When you stop to consider that every dollar in taxes you save is a tax-free dollar, it really pays to put taxes near the top of your educational agenda. Over the years, I’ve found that becoming informed about why, when, and how I am taxed has had a lot to do with the financial choices I’ve made and the amount of tax-free profit I’ve been able to glean and compound. So, my advice is to begin to take an active role in income and estate tax strategies, and to commence a self-study program to at least become familiar with those portions of the tax code that are applicable to your personal situation.
Two of the most valuable sources of tax information that I’ve used for decades are the bi-weekly Kiplinger Tax Letter (800-544-0155), and the annually published CCH (Commerce Clearing House) U.S. Master Tax Guide (800-248-3248). They are very authoritative and contain the same latest rulings and tax laws that IRS auditors use when auditing your tax return. Between the two of them, you’ll spend a little over $100 for reliable tax insights that could save you thousands of dollars each year. The foregoing are terrific resources when devising future tax strategies, but this late in the year, about all you can do is to minimize your taxes for 2005 and 2006. The taxes you save in 2005 by accelerating expenses and deferring income can materially shift your income and expenses between the two years. Except for changes in earned income and profit, most of the changes in your taxable income for 2006 will be caused by the defensive tactics you employ for 2005. Overall, you’ll pay lower taxes if you even out your tax burden from one year to the next rather than following a low-tax year with a high-tax year.
There are many ways for landlords to shift income and expenses between two years at the last minute. For instance, rents due on December 31st are taxed a whole year earlier than rents due on January 1st. If I mailed a check to you for business purposes on December 31st, 2005 and you received it on January 1st, 2006, I’d get a deduction in 2005, but you wouldn’t have to recognize the income until 2006. Bank credit card payments made in 2005 will count against income then. Merchant cards will be credited on the date they’re charged against your account. You can buy airline tickets (and seminars) in 2005 for use in 2006, and charge them against 2005. At some point you’ll see the taxable income between the two years begin to be roughly equivalent. After that, additional transfers will cost you more in taxes in the following year. If you see that 2006 is going to have a higher income than 2005, just reverse the process.
Selling a house late in the year can wreak havoc with year-end tax planning. A remedy is to close year-end sales the first working day of the following year so long as it won’t distort earnings too much. If there are unused passive losses that can offset sales, it may pay to close the deal and incur taxes in 2005. Suppose you wanted to accelerate a sale to get the taxable gain into 2005 to avoid having to carry excess passive losses into another year; you could sell the house on an Installment Purchase Contract that would require the buyer to refinance the house in the next year. Next, you could elect out of the purchase contract and declare the profit in 2005, then offset it against any carry forward passive losses. In 2006, having already been taxed on the profit, no tax will be due when the contract is refinanced so the cash will be tax-free. The occupant can get a home equity loan much easier; moreover, lender “seasoning” requirements will have been circumvented.
You can keep things in perspective by dividing a sheet of paper into two parts, one for 2005 and one for 2006. As a reference point, at the top of each year’s segment, write down your net taxable income for 2005 and estimated income for 2006. From that point on, when an expense, such as property tax, is prepaid for 2006 in 2005, ADD the figure transferred to the income figure at the top of the 2006 column. Do the same when you defer receiving income, such as December rents received in January, or sale settlements deferred into 2006.
TAX-FREE EXCHANGING PROVIDES MANY TAX STRATEGIES . . .
Today, you can sell any house held for investment or used in trade or business for at least 12 months, have the sale proceeds placed with a qualified intermediary, and buy a replacement property without being taxed on the transaction. The seller enters into a sale contract, then assigns the contract to the qualified intermediary who completes the transaction. Although the prior owner actually signs the conveyance, it is the qualified intermediary who makes the sale. Once a replacement property is contracted for, the contract is assigned to the qualified intermediary who closes the purchase transaction and the Exchanged property is deeded directly to the original seller.
There are several “wild cards” in Exchanging that are worth exploring: Both the seller’s original holding period and depreciable basis are carried forward to the replacement property. After you have taken title to the replacement property, the holding period of the prior property is “tacked on” to the new property. The replacement property need not be held one year, but can be exchanged anytime an opportunity for profit comes along. When several properties are exchanged for one property, the holding period goes back to the earliest holding period of any of the original properties.
The basis of the prior property, plus any additional debt and “unlike kind” (i.e. cash) received, become the new basis of the replacement property. The Joker in the deck is that the allocation in basis between un-depreciable land and depreciable improvements can be changed to reflect current fair market values. So, some of the basis formerly reflected in the land value of the prior property can be allocated to depreciable improvements in the replacement property. To take this to extremes, if the land and improvements were Exchanged for a condominium, all the basis could be allocated to the improvements alone and depreciated.
