Afford Anything - Ask Paula - How to Estimate Repair Costs, File Taxes on Rental Income, and More

Episode Date: December 4, 2017

#106: How do you search for rental properties out-of-state? Should I offer a lease-option contract to my friends? How can I estimate repair and maintenance costs? And can you deep-dive into bookkeeping and taxes for rental real estate? I tackle these four questions in this episode of Ask Paula - real estate edition.   Saul from Salt Lake City asks: I'm converting the first floor of my home into a two-bedroom, one-bath apartment. My "hacked duplex" will soon be ready for my first tenant. Can you deep-dive into the taxes and accounting? How should I keep records of my expenses, and what should I file?   Terri asks: I'm analyzing real estate deals, but I'm getting stumped about how to estimate the repair, maintenance and capital expenditures. It seems like everyone has a different approach for calculating this. Should I estimate a percentage of the purchase price? A percentage of the rental income? A flat amount per unit? Or something else? How can I estimate costs accurately?   Kirsten from Madison, Wisconsin asks: My husband and I recently moved to Madison, but we've kept our old home in Oshkosh, Wisconsin. The home is worth $120,000, and we have a 15-year note. Our friends would like to purchase that home, but their credit is bad. They'll need two years to improve their credit situation.   We're considering renting to them through a lease-option contract. Our mortgage is $950 per month; we're thinking of charging them $1,100 - $1,200 per month on a rent-to-own lease. Do you think this is a good idea?   Chrissy from North Vancouver, Canada asks: I loved your description in Episode 92 about building a team in a different state. Could you please further flesh out the steps that you use when you're searching for a rental property in a different state? I tackle these four questions in today's episode. Enjoy!     For more, visit the show notes at http://affordanything.com/episode106  Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything but not everything. Every decision that you make is a trade-off against something else. And so, the questions become twofold. Number one, what choices are you going to make? What's most important to you? And number two, how do you align your day-to-day behaviors to reflect those choices? Answering these is a lifetime practice, and that's what this podcast is here to explore. My name is Paula Pan.

I'm the host of the Afford Anything podcast. Every other week, I answer questions that you, the listeners, have sent in. And I alternate. Some weeks I answer general personal finance questions, and some weeks I answer questions specifically related to real estate. I know that not all of you are interested in real estate, so I try to single those out into specific episodes. That way, if you're into the topic, you can keep listening. And if you're not, you can listen to some different episodes of this podcast. So today we are specifically answering questions about real estate that come from you.

And our first question comes from Saul from Salt Lake City. Hey, Paula, this is all outside of Salt Lake City, Utah, second time caller. I'm hoping you can come through for me again. I am currently working on a hacked duplex, meaning I'm finishing the first level of my very large Utah home to be a two-bedroom, one-bath apartment. I started an LLC, and I'm working through all of that. I was wondering if you might be able to do a deep dive someday or offer some resources to get me up to speed on the tax side as soon as possible.

I've basically put about four months straight of every free minute doing renovations and sinking a ton of money into this. It should work out very well for me in the end. I just am worried about keeping up with the accounting. And I'm hoping to do that without too much cost. I know in the beginning I think you managed your own properties entirely. I was warning if that included taxes and accounting. So if you could offer anything along those lines, I'd greatly appreciate it.

Thank you. Welcome back, Saul. Thanks for calling in again. So there are a couple of ways that I want to address your question. Number one, I'd like to talk about rental property taxes generally. And I'm doing that both for you and for the sake of everybody else who's listening who has the same question. Second, because you have a hacked duplex, meaning you will be living in one of the units and renting out the other, that puts you in, a different tax situation than somebody who had a standalone rental property.

So we're going to talk about that second in the answer. But first, let's discuss IRS tax treatment of rental properties generally. The first thing that you need to know is that the IRS regards rental properties as a passive source of income. And what that means is that you fill out a different form when you file your taxes. If you are running an active business, like me with this podcast, I would fill out a Schedule C form, which is where I report the income and the expenses associated with this active business that I'm running, which is the podcast and the blog. With a rental property, it's totally different. With a rental property, you fill out what's called the Schedule E. And that form is specifically dedicated to passive activities. I realized, by the way, Saul, that this is, it is very frustrating.

frustrating to spend every evening and weekend working on a rental property and then have it classified by the IRS as a passive activity. I absolutely know that feeling because the DIY approach is very hard. It's very time consuming. But hey, that's how the rules are written. So the reason that that distinction is important, by the way, the reason that I'm discussing the distinction between filing taxes on an active business through a Schedule C versus filing taxes on a passive business through a Schedule E is because this has major implications for the losses that can be claimed against your rental income. So with a rental property, with the Schedule E reporting, the maximum loss that you can report in one year from all of your rental properties combined is $25,000. Now, Saul, in your

case, with just one property that's probably not an issue right now, but that is something to keep in mind in the future, particularly if you have multiple properties with vacancies or big repairs or other such factors. That will be something as you progress as a landlord, that will be something that you will want to stay aware of. The other thing is that passive losses can only be used to offset passive gains or passive income. So your passive losses cannot offset active income, such as income from a job. If your passive income is zero and your losses, as you get this property up to speed are $10,000, you can't offset your job, your nine to five day job money from that $10,000 passive loss. In that case, your rental losses become suspended losses until you have

the passive income to be able to offset them. Now, by the way, I'm going to make a disclaimer here and say, I am not a tax professional. And everything that I am saying here is absolutely not tax advice. I want to be very clear about this. Anytime I'm talking about this on a podcast, I need to make sure that I'm very, very clear. I'm not a professional. This is not tax advice. Do not listen to me. I am just some random person with access to the internet. This information is for entertainment purposes and please consult a professional. So that's my disclaimer. Okay, with that being said, let's go into some more entertaining tax talk. When you report your rental property income and expenses on your schedulee, there are two different ways that you could do it. One is called the cash basis

method and the other is called the accrual method. Generally speaking, most individuals, I shouldn't say most, but many individuals use the cash method. And so for the rest of this podcast episode, that's the assumption that I'm going to make. The definition of that is if you are a cash basis taxpayer, you report rental income on your return for the year in which you receive that money, regardless of when that money was earned. And same with expenses. You deduct expenses in the year that you pay them, not in the year that that expense was applied against you. In other words, the cash basis method looks strictly at money that lands in your bank account from January 1st through December 31st and money that leaves your bank account during those

