Creating Wealth #246 – Building a Family Legacy

Broadcasting from Washington DC, Jason Hartman interviews financial planner, Randy Luebke on an amazing client case study of how Jason and Randy helped a client turn one property into a sizable, diversified, high cash-flow income property portfolio that will create a lasting legacy for generations to come. You’ll learn more about the 1031 tax-deferred exchange strategy and much more. More at or on iTunes at Rental real estate offers incredible opportunities when investing correctly.

Prior to the case study, Jason addresses various current events including; the gold house price ratio, why you should not be investing in foreign markets like Costa Rica, Nicaragua, Belize, Panama, etc., median priced housing at the highest affordability since 1971, the year Richard Nixon took us off the gold standard completely creating fiat money devaluation and massive price inflation and several other issues. Be sure to join Jason and his team at “Meet the Masters of Income Property Investing” at the Hyatt Regency Irvine, more info at:

Introduction: Welcome to Creating Wealth with Jason Hartman. During this program, Jason is going to tell you some really exciting things that you probably haven’t thought of before. And a new slant on investing, fresh new approaches to America’s best investment that will enable you to create more wealth and happiness than you ever thought possible.

Jason is a genuine self-made multimillionaire who not only talks the talk, but walks the walk. He has been a successful investor for 20 years and currently owns properties in 11 states and 17 cities. This program will help you follow in Jason’s footsteps on the road to financial freedom. You really can do it and now here is your host Jason Hartman with the complete solutions for real-estate investors.

Jason Hartman: Welcome to the Creating Wealth Show. This is your host Jason Hartman and this is Episode #246. And I am talking to you today from beautiful Washington, D.C, yes, the land of politicians, lobbyists, and the people who are destroying America.

Yeah, it’s interesting to be here. It’s interesting that it used to be London and New York that were really the capitals of capitalism around the world and I guess Hong Kong you would throw in now, and a few other cities of course, but they were always known as the places where capitalism took place and where all the business people constantly flew to, to go and make deals and so forth, but oddly and ironically and, I guess, terribly enough that new capital is now Washington D.C., the land of government bailouts, and subsidies, and stimulus programs, and all of those things lead to one very important thing for us as investors, of course they lead to higher tax rates ultimately. But what they really lead to, even more so, is that hidden tax, that hidden destroyer of wealth, that liar and thief, that pickpocket, known as inflation, the devaluation of our currency through endless, irresponsible government spending. And so here I am in the home of that and actually attending a marketing seminar for the next few days. It’s been really interesting, very educational and it’s nice to talk to you from here.

So, a couple of things, we’ve got a case study for you today from one of our current clients and thought it’d be nice to hear from an actual current client. Well actually, on this one, you’re not going to hear form the actual client this time. You’re going to hear from the financial planner that referred the client to us and you’re going to hear an analysis of how we’re helping this client and how we’ve dramatically, dramatically improved their position, where they’ve gone from owning one property, all the eggs in one basket, an older property where the depreciation schedule had completely run out and again, that depreciation is the very best tax benefit of all because it is a non-cash or a phantom write-off. So that’s very important that had gone away.

Basically what this family is doing is taking a single house that grandma owned and turning it into a multi-generational legacy, a mini real estate empire that will create a lot of wealth for them for many, many years, decades, and maybe even centuries to come. So, a pretty exciting story that we’ll have today and it’s actually pretty short, too, so you’ll get the hang of that here in just a moment.

But a couple of announcements and articles that I wanted to share with you. I was emailed an interesting article by one of our investment counselors recently. Molly sent this to me, thank you Molly for sending this. It says “homes have not been this affordable since 1971.” When you look at the effect of cost of the median price single family home in the United States, they have not been this affordable since 1971.

Now why is 1971 such an ominous or coincidental year? Well, that’s the year that Nixon closed the gold window. That’s the year we went off the gold standard and we became a 100% fiat money currency in terms of the dollar and that changed the whole game for us as investors because of course, it meant that the old rules, the rules that our parents, our grandparents, taught us about saving for a rainy day, about doing what used to be the right thing, and what still should be the right thing, is no longer the right thing because the rug was pulled out from under us, and so everything has changed and we constantly talk about that on the Creating Wealth Show of course. So, I don’t need to belabor that point.

But this article, just a couple of snippets from it. According to the US Department of Housing and Urban Development, HUD, due to record low mortgage rates and falling home prices, home affordability has hit 1971 levels. So, that’s really amazing because if any of you felt, and this is just me talking, but if any of you have felt like you missed the boat, remember those regrets, those “coulda,” “Shoulda,” “woulda,” stories, well maybe this is your reprieve. This is your second chance.

Bob Nielsen, chairman of the National Association of Homebuilders said in a statement “With interest rates at historically low levels and markets across the country beginning to improve, homeownership is within reach of more households.”

Today’s homeowners are making close to double the median income needed to cover the cost of the average home and home sales have been increasing nationwide despite the fact that it’s a very slow and conservative pace. The sentiment of many potential homebuyers today is that their hope that lending and underwriting standards will ease because both are seen as major roadblocks to the housing recovery.

