I just got back from Memphis, Tennessee where I had a great three days there. We had a two-day event. The first day was all about education, getting to know new things about things related to real estate and real estate investing and taxes and whatnot. Then we had a great networking event that evening where I got the opportunity to meet a lot of investors from all around. In fact, we had one person there from Australia, we had a couple there from Hawaii, and it was fun. These people are there to learn and they’re people who listen to this podcast and it was just a lot of fun to meet people who listen to and from their drive to work. It’s great to put faces and names to people who are out there listening and educating themselves, learning to better their financial future and create financial freedom for themselves. That first day was all about education, the evening was all networking. We got to sit around and have something to eat and have a few drinks and just overlook the Mississippi River. It was just a great time.
The second day was all about a property tour. We got to go around the Memphis market, learn about various neighborhoods, get to see properties at different stages of the game; some being pre-renovation, some of them being in the middle of renovation, some of them having completed renovation. It was an exciting event. Then we had some more networking after that. It was great two and a half days of mingling and meeting other real estate investors.
One of the things we got talking about there was taxes and taxation and whatnot. The question comes up, “Why do people hate paying taxes?” One reason is because they just simply don’t understand them. Albert Einstein said, “The hardest thing in the world to understand is the income tax.” Aside from that, we just simply don’t like to pay any more than we have to. Some people feel that there is an obligation to pay, but at the same time I think you have an obligation to learn how to reduce, minimize or even eliminate the taxes that you pay when the opportunity is there. The thing is you may not know what opportunities exist because it’s just a simple matter of honest ignorance. I always say that ignorance is expensive, but knowledge leads to increased wealth and the ability to lower your taxes. If you don’t, you would think that your tax adviser would be well-educated on this stuff, but that’s just simply not the case as you’re going to learn today with my guest Bruce Jones.
I had a great interview with Bruce. Something that he’s going to share a few things actually are things that I’ve looked at in the past but never quite completely grasped because it’s just what most financial planners and advisers don’t really know or understand. This is a great episode and there’s some stuff that we’re going to talk about today that might go over your head. Don’t let that get you lost just because we’re getting deep in the weeds. You could always go back and listen to this episode over again, or better yet, you can just contact Bruce and his team and learn more about it. It’s just free education.
If you missed our last episode, be sure to listen to Sheltering Your Rental Income from Taxes.
Enjoy the show!
– – – – – – – – – – – – – –
Download your FREE copy of: The Ultimate Guide to Passive Real Estate Investing.
Get your FREE coffee mug by leaving us a Rating and Review on iTunes. Here’s how.
See our available Turnkey Cash-Flow Rental Properties.
Please give us a RATING & REVIEW (Thank you!)
SUBSCRIBE on iTunes | Stitcher | Podcast Feed
[spp-player]
Deferring Taxes for Decades (and the Dangers of 1031 Exchanges)
It’s my pleasure to bring Bruce Jones onto the show. Bruce is the President of Tax Wealth, a tax analysis and solutions research company which for 23 years has served owners of real estate and privately-held businesses. Bruce himself entered the financial services industry in 1970 and has taught the subjects of Tax Management and Financial Strategy Planning since 1974. He’s also a contributing editor to real estate and other industry publications, and speaks extensively on tax planning issues at public and trade association forums. Bruce is very effective in helping to reduce, defer or even eliminate income taxes and solve the capital gains and other tax concerns that are triggered when investment property is to be sold. Bruce, welcome to the show.
Thanks very much. I appreciate it.
Bruce, you have an interesting background and you’re so deep into tax, tax strategy, and tax planning that I’d like you to tell us a little bit about yourself and how you got into this.
I’ve been in business now for 47 years. As you just pointed out, I got involved in tax mitigation planning way back in late ’73 and then moving forward from then on. It’s a passion I have. I was in the financial planning industry for 41 years, retired from that three years ago and decided I want to live longer because I know the statistics of how people retiring and losing purpose and then dying. I got very selfish very quickly and decided that I want to live longer. I got my tax planning company which is Tax Wealth. Our focus is strictly on mitigation of income taxes and capital gains taxes when folks are selling their capital assets like real estate for example. It’s something that I have a passion for and I’ve done for quite some time.
It’s great that you want to share that wealth of information with people to help them in their finances and their wealth planning. This is great and this is what this show is about, it’s sharing this information with people to help educate them. The US Tax Code, as big as it is, is probably nearing 80,000 pages right now. I think it’s confusing for most people and it probably leaves a lot of people paying more in taxes than they should. Nobody really likes to pay taxes. They do it because they’re obligated to. They really don’t have a choice. This is especially true when it comes to more sophisticated income and capital gain situations. I’d like to ask you, what is your philosophy when it comes to tax planning and tax strategy?
