Cover Page

LANDLORDING
ON AUTO-PILOT

A Simple, No-Brainer System for Higher
Profits and Fewer Headaches

MIKE BUTLER

Wiley Logo

Landlording on auto-pilot : a simple, no-brainer system for higher profits and fewer headaches / Mike Butler.

p. cm.

Includes bibliographical references and index.

ISBN-13: 978-0-471-78978-9 (pbk.)

ISBN-10: 0-471-78978-X (pbk.)

1. Real estate management. 2. Landlord and tenant. I. Title.
HD1394.B88 2006
333.5’4068—dc22

2006005815

 

 

In loving memory of
“Pretty Girl”
Tammy Butler
September 12, 2004

Our phenomenal success in real estate investing came from the
support, confidence, enthusiasm, encouragement, commitment,
love, and sacrifice I received during 21 wonderful years with my
Pretty Girl, who allowed me to “break my chain”
to invest aggressively and safely.

Most investors can only dream
of having a life partner and soul mate so perfect.

LIST OF DOWNLOADABLE FORMS

Form A.1Application: Key Sign Out

Form A.2Application: Rental Application

Form A.3Application: Deposit to Hold with Application

Form A.4Application: Worksheet

Form A.5Application: Deposit to Hold after Approved

Form A.6Application: Employment Verification

Form A.7Application: Landlord Verification

Form A.8Application: Qualifying Poster

Form A.9New Tenant: Information Sheet

Form A.10New Tenant: Office Checklist

Form A.11New Tenant: Renter’s Insurance

Form A.12New Tenant: Rental Agreement

Form A.13New Tenant: Lead-Based Paint Disclosure

Form A.14New Tenant: Plumbing—Sinks and Drains

Form A.15New Tenant: Move In Inspection

Form A.16New Tenant: Welcome New Residents!

Form A.17New Tenant: All-Star Program

Form A.18New Tenant: Animal Addendum

Form A.19New Tenant: Cosigner Agreement

Form A.20New Tenant: Information Release

Form A.21New Tenant: Information Disclosure

Form A.22New Tenant: Landlord’s Additional Provisions to Rental Agreement—Section 8 Housing

Form A.23New Tenant: EPA Publication—“Protect Your Family from Lead in Your Home”

Form A.24Move Out: Package Summary Instructions

Form A.25Move Out: Head Off Eviction—Cash for Keys

Form A.26Move Out: Receipt of Notice to Vacate

Form A.27Move Out: Instructions for Tenant

Form A.28Move Out: Price List and Fees for Tenant

Form A.29Move Out: Survey for Tenant to Grade Landlord and Your Property

Form A.30Move Out: Summary

Form A.31Move Out: One-Page Move-Out Inspection

Form A.32Move Out: Office Move-Out Checklist

Form A.33Move Out: Return Possession Notice

INTRODUCTION

How I Operated 75 Rental Properties While Working My Full-Time Job as a Cop

Fellow landlord investors, my goal in this book is to share my successful investing programs with you. Not all of it has been pretty: I have an honorary PhD from the School of Hard Knocks. I developed the auto-pilot system of holding and managing solid rental properties to help me to manage dozens of rental properties while holding down a full-time job as a police officer. First, I want to share with you a little bit about where I’ve been, what I’ve done, and how I’ve ended up.

My mom and dad raised seven kids (including me) in a two-bedroom home in Kentucky (see top of p. xii).

I grew up just a few blocks from the world-famous Churchill Downs, site of the Kentucky Derby. Most of our neighbors were blue-collar workers, whose definition of successful was to land a good job, at a good company, buy a home and get it paid off, buy a riding mower, and retire. In our neighborhood and church, I don’t recall any doctors, attorneys, or certified public accountants (CPAs). Those folks lived on the other side of town.

Being the oldest of seven kids, I grew up with a strong work ethic. Pop worked at a slaughterhouse and proudly identified his occupation as a meat cutter. He would quickly let people know that anybody could be a butcher. Mom stayed at home and did a great job of keeping everybody fed, healthy, and in clean clothes. We had no clue that times were tough. We knew Dad worked hard; I admired him and wanted to be just like him. I got a paper route delivering daily morning and afternoon papers the summer after I finished eighth grade. This paper route was passed on to my brothers and sisters for almost a decade, and the money we earned allowed us to attend a private high school.

