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Tax Free Income From Your Real Estate Investment Success

by Jeff Brown on January 12, 2010 · 18 comments

  
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How often have you heard or read somebody declare that when you retire, your tax rate will go down? The third rail, at least when I’ve written about it, is the 401k — which might be the best designed transfer of private wealth to government coffers ever. One might gently ask the question, “How’s that been workin’ for ya lately?” But I digress — if you love your 401k far be it from me to dissuade you.

If however, you’ve been wondering if there’s another option out there, here’s some food for thought. I sincerely hope this helps.

Just the highlights though, so we can get to our tax free basket of retirement income.

  • The average 59 year old has less, far less, than $100K in their 401k — in fact it’s less than $60,000 — FAIL
  • Even those with a million bucks or more in their 401 when they quit working will pay more taxes in the first 3-9 years they draw income from it, than taxes saved in the 30 previous years — really.
  • The gov’t will force you at times, to withdraw more than you choose.
  • They will also at times force you to bite into your principal when you don’t need it — when that happens, you’re a financially dead retiree walking.
  • When you die, your heirs might as well divide their inheritance from your 401k in half. It’s (pun intended) taxed to death.
  • So I ask you — why do folks put themselves in this position on purpose?

Not gonna deal with the whole 401k topic though, as that’s another post altogether, and frankly its track record speaks for itself. I made the points above merely to set the stage for your alternative — a tax free basket of income to supplement your hard earned real estate investment cash flow.

What the heck is an EIUL? An Equity Indexed Universal Life insurance policy, that’s what. It’s most often tied to the S & P. It can be grown through years of monthly payments, or just a few big ones, depending upon each investor’s Purposeful Plan. Let’s talk about how they’re different than 401k’s.

First of all, you can’t lose money in an EIUL by definition of the contract. Yeah, I know, Grandma’s spinning in her grave listening to that one. This is the exception proving the rule she most lovingly taught us about things seeming too good to be true. In fact, the wealthy have been employing EIULs for decades now for both asset protection and tax free income.

Principle: EIULs aren’t used to create wealth — wealth is used to fund EIULs in order to create tax free income and shield said wealth from our favorite greedy Uncle.

Principle: Though they won’t create wealth, they can and certainly do create impressively large tax free annual incomes for those who contribute regularly for long time periods.

OK, Here’s the Strategy For Real Estate Investors

If you’ll recall, my last post talked about the double positive Catch 22 of increasing your annual depreciation AND being able to pull tax free money from appreciated real estate while selling and/or exchanging. If done with knowledge, skill, and forethought that approach often finds the investor nearing retirement with enough capital gain ‘offset’ to fund a pretty impressive EIUL. I’m not implying, and please don’t infer this to mean you should convert all your hard earned investment property equities to insurance policies. Far from it.

It’s merely another income basket you should consider developing.

Since they’re heavily front loaded with fees, a minimum of 10 years is required to generate income. In a recent example, I had an analysis run by my EIUL expert. It was for a 35 year old guy who paid $500/month into his EIUL for 30 years. Aside from his real estate income, Social Security (wink, wink) and any other income, he’ll be gettin’ just over $50,000 a year tax free — year in and year out.

If he decides he can forego the income another decade, the tax free income will skyrocket.

Those who opt for this strategy, investing one large chunk, or a very few large chunks of cash just before, during, or after retirement, will almost always end up generating far more tax free income than that. Far more. (Note: Sometimes the IRC requires large policies be funded over a period of four years.)

Here are some points to ponder

  • These must be set up correctly by a slam dunk expert — in other words, don’t have your cousin Larry the insurance guy do it for you. As it turns out, I know one.
  • Unlike most annuities, IRA’s, and 401k’s, this income is tax free — period.
  • You can borrow from them without having to pay it back. Really.
  • YOU decide when you wanna start taking income from it, not Uncle Sam.
  • You aren’t compelled to take an arbitrary minimum amount. In fact, you can distribute when, how much, etc., as you see fit, within the parameters of your particular sized contract.
  • When you die, your heirs get 100% of the death benefits — EIULs are not part of your estate. How cool is that?
  • If you so choose, you may take out a lump sum — tax free — at retirement and do with it what you will. Try that with a 401k. :)
  • Because you can’t ever have a losing year, you will never experience multiple ‘treadmill’ years of playing catch-up just to get back to where you were.

Warren Buffet once said, (badly paraphrased) “Rule #1 when investing is, ‘Don’t lose money’. Rule #2 is, ‘Never forget rule #1′.”

If you’re a real estate investor, and 30-55 years old, this strategy could produce some pretty significant ‘supplemental income’. Supplemental my Aunt Fannie. When done on purpose with enough time to work, many have reaped tax free incomes of $100,000 yearly and more — much more. Don’t forget, you’ll also have a splendid cash flow from your real estate portfolio — 50-100% tax sheltered.