First of all, I would disagree with the statement you just made that they’re obligated to pay it. The obligation only comes when you don’t know what’s available. That’s the very reason we’re on this conversation today is to inform your listeners that there are options in there that they are probably not aware of in the close to 80,000 pages now probably in the Tax Code today. There is so much there that’s available that folks are not aware that is available to them that they can tap into to eliminate, reduce or defer taxes. The problem is that they rely upon the accountants of the world to try to direct them toward that. The fact is that the CPAs and the enrolled agents and the accountants of the world, most of them, are not trained in tax planning. They really don’t know how to do it. They don’t know how to delve into tax law to find solutions. They’re very good at uncovering tax problems but they’re very ill-equipped in how to solve them. That’s what we do. We’re proactively trained in how to delve into tax law. What we endeavor to do is to collaborate with the clients’ accountant or CPA that they have and develop a synergistic cohesive team that works together for the favor of that client.
In regards to taxes themselves, I do a lot of mitigation of income taxes for the self-employed and business owners and real estate owners as well with the larger portfolios because that’s what opens up a lot of opportunities in law to find ways being able to mitigate taxes. The fact is that there’s a lot there that can be looked at and can be, with the taxes that have been paid and are probably do not need to be paid can be identified and then the taxpayer can be shown how to lawfully be able to retain those money rather than give it needlessly to the government.
I’ve heard it said that most of the Tax Code talks about ways to defer or avoid or reduce how to pay your taxes as opposed to what should be paid. Understanding what’s in there is to your advantage to reduce what you’re required to pay. Would you say that’s true?
Very true. In fact, let me tell you a true story. Bill Gates, we all know who he is, when he made it big at the very forefront of his career with Microsoft, he was interviewed by some reporter. The question he was posed was, “Mr. Gates, what would be the one piece of advice that you can give that would really help others gain somewhat the type of success that you’re now enjoying?” One would think that he would have responded something along the lines of, “Learn about this tax situation or that tax situation, you’ll be in great shape.” His answer was, “Having a working knowledge of the Tax Codes.” I think that speaks volumes and I think he’s absolutely correct.
If a person will take the time to start learning what is available within the scope of their own situation, they will find in most situations that there is a lot there that they can take advantage of. They just need to mine it out. The CPAs and the accountants of the world are not trained to do that. I refer to them as financial historians. That’s not to slam on them at all. It’s just what they do. They take information that is historic in nature, things that people have already done after the fact, and they filter through the laws that they need to filter through to come up with an accurate tax return. That’s great, but that’s accounting, that’s not tax planning. It’s very important that these folks seek out somebody who is trained in proactive tax planning so that they can really take advantage of those skills and uncover what is in tax law that they can take advantage of, and thereby lower their taxes.
Do you think it’s more of the responsibility of the CPA, tax planner or EA or is it more of a responsibility that is on the shoulders of the investor or business owner?
It’s absolutely on the business owner or the investor because when they talk or they hire a CPA or they hire an accountant, they’re hiring them to do their books and they’re hiring them to do their tax returns. Those professionals are doing exactly what they’re hired for. They weren’t hired necessarily to do tax planning, were they?
Right and they’re professionals so we rely on what they say as if it’s gospel. I like to say to people often that you don’t know what you don’t know. If you’re not aware that there are other strategies and techniques out there, then you don’t question your tax professional as to what they do know or what they don’t know because you don’t know what to ask. Education like this helps to expose the other options that are out there. When you do talk to your tax professional at least you can ask them what those possibilities are. If they’re clueless then maybe you should find another tax strategist.
Certainly find somebody who would be more open to exploring what can be done. Again, most of them are very ill-equipped on how to solve taxes. Although they’re able to unveil tax problems, they just don’t know how to solve them. If you were to go to a CPA generally and you know that you want to sell a piece of property and you ask them for their advice as far as, “How can I solve the taxes I’m going to pay?” Here’s what is usually heard, “Do you really want to do that? It might be “safer” just to pay the taxes.” “No, I don’t want to pay the taxes.” “Then you can do a 1031 exchange.” “I know that but really right now I’d rather be out of real estate.” “If you don’t want to pay the taxes, you don’t want to do an exchange, then you can sell the property and take back the paper, do a seller carryback financing and defer the taxes that way.” “No, I don’t really want to rely upon somebody to make me payments. They may not be able to continue on that.” “If you don’t want to pay the tax and you don’t want to do an exchange, you don’t want to do seller carryback financing, about all you can do is keep it in your portfolio then die. There’s a step-up in basis under current law to the value of the time of the property at the time of your passing and if your heirs sell for that value, they’re not going to pay any taxes.” Not a great choice for the property owner, is it?
