Afford Anything - Ask Paula: How Do I Make Sure I Don't Spend the Money I've Invested?

Episode Date: December 16, 2021

#354: Charlie in Cali has enough money saved to pay cash for a house, but she and her husband decided to finance their home, instead. They’d rather invest the money and arbitrage the spread. But one problem: how can they keep themselves from touching this investment? Jay is choosing between Fidelity and M1 Finance, and has questions about tax loss harvesting. Nicole and her siblings will be inheriting some properties that they eventually plan to sell. How should they set up or organize these properties among so many owners? Should one person take the lead? Do they need a shared business account? Also, how should they evaluate a property and make sure they get a good deal when they sell? Ed owns three homes, two of which he plans to sell in the next few years. He plans to live in them long enough to establish residence and take the capital gains exemption when they sell. Is his plan for handling the taxes solid? We answer these four questions in today’s episode. Enjoy! Subscribe to the show notes at https://affordanything.com/shownotes Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything but not everything. Every choice that you make is a trade-off against something else, and that doesn't just apply to your money. That applies to your time, your focus, your energy, your attention, any limited resource that you need to manage, saying yes to something implicitly means turning away all other opportunities. And that opens up two questions. First, what truly matters?

What matters most? Second, how do you align your decision-making on a daily, weekly, monthly, yearly basis around that which matters most? Answering these two questions is a lifetime practice, and that's what this podcast is here to explore and facilitate. My name is Paula Pant. I am the host of the Afford Anything podcast. Every other episode, we answer questions that come from you, the community. And my buddy, former financial planner Joe Sal Si-high, joins me to tackle these questions. What's up, Joe?

I am ready to rock. Joe, you've got a crazy book tour coming up. I do. You're going to how many cities in how long? 42 cities in about 80 days. 42 cities in 80 days. Afford anything nation, I'm coming to see you. Wow.

I'm coming to see you wherever you are. I just went to eight cities in the last 25 days and I'm spent. And boy, are your arms tired. I didn't even say I flew. Oh, I missed it. I'm not great at the dad jokes yet. But you know what we can set all that aside? I'm still a month away from that, Paula.

We've got to stay focused because we got four kickbutt questions to answer today. We totally do. So Charlie in Cali has a question about behavioral finance. She has a significant amount of money in a taxable brokerage account and wants to know how to put guardrails around this account, basically how to protect herself from herself. How does she not tap this money, but at the same time also not be a total miser about it? You'll enjoy hearing her question. It's really good. That's Charlie's question. We're going to kick off with that. After that, Jay has questions about tax loss harvesting. Say that five times fast. Nicole and her siblings are

going to be inheriting some properties that they will be co-owning and co-managing together. So how do they deal with that? And Ed owns three homes, two of which he plans to sell in the next few years, and he's got some questions about residency and the capital gains exemption. So we're going to tackle all four of those questions in this episode, starting with Charlie. Hi, Paula and Joe. I'm a longtime follower, and I'd love yours perspectives on a financial conundra my husband and I have been debating. After many years of renting and saving, we bought our first house earlier this year. We actually had enough money in our taxable investment accounts to buy in cash, but we decided that we would prefer to keep our money invested and instead put

20% down about $200,000 and got a mortgage at 3% for the remaining balance about $800,000. By keeping the money invested, we believe that we'll outperform our mortgage rate over the long term and we're comfortable with the risk of market fluctuations. We feel happy and at peace with that decision. However, this plan has brought up a new budgeting challenge that we haven't faced in the past. After so many years of working and saving, we have some other large discretionary purchases we'd like to make over the next several years. For example, my husband wants to buy a camper van. This would likely cost about $100,000 and clearly cannot come from normal cash flow. I'm worried that we may fall into the trap of rating our mortgage money in the taxable brokerage account over the years,

especially as we see it grow. In order to beat the 3% mortgage rate, of course, we have to actually keep the money invested and keep all of the returns invested. But my husband, probably rightfully so, is a little worried I'm never going to let him spend any money. And you know what they say, happy husband, happy life, right? So do you have any ideas from a practical point of view on how we could put guardrails around that invested mortgage money yet still continue to invest other money that we would use over the next few decades to make large discretionary non-investment purchases. Thank you so much. I look forward to hearing what you have to say, and I absolutely love your podcast. Charlie, fantastic question. First of all, congratulations on being in the

position that you're in, being in a position where you could pay cash for a million dollar home, but you chose not to. You made a 20% down payment. You've got another $800,000 invested. Your comfortable with the risks, you're arbitraging the difference, you're in a fantastic position. And I think that the aspirations that you and your husband both have for the future, you've clearly been earning and saving and being very diligent with your money for several years. So having aspirations in the future of enjoying some of what you've built, buying a camper van, that sounds great. but let's talk about how to prevent the pendulum from swinging too hard in the opposite direction.

