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How to Maximize Retirement Income with Real Estate Through Investment & Tax Strategies

by Jeff Brown on November 1, 2011 · 9 comments

  

The strategies available to the typical long term real estate investor have been more than somewhat limited. Either their ‘strategy’ is cash flow or it’s capital growth. They employ leverage as it relates to down payment, or opt for overwhelming down payments, even all cash. They’re from the school saying you buy, but never, as in never ever, sell.  Then there’s the school preaching tax deferred exchanges are mirages, leading to nowhere and fast. Or, they think responding to ever-changing markets, being flexible, makes more sense.

It doesn’t hafta be Either/Or 

In fact, I’m here to tell ya that if your long term real estate investment experience has been defined by the either/or straightjacket, your results have likely been unintentionally limited from the beginning. Let me illustrate by showing how one of my active clients is beginning their journey towards retirement. I’ve changed some details, but nothin’ that impacts their status quo or their Plan.

Note: Those who’ve met me will attest it doesn’t say ‘TaxGuy’ on my ample forehead. However, since I’ve been using the strategies since they’ve been available, I do have extensive experience. Still, don’t run off and try any of this till you’ve spoken to a real, bona fide, CPA who specializes in real estate investment. It would be foolish to behave otherwise. 

Randy and Connie

They’re both in their 30s, both work, and between them earn around $165,000 annually. This can change due to Randy’s job as he earns bonuses from time to time. They live in a triplex on the west coast which they bought, fixed up a bit, then rented the other two units at top rents. They don’t have a housing allowance, as their efforts resulted in being paid a few bucks a month, sometimes several hundred to live there. Sweet, eh? They’ve lived for many years below their means, and have saved like demons. They now have about $300,000 they’d like to use as down payments on income property with an eye towards creating generous retirement income.

Strategies Employed

1. Given their ages capital growth is first up. That’s a no-brainer. Though like most folks they’d love to be able to retire around 4:30 yesterday afternoon, they’re lookin’ towards a loosely defined time period of 10-20 years. We’ll see.

2. Of course, all the properties they’ll acquire will sport cash flow of about 6-10% cash on cash (positive leverage), the strategy used in their acquisition will be relatively low down payments. The current regs allow for 25-30% which is what they’ll be doing.

3. Since they make more than $150,000, the IRC (Internal Revenue Code) bars them from applying any leftover depreciation (after sheltering cash flow) to their ordinary income. (job income) We’re gonna turn that lemon into lemonade by way of increasing the depreciation over the first 5-10 years via what’s known as cost segregation. (CS allows your CPA to depreciate each physical part of your property separately and for 3-15 year periods — mostly five or so. As you might expect, this tends to increase your annual depreciation very nicely.) Each property they acquire, four in their case, will generate roughly $25,000 annually for the first five years of ownership. That’s $500,000 of tax shelter in five years. They’ll use, give or take, about 20-25% of that covering the properties’ yearly cash flow. The remaining $375-400,000 will remain unused, gathering dust on the shelf — until needed.

Note: The IRC allows taxpayers to apply unused depreciation to offset capital gain and depreciation recapture on a sale. This is no small tool to have in your arsenal. The idea is to PLAN to have it available to enhance future strategies. {Reg. § 1.469-2T(c)(2)} Thanks to BP writer Charles Perkins for the citation. 

4. In addition to their cash on hand, Randy has been contributing about $1,000 monthly to his 401k at work. This will stop immediately. He will now begin diverting about that sum monthly to their new EIUL. This will act as a second and completely stand alone retirement income basket for them. They’ll likely convert to income 15-20 years from now.

5. We’ll leverage their proven ability to save by redirecting significant portions toward the pay down of their income properties’ mortgages. This task should be completed in about 8-12 years without too much problem.

6. The strategy they’ll keep open for themselves is the ability to take a cash sale without paying either capital gains or depreciation recapture. This strategy would be executed when the alternative to the status quo was so obviously superior it would be foolish not to pull the trigger. Though there are several possibilities, one easy one would be to take a $250,000 tax free net proceeds check from a sale and apply it to the existing EIUL. Another would be to take advantage of unplanned for but welcomed appreciation, which might allow for a strategically timed acquisition of more and/or higher cash flowing property(s).

How it might roll out.

The first 10 years pass by. They’ve successfully eliminated all the loans from the properties they bought in 2011. This has resulted in the following options/realities, assuming no appreciation in value or increase in NOI (net operating income) has occurred:

•  Their new debt free cash flow would be just over $6,000 monthly — $72-75,000 a year.

•  One of the options on their menu at that point would be to take that income virtually tax free the next five years or so. I wouldn’t advise them to do that, but it’s an option nonetheless.

•  Since at that point they’re still not 50 years old, they could then use the income to pay off their home mortgage.

