Just Following The Rules | Part 2

Last week I discussed the tax advantages of being an entrepreneur, developer, creator, and explorer.

We don’t make the rules that the IRS has established that favor the business owner, but we would be crazy not to take advantage of every one of the benefits available to us as individuals and our businesses to ensure the viability of our enterprises and the security of our employees’ jobs.

This week’s article is focused specifically on the tax benefits of real estate and how those benefits can be super-charged through a retirement plan.

Let’s dive right in…

TAX BENEFITS OF PRIVATE REAL ESTATE OFFERINGS –

Passive investments in private real estate offerings – whether investing directly in a private real estate investment company, through a private equity fund, or through a tenancy-in-common – offer an additional layer of tax benefits.

Some of the most common real estate-related deductions include:

• Depreciation (Accelerated).
• Mortgage Interest.
• Property Tax.
• Operating Expenses.
• Repairs.

In a private real estate investment fund, these deductions are distributed to their partners on a pro-rata basis and reported on each partner’s annual K-1. Deductions considered passive losses can be used to offset passive income while any other deductions can be used to offset ordinary income to reduce tax liability.

So for the professional still collecting a salary from their day job, a passive real estate investment could even reduce that ordinary tax liability.

Here’s a rundown of the major real estate tax benefits:

Regular Depreciation.  

Regular depreciation deductions allow investors a business deduction for the cost of items that have a “shelf life” like a building. The typical depreciable time period is 27.5 years.

For example, if the cost basis of a multi-family property (the building only and not including the land or improvements) is valued at $1,000,000, the annual depreciation deduction allowed over 27.5 years would be approximately $36,400.

In a passive investment, this depreciation would be distributed pro-rata to all the partners. The practical effect of depreciation deductions is that a passive investor will pay little to no taxes on their periodic profit distributions.

Cost Segregation.  

Cost segregation is a tax strategy that dissects construction costs from the purchase price of the property that would otherwise be depreciated over 27.5 years. Cost segregation is typically conducted by an engineering company and reported on a cost segregation study.

The primary goal of a cost segregation study is to identify all property-related costs that can be depreciated over 5, 7, and 15 years as opposed to 27.5 years for the building. This accelerated depreciation allows greater deductions in the earlier years of the life of an asset.

Bonus Depreciation.  

One of the major changes from the Tax Reform Act was the bonus depreciation provision, where businesses can take 100% bonus depreciation on a qualified property purchased after September 27th, 2017.

1031 Exchanges.  

A 1031 exchange doesn’t typically come to mind when considering private real estate investment funds but there are options for passive investors to take advantage of this tax benefit that allows a swap of like-kind commercial property to defer the capital gains.

Although most private real estate funds are not set up for qualified 1031 exchanges from an investor’s personal property, this same investor could do a qualified 1031 exchange flipping his interest in one private real estate fund to another real estate fund under the same sponsor.

Qualified Opportunity Zones. As part of the recent Tax Reform and to encourage private investment in distressed communities, the government has instituted significant tax breaks for investors who invest in Qualified Opportunity Zones.

By investing in an Opportunity Fund, an investor can:

• Defer taxes on the original capital gain until the end of 2026.
• Reduce up to 15% of the tax bill on the original capital gains if remain invested in the Fund for at least 7 years.
• Completely eliminate the tax on any appreciation (new capital gains) on the original investment after the 10-year mark in the Opportunity Fund.

INVESTING THROUGH A RETIREMENT PLAN –

Many investors know about the tax benefits of investing in real estate, including the long-term capital gains benefits as well as the various regular and depreciation deductions available for commercial properties.

While most investors are familiar with the capital gains deferral benefits of 1031 exchanges, many are unaware of the tax deferral and even the tax elimination benefits of investing through a Solo 401 (k) or a Self-Directed IRA (SDIRA).

A Solo 401(k) plan is an IRS approved retirement plan, suitable for business owners who do not have any employees, other than themselves and perhaps their spouse. It is basically a traditional 401(k) plan covering only one employee.

A Self-Directed IRA is an IRA that gives you control over your investments. Unlike other IRAs held at banks, brokerage firms, and other institutions, you’re not limited to stocks, bonds, or mutual funds.

Both the Solo 401(k) and the SDIRA allow you to invest in alternative assets including real estate, private investments, limited partnerships, commodities, etc. This is what distinguishes Solo 401(k)’s and SDIRAs from 1031 exchanges, which are limited to direct real estate investments.

Solo 401(k)’s and SDIRA’s both offer traditional (tax-deferred) and Roth (tax-free) options. Whereas the traditional options are funded with pre-tax dollars, the Roth options are funded with after-tax dollars.  The main advantage of the Roth option is that the gains are accumulated and withdrawn TAX-FREE.

Solo 401(k)’s vs. SDIRA’s.

The following table highlights the major differences between Solo 401(k)’s and Self-Directed IRAs.

Why You Should Consider a Roth Self-Directed Solo 401(k).

Sophisticated investors love the Roth Self-Directed Solo 401(k) because not only are they not limited by income but the Roth option also allows for higher contributions, loans against the balance, and all gains are tax-free and unlike a traditional 401(K) that is limited to investing in mutual funds, the self-directed solo 401(K) allows investments in alternatives like real estate and private debt and equity.

Sophisticated investors are happy to pay taxes upfront when their tax rate is likely to be lower than later when they’re more likely to be in the highest tax bracket.

The following table highlights the massive financial advantage of leveraging a Roth 401(k) vs. a traditional 401(k):

Assumptions:

• The maximum annual contribution (both Roth and traditional) will be taken: $57,000 ($4,750/month)
• Each post-tax contribution of $57,000 represents $83,823.53 of pre-tax dollars and $26,823.53 in taxes at the 32% tax rate in the Roth scenario.
• The annual rate of return from investments: 10%
• The tax bracket at the time of contribution: 32%
• The tax bracket at the time of withdrawal (retirement): 37%
• With the Roth option, after completion of the second year, a loan in the amount of $50,000 will be obtained against the account balance of $125,447.60 for investment.
• Interest rate on 401(k) loan: 5%

Investing with post-tax dollars in a Roth IRA results in a $2,766,800.81 advantage over the traditional option.

Entrepreneurs are the engine of growth in the economy and are on the forefront for much good as well.

We build companies, develop real estate, explore green energy and oil & gas, initiate sustainable agriculture, etc. We reap the potential rewards of our efforts along with significant tax breaks, but we also take on significant financial and personal risk by devoting capital, time, and effort to making our ventures successful.

I’m not pumping my chest and saying I’m entitled to these all the tax benefits available to entrepreneurs but I’m not ashamed to play by the rules that IRS has established to ease my burdens as a business owner.