Because often what can happen is if a person or a couple is incredibly disciplined about money management and frugality and side hustles and doing all the right things, sometimes the pendulum can swing a little too hard in the opposite direction when it comes time to breathe a sigh of relief. and start drawing down from the accounts. So I love your question. I love that the root of the question is psychology and behavioral finance, because that is the most important key to understanding how to manage our money. And I'm going to answer with two tactics and one overarching strategy that links these tactics together. Now, the overarching strategy is, regardless of what tactic you use,

have your rules around when you draw down from this account, How often you draw down from this account and how much you draw down from this account, how that amount is calculated, have those rules written. And this is incredibly important because in the heat of the moment, when you see balances rise, when we're in a bull market, everything feels great. It can be easy to violate the rules that you set for yourself six months prior or one year prior. The strategy is basically have written rules. don't rely on memory and don't make spontaneous or in the moment decisions that are based on market

performance. And make sure that the written rules cover not just how much money you draw down, like how you calculate that amount, which we're going to talk about in a second, but also how often you draw down. Are we talking quarterly? Are we talking yearly? Are we talking only for big ticket items, and if so, what are the parameters around what dollar amount constitutes big ticket and how many big ticket items over what period of time will you allow, each of you allow yourselves, right? All of those parameters, the when and the how much, need to be written down. So that's the strategy. Now, let's go into specific tactics. For the mortgage arbitrage to work, you need the long-term aggregate investment performance to be at least as good as or better than

your mortgage rate. And so one possible tactic is to set that return as the minimum amount that you need to amass in, let's say, a given year, or maybe that return plus an additional one or two percent to create a buffer for those down years. That's the minimum amount that in a year that the account needs to return, and then any surplus beyond that is what you're willing to harvest, that's one suggested possible tactic. The other suggested possible tactic, tactic number two, would be to approach it in the same way that a retiree does, where you set a annual drawdown number like 3%, or perhaps even 2%, and that's the amount that you withdraw from that taxable brokerage account every year.

So those are two tactics. One is requiring minimum market performance and only taking the surplus. That's tactic number one. And the other is approaching it with a fixed drawdown amount that is ideally a more conservative amount than the standard 4% that retirees use. That would be tactic number two. I didn't disagree with any of that, Paula, but I still think that if I'm husband in Charlie's scenario, I think the fun is still all sucking.

out of it because because I think if I've got this all written down and I'm only doing things based on what the market does and I'm thinking his his point seems to be I'm only going to live so long. So why don't I live a little now? And I think I think to answer that question, that piece of it before you go to the tactics that you talk about, I think we have to talk about a couple things. Before I went into financial media after I sold my financial planning company, I actually went back to school to become a teacher. And I took a couple really interesting classes on human development. And the way adults learn is fascinating versus the way children learn.

The way that children learn is you tell them what to do, you can give them the why, but it really doesn't matter. In most cases, brains aren't developed enough just because I said so, even though that sounds like an awful answer, in many cases, these classes taught me is actually a fine answer. because if mom or dad thinks that it's what we should do, then it's probably right. And you'll find out the way as you go. By the way, still, because I'm an adult, I don't like that. And if you're listening to me say that, you're like, yeah, I don't like that. It's because adults don't learn that way. Adults need the why.

Adults really need the why. And for Charlie and her husband to have the why, I think it comes down to two things. It's purpose and comparative value are the things that we want to look at. So number one is what is the purpose of the money in this account? Whenever I'd help people save money, we would try to put a name on that account so that this account was for X. Specifically, the account was 4X. It wasn't my non-qualified brokerage account because of my non-qualified a brokerage account,

it kind of implies I can use it for anything now. It's flexible money. If I put a name on it that this is X money, then that's the purpose. So what I have to know is to determine the purpose, is what is the intention of that money and how much money has to be there at any point in time to reach that goal, which gets back to Paula, then your tactic, which is if we're over that dollar, if we're over that dollar, then we can skim that off for other things. If we're not over that dollar, then we have to figure out how to get to that milestone, maybe once every

six months. We regroup and we say we had to be behind. Okay, so let's say in this case, the goal of the money is that they want to preserve the ability to be debt-free at the snap of a finger, which means that the goal of the money is that they need to have enough that they could write one big check and pay off their mortgage today if they wanted to. And because they are paying interest for the mortgage that they currently shoulder, they want to make sure that the money is growing at a rate that at least matches that interest or beats it slightly. So let's say, let's say that's the purpose of the money. The purpose of the money is preserving the ability to be debt-free, preserving the ability to pay off the mortgage. But I love that. See, I love what you just did. And I would have them do the same thing,

agree on what the purpose is of this money. Because part of the issue is going to be that they're going to change purposes, right? Part of the issue, the reason they'd rate it is because they chain purposes. But once they're clear on that that specifically, Paula, what you just said is the purpose of the money. And they're both clear on that. And then they're both also clear that once we're ahead of X, then the purpose of the money is this other thing. Then our purpose is really clear. So we know that as long as we achieve X, then Y comes into being. If we don't achieve X, then Y doesn't come into being because we're all worse off. But I think they have to start there. I think they have to start. I think they have to with what is this purpose and agree? Because that's, there are no guardrails that are going to work

if you don't agree on that purpose. So what you're saying is step one, define the purpose. Step two, calculate the amount needed to achieve said purpose. And then step three, siphon off any extra. Siphon off the extra for what the, you know, if we've got a plan and then B plan, the B plan is fine as long as everybody recognizes this is a B plan. It's great. We can do this. the B thing we're doing with the money as long as A gets achieved. Whenever I saw money getting siphoned off, it's because we didn't agree on the priority. We called it the plan to make sure the mortgage was paid. And instead, it became the, my daughter's graduating. We want to have a party for her money. Or it became the next thing and the next thing. And ultimately, when I would work with people,

it was because we weren't definite about what the purpose was. We didn't. didn't hold to our guns on what the purpose was. That's the first thing. Which brings up the second thing, comparative value. What the husband's questioning is, is this more important than having the camper fan today? I mean, maybe Charlie didn't say that, but that's what I heard is that is that's his question, is what's more important? That's also a great discussion. Is it more important to pay off this mortgage early?