And you know that is so true. It’s kind of an interesting paradigm right now because although, it is so affordable, I mean properties are so cheap, and mortgages are so cheap and those mortgages are such a big asset, they’re such a big part of the real estate asset now, again, paying off a low rate mortgage like this would be – you’d have to absolutely have your head examined to do that, a three decade long mortgage that you’re not going to retire until 2042. At these rates, never pay that off. Just keep it. It’s an asset.
And so the paradox is though, most people can’t qualify. So at the same time we have that huge advantage for those who can seize that opportunity, so many people can’t qualify because underwriting standards are so strict, because so many people have either due to economic hardship or due to choice, I’m meaning strategic default there, have defaulted on mortgages and they have destroyed their credit. And that means rents at the same time are rising. This is very rare that you have both of these factors working in favor of our favor as investors at the same time. That almost never happens.

Another thing, oh and before I get to this next thing, let me just tell you also this about home prices: Do you know that the – we talked a lot about gold and precious metals on the show, not because I like them as an investment very much, I think they’re pretty much a defensive strategy, I don’t think that they work very well. I think they’re okay. I think they’re so-so. I think they’re better than fiat dollars or any fiat currency, whether it be the euro, the dollar, or any other currency in the world because they’re all fiat currencies. But the one thing that metals are good for, gold and silver especially, they’re a good measuring stick because they remain a fairly consistent gauge of value. And so, when you look at it, now another interesting point on affordability, is that the gold housing ratio, in other words the number of ounces of gold it takes to buy the median price home is now at a historical low and we’re going to get a lot more into that on another episode coming up but folks, this is the time to seize that opportunity.

And you know, one of the markets that I haven’t talked very much about lately that I very much like, I own a 10 unit property in this market myself and it is this little under the radar market that Forbes recently named the third fastest growing small town in America by Forbes and it is Saint Robert, Missouri, where Fort Leonard Wood is. Big, giant military base, very little risk of closure or downsizing of the base like that because it’s a training base and again, this is my opinion, things can change. I can’t predict the future like nobody else can, but I think this market is a good future. I thought it was good enough to put my own money in it and here’s just an example of a property there.
This is a brand new fourplex, brand new construction, where you can purchase this fourplex for $220,000. Total cash needed would be about $46,000 and positive cash flow right out of the gate and I’ll read you all of the projections here, but positive cash flow is projected at $633 per month, or $7600 per year at only $46,000 invested. Now, get this. The cap rate here 9.1% is good, it’s solid, but it’s nothing to write home about. It’s not incredible, but these next couple of metrics are pretty darn incredible. Cash on cash return on this property, 17%. 17%. That means if the property depreciates, and it’s only worth half of its value the day after you buy it, as long as you maintain that income-expense ratio, your cash on cash return will be 17% annually, so pretty phenomenal there. The overall return on investment is projected at 34% annually, so pretty, pretty darn incredible.

By the way, we will have our Saint Robert local market specialist as well as several of our other local market specialists from many cities around the United States, Dallas, Atlanta, Saint Robert, MO, Phoenix, Indianapolis, all at our Meet the Masters event coming up March 24th and 25th at the beautiful Hyatt Regency in Irvine, CA, Southern California. Airport code to fly in is SNA for Santa Anna Orange County or John Wayne Airport. That airport has about three names. It’s a beautiful airport. The hotel is right near the airport and so you do not need a rental car. Easy taxi cab ride or hotel shuttle for free and I think, although I cannot guarantee this at the time of the recording because I have not checked, but I believe our very low price room block of $99 per night, there are still a few rooms available on that. So register at for Meet the Masters and we look forward to seeing you there. Again, we only have that event twice a year, so be sure to join us for that one and we’re thinking that we’ll do the next Meet the Masters in probably about 6 months afterwards in Phoenix, Arizona, just so you know.

Now I have a friend of mine who I met several months back and he was asking me some real estate advice and he is actually a Canadian citizen, not living in Canada at the moment but owns a property there and he was thinking of selling that property and buying a really nice, I mean he sent me photos of it, a beautiful luxury condo, a very swanky place. And just as a general rule of thumb, folks, I think that the sexier the property, the worse the deal, most of the time. Again, the stuff we invest in, it’s very sexy from a return on investment standpoint from the money you’re going to make but the properties aren’t that sexy. They’re pretty bread and butter type properties.

