Conventional Tax Strategies for Real Estate
Many real estate investors boast of their tax strategy as involving one or more of the following:
Depreciation – This is a tax concept where the property owner pretends that his property is decreasing in value. For residential real estate, it assumes that the property’s improvements will become worthless over 27.5 years. In commercial real estate, the calculation is for 39 years. During each year of property ownership, the owner can take that year’s pro rata depreciation as if it is a loss against the income of the property… which reduces the taxable income of the property, thus reducing the amount of taxes due. Upon future sale of the property, depreciation normally must be “recaptured” which means that there is no more pretending, and the taxes on the truly realized gains must be paid anyways.
Cash out Refi – This is where the owner of the property will refinance the mortgage. The new loan will have a higher balance than the old one, resulting in “cash out”. Because this is just borrowing, it is not a taxable event. Upon future sale of the property, however, taxes will normally be due on the actual gains anyways.
1031 Exchange – Upon the sale of real property, the gains can be deferred if they are used to purchase property of “like kind” within a certain time period. It goes something like this:
- Sell Property A
- Have a “qualified intermediary” receive the proceeds of the sale
- Replacement property (“Property B”) must be identified in writing within 45 days of the sale of Property A
- Property B must be purchased (closed) within 180 days of the sale of Property A
- Property B must be of equal or greater value to Property A
- Both properties must be “like kind”. For instance if Property A was U.S. real estate, Property B must also be U.S. real estate.
So, savvy real estate investors often pride themselves in combining these tax strategies to drastically reduce or even eliminate taxes. This can be a very powerful strategy.
Don’t let the tail wag the dog
Perhaps an even more powerful strategy is to use a Self Directed 401(k). I think where using retirement accounts can add an advantage is by not requiring you to 1031, refi, or follow any restrictive plan in order to defer or eliminate taxes.
Let’s imagine I buy an investment property in my Self Directed 401(k), and you buy a similar property outside of your 401(k). We both want to eliminate or defer taxes. I have more options on how I can proceed with my investment than you do.
- When I sell my property, I don’t have to buy another one within a few months.
- I don’t have to continue buying more expensive properties; i.e. “trading up”.
- I don’t have to use a certain amount of leverage to ensure I have enough interest expenses to sufficiently reduce my taxable income.
- I don’t have to borrow my gain through a refinance and bear the interest expense. I can just sell.
- I can focus on maximizing cash flow instead of trying to hit a sweet spot of only getting enough cash flow that can be hidden by depreciation deductions.
- I can invest in real estate options, mortgage notes, revenue participation contracts, and virtually anything else with my proceeds… including assets in a foreign country.
Repeat this situation over and over, and I believe my additional options will sometimes result in better bottom line investment performance. I want maximization of investment performance as my unconditional primary focus, and that is only possible when I can buy what I want when I want.
Simple Advice: Buy & Sell at Different Times
When I had my mortgage company, I asked one of my wealthiest clients why he didn’t use 1031 exchanges. He explained to me, “Jeff, I’m not a genius. I don’t know everything about the real estate market and what it’s going to do. So I have to keep things simple: I buy when property is cheap, and I sell when property is expensive. Normally these two events are further apart than 180 days, so I don’t use the 1031.” He was basically playing on market cycles. Things go up and come down. He buys when they are down, and sells when they are up. I like to take his philosophy a step further: to fully make use of market cycles you must be prepared to invest in real estate in different locations, and in different ways… (i.e. real estate options, debt instruments secured by real estate, different purchase prices, etc.)
In another item of notability, the inflationary situation is creating an encouraging opportunity for investment into any asset not exposed to US Dollars. You can’t use 1031 to defer the gains of a US property into a foreign property.
Imagine how your next real estate investment will go if you knew you could buy and sell when and where you want and still defer the taxes on income and gains.