I did a short stint at a Winn-Dixie supermarket. I started as a bag boy and worked my way up to store manager. In November 1982, I had the wonderful opportunity to get robbed at gunpoint, with a revolver nervously shaking inches from my nose.

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This event, along with my experiences catching shoplifters (some violent), sparked my interest in law enforcement. I had never been satisfied with punching a time clock and relying on a single full-time job to take care of my family and me. While in high school, I took on odd jobs such as painting houses. In fact, for the first house I painted, I gave the elderly owner a quote of $60, which included painting the exterior from the foundation to the roof, all the windows, and all the doors. What a huge mistake that was, but I learned that lesson very quickly! For the next house I painted, I charged $400. At this time, I hauled all my supplies, ladders, bucket, and brushes on my Western Auto 10-speed bicycle with no brakes. I roofed garages and houses and took on small remodeling projects before I started driving. So, I guess I’ve always been a worker. You will need to be one, too, if you want to be a successful landlord, but it has sure paid off handsomely for me and for thousands of other landlords that I have trained or mentored.

I got married and when my second child was born, I pulled the plug on Winn-Dixie and changed careers, becoming a Louisville, Kentucky, police officer. I took a sizable cut in pay to become a cop: My starting salary was $17,000. I worked all the overtime I could get and worked off-duty jobs for extra income.

I also looked for something to supplement my police pension down the road. I read the classified ads daily, especially the “Business Opportunity” sections. Like many people, I was searching for a “magic pill.” I thought it might be found in vending machines or coin-operated car washes and laundromats. There had to be a simple, easy way to financial success.

My goal was to spend my time and energy (because I had no money) on something that would grow in value and income. I wanted to find a way to make money as an absent owner, a hands-off system. My gut instinct kept directing me to real estate and rental properties, but I didn’t have a clue how to get started and had no money.

In those days, the Department of Housing and Urban Development (HUD) advertised properties for sale in the classified ads of Sunday newspapers. I would drive by these properties in our 1986 Ford Ranger because I thought I could learn my market by seeing how much HUD was asking for the property. Then I would try to catch how much they sold for in just a few days or weeks. One Sunday in December 1990, a two-bedroom house on my old paper route showed up on the HUD list. I made an all-cash offer below the asking price although I had no cash. I just wanted the experience of going through the bidding process.

Low and behold, my bid was accepted!

Now what? We had about $1,000 in our bank account, and I got pretty nervous. I went to the Louisville Police Officers Credit Union and got a loan on my 1986 Ford Ranger, our old Monte Carlo, and an unsecured signature loan with automatic payments to be deducted directly from my paycheck. This still wasn’t enough to pull it off and do the rehabilitation needed. I resorted to my last resource—cash advances on several credit cards.

We bought the house for $17,000, spent $2,000 on needed repairs, and completed it all in 13 days. I hauled trash and debris to my police station dumpster at night. After renovating this little house, I went to Office Depot and purchased a generic rental application and lease agreement and put a tenant in the property. (I was lucky. This tenant is still with me today in his third home with us.)

I quickly refinanced this house, paying off the truck, car, signature loans, and credit card advances and ended up with $5,000 cash in my pocket plus almost $200 per month in positive cash flow.

Another pretty house, ready to go, went up for sale across the street, and I repeated the process without having to do any repairs except for changing the locks. Wow! This was awesome. At this point, my wife, Tammy, jerked my chain and said whoa! Being wise and conservative, she ordered me to ride it out for 12 months to see if there would be any “too good to be true” jinxes.

After a year, we had over $6,000 in our real estate savings account, and she allowed me off my chain. I continued buying rental houses. In the beginning, it was simply a lot easier to buy stinky, broken, ugly houses in need of repair than to pay for more desirable real estate. I would fix up my houses and rent them out. People thought I was nuts. I was buying properties at a good price; but I was not selling them. The rest of the world seemed to want fast cash now. I was just trying to build something that would double or triple my police pension in about 15 years.

I accomplished several interesting achievements by accident:

We started our first year with two properties, then added two more the following year, and I set a 1 year goal of one house per month resulting in eighteen properties purchased. After this, I planned to set an annual goal of two houses per month (twenty-four for the year). My good friend, local competition, and real estate education partner Jay Long and I had the opportunity to see Brian Tracy, the noted self-help speaker and author, in Florida during an annual real estate investor conference. Brian Tracy did a presentation on setting goals and challenged the listeners to “shoot for the moon! If you fall short and miss your goal,” he asked, “Are you a loser?” His answer: “No, you’re not a loser, you’re just a star!” Because of Brian Tracy, I adjusted my goal from twenty-four houses for the year to ninety-six houses—and rounded it up to one hundred.

