How To RetireTax-Free

Since my last newsletter on real estate investing, I've received a great response from many of you. Some already own investment homes, and others are thinking about it, and want to know more. Since you asked, here's what I'm personally doing.

Besides my personal residence, I currently own 12 rental properties, and I'm in escrow on 3 more. Properties I buy need to cash flow with low down payment, at a price of $125-200K per property.

I'm now 54 years old. I will wait 8 to 11 years, and retire when I am between 62 and 65 years of age. By then the properties should have doubled in value, giving $125-200K of equity in each.

There are so many ways to retire using real estate. Strategy #1 used to be my plan, but that was before I had a granddaughter! See how things can change? My own personal plan is now a combiniation of strategies. So you'll have to see which ones fit with your own lifestyle.

Exit Strategy #1. Convert rental properties to personal residences.

I will live in each property for two years, converting it into a primary residence, and then selling it, keeping the gain tax-free. Each house should provide enough money to live on for two years, until selling the next one. This will work for 20 years, at which time I will be 85 years of age.

Let this sink in for a minute and you'll appreciate the power of it. There is no other place you can invest and keep the gains tax-free. All other retirement plans are merely tax-deferred, meaning you pay taxes on it when you retire. They say that your tax rate will be lower at that time, but not if you still have other residual income. Many of my retired clients still do have income, from a sale of a business or other assets, so their tax rate is still the same. That means to calculate what you have to live on, take what you've accumulated and reduce it by 40%.

With this plan, you don't need as much to retire as with a 401K tax-deferred plan. I've been to all the seminars saying how you need to have 5 billion dollars in future money to retire, so therefore you need to contribute 100K per year into our mutual funds! (I exaggerate, but only a little.) It doesn't matter if stocks are down or up, just keep giving us your money every month. This is called "dollar cost averaging".

Well, guess what, I'm too old for that plan, and I don't like it anyway. What if the stock market is down when I need the money to live on, like it is now? What happens when all the baby boomers take their money OUT of the stock market at the same time to pay their bills? No mutual fund salesperson (a.k.a. "financial planner") has an answer for that one. I know many people who thought they had their retirement all planned, but now have to continue working. They're hoping the stock market comes back, but what if it takes 10 years? The biological clock keeps ticking regardless.

I know you have lots of questions. I'll try to cover them.

Where can you find properties with low down payments that cash flow?

In San Diego County, it's impossible to find single-family residences that cash flow with 10% down. Even figuring in the tax advantages of depreciation, it still doesn't work. That's why it took me so long to get the San Diego properties I own! I had to come up with huge down payments.

But I'm getting older, and so now I'm looking into other areas that DO cash flow. For example, the Riverside and San Bernardino Counties are booming, and the numbers are much better than San Diego. We just closed escrow on one in Victorville.

If you're younger and not in such a hurry, you can buy San Diego property, maybe one every few years as you save up the down payments. One benefit of your investments being close to home is that it's easier to manage them. If the properties are further away, you can hire a property manager, you just have to add $50-$100 a month to your expenses, and make sure the property still cash flows.

What if I don't want to live in them?

Good question - some of my properties may be too small, or in areas that I wouldn't want to live in for two years. I would of course leave those properties until last - maybe I won't need them, and they'll be in my estate. I could always do a 1031 exchange to a property in San Diego, or someplace else that I do want to live in. I may have to take two properties and exchange them for one, but you get the idea.

What if I live past 85?

I'm being very conservative on these estimations. Did you know that the average appreciation rate in this country is 7%? Did you know that there has not been a down year in real estate since the National Association of Realtors started keeping track of prices in 1968? Now certainly some areas have had ups and downs, but prices in the country as a whole have never gone down. By the way, that's a good reason to diversify, and not have all your properties in one location.

Anyway, the plan calls for a double in 11-14 years. That's below the average appreciation rate. And remember, it will be 10 more years before I get to property number 5. What if those remaining 5 properties double again? I should then be able to live 4 years each in the remaining 5, getting me to 95. And by the time I get to the tenth one, it would have doubled again, and now I can live 8 years in that one, when I'll be 99.

What about inflation?

If we have inflation, rents will go up, and property values will go up as well. So yes, I'll need more money to live on, but the house will appreciate even faster. Remember, we only put 5 or 10% down, but the ENTIRE house is going up at 7% a year. So if we have 10% inflation, I will need $110K a year to live on instead of $100K, for example. But my $2 million worth of properties would have just gone up another $200K.

Oh yes, and if rents go up faster, I can add that to the mortgage payment, building more equity faster. So I'm not afraid of inflation, but welcome it!

What about multi-family buildings?

You certainly can make money investing in units. I've owned an apartment building in Vista, so I have experience in multi-family as well as single family residences. But units are very different from single family homes.

First of all, units don't work for this plan, since you can't live in them and pocket the gain tax-free, which is the whole point. And here's some other points to consider: Over 4 units and you're dealing with commercial loans, not residential, and you'll need at least 25% down. The price of units is purely a function of the rents - home prices may be skyrocketing, but if rents aren't going up, the value of your building isn't either. The tenants are more mobile, meaning you'll have greater turnover, and turnover means expenses. Maintenance is higher, as one overflowing toilet upstairs can damage four apartments!

On the plus side, the opportunities for cash flow are greater. If you want to explore that area, you'd be better served by finding an agent who invests in units himself, and has a passion for it. My passion is single family homes, it's what I know and love.

What if they change the tax laws?

That's always a danger. Uncle Sam giveth and Uncle Sam taketh away. But the new tax law actually extends the primary residence exemption to your heirs beginning in 2008, so it looks like that intend to keep this rule around for awhile.