same dates. By the way, from a general bookkeeping point of view, in my opinion, the cash basis method is much easier. So that's what I use. Now, when you're reporting your rental income, You must include your entire gross income within that report. And so that means not just the rent money that you earn, but also any pet fees, parking fees, storage fees, any of those other supplementary forms of income that you receive from a tenant. Security deposits get a little bit trickier. So if you use the security deposit as rent for the final month, then that security deposit is considered to be advanced rent and must be. reported in your income as rent that you've received. However, if you plan on returning the security deposit to your tenant at the end of the lease and you will not be using that security

deposit as the final month's rent, then do not include the security deposit in your income. However, if you end up keeping part of that security deposit because, you know, the tenant damaged the carpets and you need to keep part of their deposit in order to deal with that, then you do have to include the part of the security deposit that you have kept in your income reporting. Those are the rules regarding how to report security deposits. Now, if your tenant pays you for, let's say, terminating a lease early or anything like that, that's all also included as rent. So basically, if money enters your bank account, it's rental income with the exception of security deposits. But honestly,

So most states require that security deposits are kept in a separate account anyway. So, you know, a lot of states require that security deposits be kept in an escrow account in order to ensure that there's no co-mingling funds. So if you're using bookkeeping software that just reads your business bank account, then the security deposit thing won't really be an issue because you won't have commingled those funds to begin with. That being said, let's talk about the next batch, which is what type of deductions can you take? With a rental property, you can deduct normal and ordinary operating expenses, such as the interest on your mortgage payments, the property taxes, the homeowners insurance, repairs, maintenance, any utilities that you pay for, additional liability coverage, and you can report depreciation as well. And we're going to talk more about that in just a second because that's incredibly important and very technical. This is where you would definitely want a CPA. So the reason that you can report depreciation is because you are not allowed to deduct the cost of major capital expenses. You can deduct ordinary repairs and maintenance, but you cannot deduct major improvements, renovations, upgrades. What that means at a practical level is if you've got a rental property and the dishwasher is broken and you send a repair person, over to fix the dishwasher, and that repair person goes to Home Depot and buys 20 bucks worth of parts, then you can deduct the money that you've paid to the dishwasher repair person and the 20

bucks worth of parts from Home Depot. You can deduct that from your income because that is the cost of making a repair. It's part of your operating expenses. But if you decide to demo and renovate the kitchen and you put in a new dishwasher or new cabinets or a new countertop and you sink, you cannot deduct those expenses. And that's why, more broadly speaking, zooming out a little bit, when you are planning for the cost of renovating a rental property, you have to actually plan for not just the budget of renovating that property, but also the fact that you will not be able to deduct that money from your taxes. So you'll be paying taxes on that money in the same year that you're also spending it.

So how do you recapture the money that you've spent in improving a property? Well, you recapture it through depreciation. What that means is that each component within your rental property has a life schedule. You know, so a component might have 27.5 years of workable life. Each year, you depreciate a portion of those new cabinets, that new countertop, that big kitchen remodel, the new roof that you put on, the windows, you depreciate the cost of improvements year after year in order to slowly recoup those costs. Essentially, what the effect that that has is that in the year that you make renovations, that year sucks when it comes to

taxes. But every subsequent year thereafter, things actually get pretty awesome because you're not spending that money out of pocket anymore, but you are still able to depreciate it. So, TLDR, only a percentage of your renovation expenses are deductible in the year in which they are incurred. Everything else gets depreciated over time and you report that on Form 4562. Finally, Saul, in your case, because you have a duplex and you'll be using part of it as a personal residence, this means that you'll need to treat a portion of your building as an investment property, in income-producing rental property and the other portion of it as a personal residence. You cannot deduct the expenses for the entire duplex because part of it is not being used as a

rental property. Part of it is just your personal residence. So for example, if you as the landlord pay the water bill for the entire duplex, you can't deduct the entire water bill. You have to deduct a portion of it, the portion that applies to the income-producing property, but then you will not deduct the other portion of it, the portion that applies to your personal domicile. With all that being said, how do you track and manage all of this information? Because there's a lot going on here. Here's what I do. First, I have a business bank account that is specifically for the rental properties. I also have a business credit card, or you could also use a debit card, whichever you prefer, that is specifically only for the rental properties. Any and all purchases

related to the rental property, whether it's the cost of installing new windows, the cost of carpet, the cost of paying that water bill, absolutely anything related to that rental property gets paid from the business credit card, which then is auto paid from the business bank account. Similarly, all income related to the rental property goes directly into that business bank account. So I keep that separate from all of my personal expenses. Now, both the business bank account and the business credit card are linked to bookkeeping software. And within that bookkeeping software, I will go in and I will tag expenses based on whether they are repairs and maintenance or major CAPEX. Because remember, repairs and maintenance you can deduct, but major CAPEX and improvements you must appreciate.

If there's a receipt from Home Depot, for example, I'll go in and tag whether that receipt applies to just, a simple ordinary repair or whether that receipt applies to replacing the vanity in a bathroom, some sort of bigger renovation expense that would need to be depreciated over the long haul. Then, within my bookkeeping software, I'm able to invite my accountant in to see everything that's within that. In my case, because I have multiple properties, I also tag my expenses based on the property that it's associated with. In your case, since you only have one rental property, that means that you can skip that step. That makes it a bit easier for you in terms of tracking.

Now, my accountant is aware with that triplex. He's aware that for many years, we lived in one unit and rented out the others. And so he would look at all of the expenses that were tagged for that particular triplex, and he would then calculate what proportion of those expenses could be written off. and what proportion of those expenses could not be and would be classified as purely a personal expense. That is a calculation that your CPA will make. The one big mistake that I made when Will and I first bought our Triplex is that initially we didn't have bookkeeping software. So initially, we actually manually tracked all of the expenses in a spreadsheet.

