How to Invest in Real Estate Without Paying a Penny of Tax (Legally): Part 2: "Defer, Defer and Die"
Updated: Jan 18, 2021
You can pay $0 in tax by pairing depreciation with a technique humorously called "defer, defer and die". Also, the new tax law opens up additional options...
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No one wants to pay more tax than they have to. So many investors spend a lot of time thinking about how to reduce the tax burden.
Part 1 of this article looked at traditional retirement-vehicle tax-sheltering methods and why they don't stack up. Here in Part 2, we'll look at how experienced investors like John Frederick use non-retirement money to pay zero taxes while still maintaining maximum financial flexibility. And then we'll look at the best ways to implement this without breaking the bank. Then in part 3, we'll see how "passive-pairing" can drastically reduce or eliminate your investment taxes. And then in Part 4, we'll look at how to implement that.
Taxed Both Ways
To recap from part one: when you invest in real estate, you're potentially taxed in two ways. First, the profit from renting it (net operating income) is taxed as ordinary income. This profit is taxed at the same marginal rate as if you had made more money with your employer (which for most accredited investors is between 22 - 37%).
Second, you also hope that the property is worth more when you sell it. If so, then the profit from that is taxed as capital gains (which for most accredited investors is relatively lower and ranges from 15 - 20%).
Then on top of this, some people may have state and local taxes as well. It all adds up to a lot, so it's no surprise that many people want to minimize the amount of taxes they have to pay.
So let's first talk about how to avoid paying any tax on income.
Some new real estate investors get a nice surprise/bonus at tax time. They find that their income reported to the IRS is less than they actually got in cash. This isn't a tax scam, and has to do with something called depreciation (which I'll talk about in the second). But the net result is that some investors find they are only taxed on about 40% of their income. Others even find that 100% of their income is tax shielded and they don't have to pay any tax. How is this possible?
First, let's discuss depreciation. Accounting rules allow all business owners to deduct depreciation from their profits. This deduction is intended to take into account the fact that most things that you buy lose value by the day as they wear down. So if you're a manufacturer and buying a new machine to produce parts, the depreciation deduction makes up for the fact that every year the machine gets a little more worn down and work less. Eventually your machine will break down permanently and be worth nothing, so depreciation accounts for this.
However, real estate is a little weird and different than most businesses because it generally isn't like this. When you buy property and sell it five years later, not only has it not reduced its value to $0, but it is also (hopefully) worth more than you bought it for. But due to the depreciation accounting rules that applies to all businesses, you still get to take this deduction. So the net result is that you actually have a tax bill for less than the income you made!
How much less depends on what you invested in, and how long the property is being held (because the accounting rules are set up so that the amount of the deduction goes down over time). If you invested in real estate debt, you're not going to get any depreciation, so there's no shielding. However, if you invested in real estate equity, then you'll benefit in some way. On a single-family house investment, it might be about 40% of your income that you don't have to pay taxes on. Core real estate fund with an average asset being held for 25 years, might shield 50%. And a brand-new multi family/apartment that uses cost segregation depreciation, it might shield 100% of your income.
(Side note: And with the new tax rules, many investors may find that they have an additional 20% of tax shielding on top of this in 2018).
Obviously, this is a pretty fantastic situation.
However, there is a catch. The IRS recognizes how much of an unfair tax break this is. And of course they don't let it go. So when you sell the property, they do something called "depreciation recapture." What this means is that you end up having to repay back all the tax breaks enjoyed previously.
So that awesome tax break was not really an a true tax savings or permanent deduction. In the end, it only does gives you a delay in paying the IRS. This is a really important limitation that many investors don't fully understand, and many real estate promoters gloss over (or don't understand themselves) when they are pitching the tax benefits of their deal.
And for 99% of investors, the story ends here. However, this article is about investing completely tax-free. So of course we're going to talk about how to get around that.
"Defer, Defer and Die"
Fortunately, the IRS has set up a second rule that allows savvy investors to transform the temporary tax break (which has to be paid back) into a permanent one. The rule is called a 1031 exchange. (There are also some other rules that allow this which we will discuss below). While the details of the 1031 exchange can be very complicated, it essentially allows a real estate investor to sell one investment, buy a second investment, and not have to pay any taxes on the depreciation (called "deferring" it) until the second property is sold.
That alone is nice, but not enough to avoid paying taxes completely. Thankfully, the rule also allows investments to be daisy-chained one after another, and still retain their ability to defer taxes. In other words, you can keep repeating this over and over again as many times as you want. And as long as you do, you don't owe any taxes.
And amazingly, the strategy doesn't end when an investor dies. You'd think that at that point the IRS would get their due and collect all the taxes. But the rules state that when the investor dies and passes the property to their heirs, it's inherited on what's called a "stepped-up basis". What this means is that the heirs don't owe the tax either. This is a pretty amazing thing. They say that death and taxes are unavoidable, but clearly in this case taxes can be.
Then to make it even more mind blowing, not only does this work on the depreciation, but it also works on the second part of the taxable return: price appreciation. Normally this is taxed as capital gains, but by using the strategy, it also infinitely deferred and never paid.
This is a pretty fantastic loophole. And the set-up is why some people humorously called the strategy "defer, defer and die".
"Uncertain, the future is"
The biggest danger to this strategy, is that of course, no one knows what the future holds. In an environment with rising deficits and tight budgets, the future Congress could revoke some or all of the rules required to make "defer, defer and die" work. If that happened, then presumably some taxes would be owed at some point. So anyone considering the strategy, has to take that into account.
The other danger is that the 1031 rules are complicated. There's lots of gray areas, and even conflicting information from the IRS versus court rulings, etc. So it's vital that you consult with a knowledgeable tax attorney going forward with any such strategy.
