JF1176: Tax Planning Strategies For Flippers, Landlords, And Commercial Investors with Bruce Jones
Bruce has over 47 years of experience in financial services, with an emphasis on real estate. Today he’ll share case studies with us on how he has been able to save his clients a lot of tax money. We’ll hear how a client who is a flipper is able to take his gains from a flip, use them to buy another flip, deferring the taxes until he doesn’t want to buy anymore properties. We’ll also hear about an alternative to 1031 exchanges that defers paying taxes, but does not force you to buy more real estate, along with more unique strategies Bruce helps his clients with. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Bruce Jones Background:
- President/CEO of TaxWealth, LLC, a tax analysis and solutions research company
- Over 23 years he has served owners of real estate, privately-held businesses and other appreciated assets.
- Contributing editor to real estate and other industry publications, writes on tax planning issues and speaks extensively on this topic.
- Discusses strategies for reducing taxes on flips and rentals without doing a 1031 exchange.
- Based in Orange County, California
- Say hi to him at www.capitalgainstaxplan.com or 949-627-8724
- Best Ever Book: Good to Great by Jim Collins
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Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I’m Joe Fairless, and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any of that fluff. We don’t like that fluff, we want to be respectful of your time and get to the best stuff as quickly as possible.
How are you doing, Bruce Jones?
Bruce Jones: Doing well, thank you.
Joe Fairless: Nice to have you on the show. Best Ever listeners, we’re gonna be talking about the number one expense that you have on your business – taxes. Bruce is the president and CEO of Tax Wealth, which is a tax analysis and solutions research company. For over 23 years he’s served owners of real estate, privately held businesses, and other appreciated assets. He’s a contributing editor to Real Estate and other industry publications. He writes on tax planning issues, and talks all about this topic, so we’re gonna talk to him about reducing our taxes on flips and rentals without doing a 1031 exchange, and all sorts of other good stuff.
With that being said, Bruce, do you wanna give the Best Ever listeners a little bit more about your background and your current focus?
Bruce Jones: Thank you, and thank you for inviting me to join you. This is my 47th year in financial services.
Joe Fairless: Wow!
Bruce Jones: Yeah… I’m just old. Actually, three years ago I retired from the financial planning and securities industries after being in them for 41 years. But knowing the statistics and seeing my own clients soon die after they retire, I was very selfish and I wanted to live longer, so I stayed in business. All I do is my passion, and that’s tax planning.
As you said, Tax Wealth has been around for quite some time now, and our focus is to come in in a support capacity and [unintelligible [00:02:43].20] to CPA’s, and attorneys and real estate professionals and business professionals and financial advisors of all kinds, and helping to solve their clients’ tax problems, principally real estate-oriented – when they’re selling the real estate, or a business, or some of the capital assets.
We also do a lot of work in mitigation of income taxes for those who are investors, as well as for the self-employed.
So I’ve been around a while… Tax planning is an absolute passion I have. Quite honestly, it’s a lot of fun beating up the IRS legally.
Joe Fairless: [laughs] We all live through you in that scenario. We certainly want to be in that position, or at least have a team member like you on our side. Let’s talk about reducing taxes on flips – how do we do that?
Bruce Jones: Well, with flips, unfortunately, if you’re doing really any more than probably three a year, then your flips are considered inventory; they’re not considered a capital asset. So you don’t have available the long-term capital gains tax treatments. It’s all considered ordinary income, just like you’re earning in a business, and that’s exactly what a flipping process is – it’s a business, isn’t it? So that’s all ordinary income.
There is a different approach in solving the income on flips, and it’s orchestrating actually qualified plans with some other strategies that we adhere to the qualified plans, being the IRA’s, the 401k’s and such, to where we can largely eliminate a lot of that taxable income from the flips and put everything into a tax-deferred environment by law, and then allow all the future flips that are being done with those pre-tax dollars. What the client is then doing is just really building for their future retirement on a tax-deferred environment by law, and still doing the flips.
Joe Fairless: Will you give an example of that? I am taking notes, but I want to make sure I understand it, and I’m sure it’d be good to clarify for a couple of listeners who need clarification.
Bruce Jones: Well, we can’t get into too much detail on that, because it’s for each individual’s circumstances, of course… But in general – let’s take an example. I had a client who does quite a bit of flips. He makes over $300,000 a year on his flips. He also works full-time in another vocation.