No.
You see, that’s all they hear. They have to hear all three but there are so much more. There are ways of being able to eliminate taxes if it’s a proper fit. Certainly there are ways of reducing it and absolutely there are ways of deferring it. When you’re talking about deferring taxes, you want to defer them as far in the future as you can to take value of time, value of money and take advantage of that. Now you have full use of what would have been the tax dollars for your sale that you don’t have to pay that you can turn around and invest. You use those dollars to grow and also to pay the taxes sometime down the road.
You mentioned the 1031 exchange. Most people know about the 1031 exchange. We hear it a lot and we have clients that are in a 1031 now or they’ve just recently finished one. The 1031 basically allows an investor to sell a property and then reinvest the proceeds on new properties while deferring all the capital gains taxes. Your company has come up with something that you’ve labeled or branded as specialized asset sale. I’d like to start off by you telling us or defining what a specialized asset sale is because this leads into a conversation about the benefits of it and how it compares to a 1031.
A specialized asset sale is coupling two different things together in law. We’re coupling a monetized loan together with a specific type of installment contract that the law tells us that we can defer the taxes for a very lengthy period. Installment reporting came into law in 1918, 99 years ago; nothing new at all. At the time that they installed that law, they added into the law the term ‘dealer.’ A dealer by definition is simply an intermediate buyer. Utilizing this intermediate buyer, a dealer, as part of this transaction. Essentially what is occurring is that once the transaction is between the actual buyer and the seller, it’s consummated as far as the sale agreement in there in escrow. Then the dealer is invited in as an intermediate buyer. The seller sells the property to the dealer in a specific way and defers all the taxes for three decades. What they’re receiving at the close of escrow are not the sale proceeds. That’s very important because if they received the sale proceeds, they’ll have what is called constructive residual sale proceeds which means they’re going to be taxed for that tax year. What they receive instead is a special type of loan. Loans for investments, loans for businesses is a very commonplace as are installment sales. What we’re doing is coupling the two. They sell the asset and we’re able to demonstrate to the seller and their attorney and their CPA how to stretch the transaction in such a way to where they can sell the asset utilizing specific type of installment contract that allows them to defer the taxes for a very lengthy period of time. Instead of receiving sale proceeds which will be taxable, they’re receiving loan proceeds which by law are not taxable. It’s all we’re doing.
It’s nothing on tride actually. It’s not just well-known but it’s seated in law for 99 years and actually fortified by the IRS in 1980 when they codified into law the ability to monetize installment contracts without losing tax deferral, and then re-fortified by the Chief Counsel of the IRS himself in 2012 when he issued a memorandum in favor of coupling the monetized loan with installment sale contract.
For those that don’t know what an installment sale is, it’s essentially when you have a sale and you have partial repayment of the capital gains. Is that a good way to define it?
Let’s define it as it is in law because it’s probably the shortest or most succinct definition of a law there is in law. It simply says one or more payment is made to the seller after close of escrow. That’s it. It doesn’t say how much it has to be or how little, it doesn’t say how long that contract must be or how short. It just simply says that one or more payment is made to the seller after close of escrow. The one payment made after close of escrow with this particular payment approach comes decades later but it is well within law.
I’m a very visual person. I like to visualize things in my mind. I don’t know if this is hard to do but are you able to explain or articulate a way for me and for our listeners to visualize what that looks like at a 30,000-foot level?
Imagine a box to your left and call that seller. Then a box to the further right, that’s called your final buyer. You, as seller, and the buyer now have found each other. You’ve negotiated price for the sale. Let’s say it’s $1,100,000, I’ll use that as an example. Now, you’re in escrow. While in escrow, you’re putting a box between you, as seller, and the buyer and call that a dealer, that’s the intermediate buyer which the law says their function is to buy the asset to immediately resell it. They cannot buy and hold it for long-term investment purposes. Visually put an arrow from the seller to the dealer, to that middle box, and you’re selling that asset to the intermediate buyer on an interest only in installment sale contract, non-amortized, for an extended period of time. At close of escrow, it’s the dealer that sells the actual property to the buyer whom you found for the exact same amount of sale price and all the terms that were negotiated, no different. Because you sold property to the dealer on an installment sale contract and the terms of that contract, you now have deferred the taxes for decades by law. While in escrow, below what you just wrote out or visualized, sat another box called a private lender, and then an arrow going to the right to another box which is you, the seller. That lender will then loan you a specific type of loan that will provide you a near-equivalent amount of the sale proceeds at close of escrow. The importance of that is that lax law says that you do not pay taxes on borrowed funds. It’s as simple as that. It’s no different than, for example, if I refinance my whole mortgage and I withdrew equity out of my home. I’m not going to pay taxes on it because they’re borrowed money, not until I sell the property. It’s no different than that. That’s what you receive at close of escrow.
