Where, Oh Where, Can I Find More After-Tax Income?

Imagine for a moment that you could invest in such a way that you could: 

• Receive a consistent monthly or quarterly check
• Skip the investment management…hands-free on your part! 
• Earn 5.5% – 8% return on investments … non-taxable  
• Utilize institutional investment managers to minimize risk 
• Have only a three-or four-year commitment before receiving back your initial investment plus additional returns beyond what you’ve received thus far   

An ideal world, right? 

Between market instability, the looming sunset of many tax breaks, and losing a lot of great tax deductions in and approaching retirement, what else can we do to increase after-tax income? 

I’ll share two of my favorite strategies. They avoid all or most income tax, capital gains taxes, and provide you with a dependable income stream to use when other investments should be left alone to recover from market downturns…“Imagine That™!”

Significant Income Without Management Headaches

This first strategy is only available to someone who is in the “accredited investor” tribe. (Click this link for a description.)  Also known as a “Delaware Statutory Trust” or DST, this type of investment, in most cases, provides a stable and dependable income stream and, most often, is non-taxable for at least 3-4 years.  

DSTs, as they are referred to, most commonly invest in real estate, as we will describe below. Instead of directly investing in a rental income property, for example, you can put your money into a trust managed by a real estate syndication firm. The firm gives you a return and part of the profits while they manage and improve the property. Also, there are no surprise expenses like a new heating/air conditioning unit, a roof leak, or finding a new tenant to replace the one who moved out in the middle of the night without warning you! (It happened to me when we owned an apartment building! Ugh.)

Then, when they sell the real estate 3 – 4 years down the road (7 at the longest), you get your share of the anticipated profit along with the return of your initial investment plus a “preferred return.” The preferred return – often called “pref” – is a return that the syndication sponsor must pay to investors (after the return of principal) before any profits are available for the sponsor to share. 

Some of the most successful areas of real estate investment we’re seeing great returns in right now are:

• Senior Housing
• Self-storage (we Americans do love our “stuff”)
• Apartments (with higher interest costs, many younger home seekers need to rent rather than purchase)
• High-end recreation vehicle resorts (there are great mental pictures of the guy with sagging jeans and ample stomach, but that is definitely NOT what we’re talking about here!)

Much of the income from these projects, at least in the early years, is tax-sheltered from both federal and state taxing authorities. We’re currently seeing cash-on-cash returns in the 5.25% – 8% range. In addition, after the return of the original investment, there is generally a sharing of profits from the sale of the holdings. This can juice the overall returns to 12% – 18% per year. One project in the self-storage space just closed with an annual internal rate of return of over 40% to investors! 

Personally, if I can get an all-in investment return in the 10-15% range, with some of that being non-taxable, I am a very happy camper! Especially where I am only required to tie up my capital for 3-4 years, generally speaking, with new projects. And, for those in high-taxed states such as California, New Jersey, Hawaii, Oregon, and Minnesota, a 6% double tax-free income is  equivalent to a 10% return pre-tax, assuming a 40% combined tax rate.  

(My compliance attorney wants me to inform you that past performance may not be indicative of future results. Investing in a DST involves risk, including the potential loss of principal.)

Some of these are cash-only types of investments, so the rising interest rate environment will not affect the returns. Others are using leverage to increase returns by borrowing money to invest. Because these projects are so short-term, as opposed to previous investments in this space, even with 2-3% higher debt than last year, the overall rate of return is minimally affected. 

Now, here’s another important aspect of DSTs.  

Often I will hear, “R. J., I need to do a 1031 exchange, but what if I can’t find a replacement property in the absurdly short time limit allowed?”

Great news! You can use a DST for all or part of a 1031 exchange. Name one or two different program offerings to your list of identified replacement properties. In so doing, naming this alternative investment class helps ensure you have more options available to invest your sale proceeds. A 1031 exchange is hard enough without worrying about having something to exchange into and the stressful negotiations that frequently come. 

