Introduction: Tax Strategy vs. Tax Compliance
I’m always on the lookout for ways to help Real Estate Investors take advantage of tax saving strategies — but before I get into the strategies themselves, I think it’s extremely important to note that any investor attempting to save on their taxes should build a solid foundation for operating. Therefore, I recommend that all Real Estate Investors hire a good tax strategist and a good tax preparer. A real-estate-savvy CPA, paired with a solid legal consult is an invaluable combination for an investor. One needs to work with experts on both the tax and the legal side of the equation to build a solid plan for themselves and their family.
Depreciation (AKA “paper losses”)
Moving into the strategies themselves, the first tax saving strategy I’ll cover in this letter is Depreciation (AKA “paper losses”). When one purchases an older, depreciable real estate asset (i.e. not a new construction), one has the opportunity to capitalize on depreciation through cost segregation. Through the process of cost segregation, rather than waiting half a lifetime (27.5 years for residential properties, 39 years for commercial properties) for your property to depreciate, one can work with an engineer to segment the property into several, smaller, depreciable components. Through this cost segregation, depreciation of these individual components can happen over much shorter periods of time (usually 5, 7, or 15 years, depending on the component). This process of accelerated depreciation gives a real estate investor the advantage of claiming the depreciation deduction much sooner than usual (typically within the first 3 years of purchasing the property). In doing so, “paper losses” are created. “Paper” losses are referred to as such, with special emphasis on those quotation marks, because they are expressed as losses on your tax form, while, in reality — income is being generated. Another distinct benefit here is that, even if a real estate investor is unable to take advantage of these losses within the first few years, she is able to net her passive losses carried forward against the gain at the sale of the property.
Becoming a Real Estate Professional
This Tax Saving Strategy comes down to something as simple as checking a box on your tax form – but that’s not to say it doesn’t take some work. People who read my newsletter and engage with my content know that I’ve espoused the benefits of becoming a Real Estate Professional before – but who, exactly, qualifies as a Real Estate Professional? Let’s explore. To become a Real Estate Professional, one must accumulate at least 750 hours in Real Estate professional typical activities. The easiest and most effective way to accomplish this is through obtaining a real estate license. This is a perfect strategy for an individual with a part time job, or a spouse/stay-at-home parent. These people can maximize their hours more quickly with the ability to focus their extra time single-mindedly on real estate. It is not required, but highly recommended to track all of one’s hours working in real estate. This can be as simple as keeping an Excel spreadsheet with the date, the number of hours and the description of the real-estate-related activity being performed. In order to qualify, it is required that more than 50% of one’s time is spent working in a Real Estate trade/occupation.
Typically, REPs (Real Estate Professionals) are:
- RE Brokers/Agents
- Re Operators/Managers
- RE Leasing Agents
Now that we’ve covered Depreciation to some extent, it only makes sense to touch on Appreciation as well. There are 2 “flavors” of Appreciation. On the one hand, you have Market Appreciation, e.g., what happens with the market in general. On the other hand — the hand we will be focusing on — you have Forced Appreciation, which refers to the product of the work of a fund manager or a sponsor/operator. This latter form of appreciation is a benefit of investing in projects or funds that take advantage of the Forced Appreciation Strategy. Regardless of what happens to the market — whether it goes up or down — if the forced appreciation is executed well, the value is created by the sponsor of the project or the fund manager. In a classic multifamily property, the forced appreciation comes by way of internal (living area, kitchen, floors, etc.) and external (roofing, siding, landscaping, etc.) renovations that increase the value and appeal of the property. As a result of these renovations, rents increase, which, in turn, increases Net Operating Income (NOI). In turn, the value of the property increasing right along with it. Said another way, the net worth or your property is increasing — without your paying taxes on the increase!