Through that structure then, you’re deferring the taxes for a very lengthy period of time, yet at close of escrow you’re receiving loan proceeds which by law are non-taxable that would be near-equivalent to the sale price that you’re selling that asset for. The key to all of this are not the benefits to the seller. They’re really good without a doubt, but the whole driving force on this planning approach is actually the lender relationship. I won’t go into deep detail on this at all at this point, but the reason that the lender is so important is because that loan is completely uncollateralized. There are no liens imposed on the borrowed funds and there are no liens imposed on any other personal assets of the borrower. When those funds are received by the seller at close of escrow as borrowed funds, there are no taxes and they have full control as to where they want to invest those funds under their total discretion with no liens against it and no restrictions whatsoever. The amount that you’re going to get will be for more than what they would have netted out after selling the property, paying the cost of sale, paying any debt, and then paying the taxes, and ending the rest. They’re well-ahead of the game there, aren’t they?
Structurally, there’s a way that is mandated by the lender as far as payment of the interest on the loan and also in the pay-off of its principal. It’s all done automatically. Essentially what is happening is that the interest earned on an installment contract is what is used to pay the interest on the loan over that deferral period.
For those people listening, this actually sounds more complicated than it actually is. I’m sure if you were to digest this for a bit and maybe see some visual layout of it, it’s not that complicated. One question I have though is when this transaction happens, are the funds being held by some intermediary like you would see with the 1031 exchange, or are the funds actually going back to hands of the seller?
No. The seller has sold the property to the dealer on an installment sale contract. It’s just that that isn’t paid off until the end of the time frame that was negotiated, which is decades later. That is actually what is used to pay off the loan at the end of that time frame. In the interim, they’ve got all the money on the loan to invest however they choose for growth in time and whatever properties they’re building wealth on. The sale proceeds go to the dealer because he bought the property by installment contract?
The dealer’s holding those funds and they get direction on where to invest those funds by the seller?
No, by the lender because the lender has a proprietary way to how they want the funds invested in the market over the term of the loan and the dealership that complies with that criteria. It’s really interesting because if you look into historically, the US domestic stock market over an extended period of time, you’ll find that the market has never done less than 9% to 10% as a yield over that time frame. We’re talking typically three decades. That’s one of the reasons why the loan is for that long of a period as an installment contract because that’s where the funds are invested in the market and that’s the time frame that the market had already done its very best as far as the yield. The lender is very confident that the dealer will have more than sufficient funds at the end of that time frame to pay off installment contract which are the very amounts used to pay off the loan at that time automatically.
What type of assets can this be applied to? Obviously real estate, but what else can you use it for?
Anything other than listing securities being sold through a public exchange. The reason for that is that installment reporting rules do not allow installment reporting for those types of transactions. If you wanted to sell AT&T or Apple stock or anything that’s listed on the public exchange, we cannot use this for that to solve tax issues. However, if it’s sold privately apart from the exchange, yes we can do that. I’ve been involved in transactions in airplanes, collectibles, art collections, real estate of all kinds, not only investment real estate but also personal residences, and businesses of all kinds. The minimum size transaction in this must be at least $500,000. There is no maximum. Currently I’m involved in transactions ranging from a low of about $660,000 using this plan of approach and the largest one is for $250 million on the sale of a business.
There are a lot of deferred capital gains there.
There will be, but same components to the transaction, identical to all of them. It’s just different numbers that’s beings accommodated.
This is applicable to anybody who has assets to sell or reinvest that wants to defer capital gains taxes on those assets.
