The 9 Benefits of Investing in Real Estate: 7. Tax-free cash-out refinances (or equity stripping)
I want people to understand equity stripping, which is something I did not take full advantage of over my career in real estate investing. I should have planned better. The point I would like to make in this section as you begin to understand principle pay down, overall appreciation of the asset, and leverage, is that as time moves on and your equity position increases, you can strip the equity out of an asset through a cash-out refinance (assuming you purchased right and have managed the tenants and rents accordingly) when loan terms and the situation is advantageous to do so.
Pulling your equity out of a property via a cash-out refinance is tax-free as debt is not taxed. The idea here is that you cannot take the equity in your property to the grocery store to buy bread or put gas in your car with it. So, if it is sitting as dead equity, then you should consider pulling it out and redeploying it into more assets. Don’t pull out dead equity just to blow it on liabilities that create expenses. Go purchase more assets that produce a cash flow to pay for your expenses. Think back to my example of buying a $60K business vehicle after making a $52K investment into an ATM fund. Where might the funds have come from? If you guessed a tax-free cash-out refinance for business purposes, you might be catching on to some possible strategies. For example, what if a tax-free refinance released $100,000 of dead equity while still maintaining positive cash flow on the existing asset, then an investment was made that gave substantial depreciation benefits for tax purposes to acquire a business asset that also gave great tax benefits? The result would be free money, another investment asset, and a needed business vehicle with a result of almost $100,000 in negative paper losses for tax purposes. Take your time, talk to your CPA, and wrap your head around that. Looking back, I wish I had been more strategic about equity stripping, and implementing all of the things that I better understand now.
For example, what if you had a bunch of properties with dead equity, and you decided to strategically take one property a year to do tax-free, cash-out refinances on, to redeploy into a dividend-paying whole life insurance policy with a mutual policy company to earn perpetual compounding interest, that is also designed to be a banking system for you in the future (more on this in a later chapter). Then, you could borrow against the large cash values directly from the insurance carrier via a collateralized loan without any loan application, fees, and more favorable repayment terms. (You can read Becoming Your Own Banker: Unlock the Infinite Banking Concept by Nelson Nash for more on this subject.)
A house flipper, general contractor, buy-and-hold landlord, or anyone who has access to and runs through large cash amounts yearly could very easily build a cash value war chest via a dividend-paying whole life insurance policy designed to build maximum cash value to borrow against to acquire more cash-flowing rental properties, car washes, triple net commercial properties or any other cash flowing asset. I chastise myself for getting comfortable and not being more strategic about my real estate investing strategies and wealth creation. As a general contractor, what a tool to have at your disposal where you could potentially borrow against the cash value of your policy to build another speculative home, possibly make no payments over the 6 to 12-month build time, and save thousands by not paying bank loan origination fees, appraisals, extensions, and then repay the collateralized loan after the sale. Game changer. Use this book to give yourself even more ideas and possibilities so that you can capture more of your dollars so they can work for you.
The point is that if you become more strategic about equity stripping or utilization, you can redistribute equity from one property into another property, properties, business ventures, or asset classes and get dead equity moving and building more wealth.
What allows you to accomplish this wonderful feat? 1) Devaluation of the currency, also known as inflation. More dollars in the system, thank you to central planners, chasing the same amount of goods. 2) Principle pay down. 3) Forced appreciation and valuations from keeping up with rent increases, higher quality tenants like a cooperate tenant(s) versus an individual(s) (think commercial leasing), resulting in increased rental income and higher property value and the greater ability to handle a larger loan amount if refinanced to pull your dead equity out. Remember, you cannot take equity to the store to buy bread or use it as cash as a down payment on another asset. By refinancing at the right time, you can release that dead equity, tax-free, to grow your assets and long-term wealth in mind.
When analyzing my portfolio of single-family (1-4 units) properties for equity stripping opportunities, I would look for properties in my portfolio that had a minimum of $10,000 or more of cash-on-cash returns and more than a 40% equity position. I built an Excel sheet to track those metrics and then used conditional formatting to flag properties when my criteria were met. That put specific properties in my portfolio on my radar to begin to weigh options and plan for the timing to harvest dead equity to be put to work acquiring other assets. Remember that the bank will typically require you to leave 20-25% equity in the property, thus my analysis was looking for those assets capable of releasing some dead equity while meeting the banks’ lending requirements.
