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2 + 2 = 8. Now, that equation doesn't make sense to most people, but if you understand how debt actually works, it's the most basic math in wealth building. I'm Tom Wheelwright, CPA and best-selling author of Tax-Free Wealth.
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And I've spent my entire career advising the wealthiest people in the world. And I can tell you the single biggest difference between the rich [music] and everyone else is not how much they earn. It's how they use debt.
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Most people think that is something to avoid. The wealthy think debt is something to deploy. Today, I'm going to show you how $2 + $2 = 8.
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Why the tax code literally pays you to borrow money and the exact framework the wealthy use to turn debt into their single greatest wealth building tool. Most of you are thinking right now, "My parents always told me all debt's bad." Were they wrong?
Here's the thing. They were probably right with regards to the debt that they were thinking about, credit card debt, your mortgage, personal debt, student loan debt. These are all things that take money out of my pocket. So, really what we want is we're just not going to have any of this debt. We're not going to owe anybody anything. So, were they wrong? And the answer is not necessarily, except when they said all debt is bad. See, there's two types of debt. There's good debt and there's bad debt. And it's pretty simple to distinguish between the two. Good debt puts money in your pocket. Bad debt takes money out of your pocket.
Now, conceptually, that's pretty easy to say. It's it's pretty easy in theory. But how do you actually tell the difference in real life? What's the test? And again, the test is good debt puts money in your pocket. So, I'm going to draw this out for you. And I'm going to show you exactly how Robert Kiyosaki, my good friend, and other great investors actually use debt and kind of the difference between good debt and bad debt.
Okay, so let's say that this is your financial statement, okay? This is your income statement, income and expense, and this is your balance sheet, assets and liabilities. Here's what happens. And this is really the difference between the middle class and the rich, okay? The middle class, what they do is they take money, they buy a liability. Now, they're they're poorer than they were when they started because that liability could be a house, it could be a car, could be a vacation. Frankly, it could be school. I'm an A student, so it pains me to say that school is not always an asset, but I think a lot of times it's a liability.
Now, what do the rich do? do something very differently. They'll take their money and they want to buy an asset. And then what they do is they borrow money to buy more of that asset. So, let's say that could be real estate, could be a business. Sophisticated investors, it could even be the stock market, though you better be pretty sophisticated to do that. But let's say real estate or business, these are two of the easy ones to understand.
Okay, so let's say I'm going to buy a rental property and that rental amount property is going to put money in my pocket. And I've got say $100,000 of income. And then so, if I didn't use debt, I could buy a $100,000 of property. But if I did use debt, I could borrow say $400,000, add it to my $100,000, have $500,000 of real estate. That's going to put more money in my pocket. My key to understanding debt, are you comfortable with the asset you're buying? Is the asset going to produce income? Do you trust the asset? My experience is people who do not want to use debt is because they don't trust the asset to produce income. If you trust the asset to produce income, why wouldn't you want to use somebody else's money to produce more income? On top of that, at $500,000, I get tax benefits based on what the purchase price is. So, that means if I have $500,000, I get five times the benefits if I just have $100,000. So, this is a really key aspect of good debt. Good debt is used to buy an asset that puts money in your pocket. The debt just accelerates that asset.
See, most people think debt is just another fancy word for risk. Okay, I'm going to take out debt, it means I've got more risk. Going, "Okay." Again, it is risky if you don't trust the asset. Now, you don't have the education, you don't trust the asset. Here's my question for you, though. Let's take our $100,000 example. If you don't trust the asset, why are you putting your hard-earned money into that asset? And if you do trust the asset, well, you may want to start small, but pretty soon you're going to go, "Hey, I can do this over and over and over again." So, I can continue to use leverage where it's not risky because I understand the asset.