They want to defer the capital gains taxes on the sale of those assets. It’s something more than worthy to at least explore. Understand something very, very important and that there is no cure-all in tax planning. It does not exist. This is not a cure-all either but it is, in the 47 years that I’ve been in business, the best thing that I have ever encountered in regards to deferring taxes and giving the best possible outcome for the seller at close of escrow. It, too, is not a cure-all. There are certain situations on sales of an asset especially in businesses where it doesn’t accommodate it. For example, I’m involved in the sale of three businesses right now by the same seller. Combined sale price is $56 million and he has a lot of capital equipment that has been depreciated that he’s selling. All that depreciation recapture in that capital equipment is not solved using this deferral approach. It doesn’t accommodate it. What we’re doing is to carry out the sale of that capital equipment and selling it to the same buyer in a different way. Solving the tax concerns that way and the rest of the sale of the three businesses are being done through this deferral approach. The net effect for the client by doing that, if he didn’t do proper planning on the sale of all three businesses, on the $56 million combined sale, he would actually net after payment of debt, payment of the cost of sale and payment of all the taxes. He would net out roughly about $7 million. In contrast to that, by mirroring basically two different planning approaches to solve the tax issues, at close of escrow he’s going to end up with a little more than $30 million tax-free at close of escrow.
That’s a huge difference from $7 million to $30 million.
All it is is application of law. You have to identify what the real problems are first and then delve into law to find the right solutions that fit those concerns. One thing you never want to do is try to fit somebody into a given mold or any given planning strategy. You always want to find out what their real need is, what their real concerns are, what the components are of those concerns, and then find the right solutions to fit those and thereby give the best possible outcome for the client at close of escrow.
I agree. I love this vehicle or tool. I want to say it’s very creative but at the same time it’s not, it’s just applying what’s already there in a better way.
The very first one actually was done 22 years ago on the 1995 tax year. What occurred was a gentleman had sold a bunch of timber property in the Pacific Northwest on a traditional installment sale basis which is seller carryback financing. He actually was really happy with the transaction until he got a call from the buyer telling him that they’ve decided to pay him off early. That he didn’t like because that meant that all the deferred gain was then doing the ’95 tax year with all the taxes with it. They reached out to our dealer who then was functioning as an attorney who specialized in business and real estate transactions with an emphasis of tax law treatment and economics. He’s a Harvard Law School graduate admitted to the bar in 1967 and until he transitioned in consulting businesses and becoming a full-time dealer about twelve, thirteen years ago. That’s all he did was solve major tax issues for investment property owners and business owners. He reviewed all the agreements and verified that the buyer had every right to pre-pay if he chose to. As a solution, he crafted the very first one of these types of transactions. That same program is in effect today 22 years later for the same client, so they’re now 22 years into the deferral period, which in their case is for three decades and it’s never been challenged by the IRS.
A lot of our listeners are probably thinking about a 1031 exchange. They’re familiar with it, they know about it, maybe they’re in one or they’re planning to use one. A glaring question to me is what are the benefits of this specialized asset sale over a 1031 exchange?
Let’s first of all understand what a 1031 exchange is. It is a replacement strategy. It is not an exit strategy. If a person for example wanted to sell their property, solve the tax issues and park the money and wait until they find a property that is worthy of purchase. It’s somewhat challenging in today’s market to find a reasonable upleg property. I think you’re an exception with what we’ve talked about in the past as far as the well of product that is available through your sources and I applaud you for that. It’s been reported to me by a lot of different commercial real estate brokers whom I support throughout the country that right now, about 50% of the exchanges failed in today’s market for a variety of reasons. Perhaps the client just couldn’t find a reasonable upleg within the 45-day declaration rule or perhaps for whatever reason they wouldn’t be able to close the properties on escrow by the 180th day. Whatever reason it is, there’s a problem out there.
It is a replacement strategy. It forces the client or the seller to buy more real estate. They have to identify within 45 days after close of escrow in what they relinquished. They have to carry over all the debt in the new property. They have to carry over their adjusted basis into the new property, which means if they’ve owned property that they sold for a long time, they’re down to maybe even land value after depreciating it fully or certainly lowering the net adjusted basis, and that’s the basis on the upleg property that they have to base their depreciation on. They’re getting less in depreciation benefits on the new property they’re buying through an exchange than if they bought it outright apart from the exchange. Those are some challenges.
In contrast, there is no 45-day declaration rule with this planning approach. There is no 180-day rule. If they used this, defer the taxes, they can take the very same money and buy the same property they would have bought through the exchange and now have a complete reset on the depreciation benefits on that new property that they were going to buy anyway. Plus they can diversify out. Plus they can keep some of the money if they need the money. With the 1031 exchange, you can’t do that because if you held back any money on that transaction of the 1031 exchange, they’ll call that boot and that’s going to be taxable. Not with this. They can actually diversify out with more properties if they choose to than what they could do through an exchange and they simply have more flexibility.