Or is the camper van more important? What is what is more? what is the comparative value of these two competing things? And I think that once you decide that one is A and the other one is B, or that we modify them, maybe we don't get all of A. Maybe we do pay off the mortgage a little slower this way, right, by having the money liquid, but we do siphon off some money for the camper van. But there's just got to be agreement.

Like, I don't feel like which way we go is as important as making sure that. that we have a plan on how we're going to get there, and we know that what we do, we both value. Because the biggest thing that drives a wedge in any relationship is when we begin valuing different things. I mean, we both got to be singing off the same song sheet. And that brings up an interesting point because that comparative value is so subjective.

And particularly in the context of a couple, one person might find a lot of psychological value in knowing that they could be debt-free at any time, that they could pick up a checkbook, pick up a pen, write one check, and boom, zero debt. There are certainly many people who would sleep far more easily at night knowing that they have the capacity to do that, even if they never act on that capacity.

And then, conversely, there's also a very sound argument to go tour the country in a camper van at a time when you're young, you're healthy, your job and family-related responsibilities allow you to do so. You know, those years are few and precious before either responsibility or ill health gets in the way of being able to do such things. So there is no better or worse decision, but in the context of a couple, there might be, how do I say, resentment?

That's a pessimistic way. I'm just going to say competing. Well, I think that if we don't have that discussion, there could be resentment. But can you see what a wonderful discussion this is and how horrible it is if we don't have that discussion? Because I feel like that is the thing that will destroy her guardrails is this competing thing that always seems to come up. Like we never get over it because we haven't agreed. And I think it's not an easy discussion, but I do think that that's the necessary place to begin. Because that is the guardrail.

The guardrail is we agreed that this is X. And once that money is no longer non-qualified brokerage account flexible, and it's instead pay the mortgage off money. And then once every six months, we skim off the top to put it in a different account or a different fund in the same account that is our camper van money or whatever it up being money, I think then we're all on the same page. And all of a sudden, the guardrails are up because everybody knows what this money's for. You know, another frame of looking at it that they can use to inform the discussion that they have is for whatever purpose they're thinking of using some of this money for, would you

take out a loan against your property in order to fund that same purpose? So, for example, if hypothetically they had used that money to pay cash for their home, would they borrow against the value of their home to buy a camper van? Or would they borrow against the value of their home for any other purpose that might come up in the future? That's funny. You say that. A question I used to always ask was which one would make you feel worse? Would it make you feel worse that you didn't have the camper van but you knew the house was sold or the house was paid off? or did it make you feel worse that the house didn't get paid off, but we enjoyed this time in the camper van?

And it's funny because when you look at it from the two different frameworks, you might wind up with different answers. Like, would it make you feel worse if the house wasn't paid off but we enjoyed the time in the camper van? When I hear the framing of that question, where my brain goes is like, yeah, let's enjoy the time in the camper van. But when I flip that question around, if the home were paid off, would I borrow against the value of it in ordered by a camper van? my brain immediately says no. So there's something to unpack there when you've got the same set of circumstances. Fundamentally, you're talking about moving numbers around on the spreadsheet in different ways, but the framing of it in one direction leads to a yes and the framing in the opposite direction leads to a no. So, Charlie, what we're saying is you need to frame the question the way you want it

to be for your husband. That's what we're saying here. No, I think what we're really saying, though, is that even, and if you disagree, by the way, that doesn't mean there's not a middle ground. Maybe the house, you still have money there for the house to be paid off, but maybe, maybe it's not as quickly as you had expected. Or maybe the camper van, she said, $100,000. Maybe it's not that $100,000 thing. Maybe there's an opportunity to do something differently that makes you able to compromise. But I think it's a wonderful discussion to have. It's a great, just you and I talking about them having this discussion fires me up. Yeah, exactly. Exactly. And you know, the other thing that we haven't explored is they're clearly great savers. So what are they doing with their current savings?

I would assume that they probably have a monthly surplus. I'm assuming that their income exceeds their expenses. So what are they doing in the present month by month with new savings that they're amassing? Are there other outside ways to solve this? Yeah, exactly. Yeah. So as usual, we come down with, I don't know. Well, what we do here is we never give you an answer because that would be short-changing your educational experience. Instead, we give you frameworks and perspectives that allow you to think through the answer for yourself in a more critical and more refined manner. Oh, I don't know. I think today we're going to give Jay a definite answer. Oh, with that, look at that segue. I didn't even mean to segue.

I'm just saying, I was just looking at the questions today. And I said, well, I don't know. I think Jay's going to get just a black and white answer. All right. Well, then here's what we're going to do. We're going to take a quick break for a word from our sponsors. And when we come back, we're going to find out whether or not we answer Jay's question directly. But in the meantime, Charlie, thank you so much for asking that question.

Congratulations on everything that you've built. And best of luck with whatever you decide. Feel free. By the way, call back and leave a voicemail. I love hearing follow-up. from people who have been on the show in the past, people who have asked questions. I love getting updates and sharing those updates with the audience

about what decision you end up making, how things end up turning out. So Charlie and also anyone else who has ever had a question answered on this show, please call back and give us an update. All right, with that, break forward from our sponsors. And then we're going to hear from Jay. The holidays are right around the corner. And if you're hosting, you're going to need to get prepared.