This is where I mention what you should be doing with your Social Security check. Investors in this enviable position generally use it for pocket change.

Photo: Kevan

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{ 17 comments… read them below or add one }

[email protected] January 12, 2010 at 8:09 am

I’m telling ya, I don’t know how some of the others can keep up with your great posts! The bar just keeps getting set higher and higher!

I’ve heard of the acronym EIUL before but I’m glad you put some more perspective on it. This one will be a two time reader for me to make sure I understand it better.

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Joshua Dorkin January 12, 2010 at 8:44 am

I usually need to read and re-read Jeff’s posts as well, Nick. This one was no exception.

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Jeff Brown January 12, 2010 at 8:14 am

Hey Nick — Your kind words are very much appreciated. I recently brought in my EIUL expert to contribute weekly to my own blog. He published his first piece yesterday, giving the history, and nuts ‘n bolts. I think you’ll find it interesting.

Thanks again.
.-= Jeff Brown´s last blog ..Introducing David Shafer — How EIULs Work =-.

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Joshua Dorkin January 12, 2010 at 8:44 am

Jeff – You continue to blow minds with your articles, including mine! Keep it comin’

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Jeff Brown January 12, 2010 at 8:53 am

Josh — Thanks — some of these concepts/principles/strategies are so layered, it’s difficult transferring them to the keyboard, at least for me.
.-= Jeff Brown´s last blog ..Introducing David Shafer — How EIULs Work =-.

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Eric Heckman CFP January 12, 2010 at 6:04 pm

Good article the only mistake is that a life insurance policy IS a part of your Estate when you die. The death benefit is Income Tax free but not Estate tax free. You can have a trust or someone else own it and that can keep it out of your estate but you need to do it the right way.

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BawldGuy Talking January 12, 2010 at 7:33 pm

Eric — When it comes to properly set up EIULs, they’re not part of your estate. I encourage you to speak with David Shafer, a contributing author on my blog, and an EIUL expert.

My experience with these is that four experts have maintained the same position — they’re simply not part of the estate. Of course, this could simply be a matter of semantics, but they all agree they won’t be subject to estate taxes — period.
.-= BawldGuy Talking´s last blog ..Munchin’ The Numbers =-.

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Neil Uttamsingh January 12, 2010 at 8:43 pm

Jeff,

Very cool article.

I have a question for you.

In Canada, we have the RRSP (Registered Retirement Savings Plan).
This is our equivalent the the 401K.

The Canadian Government allows real estate investors to use funds in their RRSPs and invest these monies into second mortgages. These second mortgages can be placed on rental properties, or on one’s principal residence, the home that an individual lives in.

There are also rules in place by the Canadian government that allows an RRSP holder (say for instance, myself), to invest my RRSP money directly into a rental property that I own.

As such, RRSP money in Canada is heavily sought after by real estate investors.

Can the 401K be used in the same regard? In that, can funds from the 401k be used to invest in second mortgages in the states?

Best Regards,
Neil.
.-= Neil Uttamsingh´s last blog ..What is the X Factor and how can it help me buy my first rental property? =-.

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David Shafer January 13, 2010 at 7:29 am

Jeff,

Erik is correct, life insurance is part of your estate. However as we have discussed before there are three obvious options that any competent estate planner could give you:
1. The point is to take the cash out of the insurance policy as income. As you take income the net proceeds at death decrease. So take the income tax free and have fun with it [ie spend it on things to make your life happier]. Eventually, the amount of proceeds at death would be a negligible amount and would not create an estate tax problem. This is probably what most folks with a estate of less than 3-6M would do.
2. Put the EIUL into a life insurance trust. This means giving up control to a trustee, but then takes it out of the estate tax calculation. Make your heir the beneficiary so the proceeds can be used to pay any taxes due on the rest of the estate.
3. Take out funds from the EIUL to purchase a separate life insurance policy which you will put into a trust and fund with a single premium payment. It will be structured opposite of your EIUL to maximize the face value. Make your heirs the beneficiary so they can use this to pay off any estate taxes.
Option 2 an 3 are generally for folks approaching an 8 figure estate.
However, the estate value cut off for taxes is a moving target. For example as of Jan 1st there is no estate tax. But congress has said they will probably move to put the cutoff at 2009 levels ($3.5M). This obviously creates headaches for planners. Bottom line is that not only does the EIUL allow you to take income tax free, but its flexibility allows you to plan for an ever moving estate tax levels.
Now, if you are so fortunate as to have built extreme wealth through real estate investing, you should visit a competent estate planner to figure out how to maximize all the tricks of estate planning, which general always include life insurance inside a trust. Life insurance has a long history of being successfully applied as a estate planning tool, so EIULs fit right into what has been done traditionally!