But if not, there are plenty of other ways to accomplish the same thing.

More Exit Strategies

Exit Strategy #2. Pay off the mortgages and live off the rents.

This plan goes like this. Buy rental properties that cash flow. When rents increase, don't spend the extra rent; use it to pay down the loan. In this way it takes maybe 15-20 years to pay off the first property. Then take the entire rent payment from property #1 and apply it to the second property. Things start to snowball after that. You end up with free and clear properties, and can live off the rent checks. A good plan, but too slow for me because of my age.

Actually, it will probably take less than 15 years to pay off the mortgage, because once rents go up, you can refinance to a 15 year loan. As rents rise further, throw the extra money at the principle, paying it off in less than 15 years. Remember that you'll have to pay income taxes on the rents.

Exit Strategy #3. Cash out refis.

Here's another tax-free retirement method. After rents have increased for a few years, just do a cash-out refi on one of your properties, and live off that tax-free money for awhile. Then refinance another property and do it again. Since rents have gone up, the rents cover the new mortgage payment. It's kind of like starting over again with this property, bringing it back to break even.

Exit Strategy #4. Use Real Estate gains to pay off your loans.

This one I learned from Steve Dexter. Figure out how much money you need to retire, and how much rents your houses produce, then you know how many paid off properties you need. For example, if you need $10K a month, and each property brings in $1200-$1500 in rents, then you probably need 8 free and clear properties to retire.

The plan is then to buy 16 properties, and when they have doubled in value, sell half and pay off the other 8. I know there will be capital gains to pay, but the loans will be paid down somewhat, so it works out about the same. So if your properties double in 10-12 years, that's when you can retire.

Exit Strategy #5. 1031 Exchange to improve your cash flow.

I have some clients who have used this one. You sell property in areas that have appreciated but rents have not gone up, and use the cash generated to buy properties in less expensive areas that have strong rental markets.

For example, one client of mine has sold his condo in Carlsbad that rented for $1500 and with the same money he bought 3 houses in Florida that generate $2700 a month in rents. He almost doubled his monthly income! Another client of mine did the same thing and bought 3 houses in Albuquerque. Why Albuquerque? It turns out he has relatives there, so now whenever he goes to visit his family, he does some work on the properties and the trip becomes tax-deductible.

Exit Strategy #6. The Zipper Technique

Credit for this one goes to Joe Zipper, an investor friend of mine, who has had great success in his real estate investments. This is a most unconventional and brilliant exit strategy that minimizes taxes. Disclaimer! I'm not a tax advisor, and you'll have to do your own homework on this. The numbers are accurate as best I know as of this writing (Feb. 2006), but tax laws change all the time. I'm only trying to give you the thinking that went into this strategy. You need to get your own tax counsel on how to work it out for your particular situation.

Here's what Joe did. First, he squirreled away money in an IRA over his working life. Second, he purchased a large number of lots in Florida, and has seen them appreciate very well over time. Now, how to get the money out for living expenses?

Step one is to only take out of the IRA enough money to keep you in the 15% federal tax bracket. That's $59,400 for married filing jointly. This is the Adjusted Gross Income amount that keeps you in the 15% bracket. That means you take from the IRA only enough to pay all your mortgage interest and other deductible expenses, so that what is left over is less than $59,400. So far so good. Your home interest and taxes are paid, your second home interest and taxes are paid, and you have about $5K a month left over for non-deductible living expenses.

Here comes the good part - if you are in the 15% federal tax bracket, your long term capital gains rate is 5%. So Joe's plan is to sell a piece of property each year to supplement his income, and he's only going to pay 5% in taxes to do it. At this time, you can pay 5% on about $60K of long term capital gains before you either go into the 15% bracket or AMT kicks in. Again, don't get bogged down in the details here, just get the concept.

The bottom line is that Joe has figured out how to use the tax code to pay as little taxes as possible on his IRA money and his capital gains.

Oh, and one more stoke of brilliance before I forget - Joe has moved to Florida to retire, where there are no state income taxes! Wow, talk about making what you have go farther, I think Joe has mastered it.

So to recap, first be in the 15% federal tax bracket, second, pay 5% on long term capital gains, and third, be in a state with no state income taxes.

Maybe you could use some or all of these techniques in your investing. If you live in California, how about moving to Nevada for 2 years and selling some highly appreciated real estate in Florida during that time? You can then pay no taxes on the gain of the house in Nevada because it is your personal residence, and no tax to California on the gains in Florida. It makes my mind spin with possibilities!

The Bottom Line!

The bottom line is that no matter what age you are, you can do something to improve your position. Of course if you're younger, you have more options, but there are always ways to accomplish the goal.

I recommend you all read "Cash Flow Quadrant" by Robert Kiyosaki, to learn why investing is so important. On page 90 in this book he says,

"Stop waiting for the "big deal". Get into the game with small deals, like my first small condo that allowed me to start investing for just a few dollars. Don't worry about being right or wrong at first, just start. You'll learn a lot more once you've put some money down... just a little to start. Money has a way of increasing intelligence quickly. Fear and hesitation retards you. You can always move up to a bigger game, but you can never get back the time and education you lost by waiting to do the right thing or make the big deal. Remember, small deals often lead to bigger deals... but you must start."

The good news is, you don't have to do it alone, you have me! I'll give you my best-reasoned advice and I promise I'll work hard to help you find a good investment, or help you get the most out of the investments you have. So if you're interested, call me, and let's make it happen!

(Disclaimer! I'm not a CPA, so you should verify everything I've said with your tax professional and see if real estate investing is right for you.)