This case study is about real people who’re ongoing, long-term clients. They came on board with me around eight years ago. This is their story up ’til now.
Around 2011, I agreed to meet Timm and Sherri for lunch here in San Diego. We’d first spoken on the phone when they liked one of my BiggerPockets posts and called me.
Timm is a software specialist, who’s on the road much of the time. Sherri’s been an elementary school teacher for over 20 years and really enjoys it.
When we met, they were both in their mid- to late-30’s and flush with enough cash to immediately acquire some real estate. In fact, they’d already dipped their toes in the real estate investment pool before we met, as they lived in one of the units of a fourplex fixer upper they’d purchased.
Their total housing costs back then were easily under $700 monthly. They lived in coastal SoCal.
Retirement Income Goals
They’d always lived relatively frugally, allowing them to save at least $5,000 a month—sometimes much more. In fact, these days they’re saving a lot more.
I immediately spotted the fourplex as a prime candidate for a tax deferred exchange, as the value they’d already added through fix-up was impressive to say the least. But that turned out to be a personal thing with them. Since they’d done most of the work themselves, they were somewhat emotionally invested and wouldn’t even consider moving at the time—regardless of how much closer it’d get them to retirement. (More on that later.)
Timm was the one driving the retirement date, as he’s not as into his job as he once was. He wants a minimum of $100,000 a year in passive retirement income.
The Initial Investment Strategy
They’d saved $190,000, over and above cash reserves, to begin retirement investing.
It was pretty simple at the beginning. I recommended they buy a couple brand new Texas duplexes.
This is where their high income and frugal lifestyle came in handy. Ever heard of cost segregation? It’s nothin’ more or less than a different approach to depreciation.
For those new to real estate investing, depreciation is merely a “paper” loss—translation: not a real life loss. Most investors used the normal depreciation as a tax shelter for the property’s cash flow. Any leftover is then applied to the investor’s own ordinary (job) income. The schedule most investors use when depreciating their investment income property is usually 27.5 years for residential income property and 39.5 years for office, retail, and the like.
However, cost segregation (CostSeg) is an entirely different approach.
Instead of merely subtracting the land value from the purchase price, then dividing the remaining value by 27.5, CostSeg uses much shorter lives for every single system or factor involved in its construction. An example would be all the appliances, which generally speaking, can be written off in five short years—much less time than 27.5. The electrical, plumbing, roofing, A/C, and the rest are all treated likewise, virtually always with far shorter useful lives.
Here’s the bottom line result of using CostSeg as your depreciation approach: Compared to the normal straight-line approach, the depreciation dollars per year is virtually doubled! In the couple’s case, that meant their per duplex annual depreciation would jump from around $10,000 to $20,000 annually.
Now, that sounds too good to be true, right? Turns out in one critical way it is. See, our dynamic couple easily makes more than $150,000/year, adjusted gross income, or AGI. Here’s the problem with that.
When your AGI travels from $100,000 to $150,000, the IRS slowly but surely eliminates your ability to use any extra depreciation leftover after sheltering cash flow against your ordinary income. In other words, the fact your AGI exceeds $150,000 means all the time you own that property, all leftover depreciation is shunted off to the sideline to gather dust, with one cool exception in their case. Why? Cuz you make too much money at work!
But there’s a real-life happy ending to this story.
Discounted Notes Secured By Real Estate
Fast forward a few years, and they now own four Texas duplexes. The total cash flow varies, but it stays in the range of $20-25,000 annually, all of which is tax sheltered.
They’ve been cussing and discussing my advice to branch out into discounted notes. The market was offering nice discounts, as 30 percent wasn’t uncommon. They pulled the trigger, spending roughly $85,000 on a total balance of roughly $118,000. The cash on cash return was just over 12 percent per year, with income at around $10,300.
As of earlier this year, they acquired another $400,000 +/- in discounted first position notes, secured by real estate. Their updated, current note income: just over $54,000/year.
Note: The leftover depreciation each year was used against the interest generated by the notes. This resulted in making all their note income tax-free. They’re now saving roughly $90-100,000 yearly.
Tax Deferred Exchange
They’d become comfortable with the idea of executing a tax deferred exchange (IRC Sec. 1031) on their fourplex. They’d come to understand the huge long-term benefits of exploiting the impressively increased equity they’d created over less than three years.
We got it sold, and we took the net proceeds to Texas. They ended up with half a dozen brand new duplexes in the Austin market.
As I’d forecast a year and a half earlier, this one move turned out to be incredibly beneficial. How much so?
Less than five years later, they were able to refinance all of ’em to the tune of $500,000 in cash—all of which was tax-free by IRS definition. Fast forward a few more years. They’ve now amassed approximately $1 million in cash, over and above their handsome cash reserves.