Thanks to Brian Tracy, we did 85 deals that year and purchased over 50 rental properties. Absolutely incredible! It sure blew the doors off my original aggressive goal. Getting this buying machine cranked up was a huge challenge that involved getting past many train wrecks and potholes. I share many of those stories in later chapters in this book.

One of the keys that made this plan work was my knowledge that I absolutely had to develop efficient systems, tools, and resources. There was no other way to have a realistic shot at achieving my goals. Keep in mind that I had to attain huge goals with part-time effort while working my full-time job. I hired my first part-time handyperson for my fifth rental house and have never swung a hammer from that point forward.

I was buying property, managing rentals, and keeping it all together from a small office in the corner of our basement. My communication tools were a pager and a cell phone. My real office was on wheels, my police truck.

As a cop and an undercover detective, I developed effective people skills. I had a special knack for getting bad guys to tell me their side of their story, either in a tape-recorded or a written statement. An admission of the criminal offense, taken properly and legally from a suspect, is one of the best pieces of evidence in a criminal case. What is weird is that the offenders usually thanked me as they were led away in handcuffs. I retired from the police force in March 2000 and still get pleasant calls from bad guys in prison and on parole. (Their girlfriends and family members have quite a different attitude about me.)

Although I knew I needed to have systems for our little empire to grow safely and quickly, I had no mentors or a proven system to follow. We were on our own, blazing a new trail. This was a blessing in disguise because it allowed me to create and develop an auto-pilot landlording system without any baggage or critiques from experts and professional naysayers. I simply focused on results and objectives when developing this system and procedures.

Once I realized that real estate could be more than a painful hobby, I chose to kick it into high gear and achieve financial independence. Tammy and I lived off our police officer and nurse wages. We chose to let our real estate grow itself.

I had a “Failure Is Not an Option” attitude. I researched and looked for answers and solutions without much luck. Knowing I could only spend a few hours a week on real estate, we developed a lean, trim, efficient system in our investing business. Many folks in my town thought our business was a full-time operation. I am confident that if we had a way to compare the results, we would find that our part-time effort surpassed the gains of many full-time investors in my town.

One beautiful Saturday morning, I checked the voice mail messages on my pager and found it was full, with 30 messages. I retrieved all the messages and began returning phone calls at 8:30 a.m. while sitting downstairs in our lower level kitchen. From our oak table, I could see the pond and swimming pool out back, the ducks and geese, and it was a gorgeous spring morning. I returned those 30 calls while watching my pager dance on the table with more messages. Tammy brought me a tuna salad sandwich at lunchtime, and I continued returning phone calls, retrieving and deleting messages from the pager, and calling more folks. At 8:30 p.m., I still had a list of 30 people to call, and I finally realized that I had blown an entire beautiful Saturday because of our real estate.

This was not what I wanted from our real estate investments.

I wanted our real estate to give us a higher quality of life, not a noose around my neck.

Tammy and I decided to hire a part-time office person to help manage our properties. Kim worked about five hours weekly from our basement home office. What a relief! She pitched vacancies and did a lot of clerical work in her five hours. If she got behind on something, she would work longer.

Our records showed we operated 75 rental properties, plus the rehabs and the buying machine, before hiring a part-time office person.

This book shows you exactly how to achieve the same success.

In Section I, I introduce beginner basics to show you the fundamentals, attitudes, and some pitfalls and lessons I learned from the School of Hard Knocks. But I also explain the rewards that come with auto-pilot landlording to give you the motivation and patience to stick with it. I compare it with learning to ride a bike. You will get banged up and dinged up a bit, but if you keep working at it, you’ll soon be speeding along for the rest of your real estate career.

In Section II, we move to key steps in auto-pilot landlording with detailed and thorough coverage of the rental application and the procedure for screening tenants. Just imagine what your landlording life would be like if all your tenants were perfect tenants. That is my goal; I haven’t achieved it yet, but I’ve gotten close a few times. When you have great tenants, almost all the headaches and nightmares associated with landlording seem to evaporate. Your life can be awesome.