That was a terrible idea. Don't ever do that. Because all you have to do is lose one receipt or forget to input one. expense into that spreadsheet and boom, everything gets thrown off. The spreadsheet no longer reconciles with the bank account and the whole thing becomes a huge logistical nightmare. So that was my deep dive into taxes and bookkeeping for rental properties. Congratulations on being so close to finishing your duplex. That's awesome. And I hope that everything goes really well. I hope you really enjoy being a landlord. Oh, Saul, sorry, two last things that I want to say. Number one, in the show notes, which are

available at afford anything.com slash episode 106. I will include links to a whole bunch of resources, including IRS pages about tax reporting, a fantastic book called Every Landlord's Guide to Tax Deductions that I highly recommend you read. I'll have links to all of those in the show notes. Affordainthing.com slash episode 106. Oh, and the final thing that I wanted to say is that when you get a receipt from Home Depot or Lowe's or wherever, snap a picture of that receipt, then save a copy of that picture to either Google Drive or Dropbox. Create a folder that just says rental property tax shoebox and then the year. So rental property taxes shoebox 2018. I actually have an app that converts a JPEG into a PDF directly from my phone.

Snap a picture, turn it into a PDF if you'd like, and then upload it into your shoebox file. That way, if in the future either your CPA or heaven forbid an IRS audit wants more detailed information and actually wants to see the receipts that are associated with all of the transactions in your account, you'll have a shoebox full of receipts that you can immediately produce, all organized year by year and property by property. That's my final tip. We'll come back to the show in just a second, but first, regardless of whether or not you have debt, managing healthy credit is important if you want to buy houses, whether it's a personal residence or an investment property, or if you want to open up new credit cards, if you want to lease a home in a different city for a

lots of other things, you need to manage your credit. So if you're interested in a website in which you can check your credit score for free, plus get personalized credit tips to better manage your credit, also totally free and updated monthly. Check out creditcesami.com. Now, as I mentioned, this website is absolutely free. They do not require you to submit a credit card or debit card when you sign up. You won't be submitting payment information during the sign up. And on this website, on CreditSasami.com, you can get personalized financial tips for your specific situation, which you can use to improve your financial health. With your membership, you also get free identity theft insurance worth up to $50,000,

which could be a lifesaver in the wake of the Equifax data breach. And if you need it, there's a live helpline where you can talk to identity restoration specialists, also for free, and you can check your credit score for free. So check them out. It's great to know your credit score and to get personalized. educational content. They're creditcesami.com. Creditcessamy.com. Our next question comes from Terry. Hey, Paula. My name is Terry. First off, I wanted to say, I love your blog. It's really motivated me to get into real estate investing. I'm absolutely fascinated by it. And I've been in the

process for a few months now. And I'm to the point where I'm currently looking at deals, mainly through MLS. Where I'm getting stumped is when I'm putting together all my numbers to figure out what the cap rate is and everything is getting an accurate portrayal of the expenses. I know you spoke about this recently and how to build a team and all that. But the one thing in particular that's really stumping me is the repair and maintenance category and then the capital expenditures category. As far as capital expenditures go, it seems that everybody has a different way to factor this,

whether it's a percentage of the income or a percentage of the property value or a set $600 per unit or what have you. And my numbers are just so close in the market I work in that I really need to get everything pinned down. But I'm getting confused on how exactly to and what to put in for that. I know you probably don't have an exact answer, but anything you could lend to help me get my numbers just right so I can get accurate cap rates and accurate cash flow would be appreciated. Also, any input on what you look for as far as cash flow and properties? Thanks so much, Paula. I really appreciate it. Terry, that's an excellent question. And unfortunately, there's not a clear or concise answer. So in order to get a little bit closer to finding an answer, here's what I'm going to do. First, I'm going to walk through the three ways that you mentioned

that many people estimate these expenses, which are percentage of purchase price, percentage of income, and flat amount per unit. I'm going to talk about all of those and I'm going to go through the pros and cons, and then let's more directly talk about, okay, which should you choose and how do you estimate the costs? I'll also suggest a fourth alternate approach beyond the three that you've named that might be more accurate, but will also be much more time intensive. Here we go. First, one general rule of thumb is to estimate the cost of repairs, maintenance, and CAPEX as a percentage of the purchase price of the property. Broadly speaking, a lot of people use the metric that 1% of the the purchase price of the property per year will go towards repairs and maintenance.

In other words, $1,000 per year for every $100,000 worth of house, or $83 a month per 100K worth of house. 1% is the lowest that that amount is stated at. I have heard some people say 2%. You can choose anywhere within that range if you were to use that rule of thumb. And by the way, Terry, since your broader question is how to calculate the cap rate, when I calculate Capri, I don't just calculate one number. I run a minimum of three different scenarios, one of which is the worst case, one of which is the reasonable best case, and then

I'll have a scenario in the middle. So in the worst case, I compile the worst assumptions in every category. So the worst assumption in terms of the lowest amount that I think that the property would rent for. I'll estimate a reasonable but high vacancy rate. And I will estimate higher costs in terms of repairs, maintenance, all other operating overhead. And that gives me the worst-case scenario cap rate. I'll also do the same thing with a reasonable best-case scenario. I'll estimate the rent at the top of the reasonable line. I'll estimate a lower vacancy rate.

I'll keep the cost of operating overhead down. That'll give me the best-case cap-x scenario. And then, of course, I'll find the median. And then I'll look for various midpoints within that. In fact, one litmus test that I use when I'm determining whether or not I want to buy a rental property is that I'll look at the worst case scenario and I'll say, you know what, that's not pretty because the worst case never is, but could I live with it? Not what I enjoy it, but could I tolerate it. And if the worst case is something that I could tolerate, then that's a property that I could move ahead with. But I'm getting ahead of myself. Before we get into having multiple cap rate estimates, let's first zoom back out and talk about the three ways that you're going to. could estimate operating overhead. So as I said, one of the ways is to estimate a percentage of the purchase price between 1 to 2%. Another possible way to do it is to make this estimate as a percentage of the income. Now, there's a broad rule of thumb called the 50% rule of thumb,

which states that about 50% of your gross monthly rental income will go towards all operating overhead, not just repairs and maintenance, but property taxes, insurance, all of the other operating overhead combined will come to about 50% of gross monthly rent. Both of these two rules of thumb that I just mentioned, the percentage of the purchase price and the percentage of the income, have a couple of pros and cons, which ought to be directly stated. The advantage to using either of those two is that not only are they simple and fairly easy and straightforward, their back of the napkin math calculations that you can make, But the other advantage is that they reflect local factors.

