Finance Friday: Middle-Class Trap on Steroids ($3.8M but CAN’T Retire!)

Mindy:
Today’s Finance Friday guest is hoping to retire at the age of 47, but she feels like she’s stuck in the middle class trap. Will she be able to retire given how much of her current portfolio is tied up in retirement accounts? Stick around for Scott and I to wrap up at the end because we want to hear from you our BiggerPockets money community because Allie has a lot of options to choose from. Hello, hello, hello and welcome to the BiggerPockets Money podcast. My name is Mindy Jensen, and with me as always is my photogenic cohost, Scott Trench.

Scott:
Thanks, Mindy. Great to be here and looking forward to creating a complete picture of allie’s of Angel situation here. BiggerPockets has a goal of creating 1 million millionaires. You’re in the right place if you want to get your financial house in order because we truly believe financial freedom is attainable for everyone, no matter when or where you’re starting. Before we bring in Ali, we want to thank this episode sponsor connect, invest real estate investing simplified and within your reach. Now let’s get into the show. Ali, we’re so excited to have you on BiggerPockets money today. Welcome.

Allie:
Thank you for having me. Excited to be here.

Mindy:
Allie, can you share where your journey with money began?

Allie:
My journey with money? So I came from, my parents were very frugal. I was one of four. An example of my dad’s frugality would be we would go to go out to lunch at Wendy’s and he would order one large soda, no ice and six cups. That is a sort of background that I came from. He always said, no debt, pay for everything in cash, everything. We always were saving money from a young age and that’s carried on as I’ve become an adult right now, I have a 1999 car, always been saving since I was little. My first car I bought only went in reverse, so we were able to get a good deal on that. Did you fix it or did you just

Mindy:
Drive backwards? I feel like that’s inviting.

Allie:
My dad fixed it. Yeah, my dad was an engineer. He fixed it. We got it for $400. It was a BMW only went in reverse. So yes, lots of fun stories like that, but made it interesting. I was always very embarrassed, but today I understand why he taught us that.

Mindy:
Allie, I think we have the same dad. I was also always very embarrassed about the cars that we drove, although we didn’t have one that just went in reverse. My dad was always working on them. They were so old and so breaking down, so I am right there. We are soul sisters. Where are you based and let’s talk about your career.

Allie:
Sure, so I reside in the lovely Laguna Beach in Orange County, so it’s a very expensive place to live. I was fortunate to be able to get a house here when everything was half off in 2011, so I was able to, with the money I had saved since I was little, put a down payment and buy a house where I could never afford it. Right now my job is I do sourcing for a facilities management company for a big tech client, so I do find cost savings for a living.

Mindy:
Do you enjoy that?

Allie:
Yes, very much so. Yeah, no, I really enjoy my job and my job has a lot of benefits. They let me work from home since 2008, so I was able to raise my children and I’ve never had an expensive commute or had to invest in clothing or anything like that, so I think that’s really helped me save a lot of my money.

Mindy:
Allie, let’s jump in and look at a copy of your numbers. I have a total net worth of $3.8 million, which is awesome. I’ve got income of approximately 298,000 expenses of 9,900 a month, so I don’t think that’s where we’re going to see a lot of savings. Debts are just a $600,000 mortgage at 2.75%. I consider that to be good debt and a HELOC for 440,000 at 8%, which we’ll talk about in a bit. I see that you are airbnbing your property, your primary residence for two months out of the year. Is that every year that you do that?

Allie:
We can only do it in the summer. I have two children, so when they’re out of school we put it up every summer and we’re never expecting to rent it, but it always rents and it’s, we get, I think last year someone paid 46 grand for two months.

Mindy:
Holy cats. Yeah, I would do that again. I mean is that your entire mortgage payment for the whole year?

Allie:
Our mortgage is 26 50 a month.

Mindy:
Yeah, so I am doing quick math.

Allie:
Is that

Scott:
Just p and i?

Mindy:
Yes, she’s in California. That’s not taxes or insurance

Allie:
That doesn’t include, so everything all summed up with our mortgages around 4,000, 4,000 total with taxes and home insurance

Mindy:
And I see a small pension and social security options For you, what is your retirement goal? Numbers, timeline, et cetera?

Allie:
Last month living in Laguna Beach, nobody talks about retirement. Everyone has a Bentley or a Ferrari or a cyber truck and it’s just unheard of. Right. So I never really thought about retiring early until we used to have a financial planner, creative planning that would meet with us once a year and they’d say, when do you want to retire? And they had a little spreadsheet they put up and I remember saying, well, if I move that number up, how much more money do I have to save? And the difference wasn’t that much, it was just like a couple hundred bucks a month. So that’s what got me really excited about like, wait, could I retire early if I just save more money now? So I never really had, I just always thought I would work till, I don’t know, 60 or 65 and then retire then.

Allie:
But then I started, I found Mr. Money Mustache and Scott, I read your book and I was like, you know what? I don’t have any of these. Yes, nice little plug except for life. That was a good one. And I realize that you had mentioned three expenses, right? The housing, which I cover with the Airbnb, the transportation, which I don’t really have, and food, which my husband cooks, so we always eat in. It’s better eating it than eating out. So I was like, well, maybe I could do this. And then anyone I talked to about it told me, what are you talking about? That’s just silly. Nobody was even interested in hearing about it. So that’s how I feel like I really resonated with this podcast.

Mindy:
Why would you want to work until you’re 65 when that’s the only option versus giving yourself the option to work for as long as you want to, but you don’t have to work anymore.

