When we left our intrepid couple in my last post, they were ready to execute the real estate portion of their purposeful plan. They’re going to take about $100,000 (maybe less) and put 25% down on a brand new duplex in another state. They’ll borrow the rest at somewhere under 5% on a 30-year, fixed-rate loan. That’s the current interest rate as I write this. Since their combined marital income easily exceeds $150,000 per year, using leftover depreciation after sheltering the property’s cash flow is banned by the tax code. They’ll turn those lemons into lemonade by using what I’ve come to call the cost segregation strategy. Here’s how it works.
Normal depreciation is calculated by first subtracting the land value from the purchase price of the property. The remainder is then divided by 27.5 years. This results in the annual depreciation the investor then uses to shelter both cash flow and ordinary income (if he makes under $100,000/year; if he makes $100,000 to $150,000, they’ll keep taking away more depreciation available to shelter ordinary (job) income until it’s simply unusable).
Cost segregation is exactly what it sounds like. Each and every component used to construct the property is segregated and assigned it’s own lifespan. A stove might get assigned a five-year life, whereas a roof might get far more time. The end result is simple: When it comes to small residential rentals, say one to four units, cost segregation tends to double the dollar amount of depreciation available annually. But then that begs the question, doesn’t it? Why on earth would someone do that if they can’t use the leftover depreciation to offset their job income?
Even though the unusable depreciation is shunted to the sidelines to gather dust and mold, it doesn’t disappear forever.
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The investor then has a couple lines on a chart, both with five–year lives. The first line represents how long the maximum dollar amount of depreciation lasts using the cost segregation method. After five years, all the five-year-lived components have been depreciated down to zero. The result is that the next year’s depreciation dollar amount is way lower. The second line represents how long Doyle and Marian have to completely pay off their loan. They’ll need to add $3,550/month to the loan payment to make this happen; $5,000/year of that will come from cash flow. They’ll use their own money for the rest—around $3,133/month.
They sell the property, timing it to close escrow as near to the end of the five-year period as possible. For this example, we’re going to assume the property only rose in value enough to pay selling costs during the five-year holding period. This results in an annual rise in value of 1.68%. Could it be less? Or even lose value? Of course it could. What I’m trying to demonstrate here is that they would, in this example, only sell at a price high enough to result in net proceeds of what they paid for the property. More simply put, they paid $350,000 and netted the same in five years.
Why on Earth Would They Do That on Purpose?!
Remember the tax law forbidding them to use any leftover depreciation against their job income?
With an annual cash flow of roughly $5,000, and $20,000/year in depreciation, they were putting $15,000/year, every year, on the sidelines. The thing is, now that they’ve sold that property, the IRS doesn’t have a hook to hang its hat on any more. It can’t stop them from bringing all that unused depreciation into their personal income-tax return for the tax year the property was sold. Here’s how that looks:
The normal annual depreciation would have been about $10,000/year. Using the cost segregation method brought it up to about $20,000/year. This resulted in roughly $15,000/year being shunted to the sidelines, unusable due to the tax code. After five years, the unused depreciation grew to roughly $75,000 (5 x $15,000/year = $75,000). If their gross pretax income was roughly the same as when they bought the property, then in the year of sale it decreases to about $155,000 ($230,000 – $75,000 =$155,000).
That year, in state and federal income taxes (based on current tax rates) they will save a couple of cheeseburgers less than $29,900.
On the Other Hand…
You didn’t think they sold that property and weren’t liable for some sort of taxes, did you? They’re actually on the hook for a couple different tax liabilities: capital gains tax and depreciation recapture tax. We can pretty much nail the tax on excess depreciation, because we know the tax rate and the amount being taxed. Since the $20,000/year depreciation they took was about $10,000/year over and above the normal $10,000/year, they’ll owe a tax rate of 25% on all those dollars. In this case, it was $50,000 at 25%, which comes out to a tax liability of $12,500. Then there’s the cap gains taxes owed. Roughly speaking that should be approximately $18,000, maybe a bit less.
Total tax liabilities incurred from sale: $30,500.
Total taxes saved in year of sale due to that sale: $29,900.
Total taxes due net/net? $600.
Boiling it down, that means they banked $350,000 in cash in just five years, and only paid a lousy $600 in taxes, total.
But wait just a dang minute, Buster! What about their down payment and all that extra money they plowed into that loan in order to get all that cash? I’m so glad you asked!
It was $90,000 to close the escrow purchase. They used $37,596/year of their own money for five years to help free ‘n clear the property. There was $349,400 net proceeds after tax from the sale of the property, resulting in a tax-free annual return of 7.675%.
But that’s not even the best news — not by a long shot.
Doyle and Marian now have a tad less than $350,000 — after tax dollars — in the bank, that they can invest in whatever they wish. Let’s pause to reflect on this a few minutes.
What are Their Options?
- They could replace the duplex with two duplexes and still have roughly $150,000 left over for whatever.