So this friend was asking me some advice and my email reply I think is pretty telling and I think it’s something that you should consider. This condo, by the way, was $385,000 and it’s furnished, it’s a furnished property, it’s very nice property. So I basically replied with this email after he sent me the information on it. I said, that looks like a nice condo. However, I do not like condos at all, as there are far too many risk factors with common ownership and homeowners’ associations. Huge disadvantages. Additionally, the rent to value ratio, or the RV ratio should be at least1% or better. The properties we sell, you can see pro formas on my website at in the properties section have RV ratios of 1% to even 1.5%. So an unfurnished property, okay now why did I point out unfurnished? Because unfurnished, you have less risk of damage and replacement and repair and so forth. So an unfurnished property of $385,000 would produce rental income of $3850 to $5775 per month without any expense or risk to furniture or big association fees. Now, keep in mind this is a $385,000 condo that he was thinking he’d probably rent for about I think $2200 per month, right? Something like that, $2200 per month. And again folks and this is not the email, I’m just talking for a moment, I’ll get back to the email in a moment, but this is a single property. So if it goes vacant, your vacancy risk with one tenant is 100%. Now, as I go on to say in the email here, “these are just ratios and they work worldwide regardless of the currency you’re using. One more thing I don’t like about this is that it’s too expensive and non-diversified. For this much money, you should be getting 6-8 units so you lower your vacancy risk and you don’t have all of your eggs in one market. This is a simple analysis and there’s more to it, but I would probably pass on this deal as you can do much better unless there’s something I don’t know. Give me a call if you want to discuss in more detail, Jason.” So that’s just something to think about. I think that provides a good example for everybody listing as to how you should think of these properties. The sexier the property, the nicer the property, the less attractive it usually is.
Several shows ago, I mentioned that many of my products were available on and that’s a great website, one of the things I complained about it when I mentioned that to you is that audible controls the pricing of the products and the thing that bugs me as the producer of the products is that they’re giving them away too cheap because their business model is they basically sell audiobooks based on time and you can really steal some products of mine there. So, they’re bundled differently, they’re not the same products that we’re really offering at but they are somewhat similar, packaged differently, in different bundles and different scenarios. So if you want to go and take advantage of this, I just thought I’d encourage you to do so. Just go to, search Jason Hartman and since you are stealing them from me, please do me a favor and write me a nice review. I’d really appreciate it. Help get my rankings up there on audible. But I wanted to play you this phone message that Audible left me when I called them and asked them to raise the prices. I thought you would find this interesting. Here’s the message: Hi Jason, it’s a call from I’m calling about the latest products that went live. I know Anna had mentioned that there was a pricing issue and I took a look. Based on the running time, those are the prices that we’re going to have on the website. I’m leaving in about an hour and I am going to be back into the office the week of January 3rd. So if you’d like, we can schedule a call to go over it when I return. But the prices that are there now are comfortable with the running time to who else is in the store. Thank you and have a good day. Bye.

Jason Hartman: So there you have it, folks. That’s right from the horse’s mouth. And go and steal those products because they’re an awfully good deal on One more thing I wanted to share with you, this is an article by Tom Tryon and they’re talking about the year of the short sale being 2012 and this will be the last thing before we get to our guest today and talk about that interesting case study, but he says here’s the real tale of two real estate markets. One market is depressed and distressed; the property values are down since mid-2006. Residential values in Florida have declined by 51%. Hundreds of thousands of properties have been or are in foreclosure and huge numbers of homes have been repossessed.

Consider these statewide numbers presented by analyst Jack McKay during last week’s Herald Tribune Hot Topics forum. And folks, just a comment before I read a few of these bullet points to you which are very telling, we do not really recommend the vast majority of the state of Florida right now. We do our business in the panhandle areas of Florida like Pensacola and people ask us to do Florida all the time. People ask us to do Las Vegas all the time. People ask us to do these foreign properties in Mexico, Nicaragua, Costa Rica all the time, and you know what? We’re area agnostic. We have no interest in recommending bad properties because we have so many good properties. You know that may seem a little boring that we’re like consistent and to the point of boredom, but you know what we’re just recommending the best stuff we can find from the best vendors we can find.

Remember also it’s not just about the market or the locality; it’s about the vendor and the support network in that area. So again, high flying areas that get a lot of attention like Las Vegas, Florida, California, and New York, generally the Northeast in general, there will be a time when we’ll probably recommend some of these areas but the time is not today. So as Ernesto Julio Gallo used to say in those commercials, we will sell no wine before its time.

So a couple of these bullet points on Florida, you can really see the blood in the streets here though. And, this isn’t all of Florida. Again, there are a few select pockets that I like. There were a couple of pockets in Orlando I used to like but again, even if I liked that market a whole lot, we just don’t have a great vendor there right now, so I don’t really want to recommend it too much. So check this out, 150,000 residential properties in Florida have been repossessed and are owned by banks. 371,000 foreclosure cases are open in the courts. My comment: Can you believe that? The court systems are so clogged up in Florida because in Florida, foreclosure is a lawsuit. They don’t have the foreclosure rules and foreclosure systems that other states have where it can be a much more streamlined process like in California, it could go, although it never does really, as fast as 121 days.

Back to the bullet point here, 530,000 residential mortgage loans are at least 90 days past due and in default. So, my comment: Why would anyone pay their mortgage when they can stay in their home for two or three years for free? Think about it. That’s why you have so many at least 90 days past due and in default. 265,000 homeowners have not made a mortgage payment in more than two years.

