Investors are conditioned to look at pre-tax returns. It’s a learned behavior that can be traced back to the day that first paycheck arrived. But alas… somewhere between gross and net, the wages were placed in a tax grinder. Years and decades later, many investors still struggle to remember that the IRS has a voracious appetite. The key is not to focus so much on the top dollar amount; what matters at the end of the day is how much you can put in your pocket after taxes.
Utilizing Buying Power to Increase Cash Flow
Successful investors have learned that one way to turn profits into even more profits is to defer capital gains taxes. With real estate, this can be accomplished by executing a 1031 exchange or investing in a Qualified Opportunity Zone Fund.
While the IRS is not a living organism, it still encourages taxpayers to invest and save for retirement; this includes offering ways to help them defer taxes. In fact, various IRS provisions are designed so that individuals can stuff cash into certain savings vehicles, such as qualified accounts.
Not everyone has the patience to sit back and wait until the golden years to enjoy their savings. By changing your perspective, you can see how saving for the future can yield results now; shifting pre-tax pay into a 401(k), IRA, Roth IRA, or HSA will lower today’s tax liability. The IRS annually adjusts the maximum contribution amounts. For 2020, a taxpayer may contribute up to $19,500 - as an employee - to a 401(k). Individuals 50+ are permitted to stow away an extra $6,500 in 2020, under the catch-up contribution rule.
Importance of Timing
The IRS has set egg timers on the dates that assets are bought and sold. Once you sell the asset, the IRS will determine which of the two holding period buckets – long term or short term – your gains will fall into.
If you held the asset for less than one year, gains would be considered short term. These will be taxed at a higher rate, or, as ordinary income. Before you hit the ‘sell’ button, be mindful of the calendar; reconfirm the date of purchase. Holding the asset until its one-year anniversary could save you a substantial amount of money. Depending on your income, the 2020 long-term capital gains tax rate is 0%, 15%, or 20%.
Short-term, ordinary income tax brackets, unfortunately, don’t stop at 20%; the top one for single taxpayers, married filing jointly, and head of household is a dizzying 37%.
For many taxpayers, the 2017 Tax Cut and Jobs Act (TCJA) eliminated the mortgage tax break. But for households that itemize, the interest deduction cap is $750,000.
Depreciation is another write off that many overlook, as all assets have their own ‘shelf life’. As an asset ages, its depreciation can be an income tax deduction. Mortgage interest rate deductions can work alongside depreciation to shelter your investment property income from taxes. If done properly, the sheltering effect can turn your effective income tax rate to 0%, thereby boosting your after-tax return.
Importance of Managing Basis
In the world of commercial real estate, the original price paid for an investment is the starting point. Then there’s the add ons: out-of-pocket expenses or other costs associated with the purchase (closing costs, title insurance, loan origination fees, etc.).
Ways to Increase Basis
Elevating — or adjusting — the basis is advantageous. Performing substantial property improvements can increase the basis, thereby lowering the amount of capital gains tax. But performing substantial property improvements can increase the basis. Additionally, when performing a tax-deferred exchange, to the extent that investors take out additional debt (i.e., the property value), they would increase their basis — thereby giving them more to depreciate going forward.
Tax-Loss Harvesting. Reaping a tax-loss harvest can be a smart strategy, especially in investment accounts where capital gains tax applies. For example, if you have an investment in a brokerage account with a loss — and you’ve held it for less than one year, you could sell the investment to generate a deductible loss to offset taxes on gains elsewhere. Note — there are complex rules about rebuying the same investment within 30 days. Uncle Sam allows taxpayers to offset a loss by taking a $3,000 annual loss deduction and carrying forward any additional loss.
Charitable Contributions. Gifts to qualified tax-exempt charitable organizations – with a 501(c)(3) status - can make a profound impact in the lives of others. But the taxpayer can also benefit; if you itemize your deductions, this will lower your tax liability. The IRS has stipulations for cash and non-cash contributions, so keep accurate records.
Investing, tax-loss harvesting, and methodically deferring taxes may sound like too much math and too much juggling for most people. However, one of the best ways to grow wealth is to repeatedly take advantage of the various tax benefits the IRS allows.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.
What is a 1031 Exchange
The Investor's Guidebook