Wait just a second here! How’d they manage that? It’s simple everyday math.
They saved a minimum of $5-6,000 monthly, then grew that savings to $8-10,000 monthly. Add another $10,000/year from tax-free note income. Then there’s the monthly cash flow from,—count ’em—10 duplexes, which historically ended up being $50-60,000 annually. Again, this was after taxes.
Two of their original Texas duplex purchases on which CostSeg was executed were sold. Between the taxes not paid on the note income and the leftover depreciation of almost five years, they essentially offset 85 to 90 percent of what would have been their tax bill, net net. Cash proceeds easily exceeded $250,000.
They had a glob of savings and purchased an impressive portfolio of roughly a dozen more discounted notes. Their cash on cash on this purchase has proven to be about $50,000, or 12 percent.
The best thing? This new portfolio of notes sports an overall loan to value of roughly a cheeseburger less than 50 percent!
Their current annual savings rate at this point has now reached approximately $130,000 yearly.
A couple years later, they decided to invest $400,000 in one of my investment groups. They continue saving money like crazy.
Fast forward to today. The first profits are imminent, as development of a lot zoned for multiple housing and a commercial space is now up for sale. The return on investment to the investors will exceed 10 percent—likely more.
They’ve now accumulated another $1 million of investment capital. The idea is to take a touch more than half and put it into another investment group that’s also developing income property. The balance will be directly put into partnering in acquiring their own stuff in the same project as the group.
The cash flow on these two investments alone should result in at least $100,000 annually. Remember: That was their initial retirement income goal.
More Tax-Free Income
I won’t bore you with a bunch of insurance mumbo jumbo here. Suffice to say, one of the key members of my team, David Shafer, insures a minority of my clients for the primary purpose of producing a stand alone source of tax free income in retirement.
In Timm ‘n Sherri’s case, this retirement income would begin in around 20 years (age 65) and fall into the range of $70-80,000 yearly, ’til age 89. I’m putting my own kids and their kids into this product.
Actual and Projected Cash Flow in Retirement
Here I’ll be using the actual known cash flow whenever possible. Otherwise, the low end of the cash flow range will be employed.
Current annual note income: $60,000. The interest income is still sheltered, but that shelter is now reaching its limits. If they buy more notes in the future, some (if not all) of that new interest income will be taxable. The current interest income, however, is still sheltered.
It’s important to understand something about these notes. They’re like bunnies. Keep ’em warm and fed, and pretty soon ya gotta whole bunch more bunnies. What’s better is that they come with plans B and C, if needed. But that’s another post altogether.
Current annual income property income: $20,000. This used to be nearly triple that amount. But since the decision was made to refinance all of ’em for just over $500,000 tax-free, cash flow took the hit.
Bottom line? They now have all their initial down payments and closing costs back working in other investments, while only selling 20 percent of the properties.
Group investments: Currently they’ve contributed $1 million into a couple investment groups, over half of that just this month. The first group is now about to distribute some attractive profits to their investors.
From 2020, and for the next several years, the cash on cash for both groups should easily hit $100,000 yearly. Some years will be less; some years will likely be embarrassingly more.
EIUL: This will begin at age 65, though it can certainly be sooner or later at Timm’s and Sherri’s discretion. We’ll use the lowest range amount, $70,000 tax free annually.
Notes: $60,000 Income property: $20,000 EIUL: $70,000 tax-free Investment groups: $100,000
Total: $250,000 annual income in retirement
This assumes rents never rising, never making profits on notes, note payments never increasing, and group investments never doing better than 10% return.
None of those numbers factor in the roughly $400,000 they’re about to put into new nightly rental properties to be built in another state. The conservative projections say the cash on cash should easily be 9.6 percent, likely north of that.
By Christmas of 2021, my personal equity in the same project will be roughly $3-6 million. Walkin’ the talk, right?
Oh, and their cash reserves are approaching $200,000—a sensitive subject with me.
Timm and Sherri have always lived their lives frugally, though not like monks in any sense. They’ve always been huge savers, eschewing the impressive cars and lavish vacations. Combine that lifestyle with the use of multiple well-planned strategies all designed to reduce risk, and these results are what’s possible.
In fact, the not so conservative numbers on all their investments will, more likely than not, end up with them retiring on far more than shown here. They took advantage of what the market gave ’em and never tried to control the market—a circus act for clowns if there ever was one. They weathered a recession, no problem.
Oh, and about those notes. By the time the EIUL comes to fruition, the note portfolio will have grown tremendously, even after tax. The income will, of course, follow that growth.
Four stand alone sources of income. It’s now likely that Timm will retire on or before his 50th birthday.
Are you conservative with your spending? Are you saving? Are you investing? What’s your retirement plan?
Tell us your story in a comment below.