I mean folks, I read this great book a long time ago and it’s called the “Greatest Management Principle in the World” by Michael LeBoeuf. And that book is so telling about everything in life, the way government works, the way monetary policy works, the way fiscal policy works, the way it works with your children, the way it works with your spouse or your significant other, the way everything works. This rule governs everything. And here it is, it’s beautifully simple. Just remember this. It’s worth writing down. The greatest management principle in the world, what gets rewarded gets repeated. What gets rewarded gets repeated. And what are we rewarding now in our society? We reward flakiness. We reward spending, not saving, we reward borrowing, not paying off, and what gets rewarded gets repeated. And frankly, a lot of these things are the right things to do, as terrible as that might sound. When you’ve got 265,000 people in Florida, who have not made a mortgage payment in more than two years, they’re living there for free. Doesn’t that just anger you if you’re paying for your house? Either that or it just makes you feel dumb like you’ve really missed the boat, one or the other but what gets rewarded gets repeated.

More stats on Florida and I’ve got two more things. One million residences are in some form “distressed” whether in foreclosure, owned by banks or in default, 46% of mortgages are “underwater,” in other words the debt exceeds the current market value of the residential property. Add this number 809. And what is 809? It’s the average number of days it takes to process a foreclosure in Florida. So that means you can live there almost 3 years for free. Unbelievable. What gets rewarded gets repeated.
Anyway, enough of that, enough of my snarkiness, let’s go to our case study today. I think you’ll find this fascinating. Be sure to join us for Meet the Masters. It’s coming up in just about 3 weeks. We’ll look forward to seeing you there, so get your plane reservations made if you’re traveling in to see us and get your hotel booked and we look forward seeing you at Meet the Masters and we will be back with our case study in just a moment.

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It’s my pleasure to welcome Randy back to the show and he referred a fantastic client to me a few months back, maybe 3-4 months ago and this is one of those stories where you really see through this case study we’re about to share with you where you have totally changed some lives for the better. I mean, here we had a property that was in the family for many, many years and we have turned this around and increased the value of this portfolio to the client so dramatically, increased their cash flow, their tax benefits, their diversification, I mean everything is so much better now and this is just one of those fantastic case studies we wanted to share with you.

Randy, welcome, how are you?

Randy: I’m doing good Jason. Thank you again for having me and I’m glad we’re having an opportunity to share this story with your network. It really is a fantastic story.
Jason: It is, it really shows the value of what we can do for people and I’m very excited about sharing it and you’re coming to us today from Newport Beach, right?

Randy: I am.

Jason: Fantastic. Well, give us the background on this client that you referred to me and again thank you for the referral. This was a few months back and I remember when you first called me about them and explained the situation. I thought, “Wow, we are just going to massively improve their cash flow. They’re going to be ecstatic about this.” So tell me more.

Randy: Alright sure, and you know what cash flow is only part of the story. So let me bring you back through the beginning of this, which actually starts back in 1946.

Jason: You’ve been working with them for a long time.

Randy: I’ve only been working with them for about a year but, the story starts in 1946 when my client’s grandmother and grandfather bought a beach house in San Clemente and very small little beach cottage, typical 1940s style place, maybe 12-1400 sq ft. And it was actually by the railroad tracks. You know the area down in San Clemente that –

Jason: I know exactly where you’re talking about.

Randy: Yes, so you’d probably think about it that the time was not even all that desirable except for one very key thing, it happened to be on the sand on the Pacific Ocean, right? And by the way, this is a concept I call the 401 cabin. You know, the idea of a 401k where you put your money away pre-tax and then let it grow tax deferred or whatever, owning a vacation property, which is what they bought this for has the same characteristics because they buy the property, the property appreciates, you don’t pay any taxes on those gains as it grows and it creates income but you get the benefit of being able to use it too. So that’s why I call it the 401 cabin, the 401 cabin with a ‘k’.

Jason: Yeah and Randy, I just want to go on record and we’ll probably disagree on this here, but we’ll agree on pretty much everything else. I don’t recommend that people buy a vacation property. I know you own one in Park City, Utah personally, but I had a second home once. When I lived in CA, I had a second home in Scottsdale, AZ, and I remember waking up one morning and I thought, I kind of counted them in my head, I think I sais, “I think I’ve slept here 11 nights in two years. “And I started doing the math and as much as I love income property and that’s not really income property, that’s just real estate, but I even love real estate even when it’s not income property some of the time, but I thought “I could have stayed in a presidential suite in any gorgeous resort hotel here or anywhere in the world pretty much, for a lot less money than I was spending to own that place and really a lot less worry.”

So when I have properties, I like them to rent it out. I like my tenants being there watching the property for me, maintaining the property for me, some might consider that counterintuitive relative, do tenants maintain property? Well actually they do, most of them do. They maintain them really nicely. You get a few bad apples here and there, but I am not a fan of vacation property or second homes. I just want to go on record saying that, but go ahead with the 401 cabin.

Randy: Not to digress too much, but obviously if they hadn’t bought this vacation property, we wouldn’t be telling the story today.

Jason: Well that’s true. Grandma did them a favor, there’s no question.