Backdoor Roth-IRA Conversion
Another strategy that many savvy investors are considering today is a Traditional to Roth-IRA Conversion. Why are they doing this? Simple — withdrawals from a Roth IRA account are free. Unlike the scenario with a traditional IRA account, you do not have to pay taxes when you withdraw from a Roth IRA. There are a few ways to convert. The traditional way to convert is a cash conversion via an IRA custodian. This is perfectly fine, but it does require paying taxes on the income of the dollar amount you’re converting. The attractive alternative to this traditional conversion is converting while the money is invested into a project or a fund.
Imagine you invest $100,000 into a value-add fund or syndication, wherein demolition is the necessary first phase of the project. Obviously, as a consequence, the value drops. Furthermore, operating a heavy value-add fund or syndication generates substantial losses as project likely have a lot of normal expenses such as mortgage, taxes, insurance, repairs / construction, and no income stream. As a result, initial returns are often negative. It isn’t until later, when the value-add work completes, that returns become positive. This phenomenon (due to its appearance when depicted on a graph) is referred to as the “J-Curve.” If an investor converts their IRA at the low point of the J-curve, — when the value of the investment has dropped — with good documentation/justification (an appraisal from an IRA custodian), the investor would be obligated only to pay taxes on the fair market value at the time of conversion. Circling back to our example, if the $100,000 you initially invested has dropped to $70,000 (due to the demolitions and subsequent drop in value) — you would only pay taxes on that $70,000. (note: please consult with your CPA or tax advisor before attempting this strategy.)
A Little Bit About The Tempo Growth Fund LLC
The Tempo Growth Fund LLC is ideally designed for several of the aforementioned strategies. The fund invests in a number of value-add projects — such as Hotel-to-Multifamily conversion — that are perfectly suited for these tax-saving endeavors. For example, if an investor wanted to convert their traditional IRA to a Roth IRA at the bottom of a J-Curve, the Tempo Growth Fund — or another, similarly designed heavy value-add growth vehicle — would be perfectly suited to execute such a conversion. The fund also passes along significant depreciation benefits to investors. The fund features substantial tax efficiency (as depreciation passes) which can be extremely helpful. Beyond this, most of the income in this fund comes, on the backend, in the form of Capital Gains — the most tax-advantaged type of income. To go into a little further detail…
Here are a few of Tempo Growth Fund’s most attractive features:
- A Closed-ended Fund
- Target-annualized ROI = 12-18%
- 5-7 years term
- IRA Friendly
- 8% Preferred with
- 80/20 Class A ($1,000,000+)
- 70/30 Class B ($250,000 – $999,999)
Are you looking to save on your taxes? Do these strategies pique your interest? Want to learn more about Tempo Growth Fund LLC? You’re in luck!
Mike and Alina will be hosting a LIVE WEBINAR on Tuesday, May 4th @ 7pm ET, wherein they will explore examples and dive into further detail on Tax Saving Strategies for Real Estate Investors. Make sure your schedule is clear and click here to sign up!
Want to learn more about us? Reach out to us at Team@TempoFunding.com for more information about investing with us. You can also schedule a time to chat with Alina, our Investor Liaison Consultant by clicking here.
Enjoy our Content?
Also, be sure to check out my latest podcast episodes:
- 090: ‘When the Tax Tail Wags the Wealth Dog’: How Chasing Tax Benefits Can Derail your Investment Strategy with Ryan Parson
- 089: Tax Deferral Methods To Grow Your Business With Brett Swarts
- 088: Real Estate Investing During The Pandemic With Kathy Fettke
Thanks for reading,
Mike Zlotnik CEO, TF Management Group LLC
This newsletter and its contents are not an attempt to sell securities, nor to sell anything at all, nor provide legal, nor tax accounting, nor any other advice. The presenter is a private lending and real estate fund management business, and the information represented herein are purely for educational purposes and represents the opinions of the presented. Prior to making any investment or legal decision you should seek professional opinions from a licensed attorney, and a financial advisor.
TF Management Group LLC (TFMG) is a Real Estate fund management company that specializes in both short-term debt financing for real estate “fix and flip” projects, and long-term “value-add” equity deals.