Let me give you a simple example. Okay, I've been running CPA firms for 30 years. 1995, I started my first CPA firm. Before that, I'd been with big companies and big CPA firms. So, I have a little bit experience running CPA firms. I had a network of CPA firms and now I have a franchise of CPA firms. I've got some good experience running CPA firms. Were I out to go out and buy a CPA firm and I borrowed the money to buy that CPA firm, I will 100% tell you there would be no risk in that for me. I know how to run a CPA firm. I know what it takes to make money in that CPA firm. I know what kind of clients I'm looking for, I know what kind of staff I'm looking for, I know what kind of operating expenses I'm looking for. I know how to run a CPA firm. So, if I go out and borrow, I would prefer to borrow 100% of the money to buy that CPA firm. And I would find no more risk than if I put my own money in. Because the reality is, if I buy a $500,000 asset, I have a $500,000 risk. You're going, "Well, I don't want to have $500,000 risk." Okay, well, then play small. That's okay, too. If you can't get comfortable with money with debt, don't use it.
On the other hand, if you were taking a class on how to trade stocks, your instructor, I guarantee 100% of time, would say, "Do it on paper first. You know, just do a paper trade." In other words, follow the trade, don't actually put money into it, just do it and pretend you're doing it, right? Just keep track of it. Do paper trades. Just do pretend trades. Just practice. Why not do that with real estate? Why not do that with a business? Why not practice?
This is why I love the game Cashflow that Robert and Kim Kiyosaki created. I love this game because it allows you to practice with play money. It allows you to get a feeling for what it's like to invest in a game situation. I highly recommend this game to everybody watching this video. Play Cashflow. Play it over and over and over again. And what's better yet, after you played it a number of times, invite neighbors over that have never played it before and watch how they play. I guarantee you the first time they play it, you can tell exactly how they invest.
So, I'm going to tell you a quick little story. So, I did that with a neighbor. I invited neighbors over. In this game, there's you can buy stocks. You can buy real estate, too, and you can buy businesses, but you can buy stocks. And it'll always say on the card, "Okay, this stock has a trading range of typically 10 to 40." So, that means that its lowest trade is usually $10 and its highest trade is usually $40. Well, every once in a while, you'll get a card that says you can buy it at $1. So, that's a severe discount. Well, you want to buy all you can at that point, right? Cuz you know there are cards that say you can sell it for $20, $30, $40. There's even a card that says you can buy sell it for $50. Okay? So, cuz I know the game, right? I've played it a hundreds of times. So, I'm watching and my neighbor gets the $1 stock card and buys 10 shares. I'm not kidding. They bought 10 shares. And I'm going, "Okay, that makes sense. That tells me a lot about this person." Now, I'll tell you when I played it the first time, my business partner and I played it the first time before we ever met Robert and Kim. And within 30 days, we had our first property. So, we got it, okay? But I would suggest play it over and over cuz practice. Practice is how you eliminate or reduce your fear.
Now, here's a question. The government doesn't want regular people building wealth like this, right? Just the rich. Going, "False." The government provides the same incentives for normal people, for middle class people as it does for wealthy people. The exact same incentives, the exact same way. The rules apply the same whether you're doing a small deal or a big deal. So, there are a lot of people that believe the tax code is there to punish them. That's false. Now, it will punish you if you don't understand the rules. But any game will punish you if you don't understand the rules. But once you understand the rules, this is a game you can win. And guess what? It's not something you have to do anything sneaky to win, right? I guarantee you that Tom Brady, love him or hate him, understood all the rules of football very, very well. And sometimes he played a little close to the line, we know that, but he won a lot of Super Bowls, okay? A lot of it was cuz he understood the rules. He understood the game, okay? The great athletes understand their game. The wealthy understand their game. And they understand the game of taxes.
So, the tax code actually rewards certain behaviors that the government is trying to incentivize you to do, okay? So, let me give you an example. You go to buy a home. What's the one of the very first thing the realtor says? Well, the interest is deductible, you know. So, it really reduces your mortgage payment. So, that's an incentive to buy a home. Now, renters don't get that deduction, but you get it as a buyer of the home. Well, what about you put your money into a 401k? You get a deduction for putting that money into a 401k. Tell me that's not one of the reasons you put money into a 401k, it's to lower your taxes. So, these tax tax incentives are everywhere. There's thousands of tax incentives. The tax law is over 6,000 pages long. That's just the law, not even counting the regulations, which are like a million pages. But think about this. You have 6,000 pages of tax law. There's only about 30 pages that raise revenue. One line says all income's taxable unless we say it isn't. Another line says nothing's deductible unless we say it is. Some charts and tables tell you how much tax to pay. The rest of it is literally a road map for reducing your taxes. And primarily through incentives, okay?