Next, I discuss how to polish your system and crank it up to the next level where you can actually begin to get more than 100 percent of your rents. This sounds impossible, but I explain how I did it with my properties.

And finally, you can get the set of forms for the landlording on auto-pilot system in PDF and Microsoft Word format. These forms are immediately available by downloading them from a web site.

Real estate has rewarded me in so many ways. Money or cash in your bank account is not the only measure of success. Success or reward is not at the END of the road. Success is the road; it is the journey. With success (and money) we have helped more people than I ever dreamed possible with my job as a cop. I have met great generous people from all over this wonderful country of ours.

We are blessed to have all these opportunities in our world. It is up to us to take action and make it happen for ourselves and for our families.

Good luck, happy investing, and congratulations on getting your hands on a copy of Landlording on Auto-Pilot.

ACKNOWLEDGMENTS

I am not a genius. I have been blessed with a wonderful supportive family and circle of friends. I have learned a boatload of powerful life-changing information from many experts in life and in real estate. I have taken these techniques and strategies from these folks and have tweaked and twisted them to fit into my program of investing and landlording.

Thanks to my dad, mom, brothers, and sisters who lit my fuse and started me on my journey to achieve more in life. Again thanks to my wife Tammy and our daughters, who kept this fuse lit and fired me up to be the best I could be for us.

Also, thanks to my mentor and friend John Schaub who introduced me to wild man “Fixer Jay” P. Decima of Redding, California, who recommended me to Richard Narramore, my editor at John Wiley & Sons. Richard encouraged me to write this book.

I want to thank Ed Melton; Jay Long; Rue McFarland; Layne Smith; Chris McCarty; my CPA, Mike Grinnan; my attorney, Harry Borders; Henry Schildknecht; Mark Lechner; Chris Dischinger; Nick Sidoti; Pete Fortunato; Ron Legrand; Brian Tracy; Jimmy Napier; Jeff Taylor; Albert Aiello; Jack Miller; Paul Bauer, Dave Halpern, and our local Kentuckiana Real Estate Investors Association (KREIA) and Kentucky Real Estate Exchangors (KREE) groups, along with all those from whom I begged, borrowed, and stole ideas that allowed Tammy and me to keep “Cranking It 24-7.”

SECTION I

BEGINNER BASICS OF
AUTO-PILOT LANDLORDING

This section explains how to keep the big picture in perspective. If you can keep the big picture in perspective, it will give you the patience and motivation to implement your systems and put your landlording on autopilot. Attitude, philosophy, and an understanding of what you really want from your real estate investments are critical parts of this process.

I screwed up often during the first half of my investing career because I didn’t have a clue about my final objective. Sure, I realized owning real estate was good, but I operated with that Nike attitude: “Just Do It.” Too many times, I bought property and did things that did not move me toward my ultimate objective. Call it busy work, or a waste of time. I may have made some immediate money or profit, but such activities stole my time from the quick pursuit and achievement of my investment goals.

These beginner basics are the culmination of the many lessons I have learned from speakers from all over the country, along with some tweaking of my own.

One of my instructors made the following comment I’ve never forgotten: Are you stepping over dollars to pick up nickels?

CHAPTER 1

My Amazing Discovery: A No-Nonsense Plan for Getting Rich in Real Estate

In my town in Kentucky, house values do not go up in double digits the way they do in Florida, California, New York, or Las Vegas. A good solid rental house averages 7.25 percent appreciation annually in my area. I like to be conservative in my real estate investment planning, so let’s say that a property I am considering investing in would only appreciate 5 percent a year over time. With an average annual appreciation of 5 percent:

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I’ll be the first to admit and agree that this is only on paper. You won’t find it in any bank account and you cannot buy groceries with it. But, if you can hang on to your investments, just like the beer cans on the rear bumper of the limousine at a wedding, you can crank some phenomenal numbers and grow your wealth unbelievably fast.

Let me immediately remove the “Pie in the Sky” aspects here, and start with the end in mind. Ask yourself, “Where do I want to land?” What is your objective of investing? I never thought about this when I got started, and it caused me a lot of grief. I was buying properties left and right because I believed they were good deals. But I neglected being clear about my goals.

Here’s what you need to know: “$______ in my pocket monthly would make me a happy camper!” Go ahead, fill in the blank. What is your answer? After working with investors all over the country, I can tell you that most investors are not like me. They are not greedy and have absolutely no desire to compete with Donald Trump. To my amazement, the number one answer here is $10,000. That’s right, over 90 percent of investors say, “$10,000 in my pocket monthly would make me a happy camper.”

