Episode 12: Make More Money With The Tax Law

Description:

Understanding the new tax code not only allows you to pay less taxes, it may also encourage you to make more money. In this episode, hear a real-life case study of how a real estate investor educated himself, paid less taxes and used the tax code to increase his income.

SHOW NOTES:

06:03  – How Did The New Tax Code Affect Real-Estate Investors?

07:45 – What Benefits Does A 1031 Exchange Offer?

14:47 – How Do You Determine The Right Asset To Buy?


Learn more about JP Newman by visiting http://www.thrivefp.com/

Transcript

Announcer: This is The WealthAbility™ Show, with Tom Wheelwright, way more money, way less taxes.

Tom Wheelwright: Welcome to The WealthAbility™ Show, where we’re always learning how to make way more money, and pay way less taxes. We’re going to have a really interesting conversation today about how the tax law not only shows you how to pay less tax, but actually encourages you, and sometimes forces you into making more money. And, we have a real life example. I have a good, good friend of mine who’s also a client and we’ve got a real life example of legally avoiding tax and as a result, actually making more money. So, my guest here today is JP Newman from Thrive FP. JP and I are longtime friends, and we’ve been working together. I’ve been giving him some minor tax advice for a number of years now. And JP, thanks for being here on the show, it’s great having you.

JP Newman: Oh, it’s my pleasure. Thank you, Tom.

Tom Wheelwright: So, JP, just if you would, just give everybody a little bit of your background, just so that they know where you’re coming from.

JP Newman: Sure. So, Tom, my company is called Thrive FP, FP is for purpose, for profit. We are based in Austin, Texas. I’m the CEO of the company. We’re a private equity firm that focuses on commercial real estate with a couple of divisions. A primary thing that we do is apartments, workforce housing, which is simply rents between 1800 and 1300 dollars. And we are also the ones who put up the equity. We also have an internal platform that operates them. So, we also operate them and we also do joint ventures with other developers and other operators where we put up the equity capital.

JP Newman: And, then we also have a debt division, which is hard money, so we lend money on first trust deeds on commercial real estate through our fund format. We’ve been doing this for about, I guess 10 years now, actually about 12 years now, my God, time flies. And Tom we found you at the perfect time to help us navigate the amazing growth that we had. We had about 10,000 units about three years ago on the multi-family side, and we’ve been actually in kind, of a sell off period. We’re now down to just under 4,000 units. Some of them, now we’re keeping longer term, but we manage about 180 million of investor capital on about 850 million dollars of real estate.

Tom Wheelwright: Well, there you go folks. These are serious real estate people. JP and I have been friends for a long time, and JP and his partner Adrian and their other partners, Jeff and Chad, and so forth. We’ve been working together the last few years because as the market has boomed particularly down there in the Southwest where you are JP. What I’ve seen with your projects, where you were expecting to maybe fill them up and turn them over in three, four, five years, they’ve in some cases turned over in a year and a half.

JP Newman: Yes.

Tom Wheelwright: And, in fact, that’s actually … So, JP and I were talking earlier about this situation we had, well you had. But, I always think of it as we. Okay …

JP Newman: Choppy waters and out again.

Tom Wheelwright: With clients, it’s always a “we”. We had a situation where you guys had an amazing project. I mean, frankly, amazing. Because, you just bought it like what, two years ago?

JP Newman: Yeah. By the time we sold it actually it had extended just over two years.

Tom Wheelwright: So, just over two years and they developed this amazing project that had what four properties in it?

JP Newman: Yeah. So, we acquired it, it was in a suburb of Dallas, Texas. We had acquired 1062 units in an area that we identified was a rapidly transitioning area. And we took the last four ugliest dogs, really rough neighborhood. And we spent quite a bit of money redeveloping all of those properties, all of those 1062 units. And, it really was a change, the project had a horrible reputation. A rough crowd in there, lots of stories, but basically we were able through a team of about 50 people, execute a business plan. Not only for physical, bringing that whole building up for looks interior/exterior, but also changing the whole culture there. Instilling all these social programs to support the community, and we really kind of re-tidied the whole building. We did things from financial literacy, education, back to school bags, that were co-sponsored by Target.