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BawldGuy Talking January 13, 2010 at 7:32 am

Neil — The answer is yes and no. It depends upon the particular 401k. Some would allow that, most wouldn’t. The real answer though, is what Americans can do with what we call the Self-Directed IRA. If set up correctly, which is relatively easy, the taxpayer can then elect to invest in mortgages in many forms. I have clients who’ve chosen groups investments specializing in mortgages. The interest flows into their IRA tax free.

These self-direct IRAs can also invest directly into real estate, even if encumbered with a loan. The loans will generally be non-recourse, i.e. if the property is lost to the lender, there can be no further ‘attack’ on the taxpayer in any way for any shortfall. Also, the lender is generally barred from demanding a personal guarantee from the owner of the IRA.

This vehicle for real estate investment is, and will continue to be on the rise. It sounds like roughly the same thing you can do in Canada, though you didn’t say if you’re allowed to buy real estate.
.-= BawldGuy Talking´s last blog ..Munchin’ The Numbers =-.

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BawldGuy Talking January 13, 2010 at 7:50 am

Dave — Much thanks for clarifying that point. #2 is how it’s easily taken out of the estate at death, which was what I should have included with my statement. The bottom line is, as Eric so correctly pointed out, is that though the insurance CAN be part of the estate, if it’s set up by an expert, it won’t be, which would be the desire of almost any policy owner.

Eric — Thanks again for your comment. I’m so glad to have replied with the suggestion that it could be a simple matter of semantics, which it turned out to be. Much thanks for being the catalyst allowing to more clearly address this.

Also, if you have time later, I’d love you to email me, as I’d love to talk with you. Have a good one.
.-= BawldGuy Talking´s last blog ..Munchin’ The Numbers =-.

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Neil Uttamsingh January 13, 2010 at 8:20 pm

Hi Jeff,

Thanks for your response. You provided some great, detailed information.

It seem that both Canada and the U.S. have similarities with respect to the 401k and the RRSP.

As per your comment, yes, we are able to invest in real estate with our RRSP money in Canada.

As an example, if I have $50,000 saved in my RRSP, I can lend this money to a real estate investor. This money would then become an ‘RRSP second mortgage’. The rate of return is negotiable, however, an RRSP second mortgage can yield upwards of 12% per annum.

Similar to your comment regarding the self directed IRA, in order for Canadians to be able to lend their RRSP money as an RRSP second mortgage, they have to have a self-directed RRSP account set up.

In Canada, there are a very limited number of Financial Institutions that offer this type of Self Directed RRSP account. However, one of Canada’s 5 major banks offers this type of account, along with a number of other smaller financial institutions.

Awesome article again Jeff!

Best Regards,
Neil.
.-= Neil Uttamsingh´s last blog ..How you can make $450,000 in ten years by doing no work =-.

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Binh Nguyen March 26, 2010 at 5:39 pm

Jeff & David…

I enjoyed the great article and I appreciate you advising people about the minimum 10 yrs of funding an EIUL because of the significant surrender charges on any universal life policies. Most people talk about all the pros but never the potential problems.

Would it be more beneficial for IRA owners to convert their IRA’s to Roths, & then start investing in real estate? Any thoughts or ideas on the growth potential if a 35 yr started to contribute the same amount?

Thanks Guys!

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Jeff Brown March 26, 2010 at 5:56 pm

Binh — The short answer is YES, but without more facts, I’ll hafta hedge some. Still, a 35 year old would kick some very impressive booty if they started investing through a self-directed Roth. This conversation should probably take place on the phone or in person. Contact me through this site, and I’ll let you know what I think is possible in your situation. Have a good one.

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Mike Woods July 25, 2012 at 1:36 pm

What about setting things up in a living trust?

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Jeff Brown July 25, 2012 at 5:02 pm

Hey Mike — A living trust is used very often for estate planning, as you’re no doubt aware. As David said earlier, he has the EIUL, or cash value funded separate insurance, wrapped in a trust. He suggested a life insurance trust. You’d hafta ask David for a reliable answer on this. I think your bottom line might be the same as the vast majority of us, which is to ensure any insurance proceeds at death are not inside the estate.

If not, let me know, and I’ll prevail on David to give you a far better answer.

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Jaime July 31, 2012 at 2:45 pm

Jeff, this article was very eye opening. What do you think of purchasing turnkey rental properties in a Self Directed? Understanding the tax depreciations and all (appealing) how is the SD taxed after you pull from it and given that the rental will probably still be cashflowing, what is the protocol with that income?

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