So, let's talk about, for example, a rental property. Now, if you buy a a house for yourself, you get a the of that interest up to $750,000. That's what you get. And you may get the real estate the property tax deduction, but you may not because of course that we have that limit on state and local tax deductions. But if you buy a house for somebody else to live in now not only do you get the interest and taxes by the way without limitation, you also get depreciation and depreciation is magic. I talk about it in chapter 7 of Tax-Free Wealth, the magic of depreciation. And the reason it's magic is you're buying a property that you expect to go up in value, but the government is giving you a deduction as if it's going down in value. So that is pretty cool. Your wealth is going up while your taxes are going down all because you bought a property for somebody else to live in or a property for some other business to use. So real estate's a really really easy example of incentives and and debt is so easy to get in real estate. Debt is what makes real estate great. Not using debt on rental real estate is a sin in my opinion. It's like why would you do that? Why buy real estate?
I was on stage with a very high-end financial planner from Wall Street and she went on and on about how the stock market has outperformed real estate for many many years. I think she's right. Only she forgot two things. First of all, she forgot debt. Now without debt, she's right. The stock market has outperformed real estate in most years. With debt, it doesn't even come close to outperforming real estate. If you add in the tax benefits, it's light years different.
So let me give you an example of this. So let's say I buy a house and I'm going to let somebody else live in it. I'm going to rent it somebody else, okay? I bought the house, I bought the land, I bought land improvements like like trees. By the way, I live in Phoenix. This is a tree in Phoenix. We don't have leaves on our trees. It's pretty stark. We do live in the desert. So you know, we might have some bushes, right? Okay, those are land improvements. And then what all else do we have? We also have the contents of the house, right? We have the ceiling fans, right? We have the window coverings, we have the cabinetry. We probably got some furnishings, okay? So the IRS looks at this and goes, well wait a minute, the land never going to wear out. The land, I'm going to get 0% depreciation. The building, it's going to wear out, but it's going to wear out slowly. I'm going to get about 3.6% 27 and 1/2 years depreciation. What about these other two? Well, land improvements, I'm going to get about 7% normally and the contents, I'm going to get about 20% except in the big one big beautiful bill. These two, instead of 20%, it's 100% the first year. That is called bonus depreciation. Now, if you do a cost segregation, a cost segregation, you have an engineer do it, then you will find that somewhere in normal 20 to 30% of the purchase price will be subject to bonus depreciation.
So let's go back to our example. We have $500,000 house we buy, right? Cuz we bought $400,000 of debt. Let's take the low end, 20%. We get 20% of that as bonus depreciation. That's a $100,000 deduction. Let's say you're in a 30% tax bracket. That's a pretty low tax bracket. That's $30,000 in your pocket. Now tell me that's not a better deal. That's this is the deduction. This is the tax savings, okay? 401k, you put $20,000 in, your tax savings are at 30%. You put $20,000 at 30%, $6,000 versus $30,000. Why? Because of the debt, that's why. It's the debt.
Now, are there detailed rules? Yes. Have I gone over this broadly? Yes, I have. I want you to understand that there's a benefit to using debt here from a tax standpoint. We've multiplied our return. If we'd only bought that $100,000 house, we'd only have a $20,000 deduction. Instead we have a $100,000 deduction. We'd have a $6,000 tax benefit instead of a $30,000 tax benefit. So debt is magic for increasing our rate of return as well as for increasing our tax benefits.
