This is our number one reason for investing in short-term rentals. There are tons of articles about cash flow, cash on cash, appreciation etc. While these buzz words are exciting we can honestly say that our greatest return on investment has been the memories we’ve created with our family and friends.
It is the same reason we built a pool when our daughters were young. Sure, investing our pool fund into LTRs or additional STRs would have resulted in a great return but we would have delayed our pool purchase by a few years… A few years when your daughters are 3 years old is a big deal. I’ll take the years of memories in the backyard every time.
The same goes for our STR investing strategy. We have purchased STRs that we can use. This was an active decision.
Similar to our “pool investment” we don’t regret that choice in anyway.
Our philosophy is the memories we create are the best return on our investments.
The counter argument is that this type of STR is just a vacation home and one should focus solely on purchasing cash flowing investments and “rent” experiences. That strategy is completely viable. We understand that plan.
We would counter that there is something about owning your own place in a market that you enjoy. The experiences and memories are different when it is your place and you just don’t know until you do.
Maybe, the answer is to have a mix of both high cashflow STRs and personal use STRs in your portfolio. You can even purchase properties that fit both criteria.
Deciding which way to invest is a personal call and is influenced by your investing style. (Click here to learn more)
2. Cash flow
Positive cashflow should be the goal of a “successful” STR purchase. There are many ways to approach this strategy. A pure cash-flowing investment would be one that you do not use. You purchase this property as an investment with the goal of using the cashflow to purchase additional properties and to eventually supplement or even replace your physician income.
This is often the line that excites most people. The idea of replacing one’s salary with “passive income” can be attractive. That is why physician investors market heavily with this focus. “I retired from Medicine by investing in….. fill in the blank”
The thing about STR investing is it requires some work. This work is rewarded with increased revenue and significant tax savings (click here) when done right. However, it is not a get rich scheme and it is not passive.
If you are going to invest in STRs it helps to enjoy real estate and have an interest in this form of investing.
3. Tax Savings
2022 is the last year of 100% bonus depreciation and the 4th quarter is the best time to implement this strategy. There are tons of articles about this strategy (click here).
To summarize, if you can pass one of the material participation tests listed below then you can perform a cost segregation study and claim bonus depreciation.
(Note: there are 7 material participation tests, but the three below are the most commonly used.
- Spend 100 hours and more than anyone else managing your STR
- 500 hours of material participation (often achieved by managing a portfolio or a major project)
- Or substantially all… everything, cleaning, repairs etc
This strategy can be implemented to decrease your w-2 or 1099 taxable income by 20% or more of the property purchase price. That can result in significant tax savings for those in the top federal tax bracket.
There is one other “rental activity” rule to satisfy before using this strategy:
Brandon Hall CPA (The Real Estate CPA) writes: “Rental Activities” under Section 469.” Treas. Reg. Sec. 1.469-1T(e)(3)(ii)(A) provides an exception that states an activity is not a Section 469 rental activity if the average period of customer use for such property is seven days or less“. (click here to learn more)
If it is not a rental activity than it is not passive, as long as, you materially participate in management of the property and pass one of the above material participation rules listed above.
This means your average guest length of stay needs to be less than 7 days to consider your STR a non-passive activity. In addition, you need to keep your personal use to less than 14 days to use this strategy.
Let us evaluate a million-dollar STR (it just makes the math easier to follow)
You purchase a property for $1,000,000, self-mange with an average length of stay less than 7 days, your personal use is less than 14 days, you meet the Material participation rules, and perform a cost segregation study. Then what?….
The cost segregation study identifies that $250,000 worth of the property’s components fall into the 5, 7, 15-year category and qualify for bonus depreciation (25% of the purchase price).
After discussing with your CPA you elect to take 100% bonus depreciation of the cost segregated components for the tax year that you acquired the property.
If you pass one of the 7 material participation tests in managing your Short-Term Rental(s) you can take a depreciation expense of $250,000 resulting in a tax saving of $92,500 depending on your Federal tax bracket (example uses the 37% tax bracket).
Note: Bonus depreciation is subject to recapture on sale of the property. Real estate investors avoid this recapture by using a 1031 exchange when selling and then purchasing new property.
4. Wealth building
“Buy land, they aren’t making it any more” Mark Twain
“Ninety percent of all millionaires become so through owning real estate” Andrew Carnegie
Owning real estate with a buy and hold strategy is one of the safest ways to build wealth.
There are two key components to this strategy.
- Purchase a property that produces enough cashflow to cover the mortgage and all expenses.
- Maintain reserves to cover any down turns to avoid selling at a loss.
Now, we can complicate the scenario with tons of what if scenarios… What if the property gets destroyed by a volcano, hurricane, earthquake, spontaneous combustion or the market crashes and the list goes on.
As physicians, we are hardwired to think of worst-case scenarios but this mindset can also hold us back.
It is appropriate to analyze your market and potential properties but don’t let fear hold you back. Purchase a good property in a nice location, get a strong insurance policy and hold.
Let’s analyze a pre-great recession purchase in December 2007.
The average 30 year interest rate was 6.34%
The property is an $850,000 condo purchased in December 2007 with a 30 year fixed at 6.34%.
Today the balance on that mortgage is $565,000 and the estimated value via comparable sales is 1.1million.
If this property only broke even over the last 15 years you are still winning. This would not be considered a “good” purchase because it does not meet a cash-on-cash of 30% but it is still growing wealth.
The goal when investing in STRs is positive cashflow but you can see that even a breakeven property will grow wealth. The key is to follow a buy and hold strategy.
There were many years that this 2007 purchase was “upside down” and could have easily been sold at a loss. Purchasing with the ability to cover expenses and holding allowed this property to grow wealth while guests paid the mortgage down and all expenses.
Anyone purchasing an STR should have a strategy to cover expenses in case of downturns. The ultimate goal is to grow wealth and avoid selling at loss.
The standard retirement teaching is max out your 401k and then invest additional savings in a taxable brokerage account. But this is not the only way….
Investing in real estate is a great way to diversify your portfolio. If you have already maxed out your 401k, sep IRA etc consider investing your additional savings in real estate rather than a taxable brokerage account. You can choose any aspect of real estate. Our bias is short-term rentals.
Short term rentals are a great way to achieve cash flow, save on taxes, build wealth and diversify your portfolio. But in the end, the greatest return on investment is the memories you create with your family and friends while investing in short-term rentals.
Practice the Carpe Diem MD lifestyle and seize the day
Carpe Diem MD
Enjoy your Journey to Financial Freedom