Allie:
I know, and if they would let me short-term rent my house in Laguna, which they don’t, I could have been retired so long ago, so that’s a bummer for me. So sometimes I think about buying a short-term rental like in San Diego or something like that and pursuing that as well. But

Scott:
I think the most important thing here, it’s so glaringly obvious and it’s the problem that you came with to him does with today I think is this concept of the middle class trap with your net worth is $3.8 million. You’re rich,

Allie:
I feel so poor.

Scott:
The house is $3 million with a $600,000 mortgage balance, give or take left on it, and the rest of your assets are essentially all in the 401k or IRA setting for the other 1.4 million. Right, and that’s essentially the entirety of your financial position, is that correct?

Allie:
Yes, that’s correct. And it’s like how can I access those funds or how can I leverage them or what can I do without having to sell my house, which I could also do.

Scott:
Yeah, and this problem is starting to come out of the woodwork. I don’t think I’ve talked to a lot of people that had this problem in past years and then all of a sudden in the last month or two, I must’ve come across a couple dozen people with a problem that’s similar to this. Right. How do you feel about it and what have you thought about in the context of this housing decision or how to access this housing as you were putting all these numbers together and thinking about coming on the show here?

Allie:
I mean I’m always kind of torn between, okay, we have about a quarter acre, so I could build an A DU in the backyard, rent it out, I could pay probably all cash I could. One thing we’ve pursued but we haven’t actually been successful at is buying another house in Laguna that’s kind of not as nice or smaller, moving my whole entire family in because my kids are in school here and then renting out our primary. And then the other idea is just buying some real estate back where I’m from, which is a Philadelphia area where it’s a lot cheaper and you can get a lot more, but then managing it so far away would be difficult. Sometimes I think about too cashing out some of my 401k to do that, but then I had this financial planner who really said, you don’t want to tap into that 401k.

Scott:
We’ve got some exciting news. Today is November 29th, which is the very day of the BiggerPockets Black Friday book sale. Want to be set for life just like Allie, you can grab my book and tons of other books for up to 60% off. Head over to biggerpockets.com/black Friday. This offer doesn’t apply to all books and ends on December 2nd. Happy shopping.

Mindy:
Welcome back to the show. Have you read the Mad Scientist article called How to Access Retirement Funds Early?

Allie:
Yes.

Mindy:
That is one of the best, most comprehensive articles for accessing your retirement funds early so you can tap into your 401k without paying penalties. I am assuming that you have a traditional 401k. There’s no way that I know of to get around paying taxes on this unless you only pull out a little bit. But what’s the point of pulling out a little bit? You’re not going to even be able to live off of it and this would be after you leave your job because if you do it while you’re at your job, you’re paying in the highest tax bracket possible to access these retirement funds early. But there is the Roth conversion ladder, there is the 72 T. There is the just taking it and paying the penalty, although I would do that after I stop working because you will still be paying taxes on it no matter what. So I would suggest you give that article another read. Building the A DU in the backyard is interesting. You said you could pay for it with cash. How much would that generate in income? How big of an A DU can you build?

Allie:
Yeah, this is the issue. So when I have a contractor come out and bid me, they say it’s going to be minimum million bucks to build an A DU, but then you see these prebuilt ones online that are like $80,000, so like 150,000. So I think I’d go for the prefabbed one, right? Pay in cash and then I could probably get 3000 a month, something like that, but I would have people living in my garden, which I’m not sure.

Scott:
What would that do to the value of your home?

Allie:
Yeah, it would probably go up a million bucks. I would guess mean it would go up more if it was a custom one. If I spent a million dollars on it, it would probably go up significantly more than if I bought a prefab.

Scott:
That would be a truly amazing statement. If you could add $150,000 prefab a DU to this property and increase the value of the property by a million bucks, but I think that’s a good homework assignment. Has anybody done that in the local area and how did their property translate? Because there’s always rent and cash flow and income stuff. Like if you could spend 150 grand and make a million back in one year, then there’s no other that’s the best opportunity you’re ever going to get in your life. I’m skeptical that that will happen with that, but if it can, that’s the first. That would be the first avenue I’d explore from this, and in that case then I would be like, yes, how do we finance? How do we finance that? Is it an heloc? Is it something else? Because you’ll be able to justify almost any source of capital for that investment, but what’s your conviction in that value add?

Allie:
I mean, most people around here have a ton of money, so they’re getting the custom made a DU that matches their house. That’s beautiful, right? I don’t see a lot of just drop-ins, right? So I don’t know that I’d be able to find something like that to compare, but I do see the people that build the custom ADUs and their value good. There was a house down the road from me, I think it was sold for 3 million. They built a DU and they sold it for six because the property value here is so much, right?

Scott:
I’d rather do that than spend 150 K to make a million. If that’s true, you’d rather spend a million to make two. You’d rather increase the value of the property by $3 million with a million dollar outlay within $150,000 outlay to get a million bucks. That’s another one point what, seven 5 million? That’s an enormous play and

Allie:
There’s a possibility of doing A-J-D-U-A-D-U, so you could do two, you can do two ads here in Laguna, so a junior, a DU, and a regular A DU. So you could actually do it twice.

Scott:
Let me ask you this though. Do you want to be in Laguna Beach? The goal is not to retire early, it’s to retire early in Laguna Beach, right? And live something close to your lifestyle, maybe in a slightly smaller home nearby. Is that right?

Allie:
Yes. Ideally,

Scott:
What is the ideal future? Home.

Allie:
Home?

