Imagine you’ve placed an offer on a property that needs a bit of love. You know your strategy is to use the BRRRR (buy, rehab, rent, refinance, repeat) method. This method allows you to maximize the use of your cash and, essentially, acquire assets repeatedly with your original pool of funds.
Brandon Turner wrote a great article on the fundamentals of BRRRR. If this is the first time you’ve heard of this method, I suggest reading Mr. Turner’s article prior to continuing with this one.
The majority of our clients come from Do linsk site. Not surprisingly, this leads to us discussing and strategizing how to maximize the BRRRR with clients.
It wasn’t until recently, when speaking with a new client of ours, that I realized we can consistently save clients who are pursuing the BRRRR bookoos (American slang for French term beaucoup) of money by providing one piece of advice. And before today, that one piece of advice has not yet been discussed among BRRRR advocates.
Download Your FREE copy of ‘How to Rent Your House!
Renting your house is a great way to enter the world of real estate investing, but most first-timers (understandably) have a lot of questions. Fortunately, the experts at Do linsk site have put together a complimentary guide on ‘How to Rent Your House’. All the skills, tools, and confidence you need to successfully rent your house are just a mouse-click away.
Introducing the BARRRR
This is some next-level stuff. New Age innovation! I say with 100 percent confidence that the BARRRR method will save you thousands of dollars in taxes. So listen up!
As I mentioned above, the BRRRR method maximizes use of capital, but it is actually a very poor tax strategy for a number of reasons. So to enhance the BRRRR method, I’ve added an “A” for a key step I feel the standard BRRRR method is missing.
The “A” stands for Advertise.
Buy, Advertise, Rehab, Rent, Refinance, Repeat
That’s right, adding advertising is a relatively simple yet highly effective improvement. Consider it a much-needed addition that has the potential to save you gobs of tax dollars, perhaps allowing you to take your spouse out to that super high-end restaurant downtown (send me a thank-you card afterwards!).
Why Advertising is Critically Important
What most real estate investors don’t fully understand is that the date you place your property “in service” matters immensely from a tax perspective. It’s the difference between writing off the majority of your rehab costs and being forced to capitalize and depreciate those costs. More on that in a minute.
The IRS says that when a property is ready and available for rent, it’s considered to be “in service.” And once the property is “in service,” the costs incurred are considered operating costs—rather than what I like to call “get ready” costs.
To repeat, there are two key components to placing your property into service: it must be ready and available. The key part that many investors miss is the “available” part. You’d be surprised as to what properties will qualify as “ready” in the eyes of the IRS. But if you never advertise the property for rent, you never make it available for its intended use. As a result, the property is not placed in service.
So if you don’t advertise the property for rent, the property is not deemed “in service,” and all costs incurred prior to the “in service” date are therefor considered “get ready” costs. Let me explain why “get ready” costs will significantly reduce your after-tax returns.
The Tax Disadvantages to “Get Ready” Costs
There are a myriad of rules surrounding repair and rehab costs. I won’t go into great detail in this article, but I have written extensively on these rules in the past, both on Do linsk site and my own blog. For this post, I’m going to explain the overarching strategy that pieces all the rules together to maximize your tax position.
Get ready costs are costs incurred prior to the property being “in service.” These costs can include travel, research, inspections, gut rehabs, materials, labor, painting, etc. Basically, anything that you can think of putting into a rental in order to place a tenant can be considered a “get ready” cost.
You want to minimize your “get ready” costs, and we help our clients strategically plan their rehabs in order to do so. The reason we want to minimize “get ready” costs is that we are forced to capitalize and depreciate these, generally over 27.5 years.
Capitalizing a cost simply means that we add that cost to the basis of the property, rather than immediately expensing it. Any cost that we add to the basis, we assign a depreciation schedule to. We then write off, via depreciation, a certain amount of the capitalized cost each year.
For example, suppose you made a $27,500 improvement to the structure of the property. We would capitalize that improvement (increase the basis of your property by $27,500), and then depreciate the improvement over 27.5 years. So each year, we get to write off $1,000.
Can you see why that’s a bad thing?
We are only writing off $1,000 every year for 27.5 years! You’ll be old and grumpy by the time you fully recover the cost of that improvement.
That’s the first major issue with being forced to capitalize an improvement—we recover our costs over a long period of time rather than writing it all off today, significantly reducing our immediate taxes.
The second, huge—but rarely addressed—issue with capitalizing and depreciating costs is that when you sell the property, you have to pay a tax referred to as “depreciation recapture” (formally called unrecaptured section 1250 gain). This is a tax assessed on the depreciation you have claimed over time. The tax ranges from 10–25% depending on your tax bracket. If you think you can avoid the tax by not taking depreication, think again. The IRS will impute depreciation that you “should have” taken and tax you anyway!