JP Newman: So, we just kind of changed the entire energy, and occasionally you just do it right, and we really hit our plan and exceeded our original business plan, and just did it faster. And, we just did it faster. And, again it helps when the market and the winds are blowing in your direction.

Tom Wheelwright: Right, the market cooperated, for sure.

JP Newman: It certainly helped.

Tom Wheelwright: The market cooperated as interest rates came down, and cap rates came down, and so forth. So, let me just kind of set the scenario here. So, here’s this project, and we’ve been working on it, actually in reducing the investor’s taxes over the prior couple of years as you guys redeveloped it. And, then a lot of success there. But then it came time to sell the property, and we had actually, in part because we had a new tax bill that had an impact on this, we were looking at a fairly sizeable tax liability, weren’t we?

JP Newman: It was crazy. And the thing was, which I guess, Tom you’ve talked about this, how governments can change policies. Yeah, we had got in a contract in September of last year, and we never even had considered the fact that the new tax law would go backwards, as opposed to going forward. So, it really wasn’t … I call it my New Year’s … My unpleasant New Year’s realization. I sent you a one line email to you, Tom. I said, “Tom, this new tax law isn’t going to affect us right?” And, you said, “JP, It is going to affect you.” Which took ordinary capital gains and brought it up to the new rate, so we went overnight on January 1st, we went from 20% to 38% on a very large transaction. With huge tax consequences to it.

Tom Wheelwright: Yeah, so, of course. I’m thinking, “Wow, this is an opportunity, right? This is an opportunity to avoid taxes.” So, normally, when we think about avoiding taxes on a sale, we’re thinking about a 1031 exchange which, another word is a like kind exchange. Meaning we sell the property and we buy a new property, we had a couple of challenges here, one is that your investors didn’t want to buy a new property. And, the other challenge was, you didn’t want to buy a new property.

JP Newman: Correct.

Tom Wheelwright: So, the first thing we had to deal with, of course, is even if we could get … And the tax we’re just trying to avoid is not the investor tax, because they’ve decided they want the cash, so what we’re trying to decide is, okay how do we take all of these gains that you guys have earned, what we call a carried interest. All of these gains, how do we get them, and actually turn them into a 1031 exchange. So, when I suggested we do a 1031 exchange, do you remember your reaction?

JP Newman: Yeah, I wanted the money.

Tom Wheelwright: You were in the long, you were in the long, pal. Your partners wanted the money, everybody goes, “No, let’s just take the money.” And, I’m going, “Okay, let’s talk about the numbers here.”

JP Newman: Hey Tom, one point I want to make to, that I think is really important, for the investors really the new tax law didn’t affect them. Because they were still getting treated as capital gains. It really as most people may or may not know, what the new law really affects is the promote, or what’s called the promote or carried interest. So, it was really easy for the investors, because it really didn’t affect, January 1st had no effect, on them. It really was affecting us as the carried interest sponsors of the deal.

Tom Wheelwright: No. That’s a good point, and so, we’re scrambling, we’re looking at the law and how do we, can we avoid the carried interest, and so what we finally decided was, I said, “Look, this is so much money that you guys really ought to consider, I think we can figure out how to do it.” So our job is to figure out how to do it, and I said, “I think you guys really ought to consider it.” And, you guys if I remember right, were just really worried about finding a decent property to buy.

JP Newman: Well that’s true, Tom. And, I think the other thing, and you’ve been telling us this for a long time, but especially when you have a market like this, where you have a lot of capital, you have cap rates that are compressing, what you don’t want to do, you probably know, I’m sure you’ve spoken about this. Where sometimes you get so into the taxes, as worrying about your tax bill, that you kind of forget the big picture.

