The Double Play: Leveraging Life Insurance for Real Estate/Passive Investing

John the Dentist runs a successful dental clinic. He’s managed to put away a lot of money to secure his retirement. He has maxed out the contributions he can make for the self-directed Roth 401(k) that he set up so he can invest tax-free in alternative investments. John is too busy with his dental practice to hunt for deals every day, so his 401(k) purchases notes with a nice 10% interest rate on his money.

Besides the 401(k), John has another $500,000 that he uses to invest. The gains on this money are taxable. He’d love to find a way to get it into an IRA, but he makes too much money to contribute any more to a “Qualified” plan. He was looking for another tax-advantaged way to invest his money when we sat down.

We designed a life insurance policy around a 5-year funding plan of $100,000 per year. For now, he will invest the balance of his $500,000 in notes every time he makes a premium payment. So in the first year, for example, he paid a $100,000 premium to the life insurance company and kept the remaining $400,000 of his $500,000 in notes.

To help John understand the value of the Magic Checking Account, we showed him what his investment results would be with and without life insurance leverage. Since $400,000 of his money is in reserve for future premiums and is invested similarly to what he had been doing, we are only focusing on the first $100,000.

If John made this investment without using the Magic Checking Account strategy, his $100,000 would earn $10,000 at 10%. In a 28% tax bracket, the net profit after tax would be $7,200 for an effective after-tax return of only 7.2%.

Example: $100,000 Invested at 10% Yield (No Life Insurance)

Assumptions

Return on Investment                                        10.00%
Premium/Investment                                        $100,000
Tax Rate                                                                28.00%

Regular Investment (No Leverage)

Investment                                                           $100,000
Rate                                                                       10.00%
Gross Profit                                                           $10,000
Tax                                                                         $2,800
Net Profit                                                             $7,200

Now if John took $100,000 and used it to make a premium payment in a policy designed for high cash value and early access to the cash value, he would have about $90,000 of cash value at the time the policy is issued. He would also have, for all practical purposes, a credit line of $85,000 available  immediately: a “Magic Checking Account” where his money still earns interest in the “bank” while he’s writing checks on credit.

Example: $100,000 Premium, Same 10% Investment

Assumptions

Return on Investment                                        10.00%
Policy Loan Rate                                                  4.25%
Cash Value Growth Rate                                    5.00%
%CV/Premium                                                     0.9
Premium/Investment                                         $100,000
Tax Rate                                                                 28.00%

With Insurance Leverage

Premium                                                                $100,000

Investment 1 (Insurance CV)                       $90,000
Rate                                                                          5.00%
Interest/Dividend (Tax-Free)                      $4500

Investment 2 (Same as above)                    $90,000
Rate                                                                          10.00%
Gross Profit                                                             $9,000
less Interest Expense                                            $3,825
Taxable Income                                                      $5,175
Tax                                                                             $1,449
 Net Profit                                                           $3,726

Total Profit                                                         $8,226

Note: We’ve assumed John’s investing activities are done inside of a corporate entity for the tax advantage. His corporate entity is getting a credit line from a separate financial institution with an assignment of collateral against his policy’s cash value as a personal guarantee.

The total after-tax income from our $100,000 investment is 8.2%, A full 1% higher than the return without using the Magic Checking Account.

If you are not excited because it is only 1%, I want you to consider the following two factors:
1. It’s not just 1%. 8.2% is a full 14.25% higher return than the 7.2% we received without the insurance leverage.
2. Think about the “Rule of 72” . In 35 years your $100,000 investment will grow to nearly $1.65 million if you can keep up the same growth rate. $100,000 growing at 7.2% after-tax will only grow to $1.14 million. That’s 500K more!

The Power of Compounding Interest Over Time. Little Gains Make a Big Difference!

By the way, if you don’t have $500,000, this will still work for you. We are simply using these numbers to keep the math simple. Everything is relatively scalable. You can add a zero or take one off. You can cut everything in half or double it.

Let’s meet Joe. Joe is 30 years old and has limited savings and currently does about four deals every year. He tries to use hard money loans as much as possible in order to preserve his own limited funds. He often has to come out of pocket to meet down payment requirements on the loans as well as rehab costs.

Joe has grown his business to the point where he is now making about  $80,000 a year. He has about $25,000 of working capital to support his business. His lifestyle requires most of his income, but he thinks he can save about $12,000 per year that he intends to reinvest in his business. Joe is investing in an area where nice houses are selling at $100,000. He just found a
property costing $55,000 and will require about $20,000 of rehab to make it “nice”.

Joe’s hard money lender is willing to fund 65% of the after repair value (ARV) at an annual rate of 12% (1% per month). This will give him enough money to acquire the property and fund about one half of the rehab. He will need to use $10,000 of his own money to finish the rehab.

Here is what his numbers will look like on this deal:

Joe’s Project

Acquisition Cost                                                      $55,000
Rehab Estimate                                                       $20,000
Capital Required to do deal                                  $75,000

Hard Money Rate                                                   12%
Lender’s Maximum Loan to ARV                         65%
Loan Total                                                                $65,000
Joe’s Own Money                                                    $10,000

Sale Price of House                                                $100,000
Less: Loan Principal                                               $65,000
Less: Expenses                                                        $10,000
Less: Hard Money Loan Interest (6 Months)    $4,500
Taxable Income                                                       $20,500
Tax (25% Bracket)                                                   $5,125
Net Profit                                                                  $15,375

After tax ROI:                                                            53%
Investment                                                                $10,000
Net Profit                                                                   $15,375

Joe just turned $10,000 of his own money into $15,375 for a 53% return on investment. Not bad. If Joe does 4 deals per year, he can get by with a minimum of $20,000 of working cash in order to do two deals simultaneously followed by two more when those are complete. His total after-tax (take home)
income is $61,500 per year.

