Updated: Jul 4, 2020
If you're looking to max out your profits and pay out low taxes, cash out refinance is the way to go. Find out why today on the Passive Cash Flow Podcast.
The Passive Cash Flow Podcast is for beginner or experienced investors. Learn how you can diversify out of the stock market, own a part of an apartment building & start earning Passive Cash Flow! Peoples Capital Group has been helping passive investors build wealth in NJ real estate for 10 years. Visit www.PeoplesCapitalGroup.com to find out if you qualify to start earning passive income and pay less taxes via investing in real estate. IRA's and 401K's are accepted. -- https://www.facebook.com/peoplescapitalgroupnj/
Aaron Fragnito: All right ladies and gentlemen, welcome back to the Passive Cash-Flow podcast. On this episode we are going to talk about what is the cash-out refinance and why do we focus, why is our strategy the cash-out refinance? All right. This is an interesting topic. This is a strategy that we use to avoid paying the taxman thousands and thousands of dollars. This is episode number nine and we're going to talk about the cash-out refinance.
By the way, guys, you want to come to one of our seminars or webinars or learn how to get invested in one of our upcoming apartment buildings here in New Jersey, go to peoplescapitalgroup.com and you can figure out if you qualify for one of our upcoming investments. We try to make real estate accessible to all passive investors. Let's jump into it here. What is the cash-out refinance?
Why do we focus on the cash-out refinance? Why is that our main strategy here at People's Capital Group? It is really a tax strategy at the end of the day. I read Rich Dad Poor Dad years ago, about 10 years ago, if you heard my story here, if you listen to the podcast, we go over that sometimes and it inspired me to get into real estate. I have a passion for it. I want to own large commercial real estate over time and build my portfolio up and really create passive cash flow myself as well.
I've been doing that for the last 10 years and we work with a lot investors to do that. Why do I do that? Why do I do the cash-out refinance? Why don't I keep selling houses as a realtor, I used to make $150,000 a year as a realtor. That was a great income. I worked very hard for it, but in three years into acting as a realtor I was making six figures, so why don't I keep doing that?
Well, the reason is when you make $150,000 as a realtor, you have to give about 50,000 of it to the government because you have income tax, you get nailed on taxes as a realtor. You also have to work all the time. You're working weekends, you're doing open houses, you're taking calls at nine o'clock at night, you're at the bottom of the totem pole and you're working for a lot of people often for free as a realtor. It's a tough gig.
Now is great when you get started in real estate, but it was a highly taxed income. Now, if you read Rich Dad, Poor Dad, you learn about the tax strategy here, the best ways to make income are often income on assets. Even better way to make income is equity, caching on equity on assets. In real estate, you don't have to sell an asset to cash-out the equity in it, the value in it.
Normally with a stock or something like that, or a bond, you do have to sell it or to cash-out the equity in it, the value in it. There are ways to borrow against it, but in a real estate, it's very simple to refinance and the rate that you're paying for the money you're borrowing is very low. It's a very good strategy to harvest equity you created in real estate and put that equity, turn into cash, you could put it in your pocket tax-free. We'll go over why that's tax-free.
We'd used to flip a lot of houses here at People's Capital Group, we flipped over 50 houses and we had years we've made over a million wholesaling and flipping houses and those were great years and we really made hay while the sun shine here as the market grew and the Sheriff's sale auctions were a gold mine.
Now those times have changed a bit. We flipped less houses and wholesale, less real estate as the opportunities have become few and far between and the competition of the auctions has gotten very, very heavy. Those years we were making a million dollars, we'd pay the taxman a fair amount at the end of the year. Once you write a six-figure check to the government, you pretty much sit down and figure out how to never do that again. That's what we did.
We said, "How are we never going to write a six-figure check to the government again?" We figured out, well, you want to own real estate, you want to pay yourself by harvesting your equity through cash-out refinances rather than paying yourself through fees on transactions or profits earned from services.
Now it's great to have a fee-based business and a service business that collects a lot of income and we want to maintain that part of our business. We still flip houses and we still wholesale houses and that part of our business, that residential section of our business makes about $400,000 or $500,000 a year. That allows us to earn an income here at People's Capital Group, and cover our overhead as well.
Now the apartment buildings are more long-term gains, but they're also tax strategy. All the holdings we own allow us to have tax write-offs. They allow us to have operating expenses, tax depreciation. Tax depreciation is something real estate gives you where stocks and bonds don't offer that. Tax depreciation is saying, well, the IRS says, if you buy a building, it depreciates. That depreciation of value wears and wears and it lowers in value.