Scott:
Yeah. What does your future living condition look like?

Allie:
Well, I have two kids that are aged 10 and almost 12, so I think for now I need at least a three bedroom home office. It doesn’t need to be big, but I do think people need their own space when they go off to college or move out. It could be much smaller, just a one bed.

Mindy:
Another trap that you’re in is, I don’t have a cute name for it. You bought a long time ago and interest rates have since gone up. Property values have since gone up. I can see you starting to look for another house in Laguna Beach and finding a smaller house that ultimately costs you more per month out of pocket, which isn’t going to be beneficial to your goal unless you keep them both and then rent this one out. Do you have any plans to sell this house or do you want to keep it as a rental?

Allie:
Ideally I’d like to keep it as a rental.

Scott:
What’s it cost to rent the house that you want to live in for the next couple of years

Allie:
In Laguna Beach? That’s another thing we’ve thought about too. Should we just rent somewhere else? They range, right? They range anywhere from, I’ve seen rentals for a three bedroom house for like 4,800 up in a certain area of Laguna, and then they go all the way up to, I don’t know, 50,000. But I would think a normal three bedroom nice house would probably be around $12,000 a month,

Scott:
12,000 a month. Okay, that’s higher. We’re in hard territory here. That’s 140, 150 KA year rent and to buy the place. How much would one of the places you’re thinking about buying cost,

Allie:
They’re usually around 14 or 15,000 a month.

Scott:
That’s the mortgage payment. How much is the price point?

Allie:
You can’t get anything under two mil here. So what I’ve been doing, so say a house is up for a long time, I’ll sort it by length, then I’d offer one eight and every once in a while they’ll say, okay, and then they get a couple other bids and somebody outbids me. I mean that’s kind of what’s been happening. I wouldn’t pay more than 1.8, but you’re getting not a very nice house at

Scott:
All. Yeah, I don’t see a lot of $1.8 million property.

Allie:
Yeah, you have to create the 1.8 million.

Mindy:
I’m not seeing anything for less than, oh, here’s one for $7,900 a month, five beds, five baths, and if you rented out your place, could you rent out your place for 10,000 a month? It looks like you could rent it out for a lot more.

Allie:
So if I was to do an annual lease, I probably could get 10 or 11 or 12 maybe. But on Airbnb in the summer, I can always get 20. So I think if I did furnished Airbnb, a lot of people are remodeling their house. They want a place for like six months, so people will write me, I used to just have it my house up all the time on Airbnb and say people would say, Hey, can I rent your house starting tomorrow for six months? And I’m like, maybe if you could rent it in two weeks, we could do that and then I’d be frantically searching on Airbnb for a rental.

Mindy:
I mean, if you could do that and get what, 20,000 a month for your property and you’re renting a property for let’s say 10,000 a month, then you’re paying 4,000 for your expenses for your house, you’re still making $6,000 a month and your expenses are $9,000 a month. So you just need to cover 3000 a month, which you can do by accessing your retirement funds early. Scott, do you think that 3.8 could get her some $3,000 a month?

Scott:
I think that’s the big question here is if you’re going to move out of the house should sell or keep the house here and I think that’s the fundamental decision and we’re operating under the paradigm of keeping the house and how do we use that to drive income? And I think that that’s a question that needs to be posed here is there’s $2.4 million probably conservatively inequity in this house and with $2.4 million in cash or after tax, I’ve calculated the equity you would realize to 1.863 million on this at least if you could sell it there, we can generate a lot of cashflow with $1.8 million in cash in a number of buckets. I think that’s the big question here is what do we do? How does it feel to even talk about selling the place?

Allie:
I’m open to it because if that means that I could be work optional and have more freedom and still live a life in Laguna Beach traveling and doing all these nice things, yeah, I mean I’m open to it and I don’t want to just have this house with a ton of equity and it be a wasted, you know what I mean?

Scott:
Well, let’s walk through the long-term rental case real quick. I nerded out and I did a spreadsheet here.

Mindy:
Right now Scott is using his, should I sell or rent spreadsheet to run the numbers for Allie, go over to our YouTube channel, youtube.com/biggerpockets money to see Scott in action. It’s fascinating

Scott:
And I’d love to just walk through and see how this feels at the highest level and say this is a value. You think it’s about $3 million today?

Allie:
Yes.

Scott:
We don’t have to worry about the original purchase price in. Well actually, yeah. What was the original purchase price for this?

Allie:
It was 9 49 40,

Scott:
Okay. And you bought that 10 years ago, but we don’t need that date right now. When did you get your current mortgage?

Allie:
I refinanced back when everything was really cheap, so I would say during Covid,

Scott:
So probably around this time, September, 2021 kind of deal.

Allie:
Yeah, that sounds perfect.

Scott:
And your mortgage balance was six 50 ish?

Allie:
We did a remodel, so we got a lot of work done on our house and then we took that money and rolled it into the refinanced when we did our refinancing that number.

Scott:
So I need this number to do the calculation, but what was it? Is it close to six 50? Yes. Okay, great. And then does this look reasonably close? We got 2,400 in p and i, 12,000 in annual property taxes and 2200 annual insurance.

Allie:
Yes,

Scott:
3,600 a month in mortgage. Mortgage payments.

Allie:
It’s around 4,000. Yeah.

Scott:
Okay, I’m going to bump this up to 3% then that’s probably a little closer. What is the interest rate on the mortgage?

Allie:
2.75 I think.

Scott:
Alright, so I’m getting close here, right? We’re not exactly right, but we’re pretty close with the 30.