- That ‘whatever’ might well be a whole bunch of discounted first position notes, secured by real estate yielding at least 10–??% yearly cash-on-cash on the payments alone. That doesn’t count the profits built in by the discount they got on the price, which is realized when they begin paying off early. The vast majority of notes do pay off before agreed.
- They might decide to join a note investment group, as some prefer the more hands-off approach to notes.
Captain Obvious tells us that there are endless options and combinations on their menu at this point. Why might they opt for acquiring a couple duplexes to replace the one they sold? Again, it’s simple. They’re still relatively young. If they used the remaining $150,000 to acquire, say, $15,000/year in pretax note income, they could use the after-tax dollars from the payments to assist them in repeating the cost segregation strategy on one of ’em. This would result in a significant decrease in the amount of cash needed from their job income to execute the loan payoff.
In this scenario it would likely go down to $17,846/year (give or take) from $37,596/year. (We simply subtracted cash flow from two duplexes and the after-tax monthly cash flow from the discounted notes.) At BiggerPockets we call that OPM — other people’s money.
It’s my contention that they’d be able to execute one cost segregation strategy every five years — thrice — ’til Doyle’s 52 years old. By that time they would’ve built up their privately owned discounted note portfolio to more than $500,000 in original purchase price value, possibly more. At that point, their pretax note income would likely be close to $60,000/year. Give or take, that’d allow them to apply after-tax note income of $3,500/month (plus or minus) to their remaining income-property debt. Their income property cash flow plus spendable note income plus their own disposable income would easily pay off any remaining investment-property debt by the time they reach 60 years old.
Let’s say they end up with just four duplexes, all free ‘n clear as Marian approaches 60. That’s 25 years from now, so let’s be ultra conservative and say the NOI (net operating income) of each duplex has risen from $20,000+/year to just $25,000. That’s an annual average increase of just .9%. (I’ve not yet seen anywhere where that’s not happened over that period of time.) That means the cash flow from real estate will be around $100,000 yearly, though likely more. Maybe 40% of that will remain sheltered by normal depreciation, but not for too many years.
Neither of them will even be 30 years old at the time they retire. But cash flow from real estate, at least in many of my purposeful plans, is designed as mere spending cash for various sojourns around the world.
Really, Jeff? That’s all it is? Well, no; it’s just that most investors view real estate as the be-all, end-all for retirement income. Between discounted notes in a Roth wrapper and EIUL(s), they’ll already be enjoying over $250,000/year—wait for it—tax free.
But Then, Why Even Own All That Free-‘N-Clear Real Estate, You Ask?
First off, who’s gonna turn down six figures a year in cash flow? Right; none of us. It’s simple, really. Those free-‘n-clear income properties represent roughly $1.5–2 million in net worth, likely more. What if at retirement, Doyle and Marian decide they love the surrounding hill country of Boise so much that they’d love to own a second home there? They learn $400,000 is needed. They make a call to their lender, and in four to six weeks their bank receives a wire for that amount. Oh, did I forget to mention it’s not even a taxable event? Yep, it’s all tax free. All they gave up was their lowest-yielding cash flow for the amount it takes to service that new debt. They didn’t give up a dime of their net worth, either. They just redirected some of it to Idaho. That real estate allowed them to buy the home for cash, without messin’ with either their EIUL or note income.
In other words, properly viewed, their debt-free income property is the Bank of Doyle and Marian.
With What Income Will They Retire?
•Marian’s EIUL: $70,000/year minimum, likely 10–20% higher.
•Marian’s Solo 401k: $200,000/year.
•Their real estate cash flow: $100,000, though likely somewhat higher.
•Their personal discounted note portfolio: Based upon their consistent discounted note purchases over the long haul, the conservative estimate is that they’ll have roughly $600,000 invested in that vehicle. The before-tax income on that will likely be at least $60,000/year.
•Total Retirement Income: $430,000. Just a bit over 62% of that will be tax free. Three of the four sources, pillars if you will, tend to increase over time. EIUL income is pretty much set, though it can be unilaterally altered by policy holder choice.
Bottom Line Takeaway
Nothing in their purposeful plan was anything but mind-numbingly boring. Every single executed strategy was done on purpose, and with a built-in Plan B. Heck, notes actually have a built-in Plan C. To one extent or another, what Doyle and Marian accomplished here is doable on much lower economic levels.
Think about it for a minute. What if your financial reality dictates you can only do 25% of what they did in this two-part case study? I’ll go out on a limb here and assume you wouldn’t be upset with $107,500 in retirement income. This is especially true since over $65,000 of that income would be tax free.
None of this is rocket science. You want proof? I’ll quote my dad, who never tired of tellin’ me how he couldn’t remember MIT ever recruiting me.
Here’s the fly in the retirement ointment for this couple. Sans a huge jump in the technology of physics, they won’t be able to enjoy Paris and the Virgin Islands at the same time. But now we’re just quibbling.
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