Mortgages & Creative Financing

If You Retire Well, It’s Not Likely Your Income Tax Rate Will Fall – II

Expertise: Personal Development, Personal Finance, Mortgages & Creative Financing, Real Estate News & Commentary, Business Management, Real Estate Investing Basics, Flipping Houses
247 Articles Written

Just before we took off for Denver, I wrote about how retirement income isn’t what most financial advisors on Wall Street predict. You know, they tell us our tax bracket will be lower in retirement. I countered with a couple very simple observations. Your house is probably paid off — scratch interest deduction. Your kids are having kids — that write-off is history. Most folks hit retirement with their incomes virtually naked. No clothes, or rather shelter.

So, Ron ‘n Karen are now the proud owners of four Texas duplexes. However, they’ve decided they’re just about done with living in their fourplex. It’s been very good to them, but it required so much time and work for the initial rehab, they’re over it. Though they haven’t yet made the final decision, it appears that’s the road they’ve chosen. The equity will get them another six duplexes, but they’ve also been thinkin’ very much about buyin’ instead of renting for awhile. Eliminate one of those extra properties.

They’d likely be required to execute a partial tax deferred exchange due to the significant capital gain involved. The portion in which they live would be treated as their primary residence, tax wise. Let’s now  review their projected retirement income, at least from their real estate investment portfolio.

As noted in the initial post, they’ll be able to combine total real estate cash flow with ‘disposable’ after tax ordinary income, in order to pay off all loans in 8-12 years. Even if they screw up, it’ll happen in 15. They’ll be in their mid-late 40s.

The real estate income at retirement

Assuming no appreciation in value or increase in Net Operating Income, their annual cash flow would be approximately $165-170,000. That’s just under $14,000 monthly at the bottom of the range.

EIUL income

They have choices. After consulting closely with my ‘in-house’ expert, David Shafer, the following results are available to Ron and Karen. But first, the nuts ‘n bolts of the process.

They’ll budget $1,000 a month for the premium. It’ll go on for 25 years. ‘Course, I’ve already actively applied my approach, Strategic Synergism, to goose the ultimate results. Here’s what I’m proposing.

Note: Dave says they can opt to apply an ‘inflation’ adjustment of around 3% a year to their premium, or just keep it a flat $1,000 a month for the 25 years. Adding the inflation hedge results in a tax free income of $85,000 a year. The ‘flat rate’ premium would yield $66,000 a year tax free. Both would commence 25 years from conception. They’d be about about 63 years old.

This is when I tend to stir the pot

What if — that’s the way it starts, right? What if we take the first couple properties that become free and clear, and sell ’em? What if, due to using the cost segregation approach to depreciation, any capital gain and/or depreciation recapture is completely offset? (This would happen via massive unused depreciation, kept on the shelf for precisely this strategy.

This would net our intrepid Ron and Karen around $500,000 in tax free cash. This would occur somewhere around the 50th to 55th month of the Purposeful Plan.

What to do? 🙂

First, yielding to human nature, let’s just assume at the get-go that they’ll opt to grab $100,000 of that tantalizing cash. Wouldn’t you? You know you would. Get the custom RV — or the boat — or the mountain cabin for weekend getaways. That leaves $400,000. My Plan calls for them to make one more call to David Shafer about another EIUL.

Turns out that if they put the remaining $400,000 into a newly created EIUL, with five payments of $80,000 made over four years and a day, it’d be a good thing. (Don’t ask, it’s a regulation.) If structured to merely sit and grow ’til the same point in time the original EIUL comes to fruition, around age 63, here’s the combined results.

The original EIUL, using just the flat rate approach, will yield a retirement income of about $66,000 a year — which will, of course, be tax free. This is the approach eschewing the inflation hedge that would produce more income, but end up costing a lot more per month, as the premium increased to account for perceived inflation.

The second EIUL, funded with the $400,000 tax free, not tax deferred, capital gain, will yield around $78,000 a year. Both incomes will be triggered at roughly the same time — when they’re about 63. Also, don’t ever forget the real value of all that income being completely tax free. Not tax deferred. Not tax sheltered. But tax freakin’ free!