JP Newman: So, my fear really was, maybe we’re trying too hard because if I buy a property today, and then interest rates rise and the market changes and cap rates go up, if I buy it at basis, and it changes, well that’s a real fear. So, if I saved 18% on my taxes, I just didn’t want to be pound wise and penny foolish is what I’m trying to say. Where I became so tax focused, that I was losing sight on the big picture of taking good care of my money, and making sure that, that money continued to grow. And that’s really, it took me a while to struggle with, particularly in a market like this when we’ve had 10 years of ongoing prosperity. Everyone’s waiting for the next shoe to fall, yet it keeps moving forward. It’s a time, where I dare anyone to predict, everyone’s got an opinion, but no one knows where we’re heading going forward.

Tom Wheelwright: No. Of course, and totally a fair comment. We as we did JP, we never want the tax tail to wag the dog. So, if you have a change in cap rate of course, for everybody, it’s really how you value a property, but what happens is, if the cap rate goes up, you can lose a lot of value really, really fast. So, what we didn’t want to do, of course, what JP and his partners, didn’t want to do, they didn’t want to get that 18% tax benefit. Which was if I remember right, a few million dollars.

JP Newman: It is.

Tom Wheelwright: You didn’t want to get a few million dollars tax benefit and then give up a lot more millions dollars of financial benefit. Right?

JP Newman: Exactly. Exactly.

Tom Wheelwright: Okay, so, let’s lift the shoot up, so what’d you do?

JP Newman: Well, I did a lot of exploring. First of all, I tried to convince you nine different ways, I resisted you, of course. And I threw at you all these wacky other ideas, that really didn’t work and they were very sloppy. But, then I think after it, and then I started looking at and started talking to brokers, and trying to figure out if I am going to do this 1031, how can I address that where I am buying good real estate, and not just doing it for the taxes. And it was a journey, I spoke to a lot of brokers, I looked at tons of deals. And I think what finally brought me comfort, and where we wound up was if you’re trying to time the market in a short term deal, like trying to get out in two or three years, and hope that the market’s making, then you need to go up. That’s kind, of a scary proposition, because I say it’s 50/50.

JP Newman: But, if you start looking at things, here’s what we got going for us. Tom, you and I have discussed this. Right now, we still have historically low interest rates where you can borrow money under 5%. And you can get long term debt and money is readily available from banks. So, then it occurred to me, if an apartment, let’s say a historical interest rate is eight, and we’re below five, there’s something incredible there. And there’s still positive arbitrage between cap rates and interest rates, which simply means that your interest rate is so low right now, you can still make a spread on your leverage, and that’s interesting. So, what do you do with that?

JP Newman: And, I think for us, what occurred to us, is we’re really good at this, we operate apartments, we know what to do. But, we have to change our mentality, and say what would we want to own for 10 years, and not worry about it, even if it goes down in value. Let’s say the cycle changes and it goes down, this asset is in the right location, something we can manage, something that we want to own, that we believe in 10 years, or that in this cycle, or the next cycle, is an asset, a pride of ownership asset that will likely go up because it’s in a core location where we believe there will be job growth and population growth. At one point it will be worth more, we just don’t need to time it perfectly.

JP Newman: And, when I changed that mindset to a long term mindset, and then fixing in your debt, we got a 12 year loan, and once you kind of, starting changing that mentality, you’re not worried about am I speculating or am I not speculating. We found the perfect asset that kind of … We got clear with what we wanted, and we went out and found it. Which, was great.

Tom Wheelwright: What I want to point out, is what we talked about at the beginning of the show, was the tax laws show you how to make more money while paying less tax. So, the end result here is, you guys ended up paying no tax, and you were able to … It literally forced you, or encouraged you. Let’s say encouraged you, instead of forced you.

JP Newman: Yeah.

Tom Wheelwright: It didn’t force you, you still could have paid the tax if you wanted to.

JP Newman: We talked about it, yeah.

Tom Wheelwright: It was such a strong encouragement, that look, let’s go and see if we can find a property. And, you guys, what I think is fantastic, is you guys found a great property, as a result.