Randy: No question about it.

Jason: Over the long term, could you have done much better owning a bunch of apartment units, heck yea, but …

Randy: Yeah and vacation properties as a second home by the way that’s really just an expensive toy that you have to pay for. Rental, like you said, I own a property in Park City, Utah, it’s a vacation rental. We rent it out and it is frankly a lot of work to market it and manage it versus having a tenant in there for 12 months of the year, but we’ll save that conversation for another day.

Jason: Just this one thing and I always do this. I’m very guilty of it, of getting on tangent, but just one thing about that. People have their own vacation property like your place in Park City. And I’m still waiting for my invitation to come and go skiing with you, by the way, I just want to put that on record, too but it’s like why would you want strangers in your house? You might as well just rent a hotel room or a condo or something from somebody else and be the stranger. I like hotels where you have all the services and they’re catering to you and just waiting on you but anyway, whatever.

Randy: Yeah, like I said, maybe we’ll make that another conversation for another day. It’s been an interesting adventure for me. I’ve had it for enough years to have gotten experiences and there’re pluses and minuses like everything.

Jason: There you go.

Randy: So let’s go back to grandma and grandpa. They bought this place and they bought it on the sand back in 1946 and of course A being California where we’ve had significant appreciation over the years and B being such a unique property being located right on the water, this property grew in value to even with today’s depressed real estate market, this property was worth close to three million dollars, big, big improvement from what I’m sure they paid for it in 1946 which was probably about 60 -70 thousand dollars.

Jason: It could have even been less, frankly, but go ahead.

Randy: It could have been. Yeah, it could have been. So, the clients came to me basically with two problems that they wanted to solve and after talking to me, we discovered that it was actually 3, but the first one we were just talking about a moment ago, which is cash flow. Even though, they owned it so long and they owned it free and clear and of course with proposition 13 and the property taxes were low and so on, the long story short grandma is still alive today. However, grandma is living in a nursing home and so the cash flow from this rental property was going to pay for her care and unfortunately it wasn’t providing quite enough income to support all the care that she needed which means that my clients were dipping into their pockets every year about $20,000 a year to make up the difference. So cash flow was their number one problem.
The second problem that they knew about was the capital gains problem, right? Because someday when grandma passed away the likelihood is that they’d be selling this property and the way this thing had been handed down, or wasn’t handed down through the generations, they have a basis on this property and for everybody it’s the value that you would subtract from the net sales price of the property. They only had a basis of about $150,000.

Jason: Right. Right now Randy, one question for you on that. My understanding though is that the basis steps up to market value upon death of the person leaving the asset, is that correct?

Randy: That is correct.

Jason: That’s another great thing about how tax-favored income property is. But of course, you’re going to talk about, because I know what we’re doing here, how we’ve solved the problem through a 10/31 tax-deferred exchange. If we didn’t, there would have been a capital gains problem if the property was sold while grandma is still alive right?

Randy: That’s correct.

Jason: So we solved that through a 10/31 tax-deferred exchange.

Randy: Correct. And then the third problem that came along was estate tax. And a lot of people forget about that. Not only does Uncle Sam, and of course in California Uncle Jerry, want to take away your tax on your income but also if you make too big of a profit, you could also have an estate tax. And the estate tax is 45% and has to be paid 9 months after the deceased’s death and it can be very difficult to come up with that kind of liquidity when someone has their money tied up in real estate. So, even if we could avoid the capital gains tax through the step-up in basis, we still may not have been able to avoid the estate tax which could have forced him to sell the property anyway.

Jason: Yeah, right.

Randy: Alright. So, with those three problems in tow, what had happened is the family had some advice to basically create an LLC, put the property in the LLC and then they were going to start gifting away portions of ownership to the grandkids and the great grandkids.

Jason: I like $12,000 per year. I think…

Randy: Not exactly. $13,000, right?

Jason: Yeah, $13,000. Okay.

Randy: So, they started doing that. But now I got $2.8 million.

Jason: Yeah, that’s going to take a long time to gift that away.

Randy: I think it’ll get a long time when grandma’s doing pretty good in terms of physical health. Do the math.

Jason: It’s not going to work.

Randy: It’s not going to work at all. So, they came to me with those problems and what we did, we’re not going to divert on this a lot either, I’m just going to mention what we did was called a freeze and a squeeze and we basically stopped the growth in terms of tax purposes. That’s the freeze part of it. And then we squeezed the value down by doing some more corporate structures. And the bottom-line is we were able to completely eliminate 100% of the capital gain and 100% of the estate tax without having to sell the property through this process of freezing and squeezing.

Jason: Again, the most tax-favored asset in America.

Randy: It’s amazing. Totally amazing. Now, going back to problem number one though, cash flow. So, they were getting about $50,000 a year, net income, on this property. As I said, they were short about $20,000 a year to help take care of grandma. But if you take that $50,000 a year and divided that into the value of that asset at $2.8 million, what do you think your rate of return is on that investment?

Jason: It wasn’t very good.