So to recap, when we have “get ready” costs (those incurred prior to the property being placed into service) we not only have to slowly write those costs off over time via depreciation, but we also get nailed by depreciation recapture on that depreciation when we sell.
Tax Advantages of Operating Costs
Unlike “get ready” costs, operating costs can be fully deducted in the year they were incurred. Additionally, there will be no depreciation recapture tax to assess on operating costs when the property is sold, because we wrote the costs off—we didn’t capitalize and then depreciate those costs.
As you can see, classifying costs as operating costs comes with two huge advantages. First, we fully recover the cost during the current tax year because we get to write if all off. Second, we avoid paying a potentially devastating 25% tax on the depreciation of those costs because we’re not depreciating them at all.
But here’s the kicker: operating costs can only be incurred once the property has been placed into service.
Now you can see why I’m advocating for the BARRRR method instead of the BRRRR method.
By advertising the property for rent prior to starting your rehab, you have met the IRS’s “available” requirement (remember, to be “in service” it must be ready and available). Now all you have to meet is the “ready” part.
What constitutes “ready” for rent? As always, it depends and can be a myriad of factors. If you are running a full-gut rehab, your rental will not be “ready” until substantially all of the rehab is complete. IRS standards also indicate that a Certificate of Occupancy is a great indicator of when a property is “ready” for rent. However, this will be up to you and your CPA to decide based on your facts and circumstances.
I often tell clients that painting is always an operating cost unless you paint prior to advertising the property for rent. That’s literally the only time in which you’d be forced to capitalize the cost to paint.
Here’s an example:
Your painting costs $5,000 and you’re in the 25% tax bracket. If you advertise your property for rent prior to painting, you can deduct it in full this year. This will save you $1,250 in taxes. If you paint and then advertise your property for rent, you will have to depreciate the cost over 27.5 years, which will result in annual tax savings of $45.
Do you want to be reimbursed $1,250 today or save $45 a year over the next 27.5 years?
It is absolutely critical that you provide your CPA the flexibility to classify your rehab costs as operating costs as much as possible by advertising your property for rent as soon as you can. The tax savings may be massive.
It’s important to note that sometimes costs simply cannot be classified as operating costs even if they are incurred after advertising your property for rent. Costs that exceed $2,500 are almost always required to be capitalized and depreciated. So don’t think that you can advertise the property for rent and then deduct the cost of a new roof—that ain’t gonna happen.
How to Solidify Your Advertisement Date
Documenting the date your property is advertised is an important piece of this strategy. If you don’t have any hard evidence that you advertised your property for rent by a certain date, good luck defending yourself during an audit.
In order to document your advertisement date, you need to advertise via a third party. Think Craigslist or Zillow. You can also stick a “for rent” sign in the front yard and take a time-stamped photo.
Regardless of how you choose to advertise, you’re going to need time-stamped proof. Always remember to obtain proof.
And hey, maybe you decide to jack up the rent once the rehab is complete, so you re-advertise the property for rent post-rehab. I’m not saying whether you should or shouldn’t do this, but what I do know is that advertising pre-rehab is key.
Additional Success Factors
When undertaking a rehab, always obtain itemized invoices from your contractors. I mentioned a $2,500 threshold as being one pertinent piece of the puzzle. Don’t let your contractors give you invoices that aggregate all the costs. Instead, obtain as many itemized invoices as possible—a $10,000 expense can be broken down into ten $1,000 line items which may be deductible. I’d also argue that this isn’t just a tax strategy, it’s a best practice for any business.
Another factor for success (that should go without saying) is to be very careful who you take advice from. Some of our clients work with property managers, realtors, and lenders who love to give them tax advice. Unfortunately, this advice is often wrong and misleading, and can cost clients thousands of dollars.
You shouldn’t trust the legal advice of a CPA, and you shouldn’t trust the tax advice of a property manager. Question everything, and go to professionals who specialize in the specific areas.
I hereby formally request that all further mention of the BRRRR strategy should be changed to BARRRR (one more time, buy, advertise, rehab, rent, refinance, repeat). Let your fellow investors know that the added “A” stands for “Advertising.” It also stands for “tax savings”—indirectly, of course!
When you advertise your property for rent, and once the rental is “ready” for rent, you place it into service. When you perform a rehab after you have placed your property into service, you have a much better chance at classifying your rehab costs as “operating” costs (versus “get ready” costs). And when you can classify costs as operating costs, you stand to save a hearty amount in taxes.
I have one more article on deck about the BARRRR strategy, and it will take a critical look at the “refinance” portion. Many folks don’t know that the interest on a refinanced property may not be deductible. More on that next time.
Go make some money!
Have you tried this strategy? Let me know your own experiences in the comments below!