JP Newman: We did, we did.

Tom Wheelwright: And, here’s my question. Would you have even looked for that property, had it not been for the tax consequences?

JP Newman: Absolutely not, absolutely not.

Tom Wheelwright: So, this is my point is that, that the tax law actually shows you how to make more money. It’s not just about reducing your taxes, it’s about, “Wow, if I do what the tax law encourages me to do, and I do it right.” Course, I know you guys did all your due diligence, I know you guys looked at tons of properties, you did all of your research. Like you said, you had to shift your mind a little bit. But, as a result, you guys are … This is only a few months later and you guys are already cash flowing this property, aren’t you?

JP Newman: We are. Part of that long term thing is buying the right asset. I think we found exactly what we wanted, which was essentially, we found 200 units in a good neighborhood. I’d call it a really strong neighborhood, a highly desirable neighborhood. And we found a mid-80s building that was kind of chugging along and doing just fine. I’m so used to buying value add or distress, and turning on the magic. And this one really didn’t have that story. It really was a building that was in pretty good shape, with a nice tenant base, and always stays full based on, it’s location. And, it’s in Austin, Texas, which means it’s 20 minutes from my office in one of the fastest growing cities in the United States.

JP Newman: So, I had to change my mindset Tom. Because, you know I’m such a value add guy, it’s hard for me, as you know, to pay quote/unquote retail. So, this is one of the talks that really helped me, because in a way, I wasn’t paying retail, because there was a such tax cut with it. But, then once I actually got into it, what I found myself is, we bought it at, let’s call it just under … It turns out because the income kept rising, while it was under contract. We bought it for about a 5.7 cap, so what that means is, and we put it on this 12 year loan. I can’t tell you exactly what we locked it in for, it was under five, and we got seven years of interest only.

Tom Wheelwright: That’s fantastic.

JP Newman: Which, to me is incredible. So, now it’s got seven years of interest only, which only magnifies my cash flow from day one, which has been incredible.

Tom Wheelwright: That’s amazing. I think that’s fantastic.

JP Newman: Yeah. So, what that’s meant for us Tom, is already from the first 90 days of ownership, we’re already hovering at a 7% return, and because we’re really good at what we do. So, that 7% came from just handing me the keys, so now I’ve gotten tax-free, now that money is earning 7%, which if I had taken it as cash, I would have been happy getting 7% on that money, but now there’s upside. Because we see little areas, like for instance adding dog parks. We have a lot of people with pets, that really want backyards. So, we’re going to put washer and dryers in several units, we think most of the units. Because we know it’s an amenity that the tenants have wanted that the last owners didn’t do. So, we see value in that, that will probably take the cash flow, you know I don’t know if we’ll get to 10, but we’ll probably get to eight or nine within the next 24 months.

Tom Wheelwright: Alright. I think that’s fantastic. I love this idea. So, you’ve been doing real estate your whole life, right? I mean, this is a family business, right?

JP Newman: It’s a family business, yes.

Tom Wheelwright: So, and you’ve seen lots of ups and downs, and I presume you haven’t always done 200 unit apartment complexes.

JP Newman: I started flipping houses.

Tom Wheelwright: There you go. So, here’s the key folks, you don’t have to be big, you don’t have to have 10,000 units to do this kind of stuff. You do have to have the right advice. I mean, the reality is, that we work pretty hard on, we do a lot of research, and we did a lot of figuring on how to actually get this thing done. But, when you have the right advice, then just recognize that the tax laws there, it’s not a punishment if you don’t make it a punishment. You know, I read this great book, called “The Obstacle is the Way.” And, I went, this is a really good example of that. This was an obstacle and we had this new tax law, and once we understood that the new tax law, instead of just holding a year, you have to hold it three years. So, one of the potentials was, we could look at okay, maybe what we do is we turn it into a property that we only hold for another year, because we needed to hold it, you know we had it two years, we needed to hold it three.

