A 3-Phase Plan to Get into (and Out of) Real Estate Investing

As founder and CEO of Kay Properties, I talk with hundreds of clients each month, allowing me the privilege of listening to some fascinating life stories while helping people with their long-term investment goals. I recently encountered such a story when I met Frederick and Gloria*.

These two focused individuals met at Georgia State University. After graduating, they found jobs in Atlanta: Frederick as an accountant for a major home-improvement chain and Gloria as a history teacher at an Atlanta middle school. Eventually, the two decided to marry and begin a life together.

Neither Frederick nor Gloria came from wealthy families, but they both had a vision for building wealth and a plan for how to do it. Frederick’s background in accounting and finance taught him that one of the best ways to create wealth was through real estate while also deferring capital gains taxes. Through her love of history, Gloria also understood that the vast majority of the people in the United States who achieved financial success had done so through owning real estate.

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So, the two sat down and plotted out a long-term, three-phase plan for entering the investment real estate world.

Building a Real Estate Portfolio in 3 Phases

Phase 1: The Purchase of Their First Rental Property

The first step in their plan was to invest in a single-family home rental property. Even though they understood there would be very little cash flow from this and money would be tight, they also knew that this first step, the entry point into real estate investing, would be the most important one for them in the long term.

Frederick flashed a big, proud smile when he told me that he knew at a very young age that while the cash flow would be minimal at best, they had youth on their side – both in years and in real estate experience, and they would use this investment property as a way to gain valuable experience.

The two also knew that even with a small down payment and large loan, the money was a secondary hurdle to achieving financial independence. The first hurdle they had to jump was to overcome inertia and the urge to overanalyze, and just make the move.

This is an interesting point, and I’ve heard it before from other experienced real estate investors. When entering into the first phase of building a real estate portfolio, novice investors should not expect to find phenomenal deals or that one will just fall out of the sky. Frederick, too, believed the best strategy for acquiring anything in business was to emphasize the business strategy first over the financial strategy, then find a decent deal and move forward to secure it.

In the case of Frederick and Gloria, they knew the greater Atlanta market well, and with a handle on financing and basic accounting, Frederick also knew his numbers. He carefully detailed what their monthly expenses would be, including paying principal, interest, taxes, insurance and maintenance and what kind of rent they would have to receive to make the investment work.

After spending almost a year saving and searching, and with a little help from their parents, Frederic and Gloria purchased their first rental home – a small two-bedroom, one-bath house in the Atlanta suburbs, for approximately $62,000. While the numbers are only used as examples, the scenarios surrounding them are relatively accurate. For example, since they bought their first investment house in 1983, stagflation and high energy prices forced interest rates to reach nearly 13%. The total monthly payments on a 30-year loan were $442, and they were able to rent the house for $575. It was tight, but they watched their pennies, and soon the rental property started to appreciate as they paid down the principal, which helped them build equity.

Phase 2: Building Cash Flow and Realizing the Tax Advantages of Rental Real Estate

Over the next decade, Frederick and Gloria worked hard at their jobs, gaining promotions and raises. Along the way, they refinanced their rental property, drastically reducing their interest payments and allowing them to pull out cash — which they used to strategically acquire more rental properties. In 10 years, they had grown their portfolio to six single-family homes strategically located throughout the Atlanta market.

These six homes together created a much better cash flow picture (approximately $9,500 a month), but because the two had carefully created a long-term real estate investment plan, they understood that Phase 2 was not only about increasing cash flow, it was also about reducing their taxable income, which would reduce their tax bill at the end of the year.

One way Frederick knew he could significantly reduce his tax liabilities during these years was to gain a real estate professional status (REPS). After considerable research, Frederick learned that the IRS considers anyone who fulfills these three conditions to be a REPS:

1. Over half of the personal services you perform during the tax year were in your real estate business.
2. You worked more than the minimum threshold of 750 hours during the tax year in real property trades or businesses.
3. You are actively involved in managing real estate investments. This includes buying and renting out commercial buildings or apartments and being involved in the day-to-day management of these properties.

Having spent every available hour developing his real estate portfolio over the past 20 years, Frederick easily qualified for this status and began reducing his taxable income by writing off significant passive losses, such as depreciation. As a result, the couple were not only building equity and realizing a moderate monthly cash flow through their rental properties, they were also sheltering their personal income.