The next part is a bit more challenging. How many of these properties would it take to dump your dollar amount into your pocket monthly? You also have to consider what kind of properties you would like to hold long term. Do you want a low-income area with high management and low appreciation, but excellent cash flow; or do you want nicer neighborhoods, less management, and less cash flow with wonderful appreciation and depreciation? This is your choice, not mine.

Let’s keep this idea going. Assume that you filled in the blank with $10,000 and you want the nicer properties in a nice neighborhood. Using the market in my town would mean that about 20 solid $100,000 rental houses paid for would dump $10,000 into your pocket monthly. Using “real world cash flow” and not the dangerous definition used by many real estate agents, each one of these properties will give you about $500 monthly.

Real world cash flow on a $100,000 rental house in my town:

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These are the numbers used for single-family houses in my town. Your town might have a different property tax rate or insurance rate and may have homeowner association dues. You must factor in all these ongoing expenses associated with owning the property. If you are investing in multifamily housing, apartment complexes, or commercial properties, you should include a vacancy factor for your market. With single-family houses, I don’t include a vacancy factor because I want my tenants to stay forever. Many of my single-family properties still have the original tenants today, years later. I’m not in the hotel business, and you shouldn’t be either.

Using the preceding example, you can see that 20 of these rental houses (if paid for) would put $10,000 in your pocket every month from now on. Plus, there is a built-in hedge against inflation because you can raise the rent as the market value and market rents increase. This means you can always give yourself a raise. There is still another extra bonus behind the scene: You will have 20 houses paid for, resulting in your ownership of $2 million in real estate. At 5 percent annual appreciation, this results in an additional $100,000 increase in market value each year that you own the properties. Later in this book, I explain some tax benefits including depreciation.

So this fairly simple example of having a goal of 20 houses paid for will bring in $10,000 monthly into your pocket and your real estate will increase $100,000 in value every year.

Now, the hard part. How do you get there? How long will it take? Here is how I did it. I realized the preceding magic early on. I discovered that time was my biggest and scarcest resource. The sooner I got X number of properties under my belt, the sooner and faster and bigger the wealth would grow. I didn’t want my real estate investing to be a painful hobby. Just like you, I wanted true financial independence for my family. I wanted to do it safely and efficiently. My wife and I were sticking our necks out, taking all the risk, with no one to turn to should our investing go belly up.

Here is my answer and battle plan. If I captured 100 of these houses now, I could “ride the bull” (dealing with tenants and rental property) for four years cranking over $500,000 each year. After four years, I would have picked up another $2 million in market value. If I had the discipline to sell off 80 of the houses and keep the best 20 for rentals, I could end up with 20 free-and-clear houses on this aggressive four-year plan. It was my original battle plan.

If it ain’t broke, don’t fix it might be an appropriate description of where I’m at today. With our investments cranking some phenomenal numbers in appreciation, even with just 5 percent annually, the big picture results are overwhelming and it’s all on autopilot!

There is a common denominator for all the preceding results. Every single bit of it involves owning real estate. That means dealing with tenants as well as with the ugly word and world of being a landlord. The word sounds bad, doesn’t it? It sounds evil—something ugly, not fun, not good. In fact, I prefer the word investor.

Definition of Investor

An investor is “[a] person who purchases income-producing assets … considers safety of principal to be of primary importance. In addition, investors frequently purchase assets with the expectation of holding them for a longer period of time.” (David L. Scott, Wall Street Words: An A to Z Guide to Investment Terms for Today’s Investor, Boston, MA: Houghton Mifflin, 2003).

What about those folks who buy, fix up, and sell? Are they really investors? I don’t think so. They are in the same category as a builder, plumber, or electrician. They are getting paid for what they do, not what they own. When these people stop buying, fixing up, and selling, their income stops, too.

What about those who wholesale or quick-turn properties. These people also try to label their activity as investing. Far from the truth! Once again, when they stop wholesaling, it’s over. Stick a fork in them, they’re done!