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Our next question comes from Jay. Hi, Joe and Paul. This is Jay from the Midwest. My question today has to do with automating my finances and my taxable investment account through M1 finance versus having the opportunity to tax loss harvest from Fidelity. M-1 finance does not currently allow for any definite tax loss harvesting. That said, they do have some tax benefits to how they put your money in and take it out from what they list on their website. I don't know the back end details of all that. I am in a high tax bracket and expect to be in that in the future, probably in the 32 or 35% tax bracket. I know that we can offset about $3,000 worth of ordinary income with tax losses on investments per year.

and so that would translate to about a $960 or $1,050 tax benefit per year. By the time I transfer the money over to Fidelity, check to see when my funds have cleared, check my rebalancing sheet to see where the money should go into, which funds it needs to go into, then have to place limit orders, have those limit orders not go through, have to recheck and re-cancel the order, put a new order in. my estimate is probably at least 30 minutes per month or about a half hour a month, give or take, that I will be saving by automating everything through M1 finance. My hourly rate, this translates to about $13.50 per year.

So based on that kind of back-of-the-napkin math, it looks like automating is probably the better way to do it. In addition, I'm going to be kind of dollar cost averaging in any way. And so I don't know how much benefit I will really get from the tax loss harvesting aspect of things. is I plan on doing that every single month kind of going forward. I've always heard that having, you know, somebody with a high income should preferentially tax loss harvest and that that would be the most benefit is in the higher income brackets. But based on this math, I don't feel like it would benefit me as much as the automation.

I just wanted to see if I was missing something. If there's more benefits to tax loss harvesting that I am not seeing, if there's any other information that you guys can provide on tax loss, harvesting or just kind of help me make sure I'm mapping all this out correctly. I would greatly appreciate it. Thanks for all you do. I've learned a ton from afford anything and also from just started listening to stacking benchmarks recently and I really appreciate all you guys do for us in the DIY community. Jay, thanks for the question. Thanks for the kind words. We have a blast doing this. It's so fun to help people solve these issues. Jay, so here's the deal. I understand that

on M1's website, they tell you that they do not do tax loss harvesting, which is true. They do not automated. They don't do that for you. However, I have an M1 account, and you, I think it's still tax loss harvest. Now, it depends. And let me tell you how. So M1 Finance will do, and this is according to the help page on the M1 finance website, they will do tax minimization to help.

you minimize your taxes. And of course, if you use some of their recommended portfolios, they will use not only low-cost exchange traded funds, but those also minimize taxes. So they do that. However, if you bought a single investment and you only made one trade, you can still do tax loss harvesting by just selling that and either moving that portion of your portfolio, to a cash allocation at M1, or by buying something that's in a similar but still different, it has to be materially different investment and tax loss harvest. So if you bought it all at once, you can still do it. And for a lot of people, they do buy it all at once.

So they buy the majority of ones. So if you're going to make one swoop and you're going to sell off a single position that has lost money to take tax losses, then there's nothing stopping you from doing that at M1. Now, it's trickier if you've been buying overtime into the non-IRA account because then, Paula, you've got a mess of summer up, summer down, and you're trying to sell the ones that are specifically down and not the ones that are up. Yeah, they don't do that.

That's not what M1 does. So in that case, then you look at moving the money over to Fidelity. But I bet for most people listening, they bought it all at one time. and that answers your question. You can, even though they say that they will not, you can still do it. You just sell the position. And like most brokerages, there's no fee for that trade. So you can go ahead and sell it off and capture the loss.

Make sure you put into something different for at least 30 days to avoid what's called a wash sale rule. And you're good. It does get more complicated, Jay, if you have been dollar cost averaging in and you're part up and part down. Number one is, I'm with you, man. The efficacy of doing that you have to calculate before you move your money over to a different brokerage account.

The second thing is is also look at features and benefits. Obviously, Fidelity's got some cool stuff that they do. M1 has other cool stuff that they do. So which features are more important to you before you make that move? Because obviously, if you move it to Fidelity, you don't want to make those moves and then move it back to M1. So be very careful. that, and I'm with you, and I heard that in your voice, that you want to be careful about

this move. Generally, although you didn't say how much is in your portfolio, it feels like you've done the cost-benefit analysis. And I'm with you. For a lot of people, tax loss harvesting will give them some money. If you're selling partial positions to skim off and get a few dollars here and a few dollars there versus the automation that you get at M1 that you can't get in many other places, if you're using their pie approach and continually adjusting the pie, which is what M1 does

very differently than a lot of other brokers do, then there is a cost-benefit analysis. And I'm with you. Moving this money over is way harder than it probably should be. It drove me crazy when I was a financial planner. My co-host is stacking Benjamin's and Paula's friend, OG, who's a certified financial planner, tells me that nothing's changed in the 12 years since I left. It still is a pain in the butt to move that money. over. So, you know, my gut is with you, but obviously, like you said, I think you do the math and