Allie:
Yeah, yeah,

Scott:
I said if you sold the place you’d have a 5.5% agent fee, 1% closing and title insurance and that would net you $2.171 million after paying off that mortgage and paying those fees and that would give you net sale proceeds of $1.8 million. Okay. You are qualified for primary capital gains tax exclusions, so the first 500,000 of that are not taxed. After that you’re going to owe 20% in federal capital gains. And do you know the capital gains rate for California?

Allie:
No.

Scott:
All right, I’m going to put that at 9%,

Allie:
Probably high.

Scott:
Alright, how about 0.08%, 8% sound right?

Allie:
No, I just mean it’s probably a lot if it’s California,

Scott:
That means you’re going to pay 2 67 ish in federal and potentially about 120 in California taxes to be verified here. That leaves you with this number in terms of what you could invest in. The next thing either this model was built around deploying that towards your next house, but you could also invest it in stocks or something else there. So what comes down to is what do you believe the stock market’s going to do over the next 20 years If you think it’s going to return, I have it plugged in at 10%, you could be conservative and put at nine, but what would you say? What do you feel comfortable with? What do you think as a stock market investor you think it’ll be,

Allie:
I’d probably be conservative and say eight or nine, so

Scott:
Let’s put it at 8% and then I have some assumptions here around rents. I plugged in 11,000, you said 10, 11, 12, so I put 11 on this. I have assumptions around vacancy and all that stuff and gets you a cashflow of 5,500 a month if you keep it. What do you think Laguna Beach is going to appreciate in terms of rent and price growth? Do you think it’s going to be historical, average or higher or lower?

Allie:
Higher. I mean I think I heard some stat that house prices double every eight years.

Scott:
That’s close to an eight year one, so that’s a very aggressive assumption and if you believe these things, you’re likely to want to keep the place. And do you think that same is true for rent growth?

Allie:
Yes.

Scott:
And I’m going to put expense growth lagging a little bit behind that hopefully because you could still buy your roof shingles from Kansas City even as rents go up in Laguna Beach. Does that feel right?

Allie:
Yes, that feels right.

Scott:
Yes. It’s all what you believe here. You’re going to see that keeping it is going to produce a lot of cash flow and is assumptions. You’re going to get about $75,000 in the first year and that’s going to continue to accelerate very rapidly if you believe that rent growth is going to grow at that price range. And I can tell you already that you’re going to think you’re going to believe that the wealth you’re going to build by holding onto this property is going to be much higher than if you invest in the stock market here. So to me this says you are on the right track for keeping it if you believe these things. I will caution though that I’m much more conservative with my assumptions for real estate and I plug in a default of 3.4% because you never know what’s going to happen in the future there.

Scott:
And California is already high and I would put in 10% for the stock market. This is how I analyze a Denver property, but it’s completely based on what you believe and in that scenario you’re going to see that selling it and putting the money into the stock market would generate significantly more wealth, about 10 million incremental dollars over keeping it in that scenario. So I’d encourage you to play around with this, but that’s the big bet you’re making. The good news is you’re really rich either way. If you hold onto this asset and the stock market depending on either one of these things, you got a great problem here. It’s just that’s the tool that can help you think through it. And then one other consideration I’d just posed for you that I was reacting in is you’re going to be very heavily weighted to real estate if you hold this thing and especially if you buy more compared to the stock market because of your starting position. So just those are the things that popped into my head, but I think if you believe what you said there around that, there’s a no question. This is a keep property and we’re on the right track and I just sidetracked us unnecessarily, but hopefully that was at least a little helpful.

Mindy:
Stay tuned after one final break and we’ll be back with Ally after this.

Scott:
Let’s jump back in with Allie.

Mindy:
I don’t think that’s an unnecessary sidetrack, Scott, I’m really glad that you did that spreadsheet because that’s really helpful. You put a lot of time into that spreadsheet before you brought it up, but then you just throw all these numbers in and it shows how you can manipulate them. I think that’s great. Yeah,

Scott:
I’ll send that to you Allie as well.

Mindy:
Yeah, so you can start playing with it too and throw in different numbers and see what happens, but I think that there’s a lot of opportunity for researching your local market with more solid numbers and unless your numbers are super solid, I am always a little leery about counting on appreciation, but then I looked up where Laguna Beach is and I’m like, oh yeah, that’s probably going to be a safe bet.

Scott:
Laguna Beach is awesome. I’ve been there in San Clemente and it’s like, oh my gosh, you can live anywhere in the world. One of those two places is somewhere along that coast. It’s so awesome.

Allie:
I’m from Philadelphia so I can appreciate the beauty and the weather and everything, but yeah, no, it’s an amazing spot.

Mindy:
Yeah, it’s really gorgeous.

Allie:
Yeah, people from Texas are the ones that always rent my house.

Mindy:
Another question you had was about your pension and should you be cashing that out right now? It’s $27,000 if you cashed it out and you’d get 477 a month if you waited until 2042 to start taking your pension. I did the math really quickly. That’s like just what, four and a half years, almost five years of break even before. If you took out that 477 versus taking the 27 right now, what would you do with that 27 if you pulled it out,

Allie:
Put it towards my house in Laguna Beach, my second house, what I’d like to do is just buy another house in Laguna Beach. I just don’t know if it’s so crazy and I want to tap into whatever funds I have, so I do have a lot of Roth in my 401k and can I use that?

Mindy:
Yeah, you’ve already paid taxes on that. I don’t know how you access your, is that in your current 401k or in the previous? So you would have to separate from your company before you could access those funds. Scott, how do you access Roth 401k funds?

