In 1973, I returned from Vietnam, where I had flown helicopter gunships for the U.S. Marine Corps. Returning from the war, I was fortunate to be stationed at an airbase near my home in Hawaii. With little over a year remaining on my military contract, it was time to decide what I was going to do once my flying days were over.
My poor dad—my real dad, the former head of education for the State of Hawaii, with a PhD, suggested I go back to school, get my MBA, and climb the corporate or government ladder.
My rich dad, my best friend’s father, suggested I take a course in real estate investing.
I did both, enrolling in a 2-year, MBA program at the University of Hawaii and a 3-day real estate investing course. After I completed the real estate course, it wasn’t long before I dropped out of the MBA program.
That 3-day real estate course was much more of a real-life experience. During the real estate down turn, which began in 2007, I acquired nearly 40% of my current portfolio of properties. Needless to say, I love real estate crashes because I love buying great real estate at bargain prices.
But I do not invest in real estate just to own real estate. The primary reason I invest in real estate is to leverage debt and minimize taxes. In many ways this article is about debt and taxes…more than real estate.
A Word of Caution
I have the good fortune of teaching all over the world and no matter where I go I always hear people say “You can’t do that here.” I even hear, “You can’t do that here” from people in the United States—where I am doing what I am about to tell you about. In other words, as you read further, please keep an open mind and don’t tell me “You can’t do that here.” I just left South Africa and I know you can do what I do in South Africa.
Pictured below is the CASHFLOW Quadrant, from my book by the same name.
In this graphic below,
E stands for employee
S stands for self-employed
B stands for big business (with 500 employees or more)
I stands for active investor
We have added the average percent that individuals or companies in each quadrant pay in taxes. For example, for those in S quadrant—the self employed, small business owners, and specialists such as doctors and lawyers—pay approximately 60% in taxes. That means if I earn $1 million as a doctor I will pay 60%, on average, of my income in taxes. Percentages vary slightly from country to country, and they vary from state to state in the United States as well.
If I were that high-income-earning doctor in the S quadrant, I would also be a real estate investor in the I quadrant—not only to increase my income but to give me the opportunity to pay less in total taxes.
Here’s the way I would do it:
• Take classes on real estate investing
• Start small, as a real estate investor and gain real-life experience
• Learn to identify great properties
• Use debt as leverage in financing the property
Learn to manage the property, improve the property, and increase rents
• Then I’d refinance the property, pulling out tax-free capital that
• Use to acquire more properties.
As my confidence and experience grew, which could take years, I would gradually begin investing in larger, more complex properties.
My first property was a tiny one bedroom / one bath condominium on the island of Maui. I purchased it in 1973 for $18,000. I used my credit card to pay the $2,000 down payment, secured a mortgage and had myself an income property that cash-flowed $25 a month. In other words, the property was 100% debt financed, which gave me an infinite return, since a $25 cash flow each month—with none of my own money invested—is infinite.
My 3-day real estate course was paying off and I soon dropped out of the MBA program. It made no sense to me to spend two years in school—learning to work for a taxable paycheck—when I was learning to make money out of nothing.
About this time in my talk, the hands of the people in the audience go up and people shout, “You can’t do that here!” Years ago, I did a course on Maui and showed the class the very 1-bedroom condo I had purchased in 1973. It was right across the street from where I was teaching, on a beautiful secluded white sand beach. You’d think that ‘seeing is believing’… but I still had people who were convinced that “You can’t do that here.” And: they couldn’t believe such a great property could have been purchased for $18,000.
In 1973, once I knew the numbers worked, I purchased two more units in the same development using two different credit cards. Foolishly, I sold two of the three, for approximately $35,000 each and paid capital gains taxes on the profit.
I held on to the remaining unit, that1-bedroom condo, for about 15 years and eventually sold it for $375,000 when the real estate market boomed on the island of Maui. As I’ve said: Start small and gain experience.
A few years before I sold that last 1-bedroom unit, it was renting for $850 a month—and delivering an infinite return, since I never had any of my own money in the investment. As rents went up, I refinanced the condo, taking out approximately $100,000 in debt. That $100,000 was tax-free money, because it was debt, not income. The rental income paid the mortgage loan and I was still receiving net rental income of about $300 a month, after expenses.
I eventually sold the condo because managing a single property, on an outer island was a hassle—and I had learned enough from that experience. I had learned to make money out of nothing.
Today, in 2015, I continue to use the same formula. The only difference is that the number of units, total dollars, and number of people required making the deal work have increased.
My latest property, which closed in May of 2015, was 1,600 units for $80 million. Once again, I have none of my money in the deal. Rather than use my “hard-earned” after-tax dollars for the purchase, I used a series of rolling-equity refinances and government tax incentives, plus debt—a formula very similar to my first, $18,000 Maui property.
I’ll review the formula:
1. Acquire undervalued property.
2. Improve the property.
3. Raise rents.
4. Increase NOI (Net Operating Income).
5. Refinance—taking out cash, tax-free.
6. Reduce taxes using fundamental
accounting principles, of amortization, appreciation, depreciation, and component depreciation.
Here again, like in virtually every group in cities all over the world, hands go up and people say, “You can’t do that here.” Many of the people who say, “You can’t do that here” that are high-income professionals such as doctors, accountants, and lawyers.
Frosting on the Cake
The real financial benefit to acquiring millions in income-producing real estate is to legally pay as close to nothing in taxes as possible. In other words, because I invest in real estate in the I quadrant, I pay almost nothing in taxes on income I earn in the E, S, and B quadrants. For example, I earn considerable income as an author on my book sales in the S quadrant. The tax write-offs from real estate investments—in the I quadrant—offset my book income in the S quadrant. The same is true for income from The Rich Dad Company, income from the E and B quadrants.
Every year my income in the E, S, B and I quadrants goes up, which means I must acquire more real estate in the I quadrant—or face the taxman and pay more in taxes. This is another reason why the rich get richer and the gap between poor and middle class grows wider. It is a matter of financial education.
If you would like to learn more about this formula for real estate investing, you may want to read the books of my Rich Dad Advisors and business partners, Ken McElroy and Tom Wheelwright, CPA.
Ken’s books are: The ABCs of Real Estate Investing, The ABCs of Property Management, and The Advanced Guide to Real Estate Investing. Tom’s book is titled Tax-Free Wealth.
Neale Petersen interviews Robert Kiyosaki author of Rich Dad Poor Dad on the how to invest in real real estate and state of the world economy