I’m just thinking of some clients right now that were involved with and have recently been involved with where they were down to the wire on their 45-day identification period. They had literally eight or nine days left to identify because they fell out of escrow on a previous contract. Then we had some people who were down to the last few days on that six-month closing period and they just made it but it was literally on the last day. Those are very stressful situations for real estate investors that are moving from their sold properties to their new properties. This eliminates that.
I find it very interesting that by law, when a 1031 exchange fails it automatically becomes an installment sale by law. It’s not difficult at all to be able to transition from a 1031 exchange into this planning approach and still defer all the taxes that give them a much better outcome at close of escrow than they certainly would have if they couldn’t identify within 45 days or close within that 180-day rule that they have through the exchange. You need a cooperative accommodator to do this. A lot of accommodators out there are simply not accommodating, not that they’d be punished about it but they just won’t do it because they don’t understand this. Fortunately I have some accommodators who do understand it and they are cooperative.
Does that have to be done in the first 45 days or can it be done within the six-month period with the 1031?
It can be done within the six-month period. I got three cases right now that we put purposely into a 1031 exchange with the cooperative accommodator so that they could actually put a close by the time that it’s needed to be able to do this other. We need at least two weeks before close of escrow to be able to do this and that’s only so that all their proper documentation can be drafted and everything gotten to the clients so they can review it and their attorney can review it. We want their attorney involved, we want their CPA involved in this. They need to be involved. We need a reasonable time frame so that they could have the ability to review all these documents without being rushed so that they can indeed see that this is real, that it is supported by law, so that they can do the proper due diligence that they should do on behalf of their client.
The reason these three are now in escrow is because I was called a week before escrow was to close. We simply didn’t have enough time so we put it into a 1031 exchange with the intent that after they do the proper review of the documents and they see that it is exactly what they expect it to be, and then they sign those documents at that time, then we can transition it to this planning approach from the 1031 exchange. As I said, it does require a cooperative accommodator. I had a case, a $14 million transaction by a lady who could not close. October 15th is her 180th day and she will not be able to make it. She wanted to do this deferral approach but her accommodator would not cooperate, so she is going to be sent the money on the 181st day and she will pay taxes on it. As a result of the non-cooperative attitude that the accommodator has, she’s going to pay nearly $2 million in taxes that she does not have to pay.
That’s pretty unfortunate so it’s better to avoid it if you can right from the beginning.
It’s much better to know what your options are before you even enter an exchange.
Hence, the reason we’re talking today. What are the dangers then of the 1031? I know that’s a strong question and it’s assumptive too. Can you talk about some dangers that are involved with a 1031?
It’s not so much as to danger because the 1031 exchange has been around since the stocker decision in the late 1970s. They are very well established. The so-called danger is what happens if you passed a 45-day declaration rule, you’ve identified property, and for some reasons it falls out. What if the seller decides to change her mind and finds a loophole and decides not to sell the property? You’re past the 45-day rule, you can’t do anything. Really that’s more of the concern that I have is the inflexibility that one has with the 1031 exchange.
That’s a big factor, the lack of flexibility and control. This specialized asset sale provides more flexibility by the sound of it, greater control, strong tax benefits. The 1031 sounds more rigid and somewhat arbitrary.
It is rigid in just the way it was constructed, so you follow what the rules say and that’s what you have to do. With this other, we’re following different rules and it just gives more flexibility for the seller of the asset to be able to still accomplish deferral by giving more flexibility and actually access the cash that they would not have otherwise.
When I first came across this, I thought it was interesting and I glazed over it because I didn’t understand it in my first pass with it. Now that I’m coming back to it, it’s becoming a lot more clear and it makes a lot of sense. I’m still baffled why CPAs and tax attorneys don’t understand this, why it’s not so much more widespread. Why is that?
Actually, it’s very simple until I found out about it 9.5 years ago as did literally a handful of other financial advisers that I’m aware of. Each of us was able to orchestrate a relationship with the attorney who had crafted this and did it for his clients so that we could do it for our clients when it was appropriate. He only did it for his own clients. He was not marketing this at all. It didn’t gain any national attention until three years ago this month after I introduced it to a group of proactively trained tax advisers, including CPAs and enrolled agents, as well as other proactively trained financial advisers like myself, and I’m part of that group. After they did a very extensive due diligence process on this, they welcomed it. We introduced this in a webinar to 172 CPAs, enrolled agents and other proactively trained financial advisers.
