Case Study: How to Transition From Earned to Passive Income

The phone rang, and before I knew it, I was grinning ear to ear.

It was my favorite type of phone call. A couple we have been working with since 2008 had retirement in their sights. A year away to be exact — just the right amount of time to complete two additional acquisitions, tie up loose ends and “slide into home base.”

They were filled with excitement mixed with uncertainty. They were absolutely thrilled to be within striking distance of a massive goal they had pursued for about a decade. Yet they were unsure of how to make the transition from employment to (investment) passive income. Some of their important questions:

How many properties would they need to pay off and which ones?
What does the after-tax picture of their income look like?
Was there a way to be sure that the passive income would be enough BEFORE “the jump”?

At this point, if you are just getting started (or still deep in your acquisition phase), you might think this post is not for you. For you, this moment is in the distant future, after all — so distant that you may not even see it to be concerned about it. But remember Covey’s most important habit of highly effective people (begin with the end in mind) because it will be the “magnet” that will pull you to that moment even faster. Read on and you will not be disappointed.

The Case Study Background

I don’t intend to get into portfolio specifics here for obvious reasons, but I will provide some context that will help you understand some of the dynamics at play here.

As I mentioned previously, the acquisition phase began in 2007 and has continued until the present day at a steady pace. Over these years, the market has undergone some pretty significant changes, from the Great Recession to the subsequent rise in property values and rents. In a way, you could say that their portfolio is a pretty accurate cross section of the market over the last 10 years.

As a result, there are properties in their portfolio with mortgage balances in the low 50s (they were purchased in the low 90s), as well as mid 200s (small multifamily purchased recently).

Last but not least, readers of my previous posts know I’m an advocate of The Domino Strategy — that is, utilizing current positive cash flow to build your future capital base and therefore substantially increase future income. This couple opted for a variation of that idea. Instead of utilizing current positive cash flows to aggressively pay down debt, they decided to save it in an “escrow account” and decide what to do with it later. At this point, later is here and decide we will.

The Spreadsheet You NEED to Decide Which Properties to Pay Off

From a passive income perspective, there are only two options: The asset is either paid off or it is not. Of course, there’s the “in progress” third option, where you “pay down” the mortgage balance. But mortgage amortization schedules are set up to keep the nominal mortgage payment constant throughout the existence of the mortgage while shifting the proportion of the payment that gets applied to principal and interest.

Let’s look at some numbers to make this point crystal clear.

Suppose you purchase an investment property for $150k with 20% down and take out a 30-year $120k mortgage at 4.5%. The property brings in $18k a year in gross rents and nets $10k after operating expenses. That $10k net operating income is there to perform two functions: service the debt and provide positive cash flow.

Mortgage payments for the year in the current example add up to a shade under $7,300, leaving $2,700 in positive cash flow. It matters not if the mortgage balance is $120k, $100k, $50k or $20k. As long as there is a mortgage on the property, 73% of net operating income goes to service debt, 27% to provide returns.

Now fast forward 10 years. If you’re like the couple in the case study, you haven’t been making additional payments to the mortgage to retire debt faster (mortgage balance is now $96k). Instead, you’ve been accumulating the positive cash flow from all your properties in an escrow account and now are trying to decide how many properties to pay off and which ones.

Here’s the method that I suggested to the couple in the case study. First, you create a spreadsheet (or handwritten list) that contains the following info:

Property address
Mortgage balance
Annual mortgage payment
Interest rate type (fixed or variable)
Presence of any balloons (early repayment/refinance requirement)

Second, properties that require balloon payments or have variable interest rates contain a higher risk of disrupting the performance of your portfolio, especially after you retire. So either those loans have to be refinanced (if that’s an option) into lower risk terms, or the properties have to be liquidated or they must be paid off first.

Third, rate your properties with either a “K” or an “S.” Based on past performance (vacancy, turnover, appreciation), would you want to Keep this property long term or Sell to cash in on the equity?

Fourth, divide the annual mortgage payment by the remaining mortgage balance of the properties you decided to keep and enter the information in a separate column. That’s the guaranteed return on investment from paying off that property. For instance, if you pay off a mortgage balance of $96k and that adds $7,300 a year to your positive cash flow (since now you don’t have to service that mortgage), that’s a 7.6% guaranteed return on that capital.

Depending on the timing of the acquisition, the return will be much higher on some properties than others. Order the list based on the highest return and pay off in that order.

The (Not-So-Simply) After-Tax Implications

Now that you have a plan for which properties to pay off and in what order, you are susceptible to make a wrong (and costly) assumption. Income on a paid-off property and income on a leveraged property aren’t the same when viewed from an “after-tax lens.” That is, leveraged income is sheltered in part by the interest expense paid on the mortgage over the year. When that mortgage is paid off, this expense goes away, and that’s what leads to higher nominal income.

But let me remind you that we don’t get to spend “before-tax” income — Wesley Snipes can attest to that truism. Therefore, it’s important to meet with your CPA and go over an “after tax” simulation of your income when you finally retire. You don’t want to pull the trigger and after the fact find out that the investment income you are going to rely on for your living expenses is short once Uncle Sam gets paid. And Uncle Sam ALWAYS gets paid.

How to Avoid Underestimating: The Dry Run

Even though you think you have a pretty good idea how much passive income you really need to live on, chances are you are wrong. Why? We are hardwired to underestimate how much time/effort/money anything takes. Tell me, how many times have you been working on a project/task you thought would only take a few hours, when in fact it ended up taking 2x or 3x that initial estimate? It’s in our nature to be eternal optimists.

You may think $60k a year would be enough to cover you basic lifestyle, but it’s hard to know that for sure when you have a $250k a year paycheck that comes in like clockwork.

So how can you know for sure that the passive income will be sufficient for you to live on before you make the jump and say bye-bye to your paycheck? Enter the dry run.

Six months or so before the date you quit your job, start living on your passive income ONLY. Redirect your paycheck to another savings account and just live on your positive cash flow. It will be a highly informative experience, and you will discover obstacles you hadn’t thought about before. But the good news is now that you know about them, you have the power to overcome them and solve them before you make the jump.

So when that glorious day finally comes, you’re home free. You’ve finally reclaimed the most precious resource of them all. The one resource money can’t buy: time.

Investors: Are you on your way to having passive income cover your expenses?

Let me know about your experiences with a comment!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.