Randy: No, it was 1.8%. That’s it.

Jason: So folks, this is what I’ve talked about for years, there are so many people in this country who are paying off their properties, which I think is just terrible advice, income property is the best investment but it’s not a very good bank. Stop using it as a bank. Use it as an investment for sure. I mean, invest in it. But try and keep it as leveraged as you possibly can. As long as you, of course, do that in a prudent manner and we’ve talked about that on many episodes over the years. But it’s not a very good bank. It’s not a very good place to store money. It’s a great place to own and control a large asset. So, that’s one thing. And this is what happens as you get what I call sleepy equity or lazy equity. Where the money is just sitting in there and it’s just not working for you and that’s exactly what was going on with this client. They had all this equity on this free and clear property worth about $2.8 million or so, and it was hardly doing anything for them. If you question this, there’s a metric they use, Randy, in commercial real-estate investment. They call it return on equity.

Randy: (agrees)

Jason: And I think that metric is really faulty. I think it’s either faulty or it’s just got a wrong name. Because I say ultimately that there is really no return on equity. The return would be the same if you have the equity or not. In fact, it’d be better without the equity with more leverage. And so, that’s kind of misnomer that return on equity metric and if you question this, it’s tax-time now, just notice that every year you get these 10-99s that you need to file for interest income, for what your brokerage accounts did, what your mortgage payments were on your properties and so forth. Those are deductions, of course. But not all of them are deductions. I think the mortgage statement is a 10-98 if I’m not mistaken. On the income you get, you get a 10-99 right? So, did anyone send you a 10-99 for the equity in you real-state?

Randy: I’ve been looking for that 10-99 for years.

Jason: It doesn’t happen because there is no return on it really. The property would perform the same way structured differently. If you have a high loan balance a low loan balance, the property is going to have the same performance. Stop tying the performance of the property to the amount of equity or loan. It’s just the wrong way to do it. Anyway, I don’t to digress into that.

Randy: It’s a good point. You call it sleepy equity, lazy equity, whatever the…

Jason: Lazy money, sleepy money you know.

Randy: Yeah, but the point it, today it’s February of 2012, and at 1.8% return, it would be much better than you can get in a bank. But the reality is when things get back to normal and interest in banks are higher, it’s going to be an awful return. And frankly, it’s just not a good use of the asset. It’s just a non-optimized asset. So, we have this problem. We have to fix your cash flow. Well, what can you do to fix the cash flow? Well, you could rent it out for more money. Get more renters in it. That’d be one thing. But that’s something that you can just try on and off like the faucet.

So we did exactly what you just mentioned a moment ago which was we leveraged it up. Basically, took out a loan on the property. And then, use that money to basically provide the additional income, with use of an annuity, to pay that income for a guaranteed amount of years to grandma and we took care of the whole problem. Everything was fine and dandy until out of the blue, we are presented with a buyer. Somebody came from out of the blue. We hadn’t solicited it. The property wasn’t listed for sale. We’ve done everything we needed to do to try and keep the property in the family for as long as possible. And now some buyer comes along and wants to pay cash for this property. So, how much cash? $2.8 million. Now, that changes our game completely because now we have to basically undo a lot of the things we had done for the estate-planning purposes to do what you talked about initially which is to form this 10/31 exchange. Do you want to talk about 10/31 exchange here?

Jason: Sure. 10/31 tax-deferred exchange is a section in the IRS. We’ve done shows on it before we have regular speaker at the Meet the Masters of then, about it. But it’s a great thing because you can trade your income property all your life without ever paying the tax on it. You can just defer, defer, defer. And you can’t do that with stocks, you can’t do that with a business. Every time you trade, when you sell your business or you sell your stocks, you got to pay the tax, period. There is no way around it.

Randy: That’s right. These sales, we entered it into a 10/31 exchange and there’s basically two rules in the exchange. Two targets you have to hit. You have to re-invest all your equity and you have to also acquire the same amount of debt. And if you make both of those targets, you’ll pay no tax on the sale and move all this forward into these new properties. It’s a pretty amazing deal. And as a result of that, let’s kind of put some numbers to this now, they did sell the property for $2.8 million and in round numbers, there was about $200,000 in selling costs primarily, of course, to the realtor commissions and so on. So they netted 2.6. They had $150,000 in basis. So their gain would have been $2,450,000. The capital gains rate tax today at the federal level is 15%. Their tax on that gain at the federal level would have been $367,500.

Jason: Ouch.

Randy: Yeah. We live in California. What do you call it? The People Republic…

Jason: The Socialist Republic of California.

Randy: of California.

Jason: I think that’s such a misnomer when they call all these socialist, communist countries the People’s Republic. They are really not. They are the government’s republic. They’re the insider’s republic and that’s what they really belong to.

Randy: Yeah.

Jason: But yes. So, California governor Jerry Brown, moonbeam Jerry from the 70s, he’s going to take 9.3% or something like that.

Randy: That’s exactly correct. For another $22,000. So, all in all it’s about $390,000 of taxes that would be due on this property on sale just from capital gains.

