An Example Of Grandpa Economics’ Principles At Work

Posted @ 8:11 pm - Filed under 1031 Exchanges, BawldGuy Axiom, Cash Flow, Palo Alto, Retirement Income, San Diego Property Owners, Selling Income Property, Sominex Account, Tax Shelter

Before I get all revved up here, if ya wanna know what the heck Grandpa Economics is you can listen to the podcast I made on the subject. Bottom line — Free ‘n clear ain’t what it used to be — or, better said, never was. It just appeared to work better in Grandpa’s world because most in his day drank that Kool-Aid. But the principles available to Gramps were the same available to you today. If he’d applied those principles back in his day, he would’ve still been far better off than the Plan he executed. Again, please listen to the podcast if you’re not familiar with Grandpa Economics — it’ll shed some light on a myth that’s been handicapping taxpayer/investors for generations.

Let’s say you live in San Diego or some place with similar market characteristics. This could mean L.A./Orange County, Bay Area locations such as San Francisco, Walnut Creek, Palo Alto and the like. You own a rental home and a duplex — both unencumbered by debt.

The home has a current market value of $350,000 — the duplex about $380,000 or so. Rents are $1,800 for the home, and $2,200 ($1,100/side) for the duplex. We’ll use 8% for costs of sale in the example. Let’s establish what the annual cash flow is first.

We’ll give our San Diego investors (married couple) every possible break. No management expenses, as they’re gluttons for punishment. We’ll grant a Net Operating Income of $33,000 a year. It could/will vary from year to year, but that’s probably a reasonable figure, based on my local experience. They made these purchases recently — for cash. The current values are slightly less than what they paid, but just slightly. They’re nearing retirement so after tax numbers are about to move up to the priority A-List.

BawldGuy Axiom: The realization that after tax income is far more important than pretax income is an epiphany you don’t wanna experience post-retirement — the die will have been cast.

OK, back to our San Diego couple.

Their local properties generate annual after tax income of about $30,000 a year. That includes gross scheduled income, expenses, depreciation, everything. Let’s look at that a moment a couple layers below the surface.

The house is just over 40 years old, the duplex was built during the Eisenhower administration. Ya think operating expenses will be rising or falling each successive year? Do you think rents will keep up with younger more modern properties in the area?

Hint: Rising operating expenses combined with rents unable to keep up with competing units is not a recipe for a happy retirement. It’s a formula for stagnant after tax income, and to add insult to injury, every year has the potential to be more labor intensive than the last. ‘Course if you love constant fix-up this is the strategy for you.

If however they choose to sell, how would it be different?

First of all the sale would show a capital loss meaning no tax deferred exchange would be required. Remember, the props aren’t worth what they paid for them. It’s about a match for the little depreciation they’ve taken the first couple years.

If they take the net of around $672,000 and purchase 7 small income properties in a growth region, putting healthy 35% down payments, here’s what it might look like when the smoke clears. Before though, I’ll note our couple will be advised to bank the $43,000 or so not used to add to their Sominex Account (cash reserves). Since they already had almost $60,000 set aside, this puts them over $100,000 which makes me feel wunnerful.

Their annual depreciation would climb immediately from roughly $22,000 to about $51,000 — more than doubling their tax shelter. Not bad.

The before tax annual cash flow on the new properties would be just over $35,000. Unlike the SD props though, the after tax cash flow is the same due to the huge increase in tax shelter.

The new properties are, well, brand new. I wonder what the difference will be in repairs and maintenance over the next 20 years? Let’s see, brand new vs 40-55 years old. I dunno, could be what — significant? Um, ya think?

The new props are all 3 bedroom/2 bath duplexes with attached 2-car garages, located in stellar neighborhoods and in high demand by renters. That’s a big improvement over the SD duplex which was 2 bedroom/1 bath with attached 1-car garages located in an area fairly described as ‘average +’.

Once they execute this strategy our San Diego couple is now free from hands on management forever. In my experience that news almost never elicits tears, unless of course they’re tears of joy.

This also gives them safety in numbers, as each duplex side has its own separate tax ID. This means if there’s ever a need for cash that could be filled by a sale, they have the option of selling a side or two, without totally disrupting their long term Plan. In fact, if they did hafta sell in say 5 years, it’s entirely possible they could use some/all of their unused depreciation to offset any capital gain that might be realized.

The one factor most folks will focus on like a laser beam is how their totally sheltered cash flow will be able to grow to over $50,000/yr before they begin paying any tax on it. The feeling they get from that is called ‘peace of mind’.

It keeps gettin’ better and better, doesn’t it?

These aren’t all the reasons they should make this move, just the glaring ones.

BawldGuy Takeaway: Grandpa Economics doesn’t work as planned with your home or your investments. Once you add up all the real life factors working against you — old and aging high operating-expense (and always rising) properties, Income forever unprotected by tax shelter, and worst of all? The stolen time, spent managing when you coulda been doing something, anything else.

Speak up clearly please. Who volunteers for putting themselves in our San Diego couple’s position and sticking with their status quo?

Right, as I expected. Crickets.

How ironic that for many approaching retirement, the phrase free and clear won’t mean anything of the sort when it comes to their retirement lifestyle. There’s a way you can avoid that reality — it’s called Purposeful Planning.

If this comes close to describing you, call me now at 619 889-7100 or send me a quick email. Have a good one.

This entry was posted on Thursday, May 14th, 2009 at 8:11 pm and is filed under 1031 Exchanges, BawldGuy Axiom, Cash Flow, Palo Alto, Retirement Income, San Diego Property Owners, Selling Income Property, Sominex Account, Tax Shelter. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.