Using the above approach is why I call this planning strategy the “1031 E-Z” method of selling.   

So What Else Have You Got For Us? How About “Investment-Grade” Life Insurance – Especially If Someone Else Is Paying For It?

Some of the hybrid life insurance vehicles out there today have been geared more toward creating tax-free income and less toward producing a death benefit. 

How does that work? 

It’s like a teeter-totter. One end of the teeter-totter is to get maximum death benefit for the least cost. On the other end, we want to put in as much in premiums as possible for the least amount of death benefit. 

But why on earth would anyone do that? 

Back in the mid-80s, the IRS gave us two different regulatory guidelines to follow so that we can stuff as much cash as possible into a life insurance contract and still keep it classified under tax law as a life insurance contract. 

Why is that important? 

Because money coming out of a life insurance contract within the IRS guidelines is non-taxable! 

What????

You mean that you can take money out of a contract, keep the insurance, and not pay taxes on any gains you take out? Yes, as long as it has been properly designed and “maintained.”

As with everything, the devil is in the details. But from a macro level, one of the best ways to supplement your retirement income is to have a source of non-taxable income, and there are only three ways to do that. The first two are with a Roth IRA or Roth 401(k), and the other is using what we refer to as investment-grade life insurance. Meaning that we’re purchasing the life insurance with the death benefit as an incidental benefit. We’re overfunding it to create a significant reserve of assets that we can draw from and pay no tax while we’re alive. 

Sounds wild, right?

Taking advantage of the tax-free income stream from cash-value life insurance is not a new strategy. However, it’s gaining in popularity as insurance advisors, and consumers better understand its advantages. Also, insurance companies have better safeguards in place to protect against downturns in the equity markets … and the corresponding equity investment options inside the insurance contract.  

Years ago, I personally used cash from savings plus a large cash withdrawal from my own insurance contract to purchase a rental property on the golf course in Coronado, CA. We were able to buy it for 28 cents on the dollar and could act swiftly because we had the cash needed to put down and then get financing for the balance.  

As exciting as that aspect can be, here’s something else that can create even more leverage for you. And I will say right up front that this may not be right for you. But, there are lenders out there looking for situations to loan money to credit-worthy clients to pay the premiums for life insurance. 

Usually, the minimum premium is $100,000 or more per year and at least five years of premium. At the end of a time period … usually 15-20 years, the lender is repaid for their loans from the cash values built in the life insurance contract.  

For smaller contracts, like $1-$2 million, they’ll fund half of the first five years of premiums, then 100% of years 6-10 of premiums. They’ll take back their investment at the end of year 10 out of your cash value (plus a little interest,) and you get that leveraged growth to keep growing. 

For even larger life insurance contracts (like the $5-$10 million range) banks will pay for the entire premium as described earlier. 

So at the end of the day, that boils down to contracts that have cash built up using OPM – “Other People’s Money!” And, assuming in most years we will earn more than the net interest expense, we end up with: 

• Tax-free income, assuming a properly designed life insurance contract
• Depending upon your state of residence, life insurance cash value may be 100% protected from creditors
• Cash in your pocket to allocate in other asset building projects rather than paying life insurance premiums

Setting The Plans In Motion

Both of these strategies take some planning. It takes a good ten years to see any usable value in a cash-value-focused life insurance contract. Especially if you’re using leverage, the bank doesn’t want you to touch anything before they get their money back. 

And it helps if you’re in good health, although that is not always a requirement. You might use a healthy spouse as the insured or a son/daughter’s life. There just has to be something called an “insurable interest.” No life insurance contracts allowed on your trash collector! 

With the Delaware Statutory Trust strategy, there are minimum investments that the syndicates require. In the past, this was usually $100,000. Today, however, I am seeing as little as $25,000 permitted into certain funds or projects, with $50,000 minimums as very common.  

There are several more ideas, but these are two of my favorites for the typical client we work with … one looking for more income and paying less (or no!) taxes on it. 

More income with less tax…“Imagine That™!”