Observations on income taxes on your free and clear investment portfolio

Many of the articles I have written on InvestingArchitect.com have originated from discussions with investors like you. A few months back, Robert – a regular reader and “subscriber” to our Blueprint strategy – made the following observation.

One thing I have noticed though is that the income taxes I am paying keep increasing as the properties are paid off. Typically when you have a leveraged property the cash flow is completely tax sheltered by the depreciation. When the property is free clear a large chunk of the cash flow is not sheltered.

Keeping this in mind means that one pays a lot less income tax for the same amount of capital invested if that capital is spread out over more properties. The only problem is that one is also increasing their risk.

I think that when I finally retire with that $100K/year this will be less of a problem as my 9 properties will shelter around $40K/year and the highest tax bracket on $60K married filing jointly is 15%. As apposed to my rental income now on top of my salary which puts me in the 33% bracket.

I know you don’t like to include the topic of tax in your articles but I think this truism must be considered

I think there is an important lesson for us tucked within Robert’s observation.

Let’s look at some specific numbers in a simplified scenario that will illustrate my points.

Scenario

John owns a portfolio of nine identical properties that he purchased for $165k each and financed 75% of their purchase with a 30 year mortgage at 4.5% interest. For tax purposes, about $300k of the total asset value of this portfolio of $1.5M is allocated to land (therefore not depreciable) and the rest ($1.2M) is allocated to improvements depreciable over 27.5 years on a straight line schedule. This produces a depreciation expense of $43,200 per year over that 27.5 year time period.

While the properties are still leveraged, they produce actual positive cashflow of $34,200/year. However, the fine folks at the IRS only allow the deduction of the interest portion of your mortgage payments for tax purposes. The amount that goes to principal is not an expense in their eyes and has to be added back to you cashflow for tax purposes. Therefore, positive cashflow after operating expenses and debt service for tax purposes is $52,167.31 from which we can deduct depreciation expenses of $43,200 leaving us with taxable cashflow of $8,967 for the entire portfolio. Assuming you are crushing it on the income front, we apply a 35% tax rate to that amount and we end up with $3,138.56 in taxes and after tax cashflow of $31,061.44.

Fast forward twelve years later. John has followed our Blueprint strategy and executed it flawlessly leading to the eradication of the entire debt on his portfolio. Now he owns all nine properties free and clear so let’s look at the tax implications of such a state.

Since there are no mortgages to pay, the entire amount of the portfolio’s debt service ($67,718.49) flows straight to the bottom line and  John’s pretax annual positive cashflow is now $101,918. Now there is no income expense on the debt to deduct so the only deduction left is the annual depreciation expense of $43,200 which results in taxable cashflow of $58,718. Since we don’t plan on retiring in survival mode, we assume your income still rocks and use a corresponding high tax rate of 35% which leads to annual taxes on the cashflow of $20,551.30 and after tax cashflow of $81,366.

Income taxes on your real estate investments

Observations

Let’s address Robert’s last point first. The principal reason why I don’t usually delve into tax topics very often is because tax topics with all the convoluted numbers and IRS regulations can be as interesting as watching paint peel. However, we can only ignore tax implications at our own expense. Since I don’t suspect the government will make income taxes optional anytime soon (we can all dream…), these discussions affect the money you get to keep which is the money that matters.

Second, let’s tackle the crux of the matter. It is absolutely true that while the investment properties in your portfolio are leveraged, the actual tax rate you will pay is much lower than when your portfolio is free and clear. From Wikipedia, the effective tax rate is used in financial reporting to measure the total tax paid as a percentage of the individuals’s accounting income, instead of as a percentage of the taxable income. Or for the rest of us humans, the actual taxes paid divided by the actual positive cashflow.

Looking back at our scenario, $34,2000 of actual positive cashflow from leveraged properties resulted in a $3138.56 tax bill or an effective tax rate of 9.17%. On the other hand, when properties were paid off, the actual positive cashflow of  $101,918 resulted in $20,551.30 or an effective tax rate of 20.16%.

No arguments from me up to this point. However, let’s be clear about one crucial distinction.

In most cases, the principal purpose of a long term real estate investment portfolio is to create an after tax income stream that affords you the lifestyle you want to live in retirement. It is not to minimize your taxes or achieve the lowest effective tax rate.

If minimizing taxes was your principal goal, then you should only purchase investment properties that break even.  In that case, you will not only avoid paying taxes on the positive cashflow (since it doesn’t exist) but will likely get a tax benefit from “paper losses” that result from depreciation expenses. These paper losses are treated differently depending on your job income. If your income is $150k per year and up, all paper losses are collected into an “accumulated losses” account and can be applied toward any future gains upon the sale of the property. If your income is under the $150k threshold, you would receive a reduction in your taxes due for that year equal to the amount of the loss multiplied by your tax rate.

Let’s get back to the heart of the matter. Robert was concerned with the increasing tax liability as he paid off the debt on his portfolio. Every sophisticated investor should strive to legally reduce taxes wherever possible. However, we shouldn’t let tax reduction become our main focus. Your goal is to build a specific after tax (read: spendable) income stream using a portfolio of high quality real estate investments. Any and all tax implications can only be considered in the context of how they impact this future income stream.

When you pay off the debt on your properties, the taxes will be higher because your income will be higher. That’s no different than an individual paying far more taxes when they make 200k per year than they did when they make $50k per year. Does that mean you keep yourself from earning more to avoid writing a bigger check to the IRS? Look, I hate writing a check to the IRS as much as the next guy but over the years I’ve learned to smile as I write that check since higher taxes usually occur as a result of a higher income with which to pay them.

I’m oversimplifying, I know. And Robert’s point that taxes per amount of invested capital go up when your properties are paid off is well taken.  Unlike your job income, in your real estate portfolio, you can choose to earn that higher income by spreading your capital over more leveraged properties. But as Robert mentioned, your risk would be significantly higher to offset your higher returns from leverage as well as reduced taxes. Most importantly, your hassle would also be much higher when you manage a larger number of properties. I don’t know about you but I wouldn’t want to retire from my job only to take a position as a property manager for my own properties. You could hire a property manager but the hit to your returns from shaving 8-10% off your top (income) line will be much more substantial than the one from the higher tax liability that started this whole discussion.

So keep your eyes on the ball and focus on the number that matters: Your income goal. All other metrics: ROI, effective tax rate, leverage only matter insofar as they allow you to accomplish that income goal. If you achieve an incredible ROI on a single property that doesn’t get you to the income you need, you have not crossed the finish line. If you achieve zero tax liability on an otherwise unimpressive income stream, ditto. Focus on your goal and let the rest of the chips fall where they may.

If you are interested in a little known strategy to significantly reduce or eliminate taxes on a portfolio with multiple properties while staying on track for your retirement income goals, please email me or if you’re reading this from your email just hit reply.

 

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