Let’s now review Ron’s and Karen’s bottom line retirement income

Their real estate income in retirement, beginning in 8-12 years or so, will end up being about $130,000 a year, or $10,800 a month. Their real estate investment portfolio’s net worth at retirement, assuming no appreciation ever, would be roughly $1.8 Million.

The two properties they ‘transformed’ into an additional EIUL? Well, they gave up half a million bucks in net equity, and a tad over $3,000 a month in retirement income to make it happen. In return for that repositioning of capital, they end up with around $78,000 a year/$6,500 a month in tax free income. Here’s the difference: Real estate income of around $3,000/mo., mostly taxable, beginning some time in their 40s. OR — over twice that amount, NOT TAXABLE, beginning in their early 60s. Understand, if their ultimate tax bracket at that point is only 30% (state/fed), that $6,500 is the rough equivalent of almost $9,300 monthly. More clearly put, that makes the before tax income triple what the real estate cash flow woulda been. In fact, let’s pile on, shall we? Their total tax free income of $144,000 a year is, in reality for most folks, over $205,000 a year, BEFORE taxes.

Not a really tough decision, it turns out. But we’ll wait and see how things develop in the next five years or so. You never know what will happen, right? Right.

Their Purposeful Plan results in retirement in their 40s, beginning with about $130,000 a year. About 15-17 years later, another $144,000 in 100% tax free income begins. From about 63 years old, they’ll be living on $274,000 yearly, over half of which will be tax free. This doesn’t include Karen’s pension, which should provide superb walkin’ around cash. (Sorry, Karen) It also doesn’t take into account the possibility Social Security will be functioning at that point. Karen’s pension will nudge their retirement income over the $300,000 mark.

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And they lived happily ever after.

The end.

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.

    Replied over 7 years ago
    Jeff, What is “cost segregation approach to depreciation”, and how does this offset depreciation recapture tax and capital gains taxes when it comes time to sell a property? Are there any strict guidelines on what must/must not be done to use this?
    Jeff Brown
    Replied over 7 years ago
    Hey Greg — CostSeg does two things: Increase the annual depreciation dollar amount; and compress the timeline from 27.5 years to about 5. It does this by taking each component of the property’s structure separately and depreciating them over 5-7 years, generally speaking. An example is a client who will go from $8-10k/yr for 27.5 years depreciation to around $25k/yr for about 5+ years. It’s a strategy sensitive to each individual investors financial/income tax/income circumstances. If cash flow is a lot less than available depreciation, the unused depreciation gets ‘stored’, unused, for when it’s needed. If, down the road you have a long term cap gain, etc., the unused depreciation can then be brought off the shelf to ‘offset’ them. Knowing this, certain investors can then incorporate CostSeg into their overall longterm investment strategy. Make sense?
    Replied over 7 years ago
    Holy write off, Batman! (Channeling Bawldguy) I knew there had to be one more incredibly powerful tax write off! From what I had read of 1031 exchanges, something about them doesn’t sound too appealing. I reckon this doesn’t escape the depreciation recapture tax, but offsetting any-and-all capital gains is definitely nice. What happens after the 5-7 years passes? I guess that’s easy: no more depreciation shielding the cash flow until the day you sell, right? Does this mean many of your clients tend to sell when the depreciation is used up, and then plow their equity+capital gains into other properties? My plan has been to buy about $250,000 in SFR this year, pour all the rent into the debt, paying it off in about 10 years. Then, borrow 75% to buy another $750,000 in SFR, and be free-and-clear with $1M at the end of 20 years, hopefully earning at least $10,000/month by then. (P.S. I already have an EIUL) To plug CS into the equation, I don’t know if it would be better to sell-and-buy every five years, or just take that tax hit after the depreciation is done.
    Jeff Brown
    Replied over 7 years ago
    Love the channeling, Greg. You’ve got the right ‘bones’ of a pretty decent plan, but it could be made significantly more productive. When you have some time, gimme a call, I need a fix. 🙂
    Replied almost 7 years ago
    I hope you’ll write more about this. Retirement is so important and there are so many people unprepared.