By Ken DeLeon | Founder
One of the fundamental reasons why I left the practice of law for real estate was because I felt that real estate as an investment asset class had not been optimized. While stocks and other assets can be good, profitable investments, there is no better asset class to purchase in California than real estate. Within real estate, the greatest economic tax advantages are bestowed upon your primary residence, including 1) the deductibility of your mortgage interest up to $1,100,000, 2) the deductibility of your property tax payment against your federal income tax bill, and 3) the capital gains exemption of $250,000 per seller, for a total of $500,000 tax-exempt profit for a married couple.
Having the first $500,000 in profit be exempt from capital gains is worth more in California than any other state because we pay the highest taxes in the nation. The silver lining of our amazingly high tax rates is that tax-exempt money is even more valuable here than in other states. At the current maximum 37.1 percent combined capital gains rate, your stock market portfolio would have to appreciate by $794,913 to put $500,000 in your bank account after paying your capital gains tax. With the current top federal and state income tax rates totaling a staggering 52.9 percent, you would have to earn $1,061,571 in income to put $500,000 in your bank account after paying your income taxes.
These comparisons illustrate the true value of this $500,000 capital gains exempt gain. Yet what if I told you that you could take advantage of this $500,000 exemption every two years? What if I told you that I personally moved three times in the last five years and thereby optimized this tax exemption? What if I told you that, by following my own advice on what neighborhoods to buy in and what types of home to buy, that I made over $5 million in just over five years? What if I told you that this type of opportunity was now open to you? Now that I have your attention, please enjoy this article which I hope will change your future net worth and improve the shape of your retirement.
Before I begin, please know I am not boasting. I could have written about these sales when they occurred a few years ago, but I did not want to write about something clients could not do as well as I could. Now that clients will have the same advantages I had that allowed me to profit so much, it is important to use these sales as a case study to convey how to optimize the sale and profit of one’s own primary residence.
While my final profit was huge, the initial capital provided was not. For a home I purchased in Palo Alto about five years ago, I put down just under $400,000 and purchased a home on the market for approximately $1,250,000. There are certain variables that I know correlate with the good values that I direct my clients to purchase. This home had many of these markers, such as a reduced price, necessary cosmetic updates, and a slow time on the market. I lived in the dated home and was fine with that since I had already envisioned its updates upon purchasing.
When I moved out, I put $200,000 into the home, strategically updating and opening the kitchen and remodeling the bathrooms with cosmetic updates that my design team recommended. Michael Repka, the head of our listing team, priced the home attractively at $1,888,000 and sold it for $2,650,000—a profit of well over $1 million. While that is quite exceptional for a $400,000 investment, the key was leveraging this profit into my next Palo Alto home.
The motivated sellers of this much larger home had made several price drops, and their eclectic and distracting furniture and knick-knacks were still in the home. The home was both hard to show and showed poorly— again a recipe I follow to get my clients great values. When I showed this home to clients, they could not see much beyond the clutter besides the need for a complete remodel. I tried to persuade them to see the value in the home, but they could not get past the scope of work needed for a true update. Being unable to convince any client to tackle this much of a remodel, I realized this home would sell at a good deal and personally grasped its value. I eventually purchased the home for a bit over $2.6 million. I put approximately $500,000 into a major remodel and, after owning the home for 2.5 years, I sold it for $4.6 million—a total profit of nearly $1.5 million.
The home I traded up to after that was also a steal. I had no clients for this home, but I did all I could to have any of my clients buy it. Six weeks before I eventually bought the home myself, I wrote a client about this opportunity, describing the home and its high value in detail. Here are some of the highlights from the email: “There is a property in Palo Alto that I think is a great investment. While not an exact match with your objectives, I thought you should know about it. The home has now gone stale on the market. The listing agent…just did her fourth price reduction and should you purchase this home… I know you would do exceptionally well, as the average price per square foot in this neighborhood is $1,225 per square foot (without regard to lot size) and we would be getting the home for barely over $1,000 a square foot and have a very large lot in Palo Alto. This home is not a perfect fit, but since it is a good value I wanted to let you know about it.”
My client, a C-level executive at one of the Valley’s largest companies, appreciated knowing about the home, but did not want to have to take care of the cosmetic updates. After purchasing this good value, I estimate the home is now worth $2.5 million above the purchase price. These sales and purchases were all completed in a little over five years and resulted in a profit of over $5 million. The best part is that much of this profit was exempt from capital gains.
I have not previously recommended this route of effectively flipping your primary residence to maximize tax gains to my clients. The reason I did not do so earlier is because I could not fairly ask them to do what I was doing since I was only paying half of the transaction costs. For example, when I listed my homes, I paid the buyer agent commission but did not have to pay the other half since Michael Repka was my listing agent. But now, thanks to our “3% Solution,” this is a definite possibility for our clients. They too can do what I did.
My buyers will indirectly save on transaction costs when purchasing a DeLeon home, as the sellers will likely allocate some of the commission savings to them, and the sellers will directly benefit by paying only three percent (3%) commission should the buyer come in with a DeLeon Realty agent. We offer the same advice, remodeling, and design resources for my clients that I use myself. Given our new model, there is no longer any barrier to my clients also making millions in a few years.
There are two exceptional tax exemptions that the government gives to us. One is the $500,000 exemption on your primary residence that we just discussed. The even larger one is that the government lets you bequest $5.49 million per person (nearly $11 million per married couple) without paying any estate or gift tax. Sadly, most Americans do not even come close to taking advantage of that as the average American leaves only $177,000 to their heirs (per an HSBC inheritance study). If you properly follow my team’s advice on housing and make strategic choices about where to purchase your home and what remodeling to do before reselling, hopefully you will have the first-world problem of your heirs having to pay some estate taxes because you did such an exceptional job investing in your primary residence.