look at your hourly rate, which is what I think, Paula, you probably have a comment on. Yeah, I do. So the one thing that I wanted to comment on, Jay, was the part of your question in which you stated that if you were to do this yourself, it would take you about 30 minutes a month. And with that data point established, you then began making comparisons between your hourly rate and the cost benefit of this move. What I wanted to chime in on is the framework of that style of thinking. And so let's expand this out and make it applicable to everyone who's listening. Oftentimes, when we are deciding what we should do ourselves, what we should automate, what we should delegate, and what we should eliminate, often people start with the framework of

what's my hourly rate, and they use that to inform their decision. The flaw in this is that if you, and Jay, I'm not saying you're doing this, this is an expanded conversation for everyone listening, if a person frames decision-making in the context of hourly rate, particularly as it applies to non-work-related activities, then you quickly get to a logical, slippery slope. Like, if I'm thinking about my hourly rate, then it doesn't make any logical sense for me to fold the laundry, unload the dishwasher, take the recycling out. And sure, there are some who may argue, like, well, all right, well, then don't do that. Have someone come into your home every single day for those types of daily tasks. Okay, well, I mean, we can argue that, but sure, fine. But then,

let's take it to its next logical conclusion. If I'm framing everything in terms of hourly rate, you know, we've just discussed tasks that like pretty much nobody enjoys but you have to do. What about tasks like showering, reading a book, yoga, hanging out with friends, or simply staring off into space, zoning out for 20 minutes.

If I were to take the framework of what's my hourly rate to its logical conclusion, I would never be able to justify any type of relaxation activities or social activities. nor would I be able to justify any type of chore or errand, even the ones like unloading the dishwasher, which are more difficult to outsource, and which arguably provide a little bit of Zen and keep me connected with my environment. And so the framework that I like looking at when I'm thinking about what to delegate, what to automate, and what to eliminate is a framework that comes from Laura Vandercam, who has been a guest on this podcast multiple times. She was a guest in episode 38 all the way back in 2016, and she was also a guest in episode 147 in 2018. Laura presented the framework that you should first fill your schedule with all of the activities that you can't outsource, like exercise or calling your mom, or reading, learning, hanging out with friends, like fill your schedule with the things you can't outsource. And then only if there's time remaining, can you then infill that remain.

time with things that you could theoretically outsource. And that, I believe, is a much healthier, more comprehensive framework than a strict hourly rate calculation. So that's a big picture comment on the framing in your question. But I wanted to throw that out there since I think most people who are listening to this podcast could derive a takeaway from that. So Joe, that said, did we give Jay a black and white answer, as we promised? Did we tell them what to do? We did, but we plused it. You know the retail thing about plusing it?

Plus, I haven't heard that, but I can glean from context. That's like the supersizing of retail, I guess. Give them what they want, give the customer what they want, Paula, and then plus it, make it even better. And then plus it, under promise and over deliver. Yes. So we did answer black and white. At least one of us did. I won't call out names, but one of us did. You did an excellent job, Joe. And then the other person, you know, gave them the framework. So we plused it. Zoomed out. You're welcome, Jay. Well, thank you so much, Jay, for asking that question. And I'm glad that you're enjoying the podcast. Both afford anything and stacking Benjamins.

Our next question comes from Nicole. Hi, Paula. a long-term listening to your show, and I've learned a lot from listening to you, so thanks for that. I have two property questions for you that I don't think you've covered before. The first one is, how should a group of people who own a group of investment properties set things up? Myself and some siblings are due to inherit some properties soon. Our long-term goal is to sell them so that everyone can do their own thing with the people. proceeds, but in the meantime, I'm not sure how we should organize things. Should we set up a

company? Should we just set up a business account in everyone's name? Should one person take the lead? Should we have a contract? I really don't know. So any advice would be really helpful. The second question is to do with selling the properties. Your podcast focuses a lot on getting good value as a buyer, but how do you get good value as a seller? Are there any rules of thumb for sellers similar to the 1% rule for buyers? I know that the income that's generated obviously plays a large role in valuing the properties, but what else should be taken into consideration? I'm really keen to know how age and condition impacts a valuation of a property because one of the properties in particular, it's a larger property, but it is older.

And my understanding is that it needs a lot of work going forward. But at the same time, it is a good property in that it generates good income from rental and commercial spaces and it's in a good location. I'd like to be able to do even a rudimentary evaluation of things for myself, just so I know that we're getting a fair property. price when it comes to selling and that we don't sell ourselves short. I look forward to hearing your advice. Thank you in advance and keep up good work. Paul, I'm curious to hear what you'll say about this one because I have a very, very strong opinion about what Nicole should do in this situation. All right. Let's hear it. I think, and tell me if you agree with this, I think that if the goal is going to be to sell the property, we can go down the long and dirty road of how to set up

an entity and to make sure that things work fairly and that co-owning the property goes equitably until the time that you down the road decide to sell it. But if the goal is to sell it, I feel very strongly to avoid all that stuff as much as possible. Like if we can avoid all of that headache, all of that accounting and just messing. I would avoid all of that. Here is my thought. If the goal is going to be to sell it, leave the house in the estate and have the executor. If it's a will, you'll have somebody called the executor, work with the executor as a family,

just for the short time to have the estate sell the house. If the estate sells the house, you're done. That everybody can do, in your words, Nicole, they can do with their money what they want to do. no mess, no fuss, or some mess, some fuss, but way less mess and way less fuss than the other answer we'd give if you really want to buy property with a bunch of other people or own property. She's not buying it, but buying property with a bunch of other people. My suspicion based on her question is that they may, she and her siblings may want to

hold on to the properties for a little while because they think. think that they can renovate or improve the properties, improve the cash flow, improve the income, and then maybe sell it at a higher rate. She mentioned that one particular property is a larger property, but it's older and it needs a lot of work. She asked about how properties are valued and how the income that's generated from the property plays a role in the valuation of the property. So I'm guessing, based on the fact that she's asking about those factors, that they want to sell the properties not as they are, but as they optimally could be in order to fetch top dollar. So my question would be back to her, though. How long is that improvement going to take?

