Invest in Real Estate? Why not Modified Endowment Contracts?

Sometimes I just feel like being edgy, and throwing the words invest and Modified Endowment Contract about seems like a good way to be edgy. Of course this so called “edginess” is more a testament of my dork-dom–analogous to my saying, “I know my AGI is >$33,750 but screw form 6251.”

If you got that joke, I think I love you.

But in all seriousness a few recent events played out that gave way to this post. You see, It's been a long time since I thought real estate was a good place to invest. When I was in college I had a professor point out that the 30 year CAGR on real-estate in the United States was under 4%. Yikes! That was before the bubble popped, and let's not forget that real-estate can be super volatile.

Modified Endowment Contract

We're Here to see if we can get an Officer to…

Several months ago I had to go to the police station. I was there for a finger printing appointment and while I sat near the entrance waiting for my appointment a couple walked in and approached the front desk. The women informed the officer that was on desk duty that she was there to find out if she and her husband could get a police officer to accompany them as they went to serve an eviction notice to a tenant.

I don't know if the couple successfully acquired an officer to join them, as I was escorted inside for my fingerprinting appointment shortly after they arrived. But what little bit of the conversation I did hear, I immediately thought to myself…

“How's that whole landlord thing working out for ya?”

For those who have never rented out real-estate to someone, if they choose not to pay you, the process for getting rid of them can be quite lengthy, and expensive. They can live rent free (i.e. income free to you) for months, and your ability to boot 'em and find a more reliable renter is frustratingly restrictive in most states.

Probably a decade or so ago some family friends had a tenant situation go real bad. Not only did the tenants not pay and later get evicted, they left some really nice mementos behind. The whole ordeal sunk the “investment” into deep negative territory and they sold the place shortly after and swore never again go down that road.

And, just when you thought I was done recounting stories of ugly renter situations, I noticed a week or so ago that a Facebook friend is publicly cursing the rules regarding evictions as she and her husband are dealing with what appears to be a serial deadbeat (i.e. by the looks of it the renters have way more experience in not paying rent than my friend does in collecting it).

Okay, but there's more than one way to Invest in Real-estate

Indeed there is. And I remember a time when one couldn't flip through TV channels on a weekend morning without running into Carleton Sheets infomercials.

Since 2008 I haven't heard a peep from him. In fact, I thought he died, but nope, he's still very much alive.

I don't know about your local area, but all of the real-state developers around here have found new interests. And I haven't found too many people interested in starting a bright new career as a mortgage broker.

But what about the long term investor? I'll recount yet another story.

I have some friends who were mighty excited about the $400,000 their house sold for a few years ago. They bought it back in 1980 for $150,000. That is after all a 167% increase! But oh here we are confusing real growth and neglecting the impact time has on things.

Imagine how much of a buzzkill I was when I pointed out to them that they only fetched a miserable 3.3% rate of return on an annual basis between the year they bought and the year they sold. Then just to ensure I rubbed salt in the wounds I created, I further kicked them while down by pointing out that the mortgage interest and taxes due throughout those 30 some years further depressed their rate of return. In truth, CD's would have been a better investment choice.

Why can't I just let people feel good about their bad investments? I was actually asked this once.

So what about the Modified Endowment Contract

What if instead of plopping all of that money into a terribly illiquid and risky asset like real estate, we just bought a single premium whole life (SPWL) contract? Or we could drop a ton of money into a universal life contract (we'd typically specify an amount and solve for the guideline death benefit–for the “home gamers”).

This strategy is not one size fits all. Just as life insurance is a very malleable product that can be tailored to fit an individual's needs, so too can this strategy. I mentioned Modified Endowment Contracts because it's an easy way to move a lot of money into a life contract, and I want to be clear in pointing out that sometimes MEC's are desirable. However, for younger the investor with lots of time on his or her hands, there's no reason we couldn't put other strategies on the table–premium pre-funding could potentially be a great option–topic for another day.

That whole thought aside, the use of cash value life insurance has some noteworthy attributes vis-à-vis real-estate investing.

  • It's contractually guaranteed to increase in value every year
  • This also means it cannot decrease in nominal value
  • It's way more liquid as it allows access to cash values at any time for any reason through either surrenders or policy loans
  • It doesn't subject the investor to the same discreteness that real-estate does (i.e. if you have $250,000 and the house/land/whatever costs $275,000, you're going to have a hard time purchasing the real-estate)
  • Dividends paid on a life policy return basis first, meaning there is no income tax on dividends until the initial investment has been returned to the investor
  • It is life insurance so there is an income tax free death benefit that is transfered to the the investors named heirs without need for more complicated probate/legal work
  • You don't have to insure it against loss
  • You don't have to worry about finding a reliable tenant
  • You don't have to worry about how the neighbors take care of their property or how well the school district scores on standard tests à la property value
  • You don't have to deal with the whole buying and selling real-estate process

Caveat Emptor

While the list of benefits for life insurance over real estate is impressive. It's not an absolute solution. There are reasons one might still opt for real-estate. Real estate can create a number of tax deductions. The only chance you'll see a tax deduction with life insurance is through a somewhat obscure tax deduction regarding interest paid on loans used to procure certain income producing assets–i.e. you'd have to use a policy loan to buy an income producing asset; there are a lot of restrictions regarding this.

Life insurance as an “investment” idea does not universally apply to all shapes of life insurance. Some call it investment grade life insurance; I refer to it simply as designed properly life insurance.  So you have to be somewhat careful.

Speaking specifically of modified endowment contracts, there can be some tax implications that might restrict options.

Real-estate qualifies as a long term capital gain if sold after 1 year of ownership. This provides the investor with a dramatically better tax rate. This is somewhat negated by potentially tax free status of a life contract, but that of course would not apply to Modified Endowment Contracts.

All in all, the use of life insurance as an alternative to real-estate investing is an idea potential land lords and spec builders should consider. Many of you may still end up with real-estate–it's a lot sexier investment over which to gloat to your friends at cocktail parties. But it does deserve at least a once over, and it's a perfect example on why we shouldn't categorically run away from Modified Endowment Contracts.


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