Some of the books I have read talk about the equity you can take out each year for income. Do any of you do this? I read it as my property went up 10K in value this year so I pull that money out as income. Can you do this? If so does anyone do this?
3 points:
-
Every time you take money out of a property that’s just more debt you’re taking on which will affect cash flow on the property.
-
If you refi a property and pull out cash it isn’t income, and isn’t taxable.
-
2nd position loans, whether a HELOC or loan are getting harder and harder to get, and are almost obsolete on the secondary market right now. If you use a local bank they’re only going to loan up to 80% of the value of the property so if you have a $100,000 property they’ll loan you $80k. Next year if it appraises for $110k they’ll loan you up to $88k, so don’t think you can draw out $10k because it went up $10k.
very good to know. Some of these guys make it seems so easy, makes me wonder if they every have tried it. I think I got this info from Kiyosaki, cant remember what book as I read all of them. They make homes seem like a bank account, which i am quickly learning the equity is far from liquid.
It’s not income, Hugh, it’s debt. You can get the same effect by charging $10,000 on your credit card and living on that.
The only way to cash out your equity and to have it as income is to sell.
Yeah, technically this technique is cashing out equity so you are just exchanging equity for debt. As a result you end up with tax free cash in your pocket which spends just the same as tax free “income”.
If you want an extra $25K tax free cash (I don’t care if you call it income) every year for the rest of your life, there is a way to do this.
You just have to buy a rental property every year for ten years. The property has to cash flow to make the technique work. Beginning in year 11, refinance the property you purchased in year 1 to take $25K cash out. In year 12, refinance the property you purchased in year 2 to take $25K cash out. Keep seequentially refinancing each of your properties every ten years to withdraw $25K in tax free cash.
The idea is that at historical appreciation rates, your property should nearly double in value each decade (or so). Every ten years, appreciation has created adequate equity for you to cash out $25K, while rental increases each year should allow your property to still cash flow after you refinance.
Whether a property you bought in 2005 will double in value by the year 2015 remains to be seen, but if you bought at a discount to FMV in the first place, I bet you can still see a double in ten years.
Here is an example. Let’s assume that you bought a $50K property in 2005 with 80% financing (a $40K mortgage loan). In 2015, this property will appraise for $100K. Do a no cost refinance for $65K, taking $25K out in cash. Since you have been increasing rent each year, your property should still cash flow after the refinance. In 2025, this same property will have doubled in value again to $200K. Do a no cost refinance for $90K, once again taking $25K out in cash. Once again annual rent increases should still allow the property to cash flow after the refinance.
If you buy a property each year for ten years, then beginning in the 11th year sequentially refinance each property, you should be able to get $25K in tax free “income” for the rest of your life. If $25K in tax free “income” will meet your retirement lifestyle needs, then this strategy will allow you to retire ten years from now.
There is a local guy here in the DFW who teaches that exact same system, but he does it every five years and he teaches it where you have five house you refi every five years. So every year you refinance five house and pull out equity. The example he uses is 20K per house X five houses. So every year you are pulling 100K of tax free money from that group of five houses. Wash Rinse Repeat. It makes total sense as long as the houses keep appreciating and rents keep going up.
I don’t think it is every year, but rather once every five years. I agree that the concept is the same. I would not be that comfortable with a five year refinance schedule because real estate cycles seem to run in five to seven year periods. To complete a down cycle and fully recover may take the full five years just to get back to where you started, in which case there would not be enough additional equity to cash out and still allow the property to generate a positive cash flow.
If the DFW market can average 14% annual appreciation over those five years, then this timeline can work well. I think averaging 7% over ten years is more realistic and that is the average appreciation rate we need for our property to double in value in ten years. Since all the “experts” are suggesting that it will take another three years to fully recover from the sub-prime mortgage debacle, a five year refinance cycle is probably too optimistic under these market conditions.
If you believe market appreciation will only average 4% annually over the next 15 years, then adjust the plan. Purchase 18 properties, one per year over the next 18 years. Then beginning in year 19, cash out refinance one property each year for the rest of your life to get that $25K annual tax free “income”.
So if you have 10 properties that cash flowed when you bought them, and they cash flow a lot better now, why can’t you live on the cash flow?
If the cash flow from just one property is enough to give you the payment on $25,000 mortgage including all that interest. Why not forget the loan and just live on the cash flow? Why pay interest on it before you spend it?
You pay 12% interest, you cut your standard of living by 12%. (If you think interest rates are still going to be 5% ten years from now, you are nuts)
My income from my rentals is tax free and if yours isn’t, you need a new accountant. I don’t have to pay interest on my money just so that I don’t have to pay taxes on it.