Ideally, you have to maintain the building to keep its value. There's a cost to that, but the depreciation itself is something you can write off. You can write off the value of the building over a period of time, whether it be 27 to 37 years, depending on the type of real estate. That tax depreciation is just a huge benefit with real estate. Now in addition to that, you could cash flow on the real estate. When we buy a building, we do get cash flow.
Now that cash flow is written off with the tax depreciation. If I earn $10,000 in cash flow from an apartment building we buy in a year and I earn $10,000 in tax depreciation, I owe $0 on that cash flow in income tax. So let me repeat that. If you earn $10,000 in cash flow and you get $10,000 in tax depreciation, which by the way is usually how we structure our deals. You're getting about equal to the tax depreciation you will in cash flow, so they usually even out and you can write off all your cash flow and have no tax burden for that cash flow income by utilizing your tax depreciation from the building.
When we buy a building with investors, they get quarterly cash flow checks and then they get tax write-offs at the end of the year and those tax write-offs allow them to write off all of their cash flow on the building. Now the majority of the income comes from the cash-out refinance. We buy the building cheap, we force value into it. We figure out ways to make more income on the property, get our rents up, make different forms of income and get our expenses down and keep our expenses down, our maintenance costs low.
This all allows for a higher net operating income, a higher net cash flow. With that higher net cash flow that improves the property value. Commercial real estate is based on the appraisal value is based on how much net cash flow the building makes. Now as we get that net cash flow up, we force the value of the building up. The more the building makes, the more it's worth.
Over four to five year period, we can force that value up by a large amount because over a four to five year period, you can get a lot more and more and more cash flow out of the property. Every year we own it, we churn out better and better cash flows. We get our income up on our expenses down. So by year four or five, that baby's really trying on all cylinders and now it appraises for a nice strong high value and we're going to pull out about 70% of that appraisal value.
It's a safe amount of debt. It is debt, it's debt that we paid down by our tenants over time. It's low-interest debt, generally sub 4% rates around 3.8% or something like that. A really solid interest rate, just a few ticks above inflation really. We take out that money long term, we refinance. If we buy a building for a million dollars, we put another 100,000 into it to spruce it up, bring it up to speed, and the building appraises for let's say 1.7, okay?
At that point now, we are into the building for 1.2, our tenants have paid down the mortgage a little bit over a four or five year period. Let's say went to about a million 50 and the initial mortgage we got was 70%. So we bought the building for a million dollars. We got a 70% LTV, loan to value. That means we get a $700,000 loan because 70% of a million dollars is 700,000.
So we had a $700,000 loan, our tenants paid it down over a five year period. Let's say it's 650 now, and we also put another 100,000 into the building. We owe 100,000, we put 100,000 into the building and we have 650 mortgage on it. We go, we refinance, the building now appraises for 1.7 million. The bank says, okay, you can pull out 70% of that, so you can pull out 1.25 million.
Right there you have a profit and net profit on the building of a $150,000 bucks. Generally, it depends on what the scenario is, but we can often payout to our investors about a 30% return on investment upon a cash-out refinance. You're buying the building at a cheap price. You're forcing value into it by getting a better net operating income on the building, getting our expenses down, our income up on the building, and then we're pulling out the equity words, getting a larger mortgage. We're paying off the old mortgage, about four to five years into the property.
We're getting a larger mortgage, paying off the old one, and then we're going to pocket that cash in between. If you owe a $600,000 on a mortgage, 650, you put another $100,000 into it and you pull out $1.2 million, at that point, you have a large amount of operating cash left in the account and that cash is distributed amongst the investors. That's a cash-out refinance.
That's an ability there where the investors can get a large lump sum of cash. Now that cash is considered debt, so if they don't sell their share in the LLC, now you have the option to sell your share in the LLC at the refinance, but let's say you don't and you decide to stay in long term and you get that big lump sum of cash at the refinance table. That cash you're getting is tax-free money because it's debt.
It's safe debt. It's a 70% loan to value. The bank's not going to give you more debt than the property can handle. You're still cash flowing at the end of the quarter, and the real estate is still making good positive cash flow. You're still building that cash flow over time, but you've taken out a larger loan amount, and because of that, the business, the company is flush with cash. The LLC you create to buy the building is flush with cash and that cash can be distributed to the investors.
That's how we pay ourselves through our buildings. That's how I pay myself now about 80% of my income. That is really a very tax-advantaged way to pay yourself. At the end of the day, if I pay myself now, let's say $100,000 in a year, and if I made $100,000 five years ago as a realtor, well, I'd have to give about 25,000 of that 100,000 to the government as a realtor.
If I pay myself $100,000 by cash-out refinances as I just explained by buying a building at a cheap price, forcing the value up, getting a larger loan amount a few years later, refinancing, paying off the old debt and pocketing cash in between and then maintain the property for long-term gains and long-term cash flow. Well, that cash I get at the cash-out refinance is tax-free money. It's debt. It'll be paid back over time. It's owed back but our tenants are going to pay that back.