And working with your attorney who's helping distribute the estate, helping the executor distribute the estate, would there be a way for the estate to just do that rather than draw this out longer? So if it's going to be a year or if it's going to be two years, is everybody, is everybody fine with the fact that it's going to take two years to have this come out of the estate? And then the executor of the estate would be responsible for all of that? The executor of the estate is responsible for it. And by the way, if it's one of those family members, that's fantastic. Because then you're all working together anyway on the rest of the estate stuff. So improving this on behalf of the estate, if it makes sense for the estate, the way many estates are drawn up, that could be something. that the estate still handles.

Right. Though that does open up the question, when it comes to renovating a property, fixing it up, raising the rents, which might involve tenant turnover, there are a lot of decisions that need to be made. And so it opens up the question, is the executor of the estate and or the person who takes the lead, is that person authorized to and capable of executing good judgment? what happens if one sibling disagrees with some of the decisions that they're making? Maybe they think that they're overspending on renovations, or maybe they think that they should not raise the rent to such a point that it triggers tenant turnover, right?

How do you deal with the fact that you've essentially got a board of directors, which is what Nicole and her siblings are de facto would be? you've got a board who are all going to be weighing in with different opinions about how much money should be spent. And to what degree should a place be renovated in the spectrum of feasible to optimal, like to what extent should it be spruced up? Those are all management questions. Sure. And how she answers that, I think, answers the question. If there's no question about those, everybody's on the same page, I would try to make it less mess. messy. But if you think that there's going to be disagreement, so this is an elongated process,

then by all means, then we have to do the messy thing. But I think I would work my hardest to try to avoid the messiness. Because the question, to your point on those renovations and the new tenant is, what's the true ROI on that? This is Jay's same question with tax loss harvesting, but on a much, probably a much bigger scale, possibly on a much bigger scale. Jay didn't say how much money he's talking about he would make or lose from tax lost harvesting or not doing it. But if that isn't possible, then I think you do have to form an LLC and you're still going to have to work through those same issues, Paula.

Right. The same questions. Yeah. Those issues don't go away. But you will just need a holding tank. You'll need to figure out who's in charge. Yeah. And Nicole, you will have to have one person take the lead because that one person is going to have to be the point person who coordinates with contractors, coordinates with property managers, and makes a thousand small decisions. Do you want chrome versus stainless steel for your cabinet handles? Right? A thousand, thousands and thousands of tiny decisions that have to be made. So whoever takes the lead needs to be authorized to make those decisions and need some parameters around like, hey, if a decision is going to be greater than X amount than bring that decision to the board, the board

being the siblings. But if the decision relates to less than X amount, then just go ahead and make it. And talk about not answering the question, because I know I've heard you answer this in other places. Well, Nicole asked a question that a lot of people want to know, what is the entity I use? The entity truly isn't the important thing here. Right. Yeah, exactly. I mean, to be wrong, it's important, but that's easy. That's the easy part. The hard part is, is how are we going to manage this change? Yeah, it's not the entity. It's the agreements. Yeah. That's where the difficulty is going to be. Right. And then, of course, there's the four D's, death, divorce. Domino's pizza? No, that didn't make it? I don't think that's one of the D's. No. Free pizza with

purchase of house. I'll tell you what I'm going to do. If you do create an end. And, entity, those are conversations that you'll have to have as well. What happens if a sibling gets divorced during this process and their ex-spouse puts a claim on their share of the property? What happens if a sibling, heaven forbid, dies or is disabled during this process? What happens in all of these Black Swan scenarios? How do all of the other members of this entity deal with this? So, yeah, I'm with you, Joe. If you can get it done quick, and sell it sooner than later, that'll... Leave it in the estate, please.

Yeah, that'll minimize a lot of the headache. But if it is financially advantageous to go through the work of optimizing these properties prior to listing them, then you're going to need one person to take the lead. That person should have some level of compensation, and that person should have some authority, and then boundaries or parameters around that authority. And when I say authority, I mean authority to make decisions because there are so many decisions that will need to be made. And Nicole, to your question as to how the income of a property impacts its value,

that largely depends on if we're talking about single-family homes versus multi-units. If it's a multi-unit property, and particularly if it's a commercial property, then the demonstrable income will have a great effect on its value because investors tend to look at cap rates when they buy. So if you can demonstrate a high cap rate, then that's going to bring up the value of the property. If it's a single family home, those are typically purchased by retail home buyers,

and they're not worried about financial considerations. They're buying for emotional purposes. So thank you, Nicole, for asking that question. And best of luck with this project. We'll come back to this episode in just a minute. But first, our next question comes from Ed. Hi, Paula. I have a question for you about real estate and taxes. I own three properties, one in Wisconsin and two in Florida. The house in Wisconsin is my current residence, and the two in

Florida are both rentals at this moment. The house in Wisconsin has appreciated by about $100,000 in the last six or seven years. I plan on retiring in three years. and probably by that time it appreciate a little bit more. And then the two houses in Florida have both significantly appreciated. We'll call House number two appreciated by maybe $100,000, and House number three has appreciated by about $150,000. House number three is my final retirement home. Here is my question.