How would these deals look if Joe used this life insurance leverage strategy in his business? After sitting down with me to review his business and his finances, Joe purchased a permanent life insurance policy designed around 5 annual premiums of $12,000.

Joe is still going to do four deals per year. Two of them will be done by using leveraged cash value. The other two will be done with his liquid working cash reserves.

The only thing that will be different in his business model is that he will use a credit line secured by the cash value of his policy in place of his own money in order to meet down payment and out-of-pocket cash requirements. It is costing him $12,000 of premium to get $10,500 of cash value.

Here is what his numbers will look like on this deal:

Joe’s Project With a “Magic Checking Account”

Acquisition Cost                                                  $55,000
Rehab Estimate                                                   $20,000

Capital Required to do deal                      $75,000
Hard Money Rate                                               12%
Lender’s Maximum Loan to ARV                     65%
Loan Total                                                           $65,000
Policy Loan @ 5% interest rate                       $10,000
Joe’s Own Money                                        $0

Sale Price of House                                            $100,000
Less: Loan Principal (both loans)                    $75,000
Less: Hard Money Loan Interest (6 Months) $4,500
Less: Policy Loan Interest (6 Months)            $250
Taxable Income                                                   $20,250
Tax (25% Bracket)                                               $5,063
Net Profit                                                         $15,188

After tax ROI:                                                  ∞
Investment                                                            $0
Net Profit                                                               $15,188

Joe just turned $0 of his own money into $15,188 for an Infinite return on investment.The impact on Joe’s business is minimal. Joe’s overall take home pay only changed by less than $200 on this deal. If Joe used the loan for a second deal when this one was complete his annual income would have gone
down by $375. He also spent $12,000 of his cash reserves to purchase the life insurance premium in order to get the $10,000 loan that he will use on two deals each year.

HOWEVER, Joe’s $10,500 of cash value inside of his policy will earn $735 of interest (dividend) for a net gain of about $360.

Again, while this does not look like a lot of money, 3.6% per year compounded annually will make a significant difference over time. In five years, Joe will have a “Bank” of $60,000 that is growing at 7% per year($4,200 tax-free). He can continue to siphon premium dollars out of his business to continue
building up his “bank” reserves or he can leave the money in his business growing and compounding.

Either way, he will retire with two sets of assets where other investors would only have one. This is the “Double Play”.

This strategy was working great for Joe. After two years he had put $24,000 of premium into his life insurance policy. The nice 5-6% tax-free rate of return gave him all the benefits of contributing $12,000 per year to a retirement fund, which he hadn’t done before because he just couldn’t afford the trade-off with growing his business. Now he had his nice, safe retirement fund AND he was leveraging it to help put food on the table today.

He was able to use loans against his policy to do all of his rehab projects in the second year. He was even able to get three simultaneous deals going with the savings he had accumulated.

Everything was going great until one of his contractors filed a malicious lawsuit against him and won a judgment for $25,000.

Joe thought that the lawsuit was going to put him out of business. The $25,000 judgement represented most of his working capital. Joe was absolutely thrilled when he learned from his attorney that creditors cannot make claims against a life insurance policy’s cash value. Joe said to his attorney “but I took loans against the cash value and invested in my business. The cash value wasn’t
in the policy”. The attorney replied “Joe, didn’t your agent explain to you that policy loans are ‘against’ your cash value, not ‘from’ your cash value? As long as you have a policy loan outstanding, creditors cannot touch the loan proceeds. You currently owe about $24,000 in loans and interest back to your insurance company. The creditors will have to look elsewhere for assets. You don’t have any assets they can seize. It was a really great decision for you to put your retirement assets into permanent life insurance.”

By the way, in both the above examples, we have not even considered the other intangible benefits like – Death Benefit, Living Benefits/Disablity and peace of mind that the Insurance brings to the table which is also the primary focus
for having an insurance.

For eg. lets say, Joe didn’t make it to retirement. The following year he slipped and fell off of a roof while inspecting a potential deal and was killed in the fall.
Luckily, for Susan, Joe’s wife, the life insurance policy carried a $500,000 death benefit. She was able to hire contractors and finish the outstanding projects that Joe left unfinished. She was able to use the death benefit to set aside money for their two children to go to college as well as supplement her
income while she raised their children. She was very grateful that they had purchased the life insurance policy. But in retrospect, she wished they had purchased even more insurance so that she could have fully replaced Joe’s income. $500,000 really wasn’t enough to allow her to stay home and raise the children without going back to work herself.

If you are putting any of your own cash into your deals, this strategy will help you make more money by leveraging your retirement savings. Our retirement planning business is geared primarily toward investors like you. We teach a way to leverage your retirement to earn more on all your real estate deals. You cannot do this with an IRA or a 401(k). A self-directed IRA is great for using real estate to safely grow your assets tax-free/tax-deferred, but it doesn’t help you put food on the table TODAY.

Just imagine your cash safely earning 5-6% tax free and being able to borrow against it like a line of credit. Your returns will be amplified because your money is working in two places at one time.