I would like to clarify that by discussing strategically stripping equity it is in no way urging anyone to overleverage or to use investment properties like a casino and put yourself at risk of failure. Remember, we said at the outset that you need to determine what your desired goal for passive income is. Achieve it and be happy. Enjoy the lot in life that you have been given or created for yourself.
Before you refinance a property and place more leverage on it, make sure that it is still positive cash flow and that you have a business plan to grow your position of wealth and passive income further and achieve your goals. Whether you take that capital and push it through a dividend-paying whole life insurance policy with a mutual life insurance company, use it as a down payment on another asset, or whatever it is you’re harvesting dead equity for, then make certain that you’re going to be profitable and cash flowing. Don’t frivolously waste it or get big-eyed and blow it. Set long-term goals and plans. Keep growing and let others help build your wealth. Remember, building lasting wealth with real estate is a long-term game, not a short-term game. Plan accordingly and don’t get over-leveraged to the point that everything is cash flow negative where a little hiccup collapses, you’re your house of leveraged cards.
Whether you are just starting and are doing a light value add, a heavy lift, or salvaged from a distressed seller, then look to refinance your deal when appropriate and pull all or some of your capital back out of the deal and continue to let the tenants cover the debt with a positive cash flow while you move your capital into another cash flowing asset. This has become known as the Buy, Rehab, Rent, Re-finance, Repeat (BRRRR) method, or equity stripping. With some planning, hopefully, you will have ZERO money in all your deals while still receiving positive cash flows.
By the way, what is the cash-on-cash return after you refinance and pull all of your initial investment back out of an asset and still have a positive cash flow? For example, $5k a year divided by $0 in the deal… like free money to hold an asset and build wealth… like infinite returns! Can you calculate your cash-on-cash return of any amount IN your pocket yearly divided by NOTHING out of your pocket? I.e. $5,000 yearly income / Zero OUT of your wallet. Can you say INFINITE? How many of those can you do? Are you with me?
Some last thoughts regarding inflation and reasons to extract dead equity from an asset, besides the fact that it is a target for a lawsuit, earns no return, and is not liquid or spendable. Let’s assume we have $1M worth of real estate and a 50% debt-to-equity position. Meaning that you have $500,000 equity and $500,000 debt. If inflation is 5%, then the non-liquid, non-working equity position or purchasing power moves from $500,000 to $475,000 as there is no return on dead equity as well as a loss in purchasing power, which is a bad thing. As opposed to the $500,000 debt that you would pay back with inflated dollars, it realistically becomes $475,000 of debt, and that is a good thing.
If you captured the $500,000 of dead equity via cash-out refinance or even trade up via a 1031-like-kind exchange, then you could acquire $2.5M in real estate with 20% down and a new debt position of $2M. We are assuming that you traded up and maintained or made a better cash-on-cash position for yourself. You would still have $500,000 in an equity position. The difference however is that you would have $2M of debt that would become $1.9M of devalued debt due to the 5% inflation and you would gain the appreciation from a $2.5M asset instead of a $1M asset.
It does seem counterintuitive to acquire larger assets and assume larger amounts of debt that can be repaid with cheaper and cheaper dollars, but this is in essence what the Federal Reserve is attempting to accomplish. That is, increase the visual dollar appearance/growth of output or GDP, to increase the value of the U.S. as an asset so that they can continually take on more and more debt and theoretically repay it with cheaper inflated dollars. If you have ever heard someone say, “Don’t fight the Fed,” but have you ever heard them explain what that even means? It means aligning your activities with what The Federal Reserve and the tax system are doing and incentivizing. It means locking in today’s purchasing power and paying back debt with cheaper money. Buy real assets that benefit from dollar devaluation via inflation – like real estate and let someone else reduce your debt as costs inflate and rents rise. It is a subtle, but great transfer of wealth that is taking place. Just as tenants (commercial or individual) reduce the debt on assets that you might hold and benefit from, similarly, we are the tenants paying back the government debts where they continually increase the credit lines and deploy more and more capital (albeit the majority is blown frivolously as opposed to investing in critical infrastructure and income producing ventures). If you want to build wealth, don’t fight The Fed.