I’m not against these two activities. It just burns me when some people try to say these two methods are the safest and easiest methods of investing. These activities by themselves are not investing; however, they can be an integral part of your investment battle plan. When I got started, I wanted to have a handyperson whose hours I could control so I wouldn’t have to wait for a part-time worker to take care of my problem on one of his off-days from a regular job. I learned I could buy an ugly house, fix it up, sell it at retail, and make about $35,000 in a couple of months. This would pay a whole year’s salary for a full-time handyperson and part of the wages for his helper.

I used the wholesaling and the buy, fix up, and sell activities to “feed the machine.” By this, I mean that owning real estate is like owning a cash-eating monster business—especially when you are getting started with next to no cash and your investments are pretty much 100 percent financed with no money out of your pocket. These two noninvesting activities definitely kept me afloat while I was building my business.

I came to realize that the true path to financial independence involves ownership of real estate. This meant that it looked like I was going to be a landlord. Nobody seems to be happy about this line of investing. There are so many negative attitudes about it, toward it, and all around it. But I knew one thing. The successful investors I admired all owned real estate.

A good landlording system is the secret cornerstone of my wealth-building program. Putting my landlording on auto-pilot became my ultimate objective in achieving financial independence.

CHAPTER 2

The Hidden Tax Benefits, Especially if You Have a Job

This topic blindsided me. As a good cop raised in an old-fashioned traditional family in a blue-collar neighborhood, I didn’t have a clue about how my investment activity would affect me in the income tax arena. Big words like depreciation, tax shelters, business expense, and write-offs might as well have been in a foreign language, I was totally in the dark. Looking back today, what really scares me is that not knowing any of this didn’t bother me.

I honestly believed that good old simple math was how the whole investing thing worked. Buy an ugly, broken-down house at a bargain price, fix it up, and rent it. I thought as long as my rent was more than my house payment, I was doing pretty good and this relationship of money was called “cash flow.” Wrong.

Back in the early 1990s, I realized I wasn’t making or saving any money by swinging a hammer or a paintbrush. I needed a part-time handyperson. How did I pay for that helper? Aha—I did the buy, fix-up, and sell activity to feed the machine. I thought that was the solution. Little did I know the profit from buy, fix up, and sell was slamming me in the income tax arena. Doing a few of these properties a year and adding the profit to my wages as a cop and my wife’s as a nurse put us over $100,000 for a couple of years.

A little powwow with my CPA at the time resulted in the creation of a C corporation (C-Corp). This would allow $50,000 of my real estate income from the buy-and-sell activity to be taxed at 15 percent. At the time, I thought this was a smart move.

Here comes my tsunami! (This is a good thing.)

Jump into my shoes for a moment. You are the long-haired, bearded, undercover cop who piddles part-time in real estate and never works any overtime as a police officer. The other dozen or so detectives in your unit work all the overtime they can get, along with off-duty jobs, and look forward to tax time every year. They anxiously await their tax refund for their yearlong effort. Many of these guys would get anywhere from $1,500 to as much as $4,000 back from Uncle Sam. What is sad is they didn’t realize the IRS was holding their money all year without paying them any interest.

Here’s the frustrating part. I was buying rental property like it was going out of style. I watched my numbers, watched my cash flow, and tried to operate efficiently. To my surprise, I also started getting tax refund checks from Uncle Sam. But they didn’t come in at $1,500 or even $4,000. I was getting huge refund checks. I’m talking $15,000 and more. How? Why? I didn’t understand it. What did my fellow detectives who worked with me think? Here I was, the guy who never worked any overtime and I was getting 10 times more in refunds than they were.

They looked at me as if they believed I was doing something illegal. Honestly, I felt I must have done something wrong. I wondered how my CPA could have maneuvered this. It just didn’t seem right. It didn’t make a lick of sense to this kid who grew up by Churchill Downs.

Depreciation: This is the five-syllable word that works magic on your taxes.

Let me share with you what I didn’t know. Pretend for a moment that you are a self-employed painter. You buy your tools, equipment, and supplies such as a 50-foot extension ladder for $1,000. You write a check from your bank account to pay for it and you use this ladder in your painting business.

Although you spent $1,000 of your hard-earned, after-tax dollars on a new ladder for your painting business, the Internal Revenue Service (IRS) will not let you write off $1,000 as a business expense this year. The IRS has a schedule, or report, stating that the life of your ladder is 10 years and you can only write off $100 a year for the next 10 years to cover the cost of this piece of equipment. They might use the term capitalized expense, meaning that the taxpayer writes off the cost over the life of the item.