So if you are investing in a high cost of living area, for example, then the fact that that's a high cost area will be reflected in the purchase price of the property and will also be reflected in the estimate that you're making for repairs and maintenance, given that labor prices are likely to be higher, material costs may be a bit higher. The cost of repairs and maintenance will reflect the local economy. So by using a percentage of the purchase price or a percentage of the income as an estimate, you are essentially adjusting for that variable. You're comparing like with like. That's the drawback of the third option that you mentioned, which is to estimate a flat amount per unit. Certainly the advantage of that is that it's easy. But the drawback is that that does not adjust the estimate for the price discrepancies in different parts of the nation. That's why of the three options, that you mentioned, I would throw out the flat amount per unit because that's just a little two boilerplate. And I would stick with either the percentage of income or the percentage

of purchase price rule of thumb. Now, obviously, there are, as I'm sure you know, many holes that you could poke in both of those rules of thumb. For example, if you're making an estimate as a percentage of the purchase price, well, your purchase price is an independent variable. Like, imagine that in scenario A, you purchase a house on one, two, three main street, at the price that a retail home buyer would pay, an owner-occupant. So in scenario A, you're buying 1-2-3 Main Street at full retail home-buyer price. In scenario B, you're buying that same house, 1-2-3 Main Street, at a discount because perhaps you had a motivated seller who was about to leave the country and wanted to make the sale before

they left. Perhaps it was a short sale. It was a foreclosure. For some reason, perhaps it wasn't even for sale and you were driving for dollars and you suggested to the owner that he or she sell and you worked out a non-MLS deal. I'm just using that as an example. I'm not saying that that's what you ought to do. I'm just stating that in those two cases, you have the exact same property, but in scenario A, that property sells for X, and in scenario B, that property sells for 70% of X. In either case, the repairs, maintenance, and CAPX for that property will be the same or approximately the same. Estimating your operating overhead as a percentage of the purchase price does not adjust for. the inherent volatility that comes with inefficiencies in the market. And those are the inefficiencies that allow investors to capture homes for less than

full market retail value. So that is one of the many flaws these rules of thumb have. But that being said, of course, the advantage, like I mentioned, the advantage is that it does adjust for the specifics of the locality. And to that extent, it is at a minimum better than using the flat rate per unit model. Now, those are the pros and cons of the rules of thumbs that are commonly used by investors. With that established, what should you use? Well, there are two answers to this, and it depends on how deep in your analysis you are.

If you are doing a rudimentary high-level analysis on a property that you are thinking about making an offer on, but that you are not yet under contract for, then in that scenario, I believe it's totally okay to use one of these rules of thumb, because you're only doing an initial first pass. However, once you are under contract for a property, it is at that point that you will, during the due diligence period, want to do a much more thorough vetting. And in order to do that, here's what I would recommend. First, if the seller was also an investor,

ask the seller for a copy of their profit and loss statements or a copy of their tax returns from the previous three years so that you can see historically how much that owner paid for repairs, maintenance, improvements, utilities, and so forth. Now, in many cases, the seller did not do a good job of adequately maintaining their property, and there will be a lot of deferred maintenance, so you should not just copy-paste that information, but it will at least give you a starting point. Second, hire a general contractor to walk through the property and give you an estimate of what it would take to get that property at a minimum up to the point where it is rent ready for the first tenant. In fact, you could even

ask the general contractor to give you two different estimates. One, that would be a minimum viable job to get it habitable for the first tenant. And the second estimate, which would be a much more intensive job that would take care of all of the deferred maintenance. And looking at the difference between those two estimates, you will have a much better idea of what the repairs and maintenance will cost down the road because the difference between the habitable estimate versus the optimal estimate is probably the amount of money that you will end up paying on repairs and maintenance in the first three, four, five years of owning that particular property. I will say in many cases, in most cases, the general contractor will ask for an hourly fee in order to do this walkthrough

because you are not yet the owner. That is absolutely fair, and I would not hesitate to pay that. Typically, this fee will be around, I mean, again, this, you know, I can't make an estimate for what GC's nationwide charge, but around 40 or 50 bucks an hour is absolutely reasonable to compensate that G.C for his or her time, particularly given the fact that this is simply a property under contract, you're not the owner, and there is, quite frankly, a fairly reasonable chance that that GC will not actually end up getting the work. Now, this inspection by a GC should be done in addition to an actual inspection by a licensed inspector. So I'm suggesting this in addition to rather than instead of. Finally, number three, and this will be the most time intensive, but it is likely, particularly if you are somewhat experienced with renovations, it is likely to give you the most accurate estimate, is to do a line by line, item by item estimate of the useful lifespan of each cost. component of the property. For example, let's say that the property contains 15 windows. You know that in your area, you can purchase vinyl, double-pained windows for $300 per. There will also be additional fees for removal and holloway of the old windows, which you amortize out at a

cost of $20 per window. So the total cost, we'll just say in this hypothetical situation, of replacing each window is $320 multiplied by 15 windows. This means the total cost of all of the windows on that property are $4,800. And if you estimate that the vinyl windows have a lifespan of approximately 30 years upon installation, then this means that the windows overall cost the property $160 per year. Now, you could go through and do this line by line with each major component of the house, the roof, plumbing, electrical, drywall, foundation, motor mediation, pest control, the HVAC system. If you are experienced at renovations, this is absolutely something that you could do.