One Exchange can follow another until the owner sells it. When property is eventually sold, the holding period includes the entire period from the date the original Exchanged property was bought up to the date of sale of the final property. So, even if a person sold a brand new house that he had Exchanged for, the holding period could extend back 10 years before it had even been built. If the owner dies, when the final property is left to the heirs, its depreciable basis is increased to reflect current fair market value. Assuming that there is no estate tax due, the heirs can either sell it tax-free, or commence depreciating it all over again; hence, “tax-deferred” Exchanges can be “tax-free”.
In a delayed Exchange, the seller has 45 days to identify a replacement property, and the sooner of 180 days, or the due date of the next tax return — including extensions — to close on the replacement property. Suppose you sold a house through a qualified intermediary in 2005, and failed to find a replacement house within 45 days. If the 45 days expired in the following year, the intermediary would return the sale proceeds to you and it would be included in income in the year of receipt; 2006. If your intent was to transfer profit from one year to another, this would be disallowed and the income would be taxed in 2005; but, if it was the unintended consequence of the sale transaction, it would transfer the recognition of taxes into 2006 and the taxes would not be due until 2007.
Here’s another little quirk with tax-free Exchanging: Many States have resident as well as non-resident capital gain taxes that are levied when a property is sold for a profit. In many of them, when no tax is recognized at the federal level, none is recognized at State level, so Exchanging makes it possible to avoid these non-resident State taxes. In California, a special 3.3% tax must be paid by a buyer of real estate. This can be extremely burdensome when expensive properties are being transferred. For instance, on a $500,000 house, the buyer must come up with $16,500 in addition to the down payment. Coming up with the “front-end” cash can be a real deal-killer for some buyers. This tax doesn’t apply when a property is being Exchanged under IRC Section 1031. Suppose a seller entered into a delayed Exchange and the sale proceeds were deposited with a qualified intermediary; how would the buyer know he owed this tax if forty five days following a sale the seller had failed to find a replacement property and the money had been returned to him? As Alice said, curioser and curioser.
WHY PAY TAX ON INCOME YOU’LL NEVER NEED?
While “fixers” and “flippers” have been churning out taxable income, long term investors have been compiling fortunes from rents, appreciation and loan amortization. When I started writing this newsletter, the median price of houses in America hovered around $25,000. The median price for America’s single family houses in 2005 was $203,800. Consequently, they’ve had a lot of time to accumulate houses for the long term and have seen their wealth compound to levels they could never have imagined when they started buying houses. Many subscribers own between 10 and 30 rental houses, and a few own more.
Given the foregoing figures, those who have accumulated 20 median priced houses and let the tenants pay off the mortgages would own gross assets worth over $4,000,000 and a net worth just a few hundred thousand dollars less than this. Net taxable income is exploding because the houses no longer provide much tax shelter. They are running out of depreciation. Most of the mortgage payments are applied to reducing principal, so interest deductions are shrinking swiftly. Their income taxes are proof that they have “arrived”. This is further evidenced by the fact that where they once focused solely on making more money and building their net worth, today they seem more and more concerned with “asset protection” against a host of legal hobgoblins.
Investors with large portfolios who seem so personally concerned about potential liability somehow leave their tax planning up to others. They apparently overlook the fact that taxation poses a much more tangible threat to their financial well being than law suits that may never be filed. Moreover, they can buy insurance to protect them against legal claims, but not against IRS tax levies. They would save a lot more taxes if they’d familiarize themselves with the tax code and the way in which it is implemented in the various tax reports they file.
Wealthy entrepreneurs also continue to do things that increase their tax bills: For instance, despite chronic complaining about management chores, tenant liability, and income taxes, many of them continue to drive their income brackets higher and higher by buying and selling houses. They cut down on deductible expenses by collecting their own rents, doing their own evictions, and their own repairs. I don’t think they’ve realized that they no longer need to do this, nor should they. With increased wealth comes a different array of opportunities that have the potential for increasing AFTER-TAX income.
Their time would be better spent paying others to do routine tasks while they focus on alternative investments for their cash flow, and tax reduction strategies to conserve it.