This is my plan, and I want to see if it's going to work from a tax standpoint. We plan to retire in 2025 and sell House No. 1 in Wisconsin. Move to Florida. Take the capital gains exemption for it being our primary residence and move into House number two, which by that time it's already significantly depreciated. And by that time, it will be depreciated even further. But we want to move into House 2, live there for two years, establish that it's our residents, live there for the two years, then set up.

it and declare the capital gain, you know, not take, have to pay capital gains tax because it will have been our primary residence for two years and then move to house number three. Basically, the plan is we're going to live off all the money from the houses until I get to 70 and take my Social Security while at the same time doing some Rothrollovers and stuff like that. But I'm most interested in the tax treatment on those houses. Can I do that? Is it kosher? I'm pretty sure I can, but just wanted to hear your opinion. Thank you. Ed, first of all, congratulations on the position that you're in. Congratulations on owning three homes, on being just a few years away from retirement, on knowing what you want to do and where you want to live

when you retire. Congratulations on everything that you've built and set up. I'm very excited for what lays ahead in your future. Lots of moving. Lots of moving. By the way, I don't know about Paula, but I can say, I'm busy that day, Ed. You can't help a move. I'm sorry. Lift a couch. It used to be that offering pizza and beer worked with friends. And now, you know, you get to a certain age to start seeing through that.

Like, oh, pizza and be, yeah, I don't know. Well, Joe, if you ever move, rest assured, I will not help you. That's what kind of friends we are. Exactly. Well, luckily, since I sold most of my stuff thinking I was going to be a nomad, I don't know that there's that much to move. Maybe a lot of board games. I've seen a closet full of board games.

There's definitely that. That'll be a couple boxes, a couple few. Couple few. But this is problematic. Ed's question, you mean? Yes. Well, all right. So let's talk through it.

Now, the very first move, you know, Ed is already living in his primary residence in Wisconsin. So when he sells it, of course, he can get the capital gains exemption. It's his primary residence. It's not being used as a rental property. it's totally clean in terms of... Completely legal. Yeah.

Well, yeah, it's just a clean and simple situation where this property... Straightforward. You know, yeah, exactly. Has never been used as a rental property and has only been used as a primary residence. So absolutely. He sells it. He qualifies for the capital gains exemption. Everyone lives happily ever after.

Until, happily at least for two years in the second house, when we have to figure out this completely different scenario. Yes. So then Ed will go and live for at least two years in that second house. And for the people who are listening to this, who are wondering why we're talking about two years, it's because the rule is that a person can enjoy the capital gains tax exemption on the sale of a property if they have lived in that property for two out of the last five years. So if Ed lives in house number two for two years, then he will qualify, as having lived in that home for two out of the last five years, which means he will be able to take a capital gains tax exemption on the sale of the property. The question, Joe, that you and I have been batting around and we've actually called a couple of certified financial planners. I called three. Three. Okay, yeah, we did some legwork on this. Joe, you did the legwork. So thanks for doing that. Yeah, our answer comes from our friend, Mike. Kitts, who is a brilliant financial planning mind. And if you follow him on Twitter, it will be

both fun for you and interesting. And if you're somebody that really likes to. Fun for the whole family. Come on, kids. Gather around your computer. Let's read about rules for excluding gain on sale of residence, shall we? Oh, my favorite bedtime stories as a kid. All right. The Taxpayer Relief Act in 1997, he writes, created IRC Section 121, which allows a homeowner to exclude up to 250,000 of gain on the sale of primary residents or up to 500,000 for a married couple filing jointly. We already know that. In order to qualify, the homeowners must own and also use the home as a primary residence for at least two of the past five years. In the case of a married couple, the requirement is satisfied as long as is either spouse owns the property, though both must use it as a primary residence to qualify for the first $500,000 joint exclusion. That piece says that Paula, he's right on, right? Yeah, yeah, exactly.

So far. But wait, there's more. Because the operative question, the real question is, at what point can he start excluding it? Is it from the point of move in? Is it from the point of purchase? Does the depreciation that he wrote off? Does it get added back in?

he says, and this is funny because Kittes goes exactly to his question. He says, because the exclusion is available as often as once every two years, some homeowners not naming names that may or not be asking questions this show, may even try to sell and move and upgrade homes more frequently to continue to chain together sequential capital gains exclusions on progressively larger homes. Well, and that's not the case here. Right. But this is a question about sequential.

capital gains exclusions on multiple homes. And adding complexity to it, it's a home for which he's taken depreciation as a rental property. Right. And he addresses that also. The opportunity is especially appealing in the context of rental real estate as the potential capital gains exposure is often very large due to the ongoing deductions for depreciation of the property's cost basis that are taken along the way.

