Taxes

Sometime in March, county appraisal districts across Texas have an epic party. There’s loud music, dancing, cake, party hats and party horns. Oh and they send out the new property tax appraisals to property owners.

Coincidentally, around the same time of the year, I receive numerous calls and text messages from clients. “Ouch”, “Getting killed over here” and “This is out of control” are some sentences that may be uttered.

I’m trying to make light of it, but truth be told ever increasing tax appraisals are no fun. They take a bigger bite out of your incoming rent and reduce your positive cashflow. On average, operating expenses account for 40% of incoming rent and property taxes account for 65% of operating expenses. Therefore, they’re the principal driver of those expenses. So when you have years like 2013-2015 where average property appraisals went up by 10-15% per year to track a similar appreciation in property value, the impact will be felt.

I wish I had a magic strategy that you could put to work and reduce your property taxes right away but unfortunately my supply of fairy dust is depleted. But I would like to offer some thoughts and tips on the subject.

Property appreciation and tax appraisal appreciation go hand in hand

Some real estate investors are focused primarily on cashflow while viewing appreciation as a welcome bonus. However, cashflow and appreciation don’t exist in a vacuum, they are interrelated and they impact each other. For instance, when property values rise (a welcome outcome for any investor) property tax appraisals rise and positive cashflow drops. But in fact, what’s happening is a transfer of returns from cash on cash return to appreciation return. For instance, let’s say you own an investment property where you have invested $40,000 and it produces $3500 per year in positive cashflow (8% return) in a year during which property values remain flat. So your total return for that year is the sum of return from cashflow (8%) and return from appreciation (0%). Now in the following year, your taxes go up by $100 per month so now your cashflow is reduced to $2300 per year (6% return) but property values rose 10% that year. While your cash on cash return dropped by 2% your total return increased by a factor of 7 due to appreciation returns. How? A 10 percent appreciation on a property in which you’ve invested just 20% of the value in capital translates to a 50% return on that capital due to 4:1 leverage. Therefore your total return for the year is 56%. The counter argument to this point is that appreciation returns don’t materialize until you sell the property and it’s well noted. But that’s not exactly accurate. For a long term investor whose goal is to built up a portfolio with a certain asset value, appreciation helps them get there faster. The main negative impact of rising property taxes and shrinking cashflow is that it might require more surplus injections from an investors surplus income to pay off mortgage debt at the same pace. But once the mortgage is paid off, the higher asset value due to the same appreciation (that caused reduced cashflow) leads to higher income at retirement.

Protest your tax appraisal every year

Once the property tax appraisal is sent out the property owner typically has 30 days after the receipt of the notice to file a protest. This can be done in three different ways: 1) File a protest online with the county appraisal district website (i.e Harris County http://hcad.org, Fort Bend http://fbcad.org) 2) Local investors can file a protest in person at the appraisal district office (their address is also on the website) or 3) File a protest using a property tax consultant. I have used this last option personally and have advised clients to use as well. The property tax consultant gets paid based on a percentage of the tax savings they’re able to provide (usually 30-35%). So if they aren’t able to secure any savings you don’t have to pay anything. And you can select the perpetual engagement option which means they automatically protest your tax values each year and you don’t have to remember it.

Full Disclosure: In recent years, county authorities have been very stringent and property tax savings have been small. However, if you don’t protest, tax savings will be exactly ZERO. Something is better than nothing

In long term investing, you sign up for the whole ride

One thing you sign up for when investing long term is for the whole ride – the peaks, the valleys and everything in between. There will be times like 2008-2011 where cashflow might be plentiful but appreciation absent. And other times like 2012-present where cashflow is getting squeezed but values are rising. We all have our preferences – some investors really go after cashflow and could care less about appreciation. They’d prefer that for the decade or two that they’re investing, things should stay constant like 2008-2011. Then there are investors who feel that if you built up enough net worth, income takes care of itself and they’ve been grinning these last few years. But the reality is in long term investing the only thing you can count on is change as we move and navigate through the cycle. The sooner you get used to and embrace that idea, the better. This year property prices have not risen like in recent years in response to the oil market struggles so property tax appraisals will likely reflect that reality as well.

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.

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.