Tax reduction incorporates five overall strategies: 1. Increase deductions with valid expenses that increase net after tax income and assets. These include deductions for construction, repairs, interest, marketing, and management; and to fund retirement plans, employee fringe benefits, and lifestyle. 2. Recover capital costs as swiftly as possible through depreciation, depletion, and amortization. 3. Defer income taxes through Exchanging, installment sales, retirement plans, and annuities. 4. Minimize taxes by getting as much income as possible taxed as long term capital gain and dividends; plus allocating income to entities and family members in the lowest tax brackets. 5. Avoid taxes through Charitable Trusts, non-taxable gifts, Roth IRAs, Section 121 principal residence exemption, tax-free investments, and estate transfers.
There’s nothing particularly insightful about these five approaches; most readers are already involved in using them to some degree. What most people miss is that every dollar of saved tax that isn’t consumed will ultimately be subject to estate and inheritance taxes. Until 2010 estate taxes are going to be less and less of a factor, but after that, unless the estate tax law is changed, trillions of dollars could be subjected to estate taxation. Both the Administration and the Congress are trying to find a way to change the way estates are taxed. The current proposal is to reduce estate taxes to a maximum of 25% and to continue to give heirs a step up in basis on inherited assets. This isn’t exactly a free ride. To pay the taxes on $4,000,000 the heirs of the person with 20 houses would have to sell a third of them — or mortgage them — to raise $1,300,000; then pay tax and commissions on the sale. Is there a better way?
CASH OUT TAX-FREE WITH A SECURE INCOME FOR LIFE!
If an honest set of accounts were kept, a $4 million portfolio of free and clear houses valued at the median of price of about $200,000 each would produce about 6% net pre-tax yield if you divided the fair market value into the rent. Here’s how I figure that: In many markets, each house would rent for about $1500 per month. This would amount to $12,000 or so per year after operating expenses, property taxes, and insurance. With 20 houses, a comfortable pre-tax $240,000 per year would be realized.
Suppose these houses were contributed to a tax-free Trust to be sold. The person who contributed the property would get a tax deduction. He, and his spouse, followed by his kids, could be named Trustee for life. The terms of the trust would require that it invest the funds to provide the owner, his spouse, and his kids with income for the remainder of their lives based upon 6% of the value of Trust assets each year. The Trust could invest in a wide variety of assets including securities, discounted mortgages, and other real estate ventures. As its assets compounded tax-free for decades, the amount distributed to its beneficiaries would also increase proportionately. When the last of the heirs died, the remaining assets in the Trust would be distributed to any charity named by the original contributor.
I deliberately avoided calling this a “Charitable” Trust because most people just stop reading before they look at the benefits. Let me point out some of the less obvious of these. I’m the world’s biggest fan of single family houses, held for long term appreciation and income; but, they can also pose a threat in the form of functional obsolescence, declining neighborhoods, oppressive property taxes, tenant liability, and militant anti-landlord statutes. Of course there’s the wild card such as Los Angeles’ Northridge earthquake that wiped out a $25,000,000 real estate portfolio of one person in 12 seconds. Hurricane Andrew destroyed 110,000 houses on a slow day in Florida. Mt. St. Helens devastated miles of surrounding countryside. When you add Tsunami, Tornados, and financial disasters once a person has all the money they need, it might be prudent to start thinking about diversifying into different investments and different areas.
For those who want to retain some single family rentals and/or the cash from sale, it’s possible to have your cake and to eat it too by contributing half the houses to the Charitable Trust, sell half of the remainder for cash and have the tax offset by the deduction for the charitable contribution into the Trust, and keep the remainder. Or, the guaranteed income from the Trust could be used to leverage into more, better houses which would throw off tax benefits for years while building equity for the next generation. Speaking of the next generation, the Charitable Trust could name your own Private Foundation or Supporting Organization as the ultimate charitable beneficiary, and any or all of the Charitable Trust assets could be contributed to it, or devised to it. It could name the heirs as Trustees to be paid Administrators, thus guaranteeing them lifetime employment. Foundation employees live pretty well. The foundation can provide them housing, transportation, and travel on foundation business; all tax free.
Charitable Trusts are impervious to judgment liens against their creators. They are bound by the same rules as other tax-free entities; they can’t self deal, engage in unrelated business activities, or speculate in risky propositions. On the other hand, a Trustee who has built a fortune in the real estate business can make a lot of money tax-free by using his expertise to find high yield investment opportunities that might be too risky for other Trustees with less experience. For instance, the Trust could lend money on short term, high interest terms to people in the fixer business. It could make a “participation loan” to land developers or builders and take a share of the profits. It could buy Options on the shares of new enterprises to help fund new construction or stock offerings. It could buy insurance on its founders life and reap big profits for the next generation tax free. Incidentally, Trustees of qualified corporate pension plans, and Custodians of IRAs can also do these things to build up assets.
