Are your investments tax efficient? What does it mean for an investment to be tax-efficient? It means the degree to which the investment maximizes returns while minimizing taxes.
When assessing an investment’s tax efficiency, the two most important factors to consider are tax rate and timing. On the tax efficiency scale, the ideal investment is taxed at the lowest rates with a significant portion of the tax liability deferred – all while providing a high return.
Tax savings are an important factor in building wealth, but they shouldn’t be the focus. The focus should be on after-tax return on investment. It doesn’t matter if your investment is taxed at lower rates if your investment doesn’t make any money.
See the example below…
DEBT INVESTMENT
Assumptions –
- Term: 2 Years
- Interest Rate: 6%
- Tax Rate: 37% (Highest Individual Rate)
- After-Tax Annual Return: 3.78%
EQUITY INVESTMENT
Assumptions –
- Holding Period: 2 Years
- Total Appreciation: 7%
- Average Annual Appreciation: 3.5%
- Tax Rate: 20% (Long-Term Capital Gains Rate)
- After-Tax Annual Return: 2.8%
In this example, although the equity investment is taxed at the lower long-term capital gains rate, the debt investment is a better alternative because the after-tax return is higher than that of the equity investment.
The point is, when determining the tax efficiency of an investment, don’t forget about maximizing returns.
In terms of tax efficiency, there’s no better investment than passive commercial real estate investments (CRE) because not only do CRE investments offer the potential for above-market returns, but they also offer a variety of tax benefits that allow you to keep more of what you make in the short-term as well as long-term.
The tax benefits of passive CRE investments can be broken down into three main categories:
- Lower Rates.
- Tax Deductions and Exemptions.
- Tax Deferral and Elimination.
Lower Rates.
Passive CRE investments are typically organized as partnerships – limited partnerships and limited liability companies being the most common types.
The advantage of partnerships is that distributions incidental to ownership of a partnership interest are treated as capital gains, and distributions made after a minimum one-year holding period are treated as long-term capital gains and taxed at a maximum rate of 20%.
Suppose you invest in CRE by contributing capital to a private equity investment or private fund in exchange for a partnership interest. In that case, if you hold that interest for at least a year, all distributions after that will be taxed at the long-term capital gains rate vs. the ordinary rate. If you’re in the highest individual tax bracket, you’re paying 20% vs. 37%, the highest individual marginal tax rate.
Deductions and Exemptions.
Deductions
Like individuals who can deduct a variety of items from their gross income like mortgage interest, tuition, and home office expenses, partnerships that own CRE can deduct significant expenses that are then passed through to the individual investors at the partner level.
Some of the most common real estate-related deductions include:
- Depreciation (Accelerated).
- Mortgage Interest.
- Property Tax.
- Operating Expenses.
- Repairs.
Exemptions
An additional tax benefit for private fund investors is the exemption from paying FICA payroll taxes (social security & medicare) on their partnership income. That’s an additional savings of 7.65% per year.
Tax Deferral and Elimination.
Deferral
Without getting into too much detail, passive real estate offers several opportunities for deferring gains into future years through structures such as 1031 exchanges and investments in Qualified Opportunity Funds in Opportunity Zones.
Tax deferral can also be achieved in the form of tax-deferred appreciation, where the growth of an investment is tax-deferred until the partnership interest is sold, transferred, or otherwise liquidated or the underlying asset is sold or otherwise disposed of.
Elimination
What’s better than paying lower taxes? Not paying any taxes. The single biggest opportunity for eliminating taxes can be found through the leverage of retirement accounts.
Take, for instance, Self-Directed IRAs (SDIRAs). Because SDIRAs allow for investments in alternative assets such as passive CRE, they offer investors the opportunity to take advantage of additional tax benefits.
Consider the benefits of investing with a Self-Directed Roth IRA. With a Self-Directed Roth IRA, if you are under 50, you can contribute up to $6,000 per year into an IRA and an additional $1,000 if you are 50 or older. Because you contribute to a Self-Directed Roth IRA with post-tax dollars, your investments will grow tax-free.
Now let’s revisit our example above, but let’s throw in a passive CRE investment…
DEBT INVESTMENT
Assumptions –
- Term: 2 Years
- Interest Rate: 6%
- Tax Rate: 37% + 7.65% (Highest Individual Rate + FICA)
- After Tax Annual Return: 3.32%
EQUITY INVESTMENT
Assumptions –
- Holding Period: 2 Years
- Total Appreciation: 7%
- Average Annual Appreciation: 3.5%
- Tax Rate: 20% (Long-Term Capital Gains Rate)
- After-Tax Average Annual Return: 2.8%
PASSIVE CRE INVESTMENT
Assumptions –
- Holding Period: 2 Years
- Annual Cash Flow: 5%
- Total Appreciation: 10%
- Average Annual Appreciation: 5%
- Tax Rate: 20% (Long-Term Capital Gains Rate)
- After-Tax Average Annual Return: 8%
The return on this passive CRE investment example is an oversimplification because it doesn’t consider the time value of money from the tax deferral of the appreciation, and it doesn’t calculate the effective tax rate from factoring in factoring deductions. Still, it should illustrate the tax efficiency of these types of investments.
It’s easy to see why passive CRE investments generate high after-tax returns.
Not only do passive CRE investments generate above-market returns, but the significant tax benefits afforded allow you to keep more of what you make, making passive CRE investments one of the most tax-efficient investments around.