Michael Kitsis is a fortune teller who knew that this question was going to be on our podcast. He completely did. To limit this technique, Ooh, Congress and the IRS have implemented several restrictions to the Section 121 capital gains exclusion in the case of a primary residence that was previously used as rental real estate. The first created as part of the original rule under IRC section 121D6, my favorite one, Paula. Wow, that's my favorite IRS exclusion as well. I was dreamed about this last night.

stipulates that the capital gains exclusion shall not apply to any gains attributable to depreciation since May 6th, 1997, the date the rule was enacted. So in other words, they grandfathered everybody in before 97 and everybody afterwards, your depreciation is still going to count, ensuring that the depreciation recapture will still be taxed at a maximum rate of 25%. So basically what this means is that if he moves into that rental property and lives in it for two out of the last five years, you know, he'll meet that criteria, but he won't be able to get a get out of jail free pass on the depreciation that he took on that property when it was a rental. There's still going to be depreciation recapture. He's still going to be taxed on it.

But he will still be able to live. in it to meet the qualification of two out of the last five years and thus get the sequential chain of primary residence capital gains exclusions from the starting

point of it being his personal residence. Ready for the next piece of this? Yeah. In addition to the limitation of Section 121, regarding depreciation recapture, as a part of the Housing Assistance Tax Act of 2008, my favorite house

assisting assistance tax act, by the way, was the 2008. Congress further limited the exclusion of capital gains for property that was converted from a rental to a primary residence. Oh, we need like a, okay, we need like a sound effect, like a bolt of thunder. The new rules enshrined an IRC section 121B4, that's B4, not B4, stipulate that the capital gains exclusion is specifically available only for periods during which the property was actually used as a primary residence. Any other time since January 1, 2009, that the property was not used as a primary residence is deemed non-qualifying use.

Accordingly, yeah, to the extent gains are allocatable, allocatable, allocatable. Allocatable, yeah, allocatable. To periods of non-qualifying use, gains are assumed to be pro-Reta. over the holding period, those gains are not eligible for the exclusion. So to translate this, from the point that he moves into that property and starts using it as a primary residence, he's good. He's good. Starting from that point.

But all of the gains that happened prior to that point, both market appreciation and depreciation recapture, he's going to get taxed on because it was a rental property at the time. For more on this, for anybody who wants to see us, is it can. Kitts.com. Michael Kitz's last name is spelled K-I-T-C-E-S. So Kitses. So Kitses. You know what? I will tweet it out right now. If you go to Twitter, my Twitter is at Afford Anything. I'll tweet it out right now, so you'll be able to see it there. I think it's called the tweeter. I'm pretty sure it's Twitter. Oh, huh. Yeah. Jack Dorsey just resigned. Did you see that? Resigned from where? No, I'm kidding. Yes, I did see that. And what's interesting is I think

the new CEO is the youngest CEO in the S&P 500. Oh, very cool. Yeah. Well, we did it. We did it. We did it. Man, we were all over the place today. Tax questions, behavioral finance, investing, yeah.

Brokerage questions. Yeah, I like the diversity of questions that we had, that mix of different topics. Keep us on our toes, peeps. Absolutely. Joe, where can people find you if they would like to hear more of you? You know, what's really cool is, especially for Nicole, is that we did an interview that we often don't get a chance to do, which is it talks about being an executor of a will. We had a gentleman on named David Eadie who walked through everything about problems that executors face, about the things people fight about. And it sounds, Paula, like this would be the driest topic.

And David was so good at telling stories. He talks about Jerry Garcia and about how even Cherry Garcia, you know, the ice cream, the Ben and Jerry's ice cream. Yeah. Like that even, that was even a part of his estate. Huh. And because of the fact that he'd have multiple marriages and his kids wanted things and his band members wanted things. And he has these fantastic stories. and then how to, for you and I, regular people, how to really make sure that you avoid some of those.

So the Stackin' Benjamin show, people like David Eadie talking about doing a better job on your estate planning. We talk about stuff like that. Talk with Paula about every Friday. Yes. Yes, you do. As of the time that we're recording this, I'm in the process of possibly winning a trivia contest, but I don't know if I'm going to win it or not. It's so exciting. I'm tied for second out of three.

but you're only one question out of first. Right. Yes. It's so clear. It's neck and neck. The two of us are tied for second, but we're one point away from first. We're both one point away from first.

I think it would just be fun because our other contributor, Len Penzo, who's been with us for a long time as well, Len is a two-time champion. And Paula, if you pull ahead of Len, even just that by itself would be fantastic. We shall see.

Tune into the Stacking Benjamin's podcast to find out. Well, thank you so much for tuning in. This is the Afford Anything podcast. If you enjoyed today's episode, please do three things. Number one, share it with a friend or a family member. That's the single most important thing that you can do to help spread the message of financial independence. Number two, leave us a review in your favorite podcast playing app. Just open up whatever app you're using to listen to this show.

And please leave us a review. Those reviews are super, super helpful in allowing us to book awesome guests. to come on this show. Speaking of which, I want to thank BRC in Baltimore, who wrote, quote, great advice and insights. Paula and her guests are very knowledgeable and engaging. I enjoy watching a very smart woman

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episodes and you won't miss any of our amazing upcoming shows. Thanks again for tuning in. My name is Paula Pan. This is the Afford Anything podcast and I will catch you in the next episode. Here is an important disclaimer. There's a distinction between financial media and financial advice. Financial media includes everything that you read on the internet, hear on a podcast, see on social media that relates to finance. All of this is financial media. That includes the Afford Anything podcast, this podcast, as well as everything Afford Anything produces. And financial media is not a regulated industry. There are no licensure requirements.

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