How a Bartender Taught Me How To Save Money on Taxes

If you’re a real estate investor or plan to be, you have positioned yourself to save a boatload on taxes. But your boat could be leaking a lot of your potential savings if you don’t play your cards right. So belly up to the bar and check this out.

(Yes, I used five analogies in four sentences.)

My friend Craig built a successful shrinkage reduction company in an unusual niche: beer and liquor. Craig was the buyer on a 2008 House Hunters episode, and I was his Realtor.

Craig had a ritzy restaurant a few blocks from the White House, and he realized he was losing a small fortune to shrinkage in the bar. This should have been one of their best profit centers, but like most bars, the staff overfilled beverages for big tippers, gave away drinks to ladies, and slipped cold beers to their buddies.

Craig said studies show that average bar shrinkage runs 15-20%, but it can be north of 30%. This theft and carelessness can cost owners tens or even hundreds of thousands of dollars, quickly taking a profitable business into negative territory.

Do the math: If a bar has a profit margin of 40%, and you shave 30% off the gross, the bar owner loses 75% of their profits (30 ÷ 40 = 75% of profit lost).

So, Craig and his friend started an inventory control company that uses technology to track liquor and beer sales, right down to the half-ounce. His happy clients jack their profitability by 20% or much more without selling one additional drink.

Now, what in the world does this have to do with real estate?

I’m concerned that if you are selling a property or an interest in a syndication or fund, you may be losing a substantial portion of your profits to shrinkage. How? I’m talking about the taxman. Good old Uncle Sam.

What Taxes, Exactly?

True wealth equals assets that produce income. The larger the asset base, the higher the income. And in the end, this cash flow might become more important to you than individual hits of cash obtained through flips or one-time capital gains.

It is widely known that investing and reinvesting for cash flow with untaxed dollars will significantly outpace the growth of taxed dollars.

Check this out:

Realized 1031 Graph — *Source: Realized1031.com*

And consider this:

If you take $1 and double it (daily) tax-free for 20 days, it’s worth $1,048,576. Take that same $1.00, taxed (every day) at 30%, it will be worth only about $40,640—a LOSS of a MILLION DOLLARS! Why is this so? Because with tax-free compounding, earnings accumulate not only on the principal amount of money but also accumulate on the tax-free earnings, as well (“earnings on earnings”). Thus compounding combines earning power on principal and earning power on interest. Compounding has been called the “8th wonder of the world,” a “miracle.” Compounding money at high rates of tax-free return is a definite advantage of real estate, especially with a great tax plan.

You may argue that future tax rates will be higher than today’s rate. And you may argue that we will eventually have to pay the piper with capital gains and depreciation recapture taxes that come due.

You would be right in saying that… unless you’re not. Let me elaborate.

Avoidance Strategies

You can avoid shrinkage upon the sale of your real estate assets by avoiding taxation in a number of ways. I will briefly comment on five of my favorite ways here.

1031 Exchange

The 1031 “Starker” exchange is an opportunity to effectively swap your appreciated asset for another without paying the capital gains tax. You also defer the taxes avoided by losses along the way, which are often quite substantial due to accelerated deprecation generated by cost segregation studies.

Real estate investors are the only investors who have this option. Planes, trains, and automobiles, as well as art, collectibles, and autograph collections, were banned from this opportunity with the passage of the 2017 tax overhaul. (You may just want to hold on to that Justin Bieber signature after all.)

The 1031 exchange is a great option for investors, but the IRS seemed pretty ticked off that they lost the massive “Starker” lawsuit that upheld its validity. So they enacted onerous rules that make it hard to execute. Egregious deadlines, capricious paperwork, and other guidelines result in many abandoning this process midstream. Other investors, pressured into quick decisions, overpay for hard-to-manage assets. Many of them wish they’d just paid the tax.

But there’s a solution to the 1031 quagmire.

The Delaware Statutory Trust

One of our investors, a 72-year-old attorney, called me in early 2019. He was selling a commercial property for about $2.1 million. He was already on his third 1031 exchange, and he wasn’t about to pull the plug and pay the accumulated taxes. He was committed to the 1031. But he was sick of managing his own properties and wanted to find a passive investment opportunity.

For most people, the 1031 means a chance to continue actively managing the replacement property. He was upset, and I wasn’t knowledgeable enough to help him.

He called me back a month later and happily informed me that he had executed his 1031 exchange, and his replacement property was a Delaware Statutory Trust. He was thrilled to continue deferring gains, and now he had a cash-flowing asset that paid him a nice monthly income. And it allowed him to work on his tennis game because he had zero management responsibility.

I wrote extensively about the DST here if you want to learn more.

Nothing is perfect. Most DSTs have high sales commissions and limited upside appreciation. My attorney friend heard about some new DST products with zero front-end loads and higher appreciation potential. Recently, he called me to say he might be selling some other property and plans to go with one of those in the future.

Swap ‘Til You Drop

So, like my attorney friend, you did a 1031 exchange and traded your appreciated original property for a replacement property (either a DST or another actively managed asset). You deferred state and federal capital gains taxes. You deferred depreciation recapture taxes and that pesky Medicare surtax. Your second (or tenth) property is ready to be sold and you are on the last iteration.

