Retired Real Estate Investors — Lotta Income — Alas, Lotta Taxes Too

Posted @ 8:42 pm - Filed under 1031 Exchanges, BawldGuy Axiom, Cash Flow, Depreciation, RE investment strategies, Retirement Income, Tax Shelter

Was talkin’ with a very bright agent today from the Tacoma area. We were talking about retired folks he knew, who owned several smallish income properties locally, all of which were either free and clear or close enough for horseshoes. My immediate response was, uh oh.

These investors took Grandpa Economics to it’s logical if ill-fated conclusion. This falls under ‘be careful what you wish for’, ‘cuz you might get it.

They’re now over 70, retired and living off the fruits of decades of investing. Their Plan was Purposefully executed — which is the crux of the problem. The strategy they employed had a huge hole in it. See, they now own all these debt free properties, most if not all of which are completely bereft of depreciation. As you are probably aware, depreciation has an alternate spelling — T-A-X S-H-E-L-T-E-R. Their home is free and clear too. They don’t have a shred of an inkling of a hint of any kinda shield against all that income — and since April 15th seems to come around pretty much every year or so, that can be a problem.

Combine that with the fact most of these properties were purchased in the 60’s, 70’s and 80’s, and the problem of old buildings also mucks up the retirement income picture. They were acquired during those years — Lord knows when they were actually built. It’s almost a lock their operating expenses will rise nearly every year into eternity or ’till they burn down, whichever comes first.

So to review — they have an impressive income, but no tax shelter, with none in their future. That very income will very likely shrink from year to year, regardless of the fact younger properties will see rents rise from time to time. The functional obsolescence which no doubt already retards what rent they might demand, becomes a bigger anchor each passing year.

There’s something they can do though. It appears on the surface to be a sideways move, but in the end, it makes sense for many in their position.

There are a couple options on their menu. The easiest is to take cash or very liquid assets and acquire solid cash flow income property — no doubt not local. We’ll assume they came up with $250,000 or so. Here’s where I must convince them to resist the temptation to continue down Free ‘n Clear Highway. Though somewhat counter-intuitive, it makes more sense for them to acquire two properties with 50% down payments. One immediately wonders why not just buy one, take the income, and be happy, right?

That’s not what after tax analysis tell us though.

A debt free property will produce about $17,000 in cash flow, but only about half that in depreciation. Two of ‘em with 50% debt will yield the same, (actually about $700 a year less) cash flow — but — drum roll please — all of it will remain untaxed due to the new depreciation. Voilà! For roughly $250,000 obtained from either current property(s) or cash/assets on hand, they’ve created approximately $16,300 of AFTER TAX income. For a retired couple being taxed to death, this is no small improvement. That’s over $1,350 a month in additional income — all of it immediately useable and, more importantly — after freakin’ tax.

There’s certainly more options on their menu, but that’s one that works every time it’s tried. I’ve had clients in similar circumstances refi older, debt free properties to accomplish the same results. Their after tax cash flow increases significantly and will remain completely or mostly sheltered for many years. A kind of secondary benefit to the refi, is that property’s cash flow is drastically reduced, usually to just above ‘break-even’. This then results in an immediate reduction in taxes owed next time April 15th rolls around.

Note: At some point I’m usually asked why I wouldn’t recommend a tax deferred exchange into younger, better producing property(s). The answer is simple: Because of the rules surrounding ‘adjusted basis’ the investor’s increase in tax shelter would be more than a little disappointing. Therefore I almost always, with rare exception, advise against a 1031 as a solution to this scenario. Buying with capital unfettered by Section 1031 regs allows an investor to be treated as a sort of reconstituted virgin as it relates to depreciation.

Ask those now retired what they’d do for an additional $1-3,000 a month in after tax income. They’ll be all over it if their current income is without sufficient tax shelter. Duh.

BawldGuy Axiom: Counter-intuitive solutions are often magically converted to obvious solutions when one makes it a practice to always do the after tax cash flow analysis. What the ‘gut’ likes is often what makes us ’sick’. Don’t run headlong into so-called solutions without be armed by the results of said analysis. ‘Nuff said.

Everyone have a tremendous three day weekend. My little ‘BabyDoll’, who was in kindergarten just a couple years ago, is gettin’ her college degree Sunday! Even though, I’ll return your call if you leave a message. 619 889-7100 Have a good one.

This entry was posted on Thursday, May 21st, 2009 at 8:42 pm and is filed under 1031 Exchanges, BawldGuy Axiom, Cash Flow, Depreciation, RE investment strategies, Retirement Income, 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.