Jason: It’s just ugly.

Randy: Yeah. And then if we didn’t deal with the estate tax, or a portion of it, there’d be another 45% of the value of the property that would go away in estate taxes. So, it’s a big deal and we avoided it all. That’s the amazing part. And this is where it gets into that life-changing story. So, our buyer comes into the property, and by the way interestingly enough, the money that they use to purchase their property came from a 10/31 exchange as well. So we were part of their 10/31 exchange from the side. I came to my friend Jason with this opportunity.

Jason: And Jason is yours truly. That’s me. Yup.

Randy: That’s right and frankly, and to be honest, not to make too big of a commercial here for Platinum, I don’t think we could have pulled this off without your network,

Jason. Because our ability to diversify across markets across the United States, our ability to find good properties and property manors and all these stuff, and identify these in a 45-day period…

Jason: Yeah, it was a pretty tight window but we got good properties too.

Randy: We got great properties. I know you don’t like to talk about cap rates but, cap rates make sense to me. Again, for the listeners, capitalization rate or cap rate is basically taking the net operating income, which is your gross rents minus your expenses, and pretending you don’t have any mortgages on these properties. If you take that net operating income, divide that into the property’s cost, that 1.8%, that was my NOI, this is my cap rate on my old property. Now we’re exchanging into properties and in my projections to my clients, I gave them 8 and 9%. Now, where we are actually ending up Jason, is more like 10 or 12% cap rates?

Jason: Yeah. So, the cap rates are much better than you’re projecting. But you’re just being conservative which is our philosophy too. I completely agree with that. Promise less deliver more. That’s always been my motto. Just for the listeners, the reason I don’t like cap rates that much is because I think that the cap rate, it doesn’t give you enough information. It doesn’t include tax benefits. It doesn’t include appreciation or leverage. And it’s not necessarily even appreciation nowadays but most of that’s in the rear-view mirror for sure except in some of the very undervalued markets that we deal in. But, it’s really regression to replacement cost. It doesn’t even include that either. So, cap rate doesn’t tell enough of the story and that’s why I’m not a huge fan of it. We use it. It’s in all our performance. But I just don’t think it really gives you enough information. I’d rather look at the overall return on investment or even the cash-on-cash return given the market we’ve had where a lot of our clients are starting to pay cash more often. You know I’d like that cash-on-cash because it’s really hard to argue with that one. That’s just an incredibly simple metric.

Randy: Well, if they’re paying cash for their property, then the cash-on-cash and the cap rate would be exactly the same.

Jason: They would be but when they’re leveraging, the cash-on-cash gets better than the cap rate and that’s when they start to diverge. But cash-on-cash just means, if it never appreciates, if the value drops to zero, as long as you get the income that you’re projecting, and as long as you keep the expenses in line, that’s the return you’re going to get.

So, I live it.

Randy: For the listeners, when I do a proforma for my clients, I show them all four aspects of the real-estate. So, I’m showing them their cash flow return, I’m showing their return on depreciation, I’m showing their return on appreciation and then there’s also the principal reduction, because all four of those things contribute to the bottom line return. We’re kind of moving forward with this. Using an 8 to 9% cap rate, we were able to take, we use leverage, if we paid cash but we just took the pure exchange money and we rolled it into the new properties, they would have gone from a $50,000 net per year to $200,000 net per year. So, a 400% increase in that cash flow. Transformation number one. That’s significant by the way.

Jason: That’s huge. Yeah.

Randy: Yeah. Just there. But wait there’s more.

Jason: Let’s just give them an overview here. Basically here, this client is going from a $2.8 million property in one market, no diversification, okay…

Randy: Yes. One market, one house.

Jason: Yeah, one house. And all of the depreciation, which has the best tax benefit of any property because it’s that non-cash write-off or phantom write-off. In other words, it’s a deduction you get without spending any money. And so, the property’s been depreciated out because that only last 27 1/2 years, so that deduction has gone away. And here, they basically gone from about $50,000 a year in income to $180,000 a year in income plus diversification, plus much newer properties, plus getting depreciation back into equation, there’s so much to it. I mean, wait there’s more.

Randy: But wait there’s more. I’m thinking as we’re talking about this, I’m going to talk about the projections I gave to them. They’re actually going through this process right now and it’d be interesting to do a post log, prologue, to this interview to see what they actually end up with ’cause I know these numbers are going to be better than what we’re going to talk about today.

Jason: Yeah. They will be because that real cash flow will probably top $200,000 per year. So, they’ve more than quadrupled their cash flow probably here.