I’m the person responsible for supporting them all nationally on that planning approach. When they learned about that, believe me I got inundated by phone calls and emails from these folks who had been on the webinar wanting to know how can they apply this for their own clients. I’ve had the very wonderful experience for the last three years supporting these folks. I’m on the phone almost every day talking to some attorney or some CPA or the client themselves or their financial advisers with them about that planning approach. I get to teach and I get to share how it works and the structure of it. We do the projections on their given property to make sure it’s a fit, number one we do that at the forefront as much as we can. We just craft it out and move it in a very step by step process where the client is always in control, never pushed, never cajoled, never tried to sell. We just inform and then we go from there.
I was speaking to the dealer about that very topic, “How many advisers nationally know about this?” We were talking about it. It’s his best guess that we probably have less than 500 advisers in the entire country that are not even aware of this. That doesn’t make it any less lawful. It’s just is not that well-known, compare that to a 1031 exchange. Again, that came into existence in the late 70s. It took a while to get traction but it’s certainly well-seated in law now and very, very well-known. If you compare the amount of volume that has been done with the exchange as opposed to this planning approach, this planning approach is probably a couple of billion dollars shorter than what the exchange has done through the years. It’s just not well-known but it is gaining traction. There are two concerns that almost always pop up, and you already voiced one of them and that is, “Why isn’t everybody doing this?” I just explained that. The other one is this sounds too good to be true therefore, as the old adage says, it must be too good to be true. I understand the sentiment. However, wouldn’t you agree that the best antidote to that is education, which is the very reason why we’re talking?
That’s why I wanted you on this show and at the same time I like to tell investors often, especially when I’m in a group environment, that ignorance is expensive. What you don’t know is costing you money.
I think the greatest enemy there is in tax planning is the lack of knowledge about what’s available. I concur with what you’re just saying. It’s a matter of being proactive first in attitude, to be willing to be proactive, to work with somebody who is trained in how to find these things in law and how to appropriately accommodate the need. That’s what it all boils down to.
With tax planning and tax strategy, it’s really something that most people spend very little time on. In fact, most people probably spend no time on it. What last comment would you have or what else would you like share related to reducing or saving taxes?
Let’s talk about folks who have an existing portfolio of properties. There is a law that has been around since January 1st of 1987 that is surprisingly to me and has been for many years since I learned about it, which was close to twenty years ago. I’ve been applying it for my own clients appropriately. For those who have one or more investment properties that’s improved like single-family residences, apartment buildings, duplexes, fiveplexes, fourplexes, or commercial properties, whatever it might be, this law allows them to re-characterize certain components that are tied to the property and change the type of depreciation that they take on it. For apartments and single-family rentals that type of property, you have a 27.5 year depreciation schedule, what is called straight-line depreciation. For commercial, it’s 39 years.
What this law does is allow them to re-characterize certain components that are tied to the property and sub-compartmentalize them to such a degree that they can now accelerate that depreciation level from 27.5 years or 39 years to 5, 7, or 15 years. What that does is that it gives them an instant increase of cashflow tax-free that they can turn around, and if they choose to, buy more real estate with. They may have a whole lot of money in tax savings that they’re not aware of that they can actually turn around and use for whatever purpose that they want. There’s no restriction. It is a source that they can use to actually buy more properties and put that money as down payments and expand their portfolio.
Let me give you an example. If you look at when you’re evaluating a piece of real estate as a possible purchase and you’re looking at all sorts of different aspects of that property. You’re looking at condition, location, rent roll, history on rents, when could you possibly increase the rents, age of property, all sorts of different things, and you probably put that on a spreadsheet projected out. Based upon all that information, you’re going to make a value judgment as to whether or not you want to buy the property. If A, B and C happens, it’s going to be a great investment. If D, E and F happens, it will still be pretty good. If G, H and I happens, it’s going to be horrible. Based upon that information, you’re going to make a decision to buy the property. You might slap down $10,000 or hundreds of thousands of dollars as a down payment and leverage the rest on the purchase and now you own the property. Once you agree that that decision is based on pure conjecture, it’s what-ifs. What if that happens? What if this happens? Not what I do. Everything I do is based on written law.
Let’s look at ROI because that’s what real estate is all about, return on investment. What I would suggest you do and your listeners do is look at tax planning as an investment. The cost to do that planning is your investment and the yield on that investment or the return on investment are the tax benefits that you receive. Let me give you an actual example using this planning approach that I brought up. I’ve done a lot of writing on real estate and tax planning through the years. I’ve been published a fair amount. I got a call from a young gal, early 40s, married, husband’s a truck driver, she runs a day care center out of her home, gross income combined $175,000 a year. They’re doing fine but they have very little write-off. She called me the day after she wrote a $40,000 check to the IRS for taxes. You can imagine she wasn’t very happy about that. She reached out to me, she says, “What can I do to mitigate these taxes? It’s killing us.” I said, “I have absolutely no idea. Send me your tax returns. Let me review them. Let me see what I might be able to discover for you.” So she did.