Now, make sure when you do this, you meet with your tax advisor. Go through all the rules. Make sure that you set yourself up so that you get all of these tax benefits. Again, if you don't follow the rules, if you don't understand the rules, you don't follow the rules and you don't have a team member and a coach helping you with the rules, you're not going to get these and then you're going to be all that will right that nobody's talking about. No, I know exactly what I'm talking about. I can get you there. I get my clients there every day. Charge them a lot of money to do that, okay? But you don't have a have a tax advisor charge you a lot of money. You just have to have one who understands real estate and understands debt and you make sure that they're not afraid of debt. By the way, when you're looking for a tax advisor, you want to learn how to use debt, ask them, how much debt do you have? Truly, ask them. Tell me what kind of real estate you own. What kind of debt do you have? What's your tax strategy? I think those are all fair questions.
So how then is 2 + 2 = 8 with debt? I'm going to show you even better than 2 + 2 = 8. If I have my real estate and let's say I get if I bought it for cash, let's say I'd get an 8% return, okay? This is what's called a cap rate. And if I pay cash, so cap rate's just how much would my return be if I paid cash for it. That's what it is. Okay, now 8%. Now let's say that I have an interest rate of 6% that I'm paying the bank. Now let's say that my loan to value is 80% or that's also equal to my debt, these are important terms to understand, to equity ratio is 4.0, right? It's four times. So my debt's four times my equity. So in our example, I had $100,000 of equity and I had $400,000 of debt. So 400,000 is 80% of the $500,000 purchase price, loan to value, debt to equity ratio 4 divided by 1, that's 4.0, okay? So you with me so far? All right, now I can show you exactly how 2 + 2 now equals 8, okay? So let's say at 8%, let's say that's 2 + 2 = 4, right? I'm going to double my money about every 9 years. Okay, 2 + 2 = 4. We're going to say that's our standard equation if you pay cash.
Now what's what's happened? Well, if I take my 8% minus my 6% times my debt to equity ratio 4.0 plus my cap rate, that equals my rate of return. You can prove this out. I absolutely will work every time. Well, what does that mean? Well, that's 2 times 4 plus 8 equals 16. So now my rate of return is 16%. So now I've doubled my return by using debt.
Now what about the tax benefits? Okay, so let's add in the tax benefits. Let's say that on this, I have $500,000 and let's say I get a 30% bonus depreciation, $150,000 deduction and I'm in a 33% tax bracket. That means I got $50,000 tax benefit, which means I didn't really put in 100,000. I put in 50,000. So if I only put in 50,000, not 100,000 and my return on investment was 16%, what have I done because I only had to put in half the money? I doubled my rate of return to 32%.
So what I would tell you is 2 + 2 = 4 and that is if you use cash. 2 + 2 = 8 if you add debt and 2 + 2 = 16 if you get tax benefits. But remember, you only get 2 + 2 = 16 if you also have debt. So it's important that you have both. You have to have both sides of this. That's where you get from 2 + 2 = 4 all the way to 2 2 + 2 = 16.
Now, you've heard people 2008, they lost everything. That was the 2008 crash. Now, what actually went wrong? People got greedy. They did not pay attention to the numbers. Remember, you have to follow the numbers. I remember I lost some money in 2008, okay? I'm I'm one who I learned. That was a hard lesson for me because I kept hearing, oh well, real estate never goes down. Well, that's baloney. It has a cycle just like anything else. I saw it soften in 2007. That's when I should have sold everything. I can actually tell you exactly when it was. January. It was January. It was softening. I'm going, should have sold it. Should have sold it right then, bought it back 3 years later. So that's what happens is that you have to have cash flow. Remember, using debt, it only works if it produces cash flow. It doesn't produce cash flow, doesn't work.
So for somebody watching this who's never used debt strategically, maybe you only have a W-2 job and some savings, what do you do first? Play Cashflow. Play the game Cashflow. Now, if you got a bit of inkling, you go, okay, I'll play Cashflow. Now what? Well, if you are starting to understand that debt can build wealth, the single most important thing you do this week to take the first step after you play Cashflow is to work get with a tax advisor who really understands debt, who really understands tax incentives and make sure that you're getting the education and putting together the team so that you can make way more money and pay way less tax.