"Devil in the details"
If an investor is okay with the above risks, then how is a passive real estate investor to implement it? There are several options:
Delaware Statutory Trust
Economic opportunity zones
Tenants-in-common (TIC) is an ownership method that the IRS approved in 2002 as a way to allow multiple, unrelated investors to invest in a 1031 exchange.
TIC v1.0 was extremely popular over two decades ago, but less popular today due to problems that were exposed in many during the Great Recession. First, since every investor is a partial owner, they all have to become a borrower on the mortgage. This means the loan shows up on your private credit. Additionally, major decisions (one to sell, when to raise more money, etc. ) require unanimous consent to accomplish. This can be difficult when there can be up to 35 people involved, and there are many stories of important actions that couldn't be taken because a single person dissented. Also, the 35 investor limit constrained the TIC to smaller properties.
Delaware Statutory Trust
Delaware Statutory Trusts (DSTs) were approved in 2004 by the IRS as a way for investors to do a 1031 exchange. The DST, all of the investors are completely passive and have no say in the major decisions of the property. The sponsor does this instead, which makes coordination much easier and solves many of the problems of TIC v1.0. Of course, this makes choosing the sponsor a lot more important.
However, DSTs retain some significant limitations, such as being prohibited from raising more money. During the great recession, many funds would have imploded and gone into foreclosure, without the ability to raise more funds. Most DSTs try to minimize this risk by setting up reserves in advance. However, doing so produces a drag on the ultimate return, so many DSTs don't have severe recession reserves set up. And if the reserve is insufficient, then the investors in the DST are out of luck and the deal may implode.
The other issues with DSTs is that they tend to have very expensive hidden (or not so hidden) fees. For example, it's very typical for there to be a front-end commission that costs as much as 9%. Right now, property prices are at all-time highs, and if they don't increase by at least 9%, you might expect to sell at a loss. So this is something else to watch out for.
One site that has a lot of DSTs is 1031crowdfunding.com
UpREIT is a tax-deferred process, similar to the 1031 DSTs/TICs, that allows you to take an existing property that you own directly and do a tax-free exchange into a REIT. For example, Broadstone Net Lease has such a capability.
One big advantage over DSTs, is that there is no restriction on raising additional money. Also, if you are using a fund like Broadstone Net Lease, the fees are extremely reasonable and many times lower than a DST.
The downside is that an investor can only transfer in existing property that they own, and can't transfer in LLC interests (like a crowdfunding or syndication deal). And once in the REIT, there is no capability to do a tax-deferred transfer out. This is fine if you are doing buy-and-hold (in which a REIT makes possible easier than an individual property or small fund). However, if that's not your intention, then this could be a limitation.
Economic Opportunity Zones/ Opportunity Zone Funds
This is a brand-new tax-deferred process that was created by the tax overhaul passed at the end of 2017. It allows investors to sell property (or stocks...any type of capital gains) and then transfer into a property in a low-income area, to defer capital gains. (It's unclear if this will allow the deferral of depreciation as well, but we will get more clarification as time goes on). They are done through Opportunity Funds certified by the U.S. Treasury to make the investments.
These investments have some small advantages over 1031/DST/TICs for some investors. If the investor holds for 10+ years, any capital gain on the Opportunity Fund is completely wiped out/excluded. With 1031/DST/TIC, it is only deferred, which requires repeating the process over and over again, to avoid eventually being taxed.
Also, there are some other special perks if the investor wants to cash out earlier. After 5 years, the tax basis of the original investment is increased by 10% (meaning the capital gains will be only 90% of what they would've been). If they hold it for 7 years, the basis is increased by a total of 15% (meaning capital gains will be only 85%). In a 1031/DST/TIC, there is no discount.
This is a brand-new and very interesting development where a lot of the details have not been finalized.
The private investor club has a master list of more than 30 opportunity zone funds, and has conducted due diligence on many that club members have found interesting. Club membership is free but requires verification that the investor is not associated with any sponsors or platforms and signing a nondisclosure agreement to keep the information private. Click here to view the list or learn more.
In part one of this article, we talked about how Gary Frederick has not paid taxes on 54 investments over the last 21 years. Fredrick used a technique that I call tenants-in-common (TIC) v2.0.
TIC2.0 was created as a response to the limitations of TIC v1.0 and DSTs by some sponsors. They use a combination of one or more LLCs with a TIC to bypass many of the traditional restrictions and limitations of TIC 1.0 (such as liability, or the 35 investor limit). They also use a number of techniques (such as "drop and swap") to thread the needle of IRS issues and restrictions. Note that some sponsors may employ riskier strategies than others. And if the IRS disapproves a strategy, it could result in taxes and penalties. So it's important to check with an experienced tax attorney when dealing with these.
Fredrick chose to use a single sponsor for his TIC v2.0 strategy. The advantage of this is that the sponsor handles all the tricky issues of timing the move between the old investment and the new one,. (For example, if you take too long to move into the new property, you can lose the tax deferral). Also, the sponsor that he chose (MG Properties) does not charge an additional fee for the 1031 exchange at the end (and it is optional, so the investor can choose to cash out).
Note: As of 1/2021, MG Properties currently has an open TIC v2,0 "defer, defer and die" offering (a value-added multifamily deal that is expected to shield 100% of distributions from tax, and offer a 1031 exchange at the end).
Note: the above link is limited to members of the private investor club. Membership is free, but requires verifying that the investor isn't associated with a crowdfunding platform or sponsor.
But how do I take it further?
However, many of the above only work on limited investments and most investors would prefer a much more diversified portfolio. In part 3 of this series we'll look at how investors can use "passive-pairing" to dramatically cut or eliminate their tax bills on a wider variety of investments. (And since many of us also invest in other alternative-finance assets, I'll talk about how you can integrate those into a tax savings plan, too).