I was reviewing the tax returns and I came to casually discover they have six small unit investment properties, the largest being a fiveplex. Immediately I knew they were candidates for this law. Fortunately all the information that I needed to run a forecast with the experts in this area that I have was there in what she had sent me and they did the forecast. Four of those six properties were prime candidates for this law. When I actually met them for the first time two weeks later, I have something of substance to talk to them about, and they ended up doing it. The IRS recognizes this law as just that law. You say, “Absolutely, we know it’s law,” but the IRS says, “In order for you to apply that law, we do require that you do a formal study done by experts in that area of law, preferably with an engineering background,” which pretty much wipes out your CPAs of the world and accountants of the world because they don’t have an engineering background, “to do a formal study on the properties you want to apply that law to. As long as they comply with all regulations you’ll never hear from us.” In their case, that cost to do the study or their investment was $13,000 on those four properties to do that study, but that’s deductible when you factor in their tax bracket. Their hard dollar cost or investment to do this study net after the tax savings on that deduction was $9,000.
What do they get as a return on that $9,000 investment? The first thing that we’re able to do was to amend their previous tax return. We got $16,000 of the $40,000 that they paid back plus interest within thirty days from the IRS. That’s about 78% return on investment. Not bad. In addition to that, we got another $86,000 of tax deductions, so combining the two is about $102,000, as I recall, in total tax deductions giving them and their bracket stayed in federal somewhere around the $50,000 to $60,000 tax savings. Let’s say a $60,000 on a $9,000 investment, now you’re talking about nearly 600% return on your investment guaranteed because it’s law and with no risk because it’s law, not conjecture. When you view tax planning, it should be really viewed as an investment far more than just an exercise in trying to reduce taxes.
I agree. Reducing your taxes is the fastest way to give yourself a raise.
Without a doubt, and it’s 100% return on investment because for every dollar that you reduce in taxes, that’s a dollar more in your pocket tax-free, isn’t it?
Exactly. That’s a tax-free raise. The scenario you just outlined, how small of a portfolio could an investor have where it would make sense to invest in that strategy?
This is just a general rule of thumb. I would say if the property is at purchase, not current value but purchase price, is around the $300,000 to $400,000 mark then they’re probably a candidate. Having said that, if there is a portfolio of properties and the purchase price is worth less than that, we can look at it in the aggregate. We can take all the properties, combined their purchase prices, and they’re probably candidates from the aggregate viewpoint.
Of the same amount, $300,000?
Yeah.
That covers a lot of people.
It can and the benefits can be very, very good for them. The nice thing too is at least I’m in the position of being able to have the forecast run at no cost. We can find out what the benefits would be if they were to be able to implement this law and what the cost would be for the experts to do their job in doing the formal studies required by the IRS to comply with the regulations so that they can affect these laws. The client can weigh the benefits against the cost to do it to see if it’s worthwhile. If they don’t think it’s worthwhile, that doesn’t cost them a penny.
Bruce, we’ve had a lot of information in this episode. This is extremely valuable to a lot of people and I know that there are going to be a number of people that are going to reach out to you because they want to save going forward or maybe they can save today retroactively on investments that they’ve made. Do me a favor. Tell our listeners how they can find you and/or where they can get more information about you and what you do.
I very much appreciate that. I would encourage them, the phone number is 949-627-8724 and they can go to the website CapitalGainsTaxPlan.com.
Bruce, I really appreciate you taking an hour or so of your time here today. This has been invaluable. This is something I’m going to look into further for myself so I’m glad I brought you on the show here. It’s been wonderful. Thank you ever so much for your time today.
I appreciate the opportunity. We certainly extend the offer to be of any help to your listeners. There is no cost at all to reach out to us. Our intent and our hope is to be able to serve. The first thing we do is talk to you, identify what the concerns are, and first of all determine whether or not we can be of help. There’s no charge at all for talking to us or exploring with us as far as what can be accomplished for them.
Bruce, thanks once again.
Thank you, sir. Appreciate it.
– – – – – – – – – – – – – –
Download your FREE copy of: The Ultimate Guide to Passive Real Estate Investing.
Get your FREE coffee mug by leaving us a Rating and Review on iTunes. Here’s how.
See our available Turnkey Cash-Flow Rental Properties.
Please give us a RATING & REVIEW (Thank you!)