“In this world, nothing can be said to be certain, except death and taxes,” Benjamin Franklin famously said.
You’ve undoubtedly heard the saying. It still holds true today. After all, the U.S. federal government collected $3.3 trillion in taxes in 2018.
While you can’t avoid taxes on your investments and income, you don’t have to give it all to Uncle Sam. There are a variety of tax-saving strategies that can help you protect your wealth. The key is to make tax-efficient investments and utilize deductions (such as depreciation).
In this article, we’ll discuss how you can protect your wealth from taxation. With a good strategy and execution, you’ll be able to keep more of what you’ve earned.
Real estate: The most tax-efficient investment
Richard Delgado, DLP Capital Partners Managing Director adds, “We have a proven track record of exceeding our double-digit targeted returns in every period for all of our funds without any losses ever, elevating DLP Capital Partners as a top-performing fund manager. Investors are enthusiastic about the opportunity to invest in our flagship hybrid Housing Fund.” DLP Capital Partners is now taking commitments for the DLP Housing Fund, anticipating a launch in January 2020.
Investing in real estate is one of the best strategies for building long-term wealth, especially for high-net-worth (HNW) individuals. This is partially due to the tax advantages that real estate investments offer.
For instance, when you put money in a real estate investment trust (REIT) or fund, you get a 20% deduction on pass-through income, thanks to the 2017 Tax Cuts and Jobs Act. This lowers the tax obligation from 37% to 29.6% for high-income individuals.
Don Wenner, CEO of DLP Capital Partners, points out: “That 20% deduction is if you’re investing non-qualified money, or money not in a 401K or IRA. If you roll over the money from a retirement account, it will be sheltered from tax. Know that if you have a self-directed IRA, you can invest in any asset class, such as real estate.”
Moreover, when it comes to tax-efficient investments in real estate, you have more options than just a traditional REIT. The right fund can even deliver tax-free income for years.
For example, at DLP Capital Partners, we operate several tax-efficient real estate funds, including:
- DLP Lending Fund
- DLP Housing Fund
(Launching Feb. 6th at our Investment Dinner Gala, RSVP to learn more!)
The DLP Lending Fund earns income by providing leveraged loans to qualified real estate entrepreneurs. All the income you earn from your investment receives a 20% deduction (called a 199a deduction).
The DLP Housing Fund is a hybrid REIT. The portfolio is a mix of debt funding to experienced operators and equity investments in value-add multi-family apartment communities. The fund aims for targeted annual returns of 12% net to investors. Distributions are paid monthly.
One noteworthy benefit of the Housing Fund is that you own the property investments within the portfolio. This presents a unique tax advantage.
“It’s all about depreciation. Real estate equity funds like the Housing Fund are among the most tax-efficient places to invest your money. And that’s because of the power of depreciation,” attests Wenner.
Depreciation, which enables you to allocate the cost of a physical asset over its useful life, can shelter the entirety of your earnings from taxes. Yes, you read that right: Through depreciation, you can protect all of the cash flow you get from the properties you own.
Here’s an example of how that works:
- You buy a property for $10 million. Based on IRS laws, you can depreciate the property for 27.5 years. That equates to a depreciation rate of 3.6% each year. You can depreciate $360,000 per year.
- Each year, your investment achieves an 8% cap rate. That means you earn $800,000 in net operating income.
- You can deduct the $360,000 in depreciation on your taxes. That leaves you with $440,000 in taxable income, instead of $800,000.
This would be the case if you were to pay in cash. The reality is that you’ll take leverage—in which case, the tax advantages will be even better.
Let’s reconsider the example with a loan-to-value (LTV) ratio of 65%. That means:
- You put down $3.5 million in cash. Your loan is $6.5 million.
- On that loan, you pay $500,000 in interest each year. If you generate $800,000 in income, that means your net cash flow is $300,000.
- You still have the depreciation benefit of $360,000—but your income is only $300,000. You can wipe out 100% of your taxable income.
“In such cases,” Wenner points out, “you have a taxable loss from a tactical standpoint. You will owe no income tax on the investment. Even better, if you have a job, you can take that excess depreciation and deduct it from your taxes there.”
With real estate investments like the Housing Fund, you can often defer paying taxes on a property until you sell it. If you do so after a few years, you’ll be taxed at a long-term capital gains rate. This rate is historically much lower than those of income taxes. Plus, you will have had the benefit of maintaining a cash flow over the years (which you can use to reinvest and earn more money).
“With real estate investments, it can get even more attractive. You can defer taxes for another 5–8 years through 1031 exchanges. If you sell a property, take all the money and put it in the hands of an intermediary, such as a law firm. You then have 45 days to identify a new property and 180 days to buy that property,” says Wenner. Note: As the IRS states, 1031 exchanges are like-kind exchanges. When you sell a property then invest in the same type of property, you don’t have to recognize a gain or loss.