Randy: Yes. Absolutely. In fact, in my pro forma to them, when I was telling them why they should go ahead and do this, what I showed them is exactly what we’ve been talking about. So we took their $2.8 million asset. I’ll throw out some numbers here. But, they’re going to end up somewhere between $4-5 million of real estate. So they’re going to have almost 100% more real estate in value, period. They’re going to increase their leverage from about $650,000 loan on this property. They’ll increase the loan leverage to about $3 million. That’s about a 35% loaned of value. And then exactly as you said, what they’re going to end up with is $180,000 of cash flow, that’s net after servicing the debt, after paying property management, after leaving space for vacancies and management and everything. Right? They’re still going to walk away with $180,000 a year net plus, they’re going to get about $45/46,000 a year in principal reduction paid for by their tenants, thank you very much, plus they’re going to get about $113,000 of depreciation. I got to stop here because, as you know I’m a financial adviser and I work with my clients all day to help them do these things like we’re talking. But there are hardly any expenses out there, there’s like maybe two or three, that allow you to create an expense where you don’t actually have to write a check and depreciation is one of them. To get $113,000 worth of expenses and I don’t have to write a check for it. That’s a gift. It’s amazing.

Jason: That is totally amazing. It’s free money.

Randy: It’s free money. And then in my pro forma, to be conservative, I did add 2% appreciation. Although I know in some of the markets where buying depreciation is actually stronger, in other markets it’s flat, so we were conservative. That gave us another $90,000 a year so we add all the numbers together, $180,000 in cash flow, $46,000 in principal reduction, $113,000 in depreciation and $90,000 in appreciation, that $50,000 of income is now turned into $430,000 of return to our client.

Jason: Wow! Wow! Wow! So, basically almost nine times the return.

Randy: 900%

Jason: Yeah, 900% better picture than what they had. And folks, if you’re thinking, well I don’t have a grandma with a $2.8 million beach house…

Randy: We all wish we did.

Jason: Don’t worry about it. I don’t either. I never did. I wish I did. But you can do this at any level. You could have $60,000 tied up in a property that isn’t working for you that’s become lazy money or sleepy money. And you could make that work for you better you could have $200,000 tied up in three different properties and it might be lazy money or sleepy money. Let’s make that work for you and let’s make sure, if anybody listening has old income properties that are older than 27 1/2 years or coming up on that mark where maybe you’ve owned them for 20 years, remember, you only got 7 1/2 years left in your depreciation schedules. You’ve got to get some new properties and 10/31 exchange them into new properties so you can start the clock over again. I mean, having rental properties beyond 27 1/2 years is just crazy because you lose the best tax rate off the country has to offer.

Randy: Depreciation. And by the way, grandma didn’t have a grandma either. What I mean by that, we’re talking to people today that are just starting out with this idea, this is a way they’ll create a legacy. Grandma’s gift is going to take care of the grandkids the great grandkids and probably the great grandkids the rest of their life if they don’t blow it.

Jason: It’s just amazing how that simple little investment so many years ago turned into something so great. But you know what grandma had to do back then, because she didn’t have a grandma she inherited it from, she had to delay gratification. She had to delay gratification on other things that she couldn’t buy back then in order to make this decision, which years later, turns into a huge legacy. Now granted she could have bought a lot more properties and diversified them and done all that stuff right, this is old school okay? My mom was following the old school plan for many many years until I finally got to her and she’s finally starting to follow my plan. Hey, old school, it worked okay too. Plus, before 1971, when Nixon took us off the gold standard, she was doing the right thing. So, it’s saving money and so forth and paying houses off back then. That was the right behavior. So, anyway, really great story Randy.

Randy: Yeah. Thank you.

Jason: This is has just been really heartwarming to see what you’ve done for these clients and what they’ve been able to do through my network and they’ve now got diversification. They’ve got properties now in Dallas, Atlanta, St. Louis, and Phoenix and another one in Utah. So, gosh! Their eggs aren’t all in one basket especially in the California basket which is just a disaster. I mean, talk about a state that’s riding on a reputation developed 30 years ago. That is California.

Randy: You know what, I’m going to circle back to your point about vacation homes in the beginning because obviously this home has a lot of memories, you know growing up and all the summer that they spent there. But I basically argued the same point that you brought up in the beginning which is, you can go up and stay at the Ritz Carlton now as many nights as you want to or in many different places as you want to. Because now they totally have financial freedom to make the choices and decisions in their life that they want.

Jason: Right. Great point. Well, good stuff Randy. And just in closing, just summarize it one more time what they’re looking at here. Before and after.

Randy: So before we had a $2.8 million that netted $50,000 a year income. After, we have $5 million worth of property that with income appreciation, depreciation and principal reduction, it’s going to give him about $430,000 of income.

Jason: And just on income, without those other things, about $180,000 extremely conservatively.

Randy: Yeah.

Jason: Probably well over $200,000 just on straight income.

Randy: I think so too. And so basically, she’s able to now retire. She has job.

Jason: Yup, that’s fantastic! Well, good stuff! Good work! And maybe we’ll actually get the clients on this show in the future to talk about what we did for them.

Randy: Alright, that’s fine.

Jason: And we’ve done this for different scales for different people over the years so take advantage of it. Income property again, the most tax-favored asset in America. The 10/31 exchange is a great thing. I just did one myself. And I just love not paying Uncle Sam. It’s a great deal. Randy, thanks again!

Randy: You’re welcome Jason. Thanks for having me. Bye now!

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