Be careful that you aren’t so clever that you out-smart yourself. Using debt to pay your day to day living expenses is not good financial planning
To add to tater’s point. You keep refi’ing over and over again and you’re taking on more debt. Ok I’m pointing out the obvious, everyone knows that. But what does that do to your estate that you leave to your kid(s), if you have them. I don’t think we want to be leaving our heirs sattled with our debt, which is exactly what could and will happen if you keep pulling out cash.
You should be able to make good enough deals where the cash flow from your properties is enough to live on. If it’s not, take a hard look at the offers you are making on your properties. I have people say to me all the time that they either break-even or payout money each month on their properties and I can’t help but laugh (sometimes out loud).
The best way to use your equity, if you want to be totally vested in this business, is to use it to buy other properties without pulling out that money. For you newbies the banks call this cross-collateral. Doesn’t cost a thing, the bank simply puts a lien on your equity in another property. As you prove you can make your payments the bank will release that lien allowing you to acquire more properties with that same equity, whereas if you pull it out once it’s gone. Assuming you don’t use it to buy more property.
I have a questions for you tater. How on earth is your rental income tax free. Are you using a trust or something? And also if it’s tax free and you go to a commercial banker and show him your taxes and it essentially says $0 how do you justify that.
I wouldn’t refinance anything unless I had to. I don’t own properties that I plan on renting out yet, but when I do my goal for them is to get them paid off and enjoy the cashflow and equity and have them their for my retirement. If I refi every few years that defeats the purpose.
I have seen a few local investors crash and burn doing this with flips. I know it’s not the same deal as rentals but they would buy, fix up, refi, then sell. Well, they were selling until subprime crashed and then they sat, and sat, and sat. Eventually it caught up to them and BAM. Game over.
How on earth is your rental income tax free. Are you using a trust or something? And also if it's tax free and you go to a commercial banker and show him your taxes and it essentially says $0 how do you justify that.
JBaldwin,
I can’t speak for Tatertot, but if you’re in the rental property business full time, you will be writing off all the business expenses plus getting the depreciation on the property. Therefore, even though you have a positive cash flow, you shouldn’t owe taxes. That’s how mine works out anyway.
Mike
That’s certainly the situation I’m familiar with I’m just not sure if he means that. I guess the way it was worded I was thinking maybe he had some setup where the rents didn’t actually go to a entity controlled by him but instead a trust or non-profit or something along those lines.
Either way it still begs the question concerning which expenses to claim. I know the bank will give you back interest and depreciation, but if you start writing down ALL expenses then you’re taxable income will be so low that the bank may look at you like you’re spending all your income.
I’m kind of struggling with this notion right now, with tax season upon us. I can’t decide to not report any expenses to show more of a profit, allowing me to obtain more loans. Or if I should expense everything to show a minimal taxable income, subesuently keeping me from getting new commercial loans. If you guys have any points on this I would greatly appreciate them, I’m in the midst of trying to figure out which way to go in regards to taxable income.
You certainly should claim every expense you legally can. You don’t want to be paying taxes you don’t owe. The banks know how to back out all the figures. I claim all my expenses and the bank has able to figure it out.
Mike
jbaldwin,
Remember their are two audiences interested in your financial statements. The IRS so they can tax you on your “taxable” income and your banker so he knows you have the “cash flow” to repay your loans. The bottom line numbers they each care about are very different. So long as you follow the rules and report your income and expenses in the correct slots you will be fine.
tatertot,
I don’t think you are seeing the bigger picture. I said that if Hugh0997 could support his retirement lifestyle on $25K a year for the rest of his life, then this strategy could work for him. What if those ten properties are only producing $200 per month in positive cash flow – $200 per month total. Hugh0997 probably could not support his lifestyle on $200 per month of rental income from all of his properties combined. But, EVEN IF his properties only generate $200 per month positive cash flow, he can still sequentially refinance every year to withdraw $25K in tax free cash from his properties.
If he wants to use this money to support his living expenses, that is his decision. What if he wants to use the money to purchase more property? Would you have a problem with that? Either way, the money is tax free, and the properties still cash flow after the refinance. And the bonus is that this is not money that he will pay back – his tenants will do that for him.
At 6% fixed for 30 years, a $25K cash out refinance only adds $150 per month to your debt service – certainly not a dramatic enough increase that it won’t be recovered in the next annual rent increase for the ten properties.
Interest rates are not 12% now, they are around 6%. If you are paying 12% interest on financing for your rental property, how are you generating a positive cash flow? Before you tell me I am nuts, look at the mortage interest rate history over the past 30 years or so. Back in 1975, owner occupant 30-year fixed rate mortgages were available for 6%. In 1986, the owner occupant 30-year fixed rate was around 7%. In 1993, the 30-year fixed rate had dropped to 5.5% about where it was in 2005. Today, in 2007 in the midst of a mortgage industry meltdown, you can still get an owner occupant 30-year fixed rate at 6%. Looking back over the past 30+ years, it would appear that interest rates would have been about the same if you were sequentially refinancing at ten year intervals. I have no reason to believe that this historical trend won’t continue. Of course there will be spikes and dips in the rates, but over the long term, 6% seems to be the equilibrium point.