• They could simply opt to add to their monthly EIUL premium for the next 5-10 years. This would have an incredibly positive impact on their ultimate tax free income basket. I’d put this option on the A-List for sure.

• They might decide, IF the real estate market at the time is right for it, to invest in more small income properties. Think about it. They sell one of their props tax free in order to buy 3-4 more. Besides their own ability to add monthly bucks to payin’ down the loans, they now have an additional $3-5,000 after taxes to make it happen, relatively speaking, overnight. But again, the market at the time must welcome that strategic choice with open, welcoming arms. Only take what the market gives ya, and you’ll be OK. Don’t force square strategies into round real estate markets. :)

That’s not by any stretch a complete list of options they’d have on their menu, but you get the drift.

What’s the end game for Randy and Connie?

There are several happy endings for Randy and Connie, which of course will depend upon how, when, and if they’re able to make positive moves over time. If the real estate market surprisingly appreciates at some point, that creates multiple new options immediately. Same with increases in the NOI.

Here’s the income on which they should be retiring in the next 15-20 years.

• About $6,000+/mo., $72-75,000/yr income from income property.

• Completely tax free annual income from their EIUL of $50-100,000 — the specific amount would depend upon how long it was in force before triggering income option.

•  About $3,000/mo., $36,000/yr. from Connie’s pension.

•  The elimination of give or take $3,000/mo. in loan payments on their home.

This is the most conservative take on their ultimate end game. It assumes from Day 1 that all real estate investments will never increase in value or benefit from any increase in NOI.

They’ll be living in a free and clear triplex, if they should choose to remain there, which will generate about $2,500/mo in net income — before income taxes.

The worst case scenario for their EIUL is just over $4,000/mo., $50,000/yr. — all of which is tax free forever.

That’s a combined retirement income of — $15,500/mo., $186,000/yr. At least a third of which is either tax free or tax sheltered.

Again — that’s the lowest income they can reasonably expect from their Plan.

If the next 20 years see no appreciation or increase in NOI, it will be a first in my lifetime. Also, I strongly suspect many of the options listed above will indeed come into play. It’s entirely possible their retirement income will exceed $200,000 a year. This pleases Randy and Connie.

The TakeAway

The expert execution of multiple investment strategies as it relates to retirement planning can generate synergistic results for which the vast majority of investors never knew was possible, much less on their menu. The difference real knowledge, experience, and expertise can make for you is off the charts. Most people, when they hear about some of these strategies admit they’d never known to even ask about them. Why?

Simple — We can’t get answers to questions we don’t know to ask.

Find out what’s on your menu before you start triggering your investment dollars. Your retirement age will arrive whether you did things right or not.  Just sayin’ . . .

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{ 8 comments… read them below or add one }

Manoj November 1, 2011 at 8:11 pm

Jeff,
I am not sure if I understood the below section. With 300K down payment, acquire four properties and each property returning 25K a year?

“Each property they acquire, four in their case, will generate roughly $25,000 annually for the first five years of ownership. That’s $500,000 of tax shelter in five years. They’ll use, give or take, about 20-25% of that covering the properties’ yearly cash flow. The remaining $375-400,000 will remain unused, gathering dust on the shelf — until needed.”

Reply

Aunty November 1, 2011 at 8:17 pm

I know that I would be happy with that kind of retirement! I bow to your wisdom Jeff. I always learn SO much from you. Mahalo!!!

Aunty

Reply

Jeff Brown November 1, 2011 at 8:19 pm

You’re too kind, Aunty. Much appreciated.

Reply

Jeff Brown November 1, 2011 at 9:55 pm

Hey Manoj — Let me clear it up. The $25,000 to which I’m referring is depreciation, only. Since the investors in this case make too much per IRC to apply it to their job income on annual tax returns, whatever’s left after ‘sheltering’ the properties’ cash flow goes ‘unused’.

The code allows unused depreciation (they call it ‘loss carry forward’) to be used to offset certain capital gains and depreciation recapture tax. So, the $25,000 isn’t the properties’ return, but merely a factor in that return.

Make more sense to ya?

Reply

Troy Corman November 3, 2011 at 10:36 am

What does EIUL mean?

Reply

Chris Clothier November 3, 2011 at 11:54 am

Jeff –

Amazing blog post! Very informative and a ton of information. I had to read it twice just to digest all the data and detail you put in there.

Good stuff!

Chris

Reply

Jeff Brown November 3, 2011 at 1:36 pm

Hey Troy — Equity Indexed Universal Life = EIUL. It’s what I call an investment grade insurance policy. For rich and detailed information you should go to my blog and search for David Shafer. He’s the most knowledgeable and experienced EIUL expert I’ve ever known. Tell him I sent ya.

Reply

Jeff Brown November 3, 2011 at 1:39 pm

Much appreciated, Chris. Thank you.

Reply

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