Scott:
Well, if it’s the principle, you should be able to withdraw the funds. The gains will be subject to penalty from the Roth, so you’ll pay a penalty for withdrawing those early. Your Roth position, let me go back to this Roth’s position is in total 243,000 and you actually put out for us the contributions of 160, so you could pull out the 160 to use toward that purpose. I’m still a little hung up though here on the, should we, right, because what you’re doing, and this is fine, I just need to wrap my head around it because I’m not there yet, is we’re saying, okay, we have $3 million in Laguna Beach real estate and 1.4 million in equities and our plan is to buy another three, $2 million in Laguna Beach real estate by using the stock market funds, which is a, maybe you win, maybe if you believe it’s going to appreciate 6% a year and you lever up on Laguna Beach real estate and hold on for a few decades, you’re going to get real rich, but I already have you project it to a 20 plus million dollars net worth over the next 30 years, whether you keep or sell the first home, the risk at some point for me, the plan becomes about risk mitigation and making sure that you can just couch your lifestyle in place there.

Scott:
When would that number, when would that come in there? What net worth level if I just handed you a pile of cash would be like, okay, I’m done.

Allie:
Well, I think that’s the question, right? Can I just be done? The point of buying the second house in Laguna is to say that I could be done because I think in my mind, if I buy it now and I work hard and I move into this smaller house and I house hack in five years, could I sell it, make a profit and then I have that extra money to retire on? I don’t think I need a lot of money to retire.

Mindy:
I would look into, I would start, find an agent that can help you in Laguna Beach and start looking for an amazing property, a dumpy property that you can make beautiful or start really learning the market and looking and seeing what’s available. Because the best time to make an offer on a property is when you are absolutely sure that it’s a great deal, get it under contract and then have the super tight home inspection, see what’s going on with this property. Do you really want to tackle it? If you could buy this other property and rent out your current property for 10, $20,000 a month, it kind of doesn’t make a whole lot of sense to say, no, you shouldn’t do that.

Mindy:
I don’t know enough about Laguna Beach real estate to be able to make a determination what the market is like right there. But over here in Colorado it’s kind of slow. There was all this uncertainty with the election and now that the election is over, there’s all this uncertainty with will rates continue to come down or will they not come down anymore? And people are just a little hesitant to jump in. So if you could find a smoking hot deal right now because nobody else is out there buying houses, then I mean you’ve got such a rockstar of a property that you’re sitting in right now.

Scott:
My concern here though is just like we’re already at 3.8 million in net worth and it’s so heavily exposed to Laguna Beach real estate to double down again, could be a winner, it could be a winner. That could absolutely be the right choice. But then it’s like why? What is that end-state portfolio going to look like in five years? Is your plan to sell the property that you just purchased and then rent somewhere else, move back into the first place? What is the long term? What does the retirement lifestyle look like from there? And that’s where I continue to get hung up here on this is I’m not sure how that translates into the goal of retiring early quite as clearly. Could you maybe explain that to me, Ali, maybe what I’m missing there?

Allie:
Well, I think I just go back and forth, right between those two. Do I just take it easy, retire early and I’m good to go? Or would it be helpful if I had another revenue stream to help? Because right now I’m stuck, so I have till I retire, I really don’t have that much cash. It’s all tied up either in my house or my 401k my cash can’t get me through if I were to retire right now. So how do I bridge that gap between where I am right now at age 47 and that next 13 years with the cash that I have? So I guess in my mind, I think, well, I need another property or something providing income for me or another property I could sell that would provide income to get me to that retirement.

Scott:
Yes. Okay, so the issue for your retirement, if I’m looking I’m zooming out, is you spend very reasonably for your income level here and relative to your overall asset base. But that’s an illusion because to live the lifestyle that you want to live in, Laguna Beach is $12,000 month between rent and utilities that is being masked right now because you bought your house so long ago and have such a light mortgage on that. So to live in your house, that’s the cost right now. And you need to generate, you need something else to generate the $120,000 per year that you spend some other asset situation to do that. But what’s happening in reality is you have $2.6 million in assets locked up in order to have this expense profile right here. So you really, in some ways we could think about it as you’re locking up $2.6 million to keep your expenses 7,500 to $9,000 below what they would otherwise be for your housing.

Scott:
And that’s the fundamental problem that we’re working through here. And I’m trying to figure out, okay, if you move, you’re going to be, and you rid rent, you’d be spending that amount of money or you’d need about 2 million at least in a paid off property or a very late levered property to have the same expense profile. And so that brings me back to how do we unlock this? It’s 2.4 million in equity in the house and use it to fund retirement or what else can we use to get there? One other question we haven’t talked about in that concept is you make $298,000 a year and you spend 10,000 net of taxes. How much are we actually accumulating on an annual basis from your job? That’s another asset if you will, that we haven’t thought about over the next five years. Will you accumulate 50 KA year or a hundred KA year?

Allie:
Well, I think before I was filling out your spreadsheet and things like that. What I’ve always done in the past is I’ve paid myself first by maxing out my 401k, maxing out my HSA, maxing out dependent care, things like that. But once I started filling this out, realizing I need more cash and I did your little budget exercise, I was like, okay, why don’t I start putting away, I think I’m trying to save right now, 8,000 a month, but this is just brand new, but that’s what I can probably work to save 8,000, between seven and 8,000 a month.

Scott:
Awesome. And are you also contributing somewhat down that stack of retirement 401k dependent care FSA, all that kind of stuff?