Congratuations on having all your rental income tax free right now. I am soon to be not quite so fortunate. If you are successful and continue to grow your net worth, you may reach a point where you don’t have net passive losses from your rental activity. Hopefully, you get to the point when your passive income is a lot greater than the depreciation expense will cover, and your net passive income is then taxable. At my present rate, that will happen for me within the next two years.
I suppose I could acquire a lot more property to increase my depreciation expense, but then I would have to come up with the downpayment to secure 80% financing. I know … why don’t I just get $25K from one of my properties with a cash out refinance. If I have ten properties, I can sequentially cash out refinance each property for the next ten years to get the downpayment to buy a new one. Then with 20 properties in my portfolio, I can cash out refinance two per year to get the $50K I might want to acquire more or bigger properties.
I guess that would be too clever, and I might outsmart myself.
Exactly what Mike said. With all the nice deductions, by the time I get to the end of the tax forms, I don’t owe any taxes.
I didn’t mean to imply that I had some sort of tax immunity. I’m just taking advanatage of all the deductions Uncle allows me to take.
And actually, it’s not that I don’t pay taxes. My property tax bill is huge. So I am paying my way.
Dave T, the payment on the new mortgage isn’t going to be $150 a month. You are refinancing 10 properties and you are going to end up with payments of $1500 a month. Making $18,000 extra in mortgage payments makes it a little harder to live on that $25,000 extra you are borrowing every year. Don’t tforget to add in all the financing charges and closing costs while you are at it.
Not t mention, in order to borrow $25,000, you are going to have to have 3 times the payment in income every month, and there is a debt to asset ratio to be considered, too. I think the banks would cut you off long befoer you got to your 10th refinance where you were living on the borrowed money.
If you’ve got 10 properties each generating $200 a month, That’s $2,000 a month, or $24,000 a year. Why not just live on that instead of borrowing $25,000 a year?
I don’t share your concern about my heirs. I don’t feel obligated to leave my heirs a huge inheritance. They may get it anyway, but I am not amassing wealth for my heirs. I am doing it so my wife and I can continue to be financially independent, even when we celebrate my 100th birthday in 2049. By then, my direct descendents will be financially independent themselves, have their own seven or eight figure net worth and not need any inheritance from me.
Saddling my kids with debt? I guess you did not fully appreciate the scenario I laid out. The first 10 properties purchased in the first ten years do generate a positive cash flow. In ten years, the properties have not only doubled in value, but my tenants have paid down the mortgages so I have gained equity from debt reduction as well as appreciation. If I take $25K in a cashout refinance on only one property in year 11, I am adding just $25K to my debt load while subtracting only $150 per month from my cash flow. I will more than make up that $150 monthly cash flow with my next annual rent increase.
After the refinance, the properties are still generating a positive cash flow. The properties are still self-supporting. Equity is growing faster than new debt. My heirs will not be saddled with debt, instead, their problem will be figuring out what to do with the equity and the positive cash flow.
Chances are they will just sell all the properties and cash out the equity at a stepped up basis so there won’t be any capital gains impact.
The best way to use your equity, if you want to be totally vested in this business, is to use it to buy other properties without pulling out that money. For you newbies the banks call this cross-collateral. Doesn't cost a thing, the bank simply puts a lien on your equity in another property.
Let’s be clear about what you are saying.
I want to buy a property with 80% financing. I don’t want to use my own cash in the bank for the 20% down payment. The bank says will give me the 20% I need for my downpayment, but they will want me to use the equity I have in another property I own along with the property I want to purchase to secure 100% financing. Both properties will be used as collateral for this 100% loan they will give me to purchase the property I want to buy. This is cross collateralizing.
I have just used the equity in another property to get the money I need to make the downpayment. How is that not pulling out the money from my equity? How is end result not the same as doing a cash out refinance on the investment property in the first place?
Getting the lien released on your second property is a little harder than just making your monthly loan payments. The lender will want the loan balance to be less than 80% of the first property’s appraised value before the lien on the second property will be released. You can either pay down the debt or get to less than 80% LTV if your property has appreciated enough. If you have a different arrangement, then I am using the wrong lenders.