And the benefit to this approach is that if you know what you're doing, this could give you a very realistic estimate of what the CAPEX carrying costs on the house will be over a very long-term aggregate average. However, the drawback to this is, number one, that it's time-consuming and number two, it runs the risk of GEGO, garbage in garbage out. Because if you miscalculate or misestimate the costs or the like, lifespan of these components, or if you forget a major class of component like the exterior siding, that throws the whole equation out of whack. So this is not necessarily a tactic that I

would recommend to a beginner real estate investor. Instead, I would stick with the first two ideas that I mentioned, which was, number one, look at the actual costs that the seller incurred over the past three years of repairs, maintenance, and other operating overhead, assuming that the seller is also an investor. And number two, hire a general contractor to walk in and give you two estimates, one that would get it rent ready for the first tenant and the other that would improve it beyond that. And then look at the difference between those two. All that being said, remember, surprises do come up. There are many things that GCs aren't able to see. That's part of the reason that I advocate running multiple cap rate estimates because cap rate is an equation that is precise but not accurate. So when you're calculating cap rate and you come up with a result of 5.279, that degree of precision can have the veneer of accuracy, but precision is not accuracy. And given that so much guesswork goes into the variables that build the cap rate, it's essential to not look at that cap rate as a number that is carved in stone, but rather look at a possible range of cap rates under a range of scenarios. and know that it will most likely never be as good as the best case and never be as bad as the worst case.

Just make sure that you're comfortable being inside of that range. That was an excellent question. Thank you so much for asking it. And best of luck with your property search. Shout out to any entrepreneur who is selling physical items online. It's the holidays. And that means it's crazy. You can use shipstation.com to manage all of your online or online or orders from one place. Whether you're selling on Shopify, Squarespace, Etsy, Big

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along with step-by-step recipes, so that you have, at your fingertips, everything that you need in exactly the right amount to be able to make a fresh, home-cooked dinner from scratch in 45 minutes or less. I've been getting meals from Blue Apron for about a year, and two things I really like about it. Number one, it saves me a bunch of time

in terms of the inventorying and the procurement of what I need in order to cook dinner. And number two, it's actually become a bit of a cooking class for me. I have tried lots of different recipes that I never would have. And I've learned different cooking techniques that I never learned before. So my skill set as a cook has advanced quite a bit as a result of getting Blue Apron meals. Now, Blue Apron only sends non-GMO ingredients. And the meat that they send has no added hormones. They also have great vegetarian options, which is what I typically get.

They offer 12 new recipes each week and customers can pick two, three or four recipes based on whatever fits your schedule. So if you want to give them a try, Blue Apron is treating Afford-An- Anything listeners to their first dinner, a $30 value, for free if you visit blueapron.com slash afford. So check out this week's menu and get $30 off with free shipping at blueapron.com slash afford, a F-F-O-R-D. Blue Apron, a better way to cook. Our next question is from Kirsten. Hi, Paula. My name is Kirsten, and my family and I moved to Madison, Wisconsin about a year ago. We purchased a house here, but ended up keeping our house in Ashgosh, Wisconsin,

as our friends wanted to rent it out while one of them finished graduate school. They are great renters, but they will be moving out next summer once she graduates. Recently, another friend approached us about possibly wanting to buy our house after the renters moved out. The only challenge is that they don't have good credit, and they'll need about two years to straighten that out, as they are both now out of school and have good jobs. I'm wondering what you would suggest with regard to having them do a rent-to-own kind of lease. The house is worth about $120,000 right now. By the time the renters move out, we will owe about $72,000 on the mortgage, which is on a 15-year note. We pay about $9.50 a month total with escrow, principal, and interest. I'm wondering about charging $1,200 to $1,200, $1,200, $1,000. month for rent and having a rent to own 12-month lease. Well, I like being a landlord. I know my husband would like to sell the house before we move closer to our jobs in Madison, which will be in about two or three years. The price will go up on the house that we want to buy compared to the one we have

now, so it will be good to have the cash at that point. I really appreciate your thoughts on this, and I thank you so much for all you do. It has been so much fun to listen to your podcast, and I thank everyone who works with you as well. Have a good one. Kirsten, congratulations, on your move to Madison. That's a great city. A couple of things come to mind. First of all, do you want to be in a lease option arrangement, which is what you're suggesting? Do you want to be the landlords in a rent-to-own situation? Because what I hear from the way that you've asked that question, and I might be misinterpreting it, it's a one-minute question on a voicemail. I may be absolutely wrong about this. But the impression that I get is that this is something

that your friends want. This is something that could be beneficial to your friends, possibly, But I don't have the strong impression that this is what you and your husband actually want to do. Now, I might be wrong about that. It might be that you're super enthusiastic about this plan. And if so, awesome, proceed full steam ahead. But if you're doing this as a favor to your friends, don't. Real estate and personal favors do not mix. And there are a few reasons for that. Number one, if you and your husband view this as a favor that you would be doing for your friends, Well, most people don't like to view themselves as recipients of favors. And so generally speaking, what often happens is that the recipient views themselves as the person doing the favor for the other party. You might see this as something that you could do for your friends to help them get into a house. But there's a chance that they might see it as a favor that they're doing for you because you needed a renter and they came in to fill your space. So right off the bat, there is at least a reasonable likelihood for a discrepancy in the way that the two parties will view the transaction.

Number two, as I just said, this is a transaction. This is a business transaction. My rule of thumb is never rent to somebody whom you're not willing to evict. And if you're not willing to evict your friends, then you shouldn't rent to them. It's the same idea behind never hire somebody who you're not willing to fire. And, you know, that's a mistake. that happens in a lot of family businesses, where somebody will hire their brother or their cousin or whomever, and then that person does a terrible job, but they can't get fired and it brings the whole business down. And soon everybody's on a sinking ship. Nobody's happy. Same idea in real estate. Don't rent to someone whom you're not willing to evict because if a person knows that they can get away with stuff, then at least at somewhat of a subconscious level, there's at least a

likelihood that they will attempt to get away with stuff. They might be late paying the rent several times, or they might have damage that they don't want to repair, or they, you know, the first few months are cool, but then stuff starts to slide and things begin to happen, and there's always a personal reason, and pretty soon you get that phone call being like, come on, man, I thought we were cool. So for those reasons, I would caution against, A, gifting somebody in the form of a benevolent or generous real estate offer, and B, renting to someone whom you're not willing to evict. I would strongly caution you on those two grounds. Now, that being said, if this is still something that you choose to move forward with, here are some of the things that stood out to me from a purely mathematical point of view. Number one, you mentioned that the total PITI mortgage payments are $9.50. a month and you're contemplating charging between 1,100 to 1,200 per month, you are, to be perfectly honest, unlikely to be able to cover your costs with such a small gap between your

