Got Gains? Try This Creative Tax Strategy to Offset Big Profits

Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal, tax, or other financial advice related to individual situations. Consult with your own attorney, CPA, and/or other advisors regarding your specific situation.

It was too late to help my friend with his massive tax bill. But it may not be too late for you.

My friend, let’s call him Jay, and I were having coffee. He had been telling me about his crypto mining investments for years, and I had always been skeptical.

Jay’s son had stumbled into a crypto mining operation that had taken off and sold for a mega-profit. I admit I was a bit jealous as he described their 800% ROI. But I wasn’t jealous of his multi-six-figure tax bill. He had no shield for his passive gains, and it was early in the following calendar year.

I could have helped Jay, but I was too late.

The year before, I had tried to help Bill (not his real name), a Central Virginia furniture store owner, shield an $800,000 gain from the sale of his real estate. Bill was looking forward to retiring, and he was counting on the full $800,000 to provide part of his income. He was late in his 1031 exchange window and desperate to find a replacement property in a seller’s market. Bill’s options were to:

Overpay for a multifamily asset that barely cash-flowed and go from retirement to another J.O.B.
Try to persuade a syndicator to let him come in as a tenant-in-common (TIC) investor.
Pay the massive capital gains taxes and depreciation recapture taxes.

The 45-day 1031 exchange clock ran out for Bill. He punted on his exchange. I lost touch with him, but I know his tax bill was an awful start to a long-awaited retirement. If Bill called me today, I could have helped him shield all of his gains, even after abandoning his 1031 exchange.

Passive Capital Gain or Depreciation Recapture Looming in 2020?

If so, there may be a creative and time-sensitive solution created by the 2017 tax reform bill plus your well-timed investment in a steeply depreciating asset.

I was on the phone with my tax strategist yesterday, and he confirmed the power of this strategy. Though I’m not a tax professional, and don’t play one on TV, I trust him on this. He’s been using this strategy for his clients, and it may work for some of you.

It’s really quite simple. The bonus depreciation allowance under the new tax law allows up to 15 years of accelerated depreciation to be taken in year one. And for assets that create a lot of acceleration, it can result in well over 50% of the asset’s acquisition price being deductible as a passive loss immediately — as in 2020 (for those who invest by December).

Assets that can generate big accelerated depreciation can include mobile home parks, modular-built self-storage, and free-standing self-storage (think PODS). These are examples from my world and my CPA’s, but there are certainly others.

Shielding over 50% of your gain sounds good. But leverage in the new property adds the possibility of shielding over 100% of a prior capital gain, as well as large depreciation recapture taxes.

Why? Because a $2 million asset with 60% leverage would consist of $800,000 in equity (your cash in) plus $1,200,000 in debt. So if you invest $800,000 in cash, you should be getting the accelerated depreciation on not just that $800,000, but the entire $2 million.

But it’s even better than that.

Prior gains are taxed at a long-term rate of 20%. But the passive losses from the new investment shield income at an investor’s regular (often higher) income tax rate. This results in the possibility of shielding even more accrued gains and depreciation recapture.

For example, if that same investor has an $800,000 passive asset sale that includes a $500,000 capital gain, their tax should be $100,000 (20% long-term capital gain rate). By reinvesting that $800,000 into the $2 million asset, the investor may be able to take passive losses on accelerated depreciation of, for example, $1 million (50% of the $2 million).

But the losses are usable at the investor’s regular marginal tax rate. If this investor is at 37%, then they generate a $370,000 passive loss (37% of 50% of $2 million). Recall this investor only needed to offset $100,000 in capital gains, so that is more than accomplished.

This should work for passive gains from the sale of stocks, cryptocurrency, real estate, semi-boneless ham, whatever.

Now assume this is a real estate investor, and they are also carrying forward passive losses of $500,000 from the prior asset. Taxes owed in the form of depreciation recapture may amount to 37% of $500,000, or an additional $185,000.

Now, without reinvesting wisely, this investor may be facing a total tax bill of $285,000 ($100,000 capital gains plus $185,000 depreciation recapture). This would whittle the $800,000 reinvestment down to $515,000.

But this tax is all offset (plus $85,000) in the current tax year due to the $370,000 passive loss. This real estate investor may want to sell some of their highly appreciated stocks stuck in Wall Street’s casinos to utilize that loss. Or they can carry it forward for a future year. This may also cover state capital gains and the Medicare surtax.

Also, note that this strategy can also allow the investor to apply prior suspended losses that could not be utilized from previous projects. A suspended loss is a capital loss that cannot be realized in a given tax year due to passive activity limitations. These losses are suspended until they can be utilized by netting them against passive income in a future year. If you’re confused about suspended losses, you’re not alone. This entry from Investopedia should help.

What Form Should My Investment Take?

The power of bonus depreciation is applicable in a variety of forms, some of which you may not have considered. Here are a few examples.

Real estate syndication with a highly depreciating asset
Real estate fund with the same type of assets
Delaware Statutory Trust (DST) with similar assets (with or without a 1031 exchange)

One note on the DST: Most investors who know about the Delaware Statutory Trust assume it is only useful for 1031 exchange investors looking to defer capital gains and depreciation recapture taxes. I used to believe that, too. But many accredited investors (without a 1031 exchange) invest in DSTs just to take part in a stabilized, predictable, professionally managed asset.

These are all passive investments, which is appropriate to offset passive gains. If you have an active gain, you will need to find an actively managed asset to utilize losses, unless you (or your spouse) are a qualified real estate professional. Then you can effectively interchange active and passive gains and losses.

Who Should Do This?

You may be interested in this strategy if you…

Are looking to shield prior passive capital gains from stocks, real estate, or anything else.
Are looking to apply suspended losses from prior passive projects.
Are looking for a professional to manage your real estate in an uncertain economy.
Have a 1031 exchange but can’t find a replacement property in the face of a ticking clock.
Are fretting about future tax hikes and have appreciated stocks or other assets you want to sell but have been reluctant to.

This strategy will not work if you sell in 2020 and reinvest proceeds after the new year. So I realize the clock is ticking. But there is still time.

On the contrary, losses generated by investment in the current year might be applicable to offset gains in the following year. Check with your CPA to be certain, but if this is applicable, you may want to consider investing in a depreciating asset or fund this year to offset expected gains next year.

To prove this strategy, I’m looking at the sale of a mobile home park asset with significant appreciation in the next few weeks. I am not doing a 1031 exchange, though I could. Instead, I plan to use this strategy by reinvesting proceeds in my syndicated fund to offset all (or the vast majority) of my gains.

It’s not too late to pull off a strategy like this, but you’ll need to act quickly.

Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal, tax, or other financial advice related to individual situations. Consult with your own attorney, CPA, and/or other advisors regarding your specific situation.

What tax strategies do you use?

Share your tricks in the comments.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.