If you are a painter, what is interesting about this is considering the likely value of the ladder after 10 years (if you can find it). Odds are, if your ladder still exists, its value has dropped to next to nothing. This same idea holds for plumbers, printers, and other folks who have business expenses and investments associated with earning their taxable income.

Here’s the beauty of real estate: It is really dirt and those things attached to it—houses, buildings, and so on. Uncle Sam will not allow us to depreciate dirt because dirt will always be here; however, Uncle Sam does allow us to say the improvements or buildings on the land have their own life. You might describe it as “How long will the building last or stand up?” For whatever reason, Uncle Sam has come up with two schedules for real estate:

  1. Residential Improvements have a depreciation schedule (life) of 27.5 years.
  2. Commercial Improvements have a depreciation schedule (life) of 39 years.

So how does depreciation affect me as an investor?

Pretend you have purchased a single-family rental house for $100,000. Please understand that you did not spend money here, you invested money. At tax time, you will ask yourself, “What’s the value of the lot the house is sitting on?” Pretend the lot value is $15,000. Here is what should happen:

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This means you get a phantom expense of $3,134.54 for owning this investment property. The IRS rationalizes this by saying the life of residential property is 27.5 years and theoretically, at the end of the 27.5 year period, the building(s) on the lot is worn out and worth zero; all you have left is your vacant lot. There is still more.

Let’s say you make $50,000 year as earned income, whether from your job or as a self-employed worker. The simple version here gives you the following benefit now:

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If you are in the 33 percent tax bracket, one-third of $3,000 is $1,000 savings right now in your income taxes. Let’s bump it up a bit. Suppose you have 10 of these rental houses.

With 10 of the same rental houses:

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In this tax situation, the IRS allows you to pay income tax as if you only made $18,654.60 instead of the $50,000 you made during the tax year. Wow! This can be a huge tax savings. Let’s try one more simple scenario:

With 20 of these same rental houses:

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You lost money!

If the IRS says you lost $12,690.80 for the year, this means you pay no income tax! In fact, if you have a job and have had money withheld from your paycheck for income taxes, odds are that you will get all your withholdings refunded to you. This is exactly what happened to me. I didn’t understand this depreciation thing. So all my police officer wages and my wife’s salary from working as a nurse were completely wiped out by depreciation. Some folks talk about a limit of $125,000 and I still don’t really understand it, but I trust my CPA to handle this for me. He can cite all the pertinent sections of the U.S. Tax Code. He is the tax expert, I am the investor, and he is on my team.

Here is some icing for your cake while we are focusing on this depreciation thing. I might be using the wrong official term here, but in investor language, let’s call it a combination of income averaging both forward and in reverse. Because I began acquiring assets fast and aggressively, my depreciation skyrocketed in a very short period. In just two years, we were showing huge losses in income for tax purposes. This is where my CPA stepped in with his knowledge and expertise. He took our tax returns for the past several years and somehow took this year’s losses and amended previous years’ returns. Then he did something else to carry some losses forward, which resulted in more tax refunds from previous years.

About a year ago, my CPA contacted me to sign another tax return, but it seemed to me that I had just been in his office about a month earlier completing a tax return. I asked him what this new return was about, and he proceeded to rattle off some stuff about some kind of new tax law changes. I said okay, but why me? He told me I might want to sign this return because I would be getting another $15,000 in tax refunds. My CPA, without any direction from me, took the changes from this new tax law and amended more of my previous years’ returns, even going back to when I had my job as a cop.

This is mind-boggling to me. I didn’t understand the magic of depreciation when I started investing. My unit involved detectives who targeted people who commit crimes for profit. My excitement about the huge dollar amounts of my tax refunds leaked out. The other guys worked their butts off with all the overtime they could get their hands on and took off-duty jobs at drugstores, apartments, banks, church picnics, and so on. They all suspected that I was doing something illegal instead of just renting houses.

In fact, this was so amazing to the guys I worked with that my boss began taking a serious interest in real estate. He, too, then bought rental properties and retired; and now my former boss, Sgt. Ron Cooper, works for me at Vista Realtors. He specializes in foreclosures and bank-owned properties in our town.

What’s the catch with depreciation?

Here is the ugly part, but it, too, can have a happy ending. Go back to the $100,000 rental house you bought in the earlier example. Suppose you operate it as a rental property for 10 years and then decide to sell it for $200,000. Take a look at what might happen: