco. Exactly. Well, congratulations, Nina. And please call back and keep us updated as the plan unfolds. Joe, we've done it again. That's fabulous. What a great group of questions again. And I love the idea, you know, we've talked about this many times, Paula, that there is a theme running through the episode.

56:43And in two of our three questions, having people at the table with you who are not emotional and can help you through that. A lot of the financial geeks focus on that person being a CFP or fee only. I just think if you've got some smart friends, you know, just surrounding yourself with smart people who aren't emotional about your goals is a big key to winning. Right. Right. You need a personal board of advisors. Totally agree. But you also, in the right circumstances, need licensed professionals. So to our first question, anonymous Jenny, she a thousand percent needs a licensed and certified tax professional.

57:23But for Nina, it could totally just be a group of smart friends. Right. Exactly. So, Joe, tell us about what's happening on the Stacking Benjamins podcast. Man, we have a fun week this week. Last week was the greatest hits week. We take a week off and we play some of our favorite episodes from the past many years that we've been doing this. But this week, we kick off a new eight weeks yesterday with the NFL season started this last week, Paula, and is celebration of the first Monday night football of the season. Brandon Copeland, former NFL star, a guy that actually went to Penn and is now a professor at Wharton, helping teach one-on-one finance to people.

58:04He's talking about winning the Super Bowl, getting ready to go pro with your money. We kind of line up the NFL start of the season. So we do that. And then tomorrow, we have three dads who have worked with teenagers on a special roundtable. Wednesdays, we usually don't do roundtables. We save those for Friday. but John Acuff, who is an internationally known speaker and author, John Lanza, who has the Art of Allowance podcast, and myself, who have two nearly 30-year-olds that launched. We've all worked with teenagers. Three dads talk about our fears, teaching kids about money, what we did that worked, what we did that didn't work.

58:45So we have a very special roundtable on tomorrow's episode. Oh, that's wonderful. John Acuff has been a guest on this show as well. He's so fun. Yeah, he's a wonderful guy. Well, thank you, Joe, for bringing your wisdom as a former financial advisor to this round of questions. Always fun, Paula, of course. And thank you for tuning in. If you enjoyed today's episode, please do three things. Number one, most importantly, share it with a friend or a family member or a colleague or a neighbor, your dog walker, your babysitter. Share it with the people in your life. Number two, please subscribe to this podcast on Apple Podcasts and Spotify and go to YouTube.

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1:00:05September 23 through 27, mark your calendars. That's the week that we will open the course up to a beta test round. Now at the beta test round, you will be able to access the course for way, way, way, way, way, way, way cheaper than it will ever cost ever in the history of this course. The trade-off is it's not going to be as polished. It won't have the fancy graphics, chyrons, images, you know, it won't have the bells and whistles and pizzazz, but you will be part of that founders group that helps shape it, that gives feedback that says, this part ran long, you can cut it, or this part didn't adequately explain this concept, please elaborate.

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