PITI payments and the gross rent that you're collecting. And the reason for that is because you'll need to pay for repairs and maintenance. And by the way, even if you write it into the contract that the tenant is responsible for that, that introduces a whole batch of additional complexity. Like, all right, really they're responsible for it? To what degree? To what definition of repair or maintenance are they responsible for? What is the penalty if they don't do it? If at the end of these two years they end up not purchasing the property and you have to go in there and fix a toilet that has been broken for two years or a furnace that has been shoddly repaired or flooring that's been scraped up, what protection do you have from an instance like that? Broadly speaking,

it is not a good idea to have the tenant be responsible for repairs and maintenance. meaning that it is actually in your best interest to cover that portion of the operating overhead from the rent that you receive. That $1,100 a month that you're getting, on a place where the mortgage is $9.50 is not going to be enough to cover repairs, maintenance, bookkeeping, accounting, paying your CPA, holding an umbrella liability policy, maybe taking charge of some snow removal or gutter cleaning. That spread is far too narrow. The other thing that stands out to me is you mentioned that you really want to sell this house in approximately two years so that you can buy the place that you want to move into in Madison. A lease option contract is, as the name directly states, it is an option. Your friends will not be required to purchase the property at the end of that two year period.

They simply will have the option to do so. And so, what will you do if at that point your friends decide not to exercise that option? I mean, imagine that. Like, at that point, what happens? They move out and you then paint it, spruce it up, maybe deep clean the carpets or refinish the floors, get it show ready for a sale, have a vacancy during that entire period of time. I mean, that narrow spread that we were talking about between the $9.50 per month you're paying on the mortgage and the 11 or 1,200 that you would get from rent. How many months of

vacancy is that tiny little spread going to cover if you're at friends end up not exercising the option and you end up having to hold the property for two months while you clean it and get it showcase ready for a market sale? And by the way, you're also going to be doing this at approximately the same time that you yourself want to purchase a property, which means that you'll simultaneously be looking for your own residence and making an offer that is contingent upon the sale of your other house. I realize I'm getting a little opinionated here, but I just, I see a lot of ways for this to go sideways. Generally speaking, in real estate, as in life, the simpler, the better. If you want to hold that property and be a landlord, awesome, hold the property and be a landlord, but do it in

such a way that you are commanding a healthy spread, the type of spread that any landlord would want. And if your house is underperforming, then do what an investor does. Investors get rid of underperforming assets and then use that capital to purchase assets that perform at or above market rates. I suppose what I'm saying is if you want to be an investor, be an investor. And if you want to be a good friend, then sit down with your friends, teach them how they can improve their own credit scores, teach them everything that you know about saving, about side hustles, about earning more, about how they can improve their own financial situation. Invest that time into teaching them and guiding them and mentoring them without putting your own neck on the line. Because ultimately,

you'll be able to help the most people when you do it from a position of strength. Not from a position of personal risk. So that probably wasn't the answer that you were hoping for, but I hope that you found it helpful. And whether or not you agree with me, I hope it at a minimum opens up some discussion and opens up some new pathways of thought. Thanks again for asking and best of luck. Our final question is from Chrissy. Hey, Paula, this is Chrissy. I'm calling from North Vancouver in Canada. I'm one of your long-time listeners. I've been listening to your podcast since almost the beginning, and I love it. I think you're fantastic at podcasting. You definitely have the voice for it, and your knowledge is very

much appreciated. You are very knowledgeable, and I really like the way you work things out. It's very sensible, very thoughtful, and it's always very useful. So thank you for all the content you put out. My question is, I just listened to number 92 about how. to assemble an all-star team when investing in real estate. And I really love the part where you went into how you sussed out people in Alabama. And I was wondering if you could further flesh out the steps that go beyond assembling that team. For instance, how you managed to then purchase the property. Were you flying back and forth to see the property?

Or did you just do that all from a distance? and how did the inspections go and all of that other nitty-gritty. I'd love to hear how you do all that from a distance. Thank you again for everything and look forward to hearing your answer. Chrissy, thank you so much for being part of this show since the beginning. That's awesome. That was 106 episodes. I can't believe we've made it this far.

And the change, the progression of the show between what it was in its early days and now is pretty dramatic. Thank you for enjoying all of it and being along for that whole journey. There are a couple of different ways in which I'm going to address your question. First of all, I'm going to give two answers. There's what I did and then there's what you could do. As I mentioned in episode 104, many times when people ask, what did you do? What they're really asking is what should I do? And so I'm going to tackle both questions. Within the answer of what did I do, I'm actually going to tell two different stories. One is me living in Vegas looking for a property in Birmingham. And the The other is me being in New York and just traveling generally, being on the road, looking for a property in Atlanta. Because the thing that people often forget, or perhaps I've just done a very poor job of explaining this, is that during the years that I lived in Atlanta, I lived in Atlanta from 2010 to 2015, during that time, particularly in the latter half of that, I was rarely there. I was gone out of state for between one-third to one-half of the time, which is why it actually surprised me a lot in 2015 when I moved out, when I moved to Nevada, a lot of people asked, are you going to sell your properties?

And I was like, if that were the case, I would have done that back in 2011 or 2012 because I'm functionally out of town already, given how little I was ever at home. I've been very nomadic. That being said, I'll tell you the story about how I bought house number five. I purchased that house in 2014. And at the time that I bought that house, I was not in Atlanta. I was traveling heavily. In order to find that house, I did a couple of things.

Number one, I had already narrowed, and this is key no matter where you are, and I did the same thing for Birmingham. I narrowed my search to an incredibly specific geographically constrained area. I decided on the specific zip code that I was interested in. And then even within that zip code, I decided on the particular few blocks, the particular section of that zip code that I was specifically looking at. And the thing is, when you're looking at that small of a geographic area, there are not many properties that come up for sale. And when they do, you see them right away because you're looking very, you're an expert in that particular geographic area. So in 2014, I had picked a particular zip code. And within that neighborhood, there were probably around 50 houses for sale.