You’ve heard stories about sibling wars being fought over inherited property. You don’t want to create World War III within your family. So perhaps you should just pay the tax to create liquid assets (in the form of greenbacks) for them to divide up. (Surely that won’t cause problems, right?)

Wait! Don’t touch that dial.

By leaving appreciated assets (1031 or not) in your name at the time of your death (usually second death between you and your spouse), your heirs will have the opportunity to avoid all of the deferred taxes accumulated over years or decades. The value basis is reset up to the date of your passing, and only gains and depreciation recapture accrued after that time count (unless your heirs continue the tradition).

The potential impact of this could be enormous. I just heard of a third-generation investor who is operating assets with gains deferred by both his deceased grandparents and parents. Imagine the impact his prior generations’ actions are having on him and his kids now. This could be your legacy, too. (You always hoped to be remembered fondly, right?)

Monetized Installment Sales

The IRS code allows a property to be sold over time. This is called an installment sale. This sounds like owner financing—but hold on. The IRS doesn’t collect capital gains taxes until the installment sale is completed.

Some smart guys (probably attorney types) figured out a way to insert an intermediary between the seller and the buyer. This intermediary effectively buys the property from the seller on an installment basis. Then they sell the property to the ultimate buyer at the same price. Like a buyer in a 1031 exchange, this buyer doesn’t experience any difference. But you as the seller certainly do.

The intermediary creates a loan with a related bank to provide the seller with north of 90% of the total proceeds to “use” for 30 years. (The remaining percentage is the intermediary’s cost and profits.) The seller makes payments on this loan for 30 years. But that intermediary is making installment payments back to that seller over these 30 years, as well. And lo and behold, the installment payments equal the debt service, canceling each other out.

This doesn’t mean the capital gains tax is avoided, of course. It kicks the can down the road to year 30, and the tax is due then. The theory is that, due to inflation, the gain will feel much smaller at that time, and the tax will, too. And by taking out an insurance policy or investing a small chunk of the original profits well, the tax will be funded in advance.

Other Investment Types

Invest in assets, syndications, or funds with heavy depreciation acceleration.

I can’t say enough about the 2017 tax reform law. I’m so grateful for the provision that allows real estate investors to compress significant depreciation into the first year of investing in a new commercial real estate asset. This creates significant paper losses that can be used and carried forward in early years. These can significantly offset gains from the sale of prior assets in year one.

I’m using this provision myself this month. I hope to close on the sale of a mobile home park that will generate a nice capital gain. I was initially depressed when I calculated the tax burden. But then I remembered this provision in the still relatively new tax law. By reinvesting the proceeds from my sale into my firm’s commercial real estate fund, I expect that most or all of my painful short-term gain will be wiped out.

I just spoke with an investor who has significant capital gains from the sale of her rental home. North of $1M. She may do a 1031 exchange. But even if she doesn’t, she could invest in a fund or other commercial real estate syndications that could defer all of her taxes this year.

Her tax strategist/CPA in effect, said, “It’s your choice. You can pay the IRS $1.2 million. Or you can invest that same money in a leveraged CRE asset or fund instead. The cost segregation study and the new tax deal will likely wipe out your potential tax bill, at least for this year and years to come.”

Note: The leverage is important to make this math work.

Potential Pitfalls

I know. This sounds like another pitch to sell you semi-boneless ham. But I actually want to help you avoid some of the pitfalls that could erode the powerful tax savings you can gain through these vehicles. I’ll summarize each one.

1031 Exchange

1. Rushing to buy and getting the wrong asset in the wrong location.
2. Letting the tax dog wag the tail and overpaying in a seller’s market.
3. Getting tangled up in the paperwork and deadlines and abandoning the exchange.
4. Buying into an active role with more hassles than you left behind.

Delaware Statutory Trust

1. Paying a steep commission to a broker-dealer.
2. Not doing your own due diligence and speaking with the operator directly.
3. Buying an asset with a very low yield.
4. Buying an asset with no projected appreciation.

Swap ‘Til You Drop

1. Letting the tax tail wag the dog and making the mistakes in #1 and #2 above.
2. Not explaining this to your kids and coaching them about the next steps.
3. Telling your kids about this at all (that was a joke… think about it!).

Monetized Installment Sales

1. IRS risk. What if they rule this is illegal someday?
2. Much higher future tax rates.
3. Buying term life insurance to pay your tax bill in 30 years but outliving the term.

Other Investment Types

1. Lack of operator and asset due diligence (too many pitfalls here to name!).
2. Overpaying for the asset and counting on appreciation.
3. Investing in an asset or fund that is not (safely) leveraged enough.
4. Investing with an operator that does not do a cost segregation study before you file your annual tax return next year.

Summary

This is not an exhaustive list. Self-directed IRAs, solo 401(k)s, and other vehicles also come to mind as options. Hopefully, these thoughts will help you act before year-end to avoid shrinkage and save a boatload on taxes.

What motivates you to want to pay your taxes?

Tell us how you’d like your tax money to be used in the comments.

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