January 9, 2023

Today, we're going to talk about the BRRRR method, and why you should add another step to the BRRRR method. We're going to talk about a new concept that I've never seen anybody ever talk about before, which is called equity stripping. And we're also going to talk about another concept that I've never seen anybody talking about before, which is a wherewithal pay problem. Let’s begin!

What is the BRRRR Method?

The BRRRR Method has been one of the most common wealth-building strategies out there when it comes to real estate. You are able to buy a property below FMV, add value to the property, get it rented out, potentially cash out refinance and get all of your money back to do it all over again.

Add step to the BRRRR Method

First, we must understand that when we buy a property, the timeframe between when we buy it and when we start renting it out, those costs have to be capitalized and depreciated. It's just a fancy term for you're not going to get your tax benefit immediately. You're going to get that benefit over a lifetime of the property. 

If you depreciate something you don't get the benefit immediately - you get it stretched out over a period of years. And you also have to pay this thing called “depreciation recapture”. 

When you're able to expense something, you get an immediate tax benefit for expensing that and you don't have to pay depreciation recapture because you never depreciated anything - you expensed it. 

Let me show you an example: Let's say I bought a property June 1st and the property was ready to go August 1. I started renting it out August 1, and in between when I bought it and when I started renting it out, I had $30,000 worth of rehab costs. Well, if I'm able to do enough rehab, get the property permitted, get the water running, get all the utilities hooked up and get the property rent ready on July 1st (i.e. listing on Airbnb, VRBO or put a “for sale” or “for rent” sign out front), then my expenses might look like this

• I have $15,000 in costs before July 1st, and

• I have $15,000 of costs after July 1st

What does this mean? Well, this $15,000 before the property's rent-ready is going to be depreciated over the life of the asset and can't do anything about those costs. However, those costs that we incur after the property is available for rent can be expensed immediately.

Okay, so we talked about these costs, we're not going to get this benefit. For 27 and a half years, we're going to do $15,000 divided by 27 and a half, that's pennies, whereas this $15,000 that we spend after the property is available for rent can be expensed immediately against our marginal tax bracket.

Let's say I'm in a 40% tax bracket. I'm going to get that benefit of $6,000 in tax savings in this year as opposed to having to capitalize and depreciate it which I don't get as much of a benefit. 

This is just adding a simple extra step to the BRRRR method. 

Now, can you say the property is available for rent but it's still on studs or it's still getting framed? No, the property has to be ready for rent. But assuming you're able to do that, you're able to get all your permits and your occupancy,  this is a great strategy by adding another step to the BRRRR method. 

Equity Stripping

The next concept we're going to talk about today is what's called “equity stripping”. 

Equity stripping is where you have tons of equity in some of your properties (rental properties or primary home investment properties). The more equity you have in properties, however, the more appetizing you are to potential lawsuits, creditors, debtors, etc. 

Oftentimes, we want to get the equity out of those properties so that they're not as appetizing for people who want to come after you personally. This typically involves doing key locks or cash out refinances, and getting the value out of those properties. In the event of a lawsuit, there's really nothing there for them to come after. I would recommend stripping the equity out in your personal name rather than a business because you're going to get better rates and terms and financing conditions. 

If we have property that's been heavily appreciated recently the last couple of years, in areas like California, Florida, or the Smoky Mountains, consider removing the equity out of those properties and placing that equity in newer properties to spread out risk. 

I did a recent podcast a couple of weeks ago on the idea of how leverage impacts real estate and how actually having five properties putting 20% down on each rather than having one $100,000 property is actually more safer because you're spreading out your risk over five properties as opposed to only one.

Wherewithal to Pay Problem

The last conversation that gets brought up with this is what I call the “wherewithal to pay problem”. Here’s how it comes up with the BRRRR method:

• Suppose you bought a property for $100,000 putting 20% down, you put $100,000 into it, and now the property is worth $300,000. 

• You then take a loan against the $300,000 value at 80% LTV for a total loan value of $240,000. 

• The property then goes up in value to $500,000 years later and you decide to take another loan out against it 80% LTV of $500,000 =$400,000. You then decide to sell the property less than a year later for $500,000

This is where the “wherewithal to pay problem” starts:

• You sold the property for $500,000 but after paying realtor commissions of $30,000, the bank loan of $400,000 and other closing costs, you are left with $65,000 cash.

• You have a capital gain taxed at 20% on the difference between $200,000 and $500,000 = $60,000 capital gain

• All of your gross proceeds from that property sale will go towards your tax bill

Do not get stuck with this problem by tax strategizing around this event. You can 1031 exchange your property, accelerate depreciation and do things that are going to lower your tax bracket so you're not stuck with this wherewithal the pay problem.

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As you can see, it pays to use the New BRRRR method as part of your long-term investment strategy. By accounting for equity stripping and the wherewithal to pay problem, the New BRRRR method opens up new opportunities for tax strategy and cashflow.

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