You understood what I was saying perfectly. But I think you missed this part. After you raise your rents, forced appreciation, and make your payments for let’s say 5 yrs, passive appreciation you should be at or around 80% LTV. At this time the lien on the 2nd property is released and you can buy another property using that equity again. If you cash-out refi and use that money for anything other that investing again that money is gone. Whereas if you follow the above mentioned scenario you can use your equity over and over again. This all goes back to what tatertot said though. The deals you’re making should be good enough so that you don’t have to refi. Now if you want to take a big vacation, buy a boat, or whatever and you want to refi a single property then so be it, I will probably do this along the lines somewhere. But this nonsense of constantly refi’ing your properties is a recipe for disaster and sounds like a “system” created by a so-called “guru”. I suppose it’s just a difference in philosophy good luck with your strategies.
As I understand the taxes, with the exception of depreciation, you can’t take a legitimate expense unless you have spent the money. After you collect your rental income and pay all your expenses, what is left over is your cash flow. After you offset your taxable cash flow with a depreciation expense, you could end up with a tax loss on paper even though you had a positive cash flow.
As long as your cash flow is less than your depreciation expense, you won’t have any taxes on your rental income. At some point in time, if you get big enough and hold your properties long enough, your depreciation expense won’t shelter all your cash flow. At that point you will have taxable rental income. Limiting your growth because you will have to pay tax on your rental income is (as I told wallace) being penny wise and pound foolish.
Dave T, the payment on the new mortgage isn't going to be $150 a month. You are refinancing 10 properties and you are going to end up with payments of $1500 a month. Making $18,000 extra in mortgage payments makes it a little harder to live on that $25,000 extra you are borrowing every year. Don't tforget to add in all the financing charges and closing costs while you are at it.
Use the example in my scenario where the first property is purchased with $40K in financing. Ten years later you refinance it for $65K taking $25K cash out. If you run the amortization tables, you will see that at 6% financing, the increase in the monthly payment for that $65K loan is only about $150 greater than then monthly payment you had on the $40K loan.
Once again, you need to go back to my scenario, I am not refinancing 10 properties each year. I am only refinancing one property each year for ten years. Each year the debt service only increases $150 dollars per month using a 6% interest rate at each ten year interval. Each year, rent increases on all ten properties make up that $150 per month, so cash flow does not really decrease over time.
I don’t know what settlement charges and loan costs are for you. For me settlement costs are about $1000 or less for attorney fee, title search, title insurance, and recording fees. Lender charges run about $1000 by the time they add up all their document processing fees, underwriting fees, and whatever else. I realize these costs vary by state, but just have all these charges paid from the refinance proceeds so you have a “no cost” refinance. Since that original $40K loan balance has been paid down to about $33500 in ten years, there is plenty of room to pay off the old mortgage balance, pay all the settlement costs and lender fees, and still walk away from the settlement table with $25K in your pocket. If you want exactly $25K in cash from the refinance, tell the lender to use the excess cash at settlement to reduce the loan balance.
Not t mention, in order to borrow $25,000, you are going to have to have 3 times the payment in income every month, and there is a debt to asset ratio to be considered, too. I think the banks would cut you off long befoer you got to your 10th refinance where you were living on the borrowed money.
No, I don’t need three times my payment in extra cash flow each month. I already have cash flow. I just need to increase my rental income enough to cover the increase in my monthly loan payment to maintain the same cash flow I had before the refinance.
As far as I am aware, there is no debt to asset ratio involved in the lender’s calculations for a residential mortgage loan. Perhaps you are thinking about the debt to income ratio.
If so, then understand how debt to income ratios are computed. As far as the lender is concerned, if 75% of my rental income covers 100% of my rental expense, then I have a break even property. A break even property does not change the debt to income ratio. If you subtract 100% of your rental expenses from 75% of your rental income, and get a positive number, then you have income. That amount of income is added to your other income to calculate your DTI. If the result of that subtraction is negative, then you have a liability. That negative amount is added to your other recurring debt to calculate your DTI.
If you do a $25K cash out refinance as I have outlined, and if your rental income increases still cover the smaller increase in your debt service, your DTI will not be adversely affected.
Maybe you were thinking of the utilization ratio where the amount of debt is divided by the credit limit. This only applies to your credit cards and the result of that calculation directly affects your FICO score. The ratio of your mortgage balances to the appraised value of your property has little bearing on a lender’s decision to approve your loan. As a matter of fact, a lender may still give you a loan if you have a spotless payment history on 15 mortgages in spite of collections on your credit cards, because the lender can see that you have your priorities right as far as they are concerned.
If you've got 10 properties each generating $200 a month, That's $2,000 a month, or $24,000 a year. Why not just live on that instead of borrowing $25,000 a year?
I did not say you couldn’t. What if you are living on all your cash flow and you have nothing left over for investment? I am saying that if Hugh0997 wanted an extra $25K per year in tax free cash to invest, he could get it without sacrificing cash flow or his standard of living.
If he has enough other income to support his lifestyle, I am saying that this strategy will still give Hugh0997 that $25K tax free cash each year even if his ten properties combined only generate $200 in monthly cash flow.