Actually, I just did a Zillow search right now for that zip code. And there are currently 154 houses for sale that are in that zip code as of right now. And so if I'm focused on one particular portion of that zip code, there are probably about 50 houses for sale at the time. And then once I filtered through, you know, I wanted at least a three-bed two bath. I wanted something that was $60,000 or less because I was buying in cash. Once I filtered through all of that criteria, there really wasn't a whole lot left. So there were probably around five or six properties that I was seriously considered. that I was seriously looking at. And by the way, at this point, I was in Costa Rica, I was in

Ireland, I was in San Diego, New York, Austin, New Orleans. I was all over the map. But what I did was I had these five or six properties that I was seriously considering. I probably sent offers to about maybe three or four of them. And when I send in an offer, a lot of times I won't write up a formal offer. I will just call the listing agent and say, hey, I'm interested in making an offer of X amount. And usually, most of the time, what will happen is that the agent will say, screw you, that's way too much of a low ball, click. Or the agent will say, oh, actually, this house is already under contract. This happens a lot, by the way. The agent will say this house is already under contract. Sorry, the listing is not up to date. You can submit a backup offer if you

would like. Most of the time, that's what will happen. Now, when I was in New York in 2014, there was one property. It was a duplex. I remember this so clearly that from out of state, I went under contract for. So I was not there, hadn't seen it. I'd only looked at the online listing. I called the selling agent. I made an offer. The selling agent said, yeah, awesome. Write it up and send it in. I, acting in my own capacity as an agent, wrote up a formal offer, sent it in, and we went under contract for the property. So then what I did was I hired an inspector. So I was again from New York, contacted an inspector and had them come to the property. And so, and it cost me $400. And he was there for at least half a day and he wrote up an extremely detailed inspection report and sent it to me. I reviewed it from New York. And if I had decided to proceed with the sale, the next thing that I would have done is I would have hired a general contractor paid on an hourly rate. to go through and do a redundant walkthrough of that property.

But looking at the inspection report, I decided, you know what, this actually isn't a property that I want to move forward with. And so, because I had a buyer's general right to terminate built into the contract, I terminated the contract for that property, again, doing all of this remotely from New York based on an online listing. So fast forward three years, that is now the year 2017, I live in Las Vegas and I've decided that I want to buy a property in Birmingham. Now, as I've mentioned, I flew out to Birmingham for a three-day trip. Actually, and that trip was split between both Birmingham and Montgomery. This was my process. Step one, I narrowed my search criteria to two different cities, both based in Alabama. I narrowed my search to Birmingham and Montgomery. And so when I flew out there for a three-day trip, the purpose of that trip was to decide between Birmingham and Montgomery. That was my only goal. And in fact, I ended up doing a lot better than my initial goal. I ended up not only deciding that I wanted to invest in Birmingham, but also identifying the specific neighborhood and the specific zip code that I'm interested in, which for me personally is the East Lake neighborhood of Birmingham. Now, that's not to say that everyone listening should rush out and invest there because I have my own risk tolerance that's, you know, personal to me. But I really like that neighborhood personally. And that's where I'm looking for my next rental property.

Anyway, my point is that I ended up doing a lot better on that trip than I had initially planned for. So I identified the particular neighborhood in Birmingham that I'm interested in. Now, again, as a result of narrowing my search to an extremely specific geographic constraint, there's not a lot of inventory. Like, the narrower you get, the less inventory there is. And that's both a blessing and a curse. The curse, of course, is that if you don't like what's out there, then you have to wait for something to appear on the market. or you have to work with wholesalers or dry for dollars or, you know, do some additional work to procure non-MLS activities. But, you know, once you've narrowed your search to a very specific criteria in a very specific location, as I have, I just checked Zillow right now for the number of houses that are for sale currently in the East Lake neighborhood of Birmingham.

There are 28. And when I further narrow that search to properties that have a minimum of three bedrooms, there are only four. Those 14 houses range in price pretty dramatically. The cheapest is 17,900. The most expensive is currently listed for 62,500. Obviously, the range represents a wide spectrum of condition of the property. So, where I am at this point in the process is that I have an agent. We're looking at properties. Again, because my location is so narrow, I've got to be really patient. I'm not going to buy a property just because it exists and it's for sale. I pass up a lot of potentially good offers in order to wait for the one that's great. But I know exactly how we are going to proceed once we go under contract for a property. Right now, we're looking at properties and we're calling the listing agents and we're making unofficial offers, not going through the hassle of writing up an official offer, but calling the listing agents and talking to them about the property and making unofficial offers just to test the waters and see how low they'll go

and see how motivated the seller is. And in the majority of cases, a lot of times what we find is that the seller's hands are tied. There was a property, actually, that we contacted the listing agent. The agent said, hey, you know what, this house is a potential short sale, but it has two lien holders. And quite frankly, the probability that that second lien holder is going to allow the short sale to move forward is fairly low. so there's a pretty good chance that this house will end up in foreclosure. So in the areas where I invest, I end up dealing with a lot of stuff like that. And so it just requires a lot of patience and a lot of casting the line out there, a lot of phone calls to the listing agents, most of which are made by my, in the case of Alabama, those phone calls are made by my agent rather than by me, which is awesome because that's one less thing I have to do.