Instead of paying 35% of their salaries to the government, they dropped their tax bill down to 15%. That included both their real estate income and salary income, which they continued to plow back into their growing real estate business.

As a result, Frederick and Gloria used their rental properties to double their net worth approximately every five years.

Phase 3: 1031 Exchange Exit Strategy to Defer Capital Gains Taxes and Preserve Wealth

Interestingly, Frederick and Gloria recently celebrated their 35th wedding anniversary. After working 50 hours a week with their full-time jobs and managing their six rental properties, they decided it was time to sell their real estate portfolio, step away from active management and live off the proceeds.

One of Frederick’s and Gloria’s neighbors was a real estate broker named Sue. They gave her a call to discuss selling some or all their real estate assets in the current sellers’ market. Two weeks later, the two received an estimate of what their portfolio was worth and were surprised to realize the total was $3.5 million.

But what about the taxes, they wondered?

Capital Gains Shock: Enter Chuck, the CPA

Frederick and Gloria had worked with Chuck (their CPA) for years, so they called him to get an idea of what kind of a tax event they would be looking at. After looking into Frederick’s and Gloria’s situation, Chuck explained that if they sold their portfolio, and paid the depreciation recapture tax of approximately 25% (of the depreciation they had previously written off), their federal and state capital gains tax of 20%, and their net investment income tax, or Medicare Surcharge Tax, of 3.8%, they would be looking at a tax bill of more than $350,000.

That number was unnerving, and while they were familiar with the 1031 exchange, they were not interested in reinvesting into another piece of property that would still require active management duties. They wanted a tax-deferral strategy that offered passive asset management and diversification.

That’s when Chuck recommended the couple investigate a Delaware Statutory Trust, which qualifies for 1031 exchanges and accomplishes the specific investment goals the two were looking for.

Chuck explained that like a 1031 exchange, all capital gains and other taxes would be deferred as long as they could find like-kind properties. But, a Delaware Statutory Trust also allows investors to 1031 exchange into potentially high-quality institutional-caliber real estate assets, eliminating active management while still potentially receiving a monthly income.

Frederick started researching DST 1031 exchanges, and he found that the Delaware Statutory Trust was established in 2004 and is covered in IRS Revenue Ruling 2004-86. He further discovered that the DSTs he had researched averaged around $100 million in value, and that, in many cases, DST properties were offered and operated by many large real estate firms nationwide. He was surprised to learn that over the past several years, billions of dollars of investors' equity had been moving into DSTs via 1031 exchanges as investors had caught on to the attractiveness of this time-tested strategy.

The notion of completing a DST 1031 exchange fit with Frederick’s and Gloria’s Phase 3 goals and objectives of their real estate investment journey. But with six different properties to sell, they were facing six different 1031 identification and closing deadlines. It was too much for Frederick, Gloria and even Sue to fathom.

Frederick decided to look for a DST 1031 specialist firm.

DST Specialist Helps Complete DST 1031 Exchange and Achieve Long-Term Strategy

That’s when they called me. For more than a year, we spoke together at length about various DST investment strategies and property options. I explained that real estate investments always present risks. They then developed a flexible business plan that included six properties in individual exchanges that could be adjusted when sales were delayed or deals changed.

It was during this time that I learned about their fascinating story. The thing about Frederick was that he worked in finance for a large company, so he really wanted to explore and study subjects himself. He would do his research, and we’d all get together for a call or video conference.

Frederick and Gloria consulted their CPA, tax attorney, children and even their friends and neighbors. After they were fully educated and comfortable with their options, they decided to start selling their portfolio and moving the proceeds to a 1031 Qualified Intermediary, and then to the DST sponsor companies that offered the targeted DST investment properties.

The DST advisory firm conducted thorough due diligence on each prospective DST property, including the macro and microeconomics, the assets and markets, the financing and the past performance of the sponsor companies. Through this type of detailed analysis, Frederick and Gloria had all their questions answered and felt comfortable with moving forward.

In the end, the couple sold their entire portfolio within two months, following a carefully laid out business plan that calculated multiple 1031 exchanges across a multitude of real estate asset classes, including debt-free multifamily properties, debt-free self-storage facilities, a debt-free medical building and debt-free net lease buildings. And instead of a $350,000 tax bill, they paid nothing.

Now the couple enjoy a passive management structure with regular monthly income, and more time to spend with their children and future grandchildren.

*Note: While the events and scenario described in the following article are factual, the names and details have been altered to provide anonymity.