Tax Alpha: More than securities investments

Most people rely on investments to generate or maintain wealth. The challenge, however, is that most people base their investment decisions solely on returns. What they might not consider are the taxes triggered that could reduce the value of those returns.

This is where the concept of tax alpha comes into play. While tax alpha tends to be associated predominantly with security investments, it can also be helpful when it comes to generating wealth through real estate ownership and investments.

The basics behind tax alpha

The basic premise of tax alpha is that understanding how well an investment performs is more than cash-return knowledge. That understanding also depends on the whole picture. Specifically, the cash that is received from an investment — after taxes.

As such, tax alpha means investors rely on the tax code to reduce taxes owed on an investment’s gains. That tax reduction then leads to a higher overall return.

Put another way, investors use the tax code to create alpha, or an increase in potential value through effective tax management of investments.

Alpha versus drag

Tax alpha describes the potential value resulting from the effective tax management of investments. This value is then measured against an industry benchmark. Maximizing after-tax returns by optimizing tax-advantaged strategies is important for creating wealth and maintaining it.

Here’s the formula:
Tax alpha = excess after-tax return - excess pre-tax return

Improving tax alpha is essential for a solid investment strategy. Also important is reducing tax drag.

Tax drag happens when the potential income and rate of returns diminish as taxes increase. Tax drag is calculated by dividing after-tax returns by pre-tax returns on a specific holding, then comparing these numbers to the federal marginal income tax rates.

For example, if you own real estate with a specific return on investment, that return can be eroded by taxes. Another example is when rental cash flow is taxed at the ordinary federal income tax rate. Furthermore, a real estate sale triggers both capital gains taxes and depreciation recapture.

Stated simply, the goal of any real estate investor should be to improve tax alpha and reduce tax drag. Doing so can help maximize returns and potentially generate additional wealth.

Tax alpha strategies for real estate investments

When it comes to securities, tools to increase tax alpha typically include tax-loss harvesting or long-term holds on assets. Individual retirement accounts (IRAs) and 401(k) accounts can also be used to generate alpha.

This is especially the case with Roth IRAs. Unlike traditional IRAs, in which withdrawals are taxed, contributions to Roth IRAs are taxed upfront. Withdrawals are left alone. Because of this, savvy investors can trade securities within the Roth IRA. Any gains generated by those securities aren’t taxed as long as the account is more than five years old and the investor is making withdrawals after the age of 59½, creating higher alpha.

When it comes to real estate investments, the following tax alpha strategies can also come into play.

1031 exchange

The 26 U.S. Code §1031 — “Exchange of Real Property Held for Productive Use or Investment” — has been around for more than a century in one form or another. Also known as the “like-kind exchange,” this process lets real estate investors “swap” their properties into other types of real estate. When performed correctly, the §1031 exchange allows the investor to defer both capital gains taxes and depreciation recapture on the sale of property. This, in turn, can improve tax alpha.

The operative words here are “performed correctly.” The IRS has extremely stringent requirements when dealing with §1031 exchanges. Specifically:

  • Value. The replacement property (the one, or ones, being bought) must be of equal or greater value than the relinquished property (the one being sold).
  • Deadlines. The investor has 45 days from the close of the relinquished property to find a replacement property, and 180 days from the close of the relinquished property to close on the replacement property. These deadlines are set in stone, with no deviation allowed.
  • Process. All exchanges must be conducted through a qualified intermediary (QI). A QI handles funds from the relinquished property’s sale and uses those funds to acquire the replacement property on behalf of the investor.
  • Type. Only real property is eligible for exchange.

“Like-kind” doesn’t mean “same property.” It’s possible to exchange a duplex into a strip retail center, or farmland into a small apartment building. It’s also possible to exchange physical real estate into certain legally recognized trusts, such as a Delaware Statutory Trust (DST). The IRS recognizes DSTs as eligible real estate that qualifies for a §1031 exchange. By exchanging into a DST, investors eliminate landlord headaches while continuing to receive a positive rate of return on investment.

Here’s how using a like-kind exchange can boost the tax alpha:

  • It can allow an investor to invest in a highappreciation real estate asset and hold it for one year or longer.
  • Investors may be able to sell the asset through a
  • 1031 exchange process, with the Delaware Statutory Trust, for example, as the replacement property.

This action defers both capital gains taxes from appreciation and depreciation recapture, generating tax alpha. Additionally, the investor continues to benefit from depreciation and mortgage interest deductions, which helps minimize tax drag from the DST’s distributions.

Tax alpha advantages

Tax alpha offers a different way of examining cash flow return to generate wealth by focusing on how much remains after taxes. Tax alpha strategies can allow an investor to keep more money, thanks to tax--deferred processes and procedures.

While tax alpha can be a viable tool when it comes to a real estate investment strategy, it should be considered with help from a trained tax professional.

Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

Tax shelters: generating alpha with expenses and depreciation

People gravitate to real estate investments for many reasons. There is the potential cash flow. There is also the possibility of asset appreciation. And there is the ability to use that real estate’s expenses and depreciation to help reduce taxes on monthly income. This process is known as tax sheltering.

The IRS allows the deduction of ordinary and necessary expenses for managing and maintaining rental properties, which might include:

  • Mortgage interest
  • Property tax
  • Operating expenses
  • Repair and maintenance costs
  • Insurance

The IRS also allows real estate owners and investors to deduct from their taxes the costs of buying and improving properties. Rather than taking a single deduction in the year in which a property is acquired or improved, depreciation distributes those deductions over a property’s useful life. The useful life for residential properties is 27.5 years, and 39 years for commercial properties.

When used in tandem with an investor’s risk tolerance and investment objectives, tax shelter- ing strategies could significantly increase after-tax cash flow.