Allie:
So I just had to do my enrollment and so what I did was my company matches the first 5%, so I did 5% my 4 0 1 KHSA. I heard Mindy say you always should max out the health savings

Mindy:
If you have a high deductible plan. Yes, because you can either use it to have tax-free expenses for your medical expenses in the current year, or you can save your receipts and cashflow your expenses and go down the road and cash them out later.

Allie:
So that’s what I did. So I just signed up last Friday, but that’s what I did. So I think I put 8,000 in that and then 5% my 401k, but it’s not what I’m used to. I’m used to totally maxing that out. So I was a little bit uncomfortable lowering that and I think I’ve changed it three times since going back up and down, but I think I want more cash.

Scott:
It’s a good answer to the question of how do you finance A DU, for example, is to let that after tax liquidity position pile up instead of paying a penalty on the 401k or Roth in my view. So I like that answer. That’s a hundred grand a year, give or take, 8,000 a month times 12, I think 96 so that we’re getting close to a hundred thousand dollars a year in liquidity that will begin piling up there and that’s a piece of the puzzle over five years. That’s 500 K over tenants a million. So you can think about that in those big chunks and say, okay, we’ve got another pile of assets there. Depending on how long you want to work that’s going to apply to this. Plus you’ve probably got another 30 40 on an annualized basis when all is said and done, that will be going into your pre-tax or tax deferred accounts like the HSA 401k match, those kinds of things.

Scott:
So does that sound about right? That’s a considerable part of the position here. That’s going to be more than a couple percentage points. So I don’t think it changes the fundamental math about what to do with the house, but I’m uncomfortable. I’m reacting emo as maybe not logically here of pulling out the money from the stock market to double down in Laguna Beach. I mean that’s a play, but the play is I’m going to put 70% of my net worth on the line for the next 10 years and maybe the rest of my life in this Laguna Beach real estate territory. And that just needs to be a conscious decision that you’re saying that’s the pie chart I would draw if I had five, six, 7 million in 10 years, if I handed you cash, I would recreate that portfolio. And how does that feel? Does that feel right to you?

Allie:
Yeah, I mean I think it’s always good to have diversification. I mean, having everything in one basket, especially with all the fires and everything happening, that is scary. So it is good to diversify portfolio I think, and I appreciate that viewpoint in Laguna Beach. I love Laguna Beach, so it’s like sometimes you kind of get focused on it.

Scott:
Mindy, you seem more on the train of buy the next house and rent it out there, and what are you thinking about this, about the situation?

Mindy:
Well, I’m thinking that if she can rent her house, which costs her $4,000 a month, if she can rent it out for 20, 22, 20 $4,000 a month, that makes a lot of sense. Then that money covers her expenses for the current house plus the expenses. If she rents a house at $12,000 a month and she still has money left over for fundies, it covers, I didn’t run numbers on a mortgage payment on 2.8, and that’s a thing to think about. Where would you get the down payment for that? That’s going to be a hefty down payment, even if you’re just putting down 10%.

Scott:
Remind me again, the $20,000 is for two months of short-term rentals, which is the limit of the community. Is that correct Ally?

Allie:
So Laguna Beach has a minimum 31 day and we got 46,000 for two months, so 23,000 a month.

Scott:
Okay, and you think year round you can sustain a midterm rental cashflow in that level? That is the reality you think that could

Allie:
No, I don’t think that. I think those are the summer months. You can get probably a lot more. I think if I were to rent my house out just on a normal, not furnished or anything like that, I could probably get 10 or 11 or 12 maybe. And then if I did Airbnb furnished midterm rental, probably be rented out I would say maybe 70% of the time at probably 15 grand a month.

Scott:
Okay. So 15 grand is a more realistic number for year round rents with some of these creative strategies and that’s still, I mean these are huge levers and we’ve got a range here that we’ve heard for rent for this property of nine up to really what I’m hearing is 15 on an annualized basis for this. So that’s a big spread and probably a big piece of the answer here. If that number’s closer to nine or 10, then your net cashflow on this thing is going to be like 5,000 a month, which sounds awesome for one property and it is, but it’s not awesome relative to the 1.8 million in realizable equity that you’ve got tied up into the property and that would be more inclined to sell at that level. But if you can get pushing close to 15 or upwards of that, then the simplicity of just having a local owned rental property in one asset might be worth it to a large degree that’s 10 grand a month, you’re done game over, you spend 10 grand a month, that’s it, and you don’t have to touch the rest of your portfolio. So I think that that’s where I keep going back and forth on it.

Allie:
Well, and the thing is, it’s different. So if you do the long-term lease and you need to rent it out fast, that would be nine grand unfurnished, but if you want to do the extra work, put it on Airbnb, furnish it, which is already all done. We already have all that done, but the problem with the 15 grand a month is you’re not going to have it rented out the whole time. Someone will probably run it out for six months for a remodel, then there’ll be a month and a half vacant, then another three months. So in the end, if you average it out, it’ll probably be 11, but there’s different strategies that all create those different numbers. That’s why there’s such a difference between the numbers.

Scott:
Mindy, how do you feel about this? If the annual rent, if the average monthly rent is going to be $11,000, what do you think? Does that change things for you?