Other investments that reduce your tax burden
“With any investment, consider your net return after taxes,” Wenner advises. “Your returns can vastly improve with good, tax-efficient investments.” With this in mind, understanding how different investments are taxed should be at the forefront when allocating your assets.
There is an abundance of investments that can lower tax burdens for HNW individuals. Some common options include:
- Equity investments: Long-term capital gains have much lower tax rates than income does. As of 2019, the long-term capital gains tax is 20% for those in the highest tax bracket. Income tax for that bracket is 37%. That’s a 17% difference!
- Tax-free municipal bonds: You don’t have to pay any federal tax on income generated from municipal bonds. The debt investment may be exempt from state and local taxes as well. While the yields from municipal bonds aren’t high, they do provide tax-free income.
- Health Savings Account (HSA): Everyone spends money on medical care. With an HSA, you contribute money before taxes and all contributions are tax-deductible. That money can be invested and you don’t have to pay taxes on earnings. You can even make tax-free withdrawals from your HSA to pay for healthcare expenses.
- 529 College Savings Plan: Have a child or a grandchild? A 529 plan offers tax-free growth and tax-free withdrawals for educational expenses. On top of that, most states offer deductions for contributions (up to a certain amount).
- Retirement Accounts: Traditional IRAs and 401Ks lower your taxable income and offer tax-deferred growth. Roth IRAs and Roth 401Ks are made post-tax and offer tax-free growth and withdrawals. Roth IRAs can enable you to leave your heirs a large, tax-free gift, too. Note there are income limits for Roth IRA contributions: $122,000 for individuals and $193,000 for married folks, as of 2019.
If you own a business, a defined benefit plan could give you significant savings on payroll and income tax. You can contribute up to $300,000 per year and defer taxes on that money. For high-income earners, this can trim a tax bill significantly.
Another tax-efficient investment you may not have considered is an insurance-dedicated fund (IDF). IDFs are financial products in which money is invested into private placement life insurance. Investors get the tax benefits of a life insurance plan, including tax-deferred growth, a tax-free death benefit to heirs, and tax-free growth of dividends (if applicable). The product has become increasingly popular in recent years, with the likes of BlackRock, Pacific Life, and John Hancock all offering IDFs.
Taking advantage of tax laws
Paying attention to changes in tax laws can empower you to capitalize on tax-efficient investments. The most recent major tax legislation, the 2017 Tax Cuts and Jobs Act, introduced many tax benefits for investors, such as:
- A deduction of up to 20% of qualified business income (this includes REIT dividends)
- A tax credit of 20% of qualified rehab expenditures for owners of historic buildings
- An increase in gift and estate tax exemptions
There’s also a new tax incentive for investors known as qualified Opportunity Zones. As the IRS notes, “these zones are designed to spur economic development and job creation in distressed communities throughout the country and U.S. possessions by providing tax benefits to investors who invest eligible capital into these communities.”
However, Wenner advises that you “must be sure it’s a great investment. Risk does come with these investments. Saving taxes doesn’t make sense if the investment won’t make money.”
So how do investments in Opportunity Zones work?
Let’s say you invested $500,000 in Apple stock. After 10 years, you’re ready to cash out. The investment is now worth $2 million. You have $1.5 million in profits, but you don’t want to pay taxes on those gains yet. You can defer paying taxes by investing in an Opportunity Zone. That investment must be made for at least 10 years.
Now, let’s say that $2 million investment in the Opportunity Zone earns $1 million over the decade. You’ll have to pay taxes on that original $1.5 million in investment income from the Apple stock. However, you were able to defer paying taxes for 10 years and use the money to earn more money.
Additionally, you don’t have to pay taxes on the $1 million you earned from investing in a distressed community. That’s $1 million in tax-free income!
As you can see, staying up-to-date on the latest tax laws helps keep you alert to new opportunities for protecting your wealth from taxation. Regularly check IRS.gov and reputable news sites—and talk with your CPA—to identify the most tax-efficient investments for the short- and long-term.
Living well and building wealth for generations
You want to enjoy life while building wealth, right?
In order to achieve that, seeking tax-efficient investments that earn consistent, steady returns is your best option. That means investing in tax-advantaged assets like real estate, retirement accounts, and stocks. It also means putting your money in useful investments that offer tax advantages, like a health savings account (HSA).
Whenever you invest, think of your net return after tax—taxes can take a big chunk out of the wealth you’ve built if you don’t make the right moves.
We recommend including real estate in any portfolio—especially if you want to protect your wealth from taxation. Investing in real estate helps to maintain your wealth, provide consistent cash flow, and reduce your tax burden. Moreover, your property assets will most likely appreciate over time. What more could you want?
Would you like to learn more about how you can build your wealth and protect your money from taxation? Discuss your long-term financial goals with us at DLP Capital Partners.