He would buy a commercial property (e.g. office or warehouse) in a good near-downtown area, refurbish as necessary and put in place good tenants.
The next year he would buy another.
And, for the next three years after that he would buy another … until he had 5 such quality properties (purchase price around $1 million each).
Then he would do something pretty neat: he would sell the first (i.e. 5 year old property), taking about $1 million out to buy another property worth $1 million, and use the excess capital appreciation to fund his lifestyle.
Nice … except it didn’t make sense.
Because he was simply trading down one property (bought for $1 million 5 years ago so, hopefully, worth a little more now) for another (worth $1 million today), incurring all sorts of changeover costs and possibly even capital gains (unless he could qualify for a tax-free exchange).
He did this until I pointed out the obvious; I said: “Instead of selling one to buy another, why don’t you simply refinance the oldest property each year to release the capital appreciation, tax free?”
And, that’s what he did from then on …
People often come up with great, innovative ways to do things … but, it doesn’t mean that they’re the right way.
For example, in our former family finance company, my Dad used to give our clients a check for the full face value of their loan, and ask for a check back to cover our up-front commission.
His reasoning was that we would have the commission money in our hand and earn extra interest on it. Neat, until I pointed out that it was exactly the same as giving the client the net amount (i.e. face value of loan MINUS our commission): One check. Sensible.
Needless to say, that’s exactly what we did from then on.
Always evaluate what you are doing and how you are doing it, even if you are successful … you may be leaving (a lot) of money on the table.
BTW: I’m wondering if you picked it? There seems to be another flaw in the retirement plan executed by my friend and promoted my many a financial spruiker that I have listened to …
These real-estate investment ‘gurus’ say: “Buy lots of real-estate and when you retire you will have a LOT of equity available to fund your own retirement … simply take out a loan against this property every time that you need more money. Because it’s a loan and not income, you pay NO INCOME TAX on it, so it’s worth more to you than taking the money as rent; and, the excess rents will cover the mortgage payments. Of course, because it’s an investment loan, it’s tax deductible.”
Now, there’s so many things wrong with this strategy that I wouldn’t even know where to start (how about vacancies, as one example?), yet I have been to at least half a dozen seminars where this exact strategy and tax-effectiveness argument was put forth.
However, I take issue with the last statement:
Just because a loan is taken out on an investment property, does NOT necessarily make it tax deductible.
In many countries, the real test is “what’s the PURPOSE of the money that you are borrowing?”
If it’s to refurbish the property to increase rents (hence, so that you can pay the IRS more tax … you win, they win!), more power to you!
But, in this case, it’s not to derive more investment income … it’s so that you can go out and have a good time!
Q: Why would a government want to subsidize your personal spending habits?
A: They probably wouldn’t!
Find a good tax advisor before implementing this strategy … oh, and take what you hear from financial spruikers with a kilo-grain of salt 😉