Tom Wheelwright: But, then as you start looking at it, it forces us, this is the great thing about the tax law, it forces us to look at, okay is there another way to do this? And, I think that’s really a tribute to you and your team, JP. Is, you know, you took that on, and I know I had to twist your arm a little bit. But you took that on, and you said, okay we’ll take a really serious look at this, because this is a lot of money.

JP Newman: Yeah, well you know, Tom. We did it as a team, and you were definitely part of the team. And it was painful, I mean, the surprise. I mean, the thing is we were already under contract, so we couldn’t back out of the contract, so literally it was like, I don’t know how many times in your life, you were going to be thrown a new set of rules, and the biggest transaction of your life, as far as net dollars coming to you, and literally … So, it wasn’t like we had a lot of time to think about it, and I think that we all just worked really hard together, and went through some pain. And we went through many ideas with you.

Tom Wheelwright: We did.

JP Newman: Of what to do, what not to do. Plan A, Plan B. And, I think it ultimately paid off, but I wouldn’t say it was easy. Especially when something like this is just kind of thrust upon you. But, I am really grateful to you and our team, for figuring it out. And, then up to a lot of hard work. But, this actually was a deal that had been on the market for almost a year and nobody had bought it because it was overpriced, like everything else in the market. And, everyone had kind of given up on this property because it seemed so overpriced. But, we were able to, by actually reaching out to the owner directly, and through a lot of conversations, got it to a price where it really worked for both of us. I think she had it overpriced, because I think she actually had some financials that were just wrong.

JP Newman: And, so instead of trying to make her wrong, we literally went into a collaboration with her, and got her to come down to a price that really, I think she got a really fair price, again I don’t think we stole it at all. I think it was very fair on both sides. But, in a way it was kind of this gift, because everyone else had given up on it, and it simply took, once you and I figured it out, it took a whole other conversation and a relationship and many calls with the seller. Again, instead of making it this tough negotiation, make it more like a collaboration, and just show her the mistake that she had, which ironically was an accounting mistake on her books.

Tom Wheelwright: Well, that’s what happens. Here’s the thing, the tax law basically got you thinking about this. You did some things you wouldn’t maybe otherwise have done. Just not because they weren’t the right thing to do, but rather really weren’t your typical model. And, just remind everybody that sometimes that obstacle, a change in the tax law. This was like, you know, the tax law changed on December 23rd, and you guys were already under contract when the tax law changed. Scheduled to close in January, right?

JP Newman: Exactly, January 17th was our close date, we’ll never forget it.

Tom Wheelwright: Right. So, the point is here is that this is something anybody can do. When we have these obstacles, we have these challenges, when it comes to taxes, when we’re looking at this tax law, the tax law actually in the end, showed us the way. The tax law showed us the way. And, JP, it’s been fantastic having you. I think there’s nothing more educational than real people having real life experiences and really thank you so much for sharing this. I know it was a bit traumatic, as we were going through it. But, it worked out.

JP Newman: It’s my pleasure, Tom. And, thank you, because I think what I’ve learned in the last couple years is how important it is to have the right person behind you to guide you. And, Tom, obviously you’ve been that beacon for us. There’s, accountants, and then there’s people who really understand the way. Everything you’re saying, it takes a great coach to get your team to play. And, you really changed our mindset of how we buy, how we operate, and how we sell. It’s such a critical part of this business. I thank you as well, for being such a great coach and helping us through these easy times, and then sometimes these really hard times.

Tom Wheelwright: Yeah. I appreciate that. So, really just remember the tax law is, it’s not just a series of incentives to reduce your taxes. It’s literally a road map to be making money. And when you get the education of understanding taxes, you understand how the tax law can work for you, and how it can help you make more money. You’re always going to make way more money, pay way less taxes.

Tom Wheelwright:

Announcer: You’ve been listening to The WealthAbility™ Show with Tom Wheelwright. Way more money, way less taxes. To learn more go to wealthability.com.

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