And then once we get to the point where the listing agent says, yeah, the house is still for sale, go ahead and write up an offer. The number that you floated on the phone sounds good. So yeah, go ahead and write up an offer and I'll present that offer to my client. Sweet. When that happens, and then assuming that the client accepts the offer and signs it, then we're under contract. And that's when the real work begins. Because once we're under contract, then it's time to line up the inspectors to get the general contractor out. there and that's why it's important to have a very long due diligence period, which in my contracts are expressed as the buyer's general right to terminate. If and when I go under contract for a property in Birmingham, I'll fly out there myself and I will walk that property with the inspector. What I would do is I would call an inspector from Las Vegas, secure a date, secure a time, and then even if I only had one day, I would buy an airline ticket, fly out there the evening before, be there for that morning and that afternoon and fly back.

that evening. I would make it a 24-hour round trip if I was time-limited and only had one day. But I personally would be there with the inspector as he walked the property. Now, in my case, that's a personal decision. And there are a lot of investors who don't do that. And as I just shared, you know, when I was hiring inspectors from New York for houses in Atlanta, I didn't do that then. I didn't fly for a day for that inspection. But, you know, if that inspection had gone well and it was time to escalate to the next step, which was hiring an independent GC, I might have flown back for a day for that. Like, I don't want to purchase a property that's completely side-on-scene. I would like to lay eyes on it before I buy it. But there is absolutely no point in flying out there

and if you're not under contract. Because if you're not under contract, you're just wasting your time. You're just looking at a bunch of prospects. There's absolutely nowhere that those prospects are going. And until you're under contract, don't waste your time going out there. You know, I out once just to identify the city in the neighborhood that I wanted to be in, and that is the only time that I need to be there until I'm under contract on a property. So that is how I look for properties from out of state. It's a lot of looking at online listings and a lot of phone calls with the listing agent. That's what I did. But to the other aspect of your question, which I assume that there's part of you that's asking, all right, well, what should you do? The number one piece of

advice that I would give is geographically narrow the area that you're looking at. It is far too broad and overwhelming to say, I am interested in Cleveland or Cincinnati or Pittsburgh. Those are massive places with millions of people. But if you can narrow that to say, you know what, I am interested specifically in the 452-3-1 zip code of Cincinnati. And actually within the 452-3-1 zip code, I am only interested in three-bedroom, two-bathouses in the Mount Healthy City School District that are not located on a busy road and that are priced at $80,000 or less. All right, once you've narrowed your search criteria to that small of a basket, you can easily become an expert in that micro-nitch.

And then what happens is because you are looking every, day, or at least several times a week, at online listings within that very, very narrow niche of a search, you will see all of the movements. You will know all 14 houses that are for sale that fit that criteria, and you will have gone through them one by one and said, yeah, or nay. So you'll get to know that space very well. And then what happens is that when a property appears, a new listing appears, that is dramatically underpriced or that's a great deal or that's in really good condition relative to the price, you'll spot that right away because you know that area so well, because you've been following it closely for months.

This is how I bought house number four. I identified, again, a particular zip code. I knew exactly what type of house I wanted within that zip code. And then every day for seven months, I checked new listings in that zip code for that type of property. I realize that sounds, you know, when I say it on a podcast, it may not fully communicate what that experience actually was. Imagine checking a particular zip code every day for five and a half months and still nothing good has come up. I was seeing three-bed, two-bath properties in that area that were being listed for around 170,000, 160,000. But that was too high. I knew that if I could see something, a three-two, that was listed for about 100 to 110. and was also in pretty good condition.

I knew that that was what I wanted. But imagine every day, day in, day out, I'm checking, I'm checking, I'm checking, I'm waiting for something. Nothing, absolutely nothing. After five months, I think a lot of people would have given up. And I kept doing it. And it was insane. I mean, the definition of insanity is doing the same thing over and over,

expecting a different result. And I was absolutely meeting the definition of insanity. But it worked. Because after seven months of doing that, I finally spotted a listing and I spotted it on the day that it came to market of a property that was in excellent, well, not excellent condition, but good enough condition that was priced at, I think it was, what did I buy it for? 112, I think was what I ended up buying it for. And so that came about by having incredibly specific knowledge about a micro niche area. So that is the number one tip that I would recommend, particularly if you're searching from out of state, the further away you are, the more important it is to niche down because expertise in real estate happens by having an informational advantage. And that informational advantage comes from narrowing your niche to the point where you are the expert in that particular area. You know every three two in that zip code on the those blocks. That's the number one thing that I'd recommend. And the number two thing is,

when you do go under contract, give yourself a long contingency, a long inspection contingency, give yourself a minimum of 10 business days, not calendar days, but business days. 10 as a minimum, ideally 15, because you will want to make sure that you have enough time to get multiple third-party independent sets of eyes out there. That way, if you get bunk or incomplete information from one of the contractors that you sent out there, you can hedge against that by sending multiple people out there. But of course, that's going to take multiple days.

And it's going to cost money. You're going to have to pay these people. That's the cost of doing business. I hope that answers your question. Thank you for asking that. That's a really good question. And that concludes today's show. So coming up on next week's episode

is an interview with Scott Harrison, the founder of Charity Water. He describes the experience of starting an incredible nonprofit, it, taking it from an idea to this massive success that it is today. If any of you are interested in starting your own nonprofit organization within your early retirement, you will not want to miss this interview. So that's coming up next week.

By the way, I wanted to throw a request out there. So I got this idea. Do you remember the, I think this was episode 104 maybe, but there was a caller who mentioned that she and her husband saved, they lived on one income and saved the other. and as a result, they were able to pay off their student debt and say 40,000 towards a down payment on a house. So we aired that in a recent Ask Paula episode. And it got me thinking, there are lots of people who call in with questions. I would love to hear from some of you who have success stories that you would like to share.

So if you have a success story and you would like to share that with this community, please go to a four. anything.com slash voicemail and leave your success story. We will pick some of those and play them at the end of some of these upcoming Ask Paula episodes because I think that it's important to celebrate our wins. Talk about what your goal was, what worked, what didn't, how long it took, why you did it, what this means to you. Those stories are so important. They're inspiring. They're motivating. They're educational. So please, if you have a success story that you would like us to play on the air, Go to afford anything.com slash voicemail and leave it there. Also, I'd like to congratulate the three winners of our book giveaway for the Code of Trust.

Alex from Indiana, Kelsey from South Carolina, and Michael from California. Congratulations. You have all won a free copy of The Code of Trust, the book written by Robin Dreak, who is our guest on episode 101. So congrats to all of you. And for everyone else listening, follow me on Instagram at Paula Pant, where I will be posting more contests, more book giveaways, more general snippets of wisdom, ideas, thoughts, that sort of thing. Thanks again to everyone who entered. My name is Paula Pant.

You can find me on Instagram at Paula Pant. Thank you so much for tuning in. I'll catch you next week.