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Case Studies: Tax Advantaged Investing

CASE STUDY No. 1: Why Use a 1031 Exchange When You’ve Lost Money on a Real Estate Transaction? Changing Tactics in a 1031 Exchange May Save Taxes

CLIENT: The client invests as a family limited partnership entity. It originally invested $1,000,000 into a TIC property 10 years ago. The recent sale of the relinquished property resulted in sales proceeds of $546,540 before taxes. This represented a substantial loss. A number of investors in this situation would not have completed a 1031 exchange. They would have chosen to pay their taxes. If this entity had not entered into an exchange, the tax liability of approximately $465,000 would have reduced the original $1,000,000 investment to approximately $81,500, a 92% haircut.

The unfortunate situation is that investors often don’t analyze the tax implication of their situation until it is too late to structure meaningful taxation strategies. To fully defer taxes with a 1031 exchange, one has to acquire property with equal or greater debt and use all of the money.

STRATEGY: The client originally considered exchanging into multiple apartment DSTs with the $546,540. If the entity bought normally leveraged assets (e.g., 50% LTV) and used all of the money, there would have been debt boot, which is taxable. In this case, all of the money would have been used but there would still be tax liability of about $210,000. To avoid debt boot, the client needed to buy an asset with very high leverage to satisfy the “equal or greater debt” provision to fully defer taxable gain.

Once I established the basis, I calculated the required allocation into a highly leveraged Zero-Coupon 1031 replacement property to offset debt and assist with full deferral of taxable liability. “Highly leveraged” means, as assets increase in leverage (a greater percentage of debt to equity) the debt level can get high enough that there is no cash flow. That’s the maximum leverage that can be obtained. Zero-Coupon assets are often levered with a debt coverage ratio of one-to-one. In other words, income from the property is equal to the mortgage payment. There is no income.

Since this was a substantial departure from the client’s intended approach, I asked for and was granted permission to speak with her CPA because my focus is the tax consequences of all structured investment strategies. The CPA verified and supported my analysis and conclusions. I discussed my findings with my client who, after consulting with her CPA, agreed with and executed my proposed tax deferral plan.

RESULTS: The zero coupon holding period is expected to be 8-10 years. The net effect was that with anticipated mortgage pay down of the Zero-Coupon asset, my client could recover most or all of the dollars lost in the previous transaction. I’m now completing my second set of exchanges for this client, and her CPA is referring me business.

CASE STUDY No. 2: Tax-Advantaged Investing

CLIENT: A high net worth business owner with a significant income stream who is starting to explore estate-planning issues.

STRATEGY: The client owned two adjacent commercial properties in a major metropolitan area. One of the properties was purchased to develop and relocate the client’s expanded business. It was eventually deemed surplus and sold via a 1031 exchange. Due to the financing, all loans were paid off at closing leaving relatively small amount of sales proceeds before taxes. Since the lender agreed to refinance the retained property to the same debt level as before the exchange, funds were available not only to complete the exchange, but additional funds remained for further investment.

After reviewing the client’s tax returns in collaboration with her CPA, we determined that the additional funds could be used to: reduce the client’s effective marginal tax rate, and fund a plan that would produce tax free retirement income. An analysis showed her effective marginal tax rate could be reduced from 33.7% to 21.1% with a tax savings of $132,700.

A substantial portion of this strategy could be replicated annually, as long as tax regulations remain relatively consistent. The first area of interest was ordinary income. The solution involved the use of a charitable contribution (IRC Section 170h) to directly impact taxes at the ordinary income level. The next area of interest was rental and royalty income. The solution involved the use of depreciable assets to minimize the impact of rental income.

RESULTS: The client was able to reduce her effective marginal tax rate and realize substantial tax savings as a result of employing the recommended solutions. Furthermore, the client redeployed the savings into an insurance based retirement plan that, upon full funding of the program, would provide tax free retirement income for life.

By using assets that are not well known, and are typically non-public, we target specific areas of the tax code and take maximum advantage of those codes for the benefit of and in conjunction with a client’s specific financial objectives.

Additional Reading

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Financial Services and Wealth Strategies