Now, let's say we go and we do a 1031 tax difference 10 years later. We bought the property, we renovated it, we got better cash flow. We did a cash-out refinance at year five. In this scenario, at year 10, we say, "You know what? The market's really good. We've done well at the property. We have our eyes on a bigger property. We want to sell this property and trade into a bigger property. We're going to bring our investors along for this 1031 tax difference or 1031 tax exchange.
This is a great tax tool where you can sell a real estate building and you can put all the money from the sale into a third party and you have a certain time period where you have to identify another building at a certain time period, close on that building. If you can execute those things in that timely manner, you can trade into a bigger building and you can defer any capital gains owed on that sale indefinitely. You can continue to do a 1031 tax difference and trade up and up and up. It's how the rich get richer.
That's exactly what we do here at PCG. We buy it cheap, we refinance it at year five, we pull out a lump sum of cash. That cash is tax-free. We're making cash flow every quarter. That cash flow is tax-free too because we write it off with our tax depreciation. Our investors own a share of the LLC that owns the building. They get tax depreciation and cash flow just as any property owner would get. They just don't have to do any of the work.
Because of that, this allows the investors to really get a tax free cash flow and tax free refinance cash. Then we're going to trade into a bigger building and now we go say from a 25 unit into a 50 unit, 10 years later, now there's even a better cash flow. Now there's even bigger cash-out refinances. Now there's even more equity. Now there's more money coming in. There's more tenants paying us in and we can refinance, reposition the building over time, get better cash flow, refinance at the five-year mark and refinance may be the 10-year mark and sell at the 15. We'll play the market. We'll see where the market is at that time, make the best decision at that time.
The important thing is we have a cash-flowing asset. We can decide to harvest our equity at the appropriate time and get that tax free money by taking out a larger loan amount and dispersing out to the investors a safe loan amount but a larger loan amount that's paid down overtime at a low-interest rate or we could sell the building if the market's great or we have a certain offer or an opportunity we want to move into. We have those options down the road and that's great for our investors.
Now, of course, our investors can exit the investment at any refinance, which is every four to five years. That leaves more flexibility for them. Now there are tax consequences if you sell your share in the LLC and exit the investment and get back your initial investment. That's perfectly fine. You could do that. The refinance table and you can pocket that cash from the finance. Keep all your cash flow you've got every quarter for the last five years, get back your initial investment.
However, the taxman is going to come knocking on your door then and say, "Hey buddy, you invested $100,000 on a property of PCG. You made $50,000 in cash flow and tax and cash-out refinance cash. You made a $50,000 profit over a five year period. You're going to have to pay some capital gains on that profit earned if you exit the investment. If you don't exit the investment, you stay invested longterm and you stick with us through a 1031 tax difference. The returns just really just grow and grow and grow. Your internal rate of return could be 16, 17, 18, 19, 20% if you stay invested long term and have a good tax strategy where you avoid paying taxes on the money you're earning."
Again, the way we do that is because we get tax depreciation that allows us to write off that cash flow we're making. Because if you get $10,000 in cash flow and $10,000 in tax depreciation at the end of the year, then that $10,000 you made in cash flow is tax-free. Then if you refinance the building and you pull out a lump sum of cash to refinance, that money is tax-free as well because it's debt. It's saved up. That's paid down over the years by your tenants but it's debt. That money is dispersed to the investors.
It's a great tax strategy to avoid paying the taxman more your earnings, keep more of your earnings, move them into bigger buildings. Build that passive cash flow, build your tax advantages and just get wealthier and wealthier and wealthier as you sleep. That's what we do here for our investors at People's Capital Group. If you want to learn how you can get qualified for an investment like that, go to peoplescapitalgroup.com. Check one of our webinars. Check out one of our events here at the office in Berkeley Heights, New Jersey.
We buy new apartment building every three to four months. We work with dozens of investors here in New Jersey and we are always looking to team up with new investors. We work with you on a first come first serve basis. You do have to meet with us and sit down and go over an investment opportunity and qualify for the investment. Our minimum investment is $30,000, and we try to work with anyone and everyone who is interested in investing in real estate.
Again, to learn more, go to peoplescapitalgroup.com and continue to subscribe to podcasts here. We're going to come back with more information, more updates, more interviews with investors, more detailed information on how we buy, renovate, and refinance out of apartment buildings to earn passive cash flow and big lump sums upon refinance to our investors. Again, peoplescapitalgroup.com has more information for that and subscribe for more on new podcasts every week. Is Aaron with People's Capital Group.