Mindy:
Yeah, kind of. Because 11,000, her expenses are going to be 4,000 just for the house, so now we’re down to seven and she’s going to have to find a rental for $7,000 a month or less in order to break even. And that’s going to be difficult in Laguna Beach based on my very quick, very cursory Zillow search while we’re talking, but I mean, do you think you can find something for less than $7,000

Allie:
If I was renting, yes, I do. If I was buying, no, I mean when we’ve done the spreadsheets for buying another house, it was like, okay, my husband’s always like, okay, so we’re going to move into this horrible little house that needs a ton of work and we still have to pay $8,000 a month. Where are we getting that 8,000 a month? So my husband’s a bit more skeptical than I am. I’m a little more

Mindy:
Well, and then you could, after you’ve lived in this other house, let’s say you buy another house, you’ve lived in it for a few years, you kids are continuing to go to school, you’re continuing to make a ton of money off of this current house. You could move back into the current house. If you don’t sell it, have your $4,000 expenses. So you move out and try it. I mean, if it doesn’t work out, maybe you do rent for the first year. If it doesn’t work out, you just move back in. Oh, it was really hard to get renters all the time. Or Oh my goodness, I have 27 people that are looking for a rental at any one time, so it’s super easy to charge 20,000 a month and it was a good idea. Then you go and buy.

Allie:
Yeah, that’s a good idea. Kind of experiment with renting before I risk my entire everything.

Mindy:
What I see from Scott running his spreadsheet is that there’s no clear, absolutely sell it. This is a terrible idea to keep it answer, which is good because if there was, then that would be like, okay, don’t even bother, just sell it and move on. But there is the opportunity to work.

Scott:
The answer is super clear though. The answer is super clear. If you believe the assumptions I had for the stock market at 10% and long-term appreciation rates a three and a half percent for prices and rents, it’s an absolute sell decision. It’s a $10 million net worth decision over the next couple of decades. If you believe what Allie believes that Laguna Beach is going to appreciate at 6% a year and rents are going to go at 6%, it’s an absolute keep decision. I think we would have very different viewpoints on those assumptions, but that’s the point of the model. Now you know what, if you believe those things, you have a clear answer around it, but I think that’s the fun part about financial models is those assumptions make such a difference in terms of what to do.

Mindy:
But you’re assuming Denver appreciation and she’s saying this is what Laguna Beach appreciation is. So I like running the numbers at different places. I think this is a great homework opportunity for Allie because what I meant was there’s no, when you run the numbers, according to her numbers, it says keep it. So if both ways said sell, then we wouldn’t be having this conversation. So now is a great time to go and really dive deep into what is the historic appreciation rates in Laguna Beach? What is the historic rent appreciation in Laguna Beach and what is the historic returns in the stock market? It’s 10 point something percent. I closed the tab, but it’s 10% historic from the time all the way back to the beginning, but there’s also some years that it went negative, so I would be more in line with Scott’s 10% on the stock market, but I’m also not betting that I can say that from here, but I think that you should be really comfortable with the numbers that you’re putting in Allie, and I think that you should be comfortable with them because they’re the historic average and past performance is not indicative of future gain.

Mindy:
We should always say that, but I do think that there’s an opportunity there as opposed to both times we run it, it says no, sell it.

Scott:
Another component to this that makes it just so complex and such a great challenge. Thank you for bringing this today. I mean it’s just so many people are going to be struggling with this is if you just want to simplify it and go back the other way, a completely different way of looking at this. You say, okay, the price of retiring comfortably in Laguna Beach is tying up 3 million in a house and having the expense for the mortgage payment be zero because your taxes and insurance are nothing on a property that size for it. So if this mortgage is paid off, which is something we’ve talked about in the past, it’s 2.75, so that’s going to be a hard pill to swallow. But if the mortgage is paid off, then your expenses go from 10 9900 a month to 7,300 a month on there and you’re within a stone’s throw of $7,300 a month from your current portfolio.

Scott:
If you can accumulate a little bit of cash outside of that and bridge to traditional retirement age, you’re not that far off on that front either. And so that’s an option to think about here is like, do you keep this place rented out for a couple of years, do a live-in flip four two, I love the live-in flip in areas like a Laguna Beach because of the tax-free capital gain that ties up some money, but you’re paying interest on a much lower interest than your flipping competitors and you get the first 500,000 tax free. If you want to do that two or three times between now and the time your kids go off to college or leave the house, that would probably completely end the game for you. And now you can think about it in much simpler terms. I have a paid off property that I can live in Laguna Beach and about two and a half, $3 million in the portfolio outside of that from these live and flip capital gains. How’s that one for a complete different spin on the situation that says go all in on just paying the thing off and tying up the 3 million in equity?

Allie:
I like the idea of paying off. My husband would like that because he likes not having any debt. But now are you saying now go back out and buy some houses in Laguna and flip ’em? Is that what you were saying there?

Scott:
I’m saying move into the next house in Laguna, which is move into the next house, buy it, but treat it as a live-in flip. You’re going to own it for two. It’s a slow flip. You’re going to own it for two years and then you’re going to flip it and then you’re going to sell it. Like what Mindy does here, and I imagine the spreads are super high on that front because I imagine super wealthy people buying $3 million homes do not want to spend six months refurbishing the place.

Allie:
I see a lot of success with people doing that. They’ll buy it for under two mil, flip it for four and a half within a year.

Scott:
Dang. Then you’re going to have to pay talent if you do that.

Mindy:
No, no, no, no, no. Put both kids on title when you buy it and then they’re there for two years. It’s their primary residence too. Then you get a million dollars of tax-free capital gates.

Allie:
Yeah, I would have to live in it. I’d have to rent out my house to pay for it.

Mindy:
It’s $250,000 per person on title, not just two 50 if you’re single and 500 if you’re married. So then you get a million dollars of tax-free capital gates, and there’s rules involved of course,

Scott:
500 of which doesn’t go to your retirement. It goes to the kids’ Bentleys following that. But I think that if you take that math and you say, okay, I’m going to do a live and flip. I’m going to buy one of these properties for 1.7 or whatever that is, that’s in really bad shape. We’re going to fix it up ourselves. Now you rent out the primary and if you can get that 12 to 15 range, you’re probably going to cover the lion’s share of the new mortgage while you live in there. It’ll be slightly more expensive, you’ll save slightly less, but that’s not, that is an approach that would be reasonable in your situation since you have 8,000 a month in savings on top of your expenses right now.

Allie:
I like that idea. Just got to talk my husband and two kids in it.

Mindy:
I would find a real estate agent, if you don’t have one that you’ve been working with in the past, biggerpockets.com/agents is a great place to find an investor friendly agent. And even though you’re going to be moving into it, you’re looking for an agent who understands investments as well, so they can say, Hey, this one is going, if you fix this one up, it’s going to yield a whole lot more than this one for the same price.

Scott:
I mean, you could definitely lose, and that’s again my worry about the plan to go all in on lag Gooda Beach real estate in your situation, but there’s a good way, it’s a significant de-risking of the investment process.

Allie:
If you two want to partner with me, that would help mitigate the risk too. We can go third. These

Scott:
Hard money lenders love California because they’re big loans on these properties and they make a lot of interest in points, so you’ll have no trouble finding lenders if you can bring a material amount of cash down.

Mindy:
Good to know. Okay, Allie, this was a really fun set of circumstances and interesting financial, I don’t want to say problems because these are all really great problems to have. I have so much money, but it’s tied up in my retirement accounts, but you have so much money, but this was a fun exercise and I am super excited to see where all your research leads you to. So please keep us up to date. It might even be fun to have you come back after you’ve determined what you want to do, and we can run through some different numbers and scenarios then. Yeah,

Allie:
No, thank you. This has been super helpful and I really appreciate your feedback. I listen to your show all the time, so I’m really happy.

Scott:
Thank you so much for coming on, and congratulations on your awesome problems. I’ll be really interested to see how you untangle ’em. It’s a really tricky situation and a good thing. Congratulations. I hope you’re feeling very excited about the future.

Mindy:
Yes. Well, thank you again. Thank you, Allie, and we will talk to you soon. Bye-Bye. Alright, Scott, that was Allie and that was a really interesting set of problems and I wish I was a little more knowledgeable about the Laguna Beach area just because you and she had different assumptions on the returns, the historic returns and or not the historic returns, the forward facing returns for Laguna Beach, and I can see both of you being right, but only one of you will be right.

Scott:
I think it’s really hard for me to wrap my mind around this problem, and I’d love to get input from the BiggerPockets Money community on this because this is the middle class trap on steroids right here. I also just in responding to it, I thought of something after we finished recording. I wish I would’ve thought of it when we were there around the 10 31 exchange applies here because I’m so used to dealing with so many, such smaller dollar values on primary residences where the capital gains exclusion applies. But when you have a $2.2 million gain and only the first 500,000 is excluded, well now we’ve got to talk about how to shelter the other three or $400,000. Another option I throw out there for Allie is to consider a 10 31 exchange. Can she sell that property and move that into other higher yielding, cash flowing investments somewhere else as part of that portfolio? Because that’s going to be more, that may be a way to shelter that tax benefit if she decides to sell the property. She kind of busted my model with how big the numbers are on this property and I have to go revisit a few assumptions in there and make sure that those are tailored to these types of situations.

Mindy:
Well, a 10 31 is for investment property, so she would have to turn this into a rental for a while, I believe. And what I don’t know about the 10 31 exchange is quite a lot, but I do know that it’s for a rental property, so I’m wondering how that would work.

Scott:
I think that that’s a great accounting question for our community. Actually, I believe you can do it if you rent it out for two years, but let’s hear from a community and ask that question out there. Can you 10 31 a primary residence if you turn it into a rental? I believe the answer is yes.

Mindy:
Yeah, and if that’s the case, then absolutely that would make so much sense because then you can kick that tax can down the road and she’s saving, what did you say, $300,000 on taxes, almost $400,000 on capital gates taxes, if she does that,

Scott:
Yeah, depending on what the California marginal rate will be for that, which she’ll be in a high tax bracket between her income and the gain On this one, I calculate my crude math, that’s certainly incorrect, but ballpark of 387,000 in capital cadence. So that’s a material part of the decision here. If you can get another 400 grand by deferring it into real estate and you plan to keep real estate for the long term, that could be pretty powerful There you are giving up the primary residence exclusion though. So something there’s, there’s a tax angle to this that should definitely be explored and she should probably talk to a real estate friendly CPA

Mindy:
Probably. She should definitely talk to a real estate friendly tax provider or tax planner who can help her figure out what is her best play. They can run these numbers for her, but yeah, this was fun problem to try and figure out.

Scott:
We’d love your thoughts on it. This is a new problem for Mindy and I at this scale, so any feedback or thoughts are appreciated.

Mindy:
Scott, and I want to hear from you. What advice would you have given to Allie that differs from what Scott and I said? We would love to hear from you below.

Scott:
Well, should we get out of here, Mindy?

Mindy:
We should. Scott, that wraps up this episode of the BiggerPockets Money Podcast. He is Scott Trench. I am Mindy Jensen saying Cheerio missile toe.