In his particular case, we set up this planning approach – he contributes the income that he receives from the flips into this approach, eliminates the taxes on the front-end, and again, as I said earlier, through the structure we’re able to take those same dollars now in a tax-deferred environment and using them to buy all of the future projects that he’s flipping. So all the gain that comes from those future flips then are all in a tax-deferred environment, and as I said, he just keeps building for the future that way. But he doesn’t have to do 100% of the income that he’s generating; he can take whatever portion that he wants.
We do need for that particular planning approach at least $100,000 of income to really warrant it, but there’s a lot of folks that are making a lot of money using flips, and they certainly qualify for this.
Joe Fairless: And contributing the income from the flips to what type of account?
Bruce Jones: It’s a combination of qualified retirement plans such as IRA’s and 401k’s, self-directed types, cash balance plans, defined benefit pension plans – any of those can be utilized. In fact, any existing plans that they already have before they put this structure into place can actually be brought into the structure and used as well, and use those dollars for future flip projects as well.
So we’re combining really at least two different strategies and combining them to come up with that kind of net effect for the client. The best part of what tax planning is about is sometimes melding different strategies together to come up with the desired impact.
Joe Fairless: And he in that scenario would be paying taxes at the end, whenever he takes that money out, right?
Bruce Jones: That’s correct.
Joe Fairless: Okay, got it. How about passive rentals? If we are a buy and hold investor, long-term, we buy something, we forget about it, we buy another, we forget about it – and by forget, we just don’t sell it – what are some tax planning strategies we can employ to lower what we pay?
Bruce Jones: Well, the very first one that should come to mind is a thing called cost segregation. It really amazes me that more people don’t know about this, because it’s been available to property owners with improved properties – apartments, single-family rentals, commercial properties or whatever it might be – since 1st January 1987… Yet most people have never heard about it.
Essentially, what this does – the law allows the property owner to segregate out or partition out certain components that are tied to the property and allow them to accelerate the depreciation on those components tied to the property, from either the 27, 5 years straight line schedule if you’re talking about apartments or single-family rentals, or a 39-year straight line schedule if you’re talking about commercial properties, and allow those components to be accelerated to 5, 7, or 15 years.
What that does – it either gives the property owner more tax benefit that can be applied against taxable gain on properties they might be selling, or it gives them an instant increase of cashflow, lump-summed often times, tax-free.
Let me give you an example – a gentleman owned an office building, bought it ten years earlier, 39-year straight line schedule, he paid ten million dollars for it; he was taking a little over 250k a year of straight-line depreciation, so 2,5 million over that ten-year spread since he bought it. Cost segregation allowed him to accelerate more than $1,368,000 in the first year. He had a combined tax bracket of 35%, and that gave him an instant increase of cashflow of more than $475,000 that he could turn around and buy more real estate with, or do whatever he chose to do with it.
And it’s instant, because this is money that he already had in hand that he didn’t have to give to the government in the quarterly estimates for that tax year. He simply reallocates it.
A lot of folks don’t realize or have no idea that they have this type of benefit available to them. So for those who want to expand their portfolio, for example, this is a great way of finding money they didn’t know was available to them to use as down payments, to buy more properties and expand the portfolios.
Joe Fairless: Isn’t’ that only for commercial, compared to an investor who has a house that’s a $100,000 house and it doesn’t make sense?
Bruce Jones: Well, there’s always that balancing point in tax planning as to whether or not something makes sense or it doesn’t. In general, if a property owner has the same multiple properties – three, four, five properties – it could very well make a great deal of sense. However, having said that, let’s say that they have one property but the purchase price was 400k or 500k; they’re probably a candidate for it, even if it’s a single-family rental.
The balancing point with this is you have to subtract out land cost at purchase, because land is non-depreciable. So you take the difference as far as structure and what the depreciable basis is based on, and then we do the projections to see if it’s worthwhile or not.
I’m in a very nice position that I can do all the projections through my sources. I’ve been working with them for nearly 20 years on cost segregation, and they’ll run the numbers for me at no cost to see what the probable benefits are by doing this, and what their cost is to do it, and meet the IRS regulations. The client then can weigh the benefits versus the costs to see if it’s warranted or not. In most cases, it is.
Joe Fairless: When you are looking at tax planning and you’re working with your clients, what are some other strategies that you like to employ that they typically aren’t already being used by your clients.
Bruce Jones: Well, let’s take an example if they wanna sell a property. Most people in the real estate ownership field, about the only choices that they know are available to them is usually a 1031 exchange. The 1031 exchange has been around a long time, since the late ’70s, under the Starker decision.
It’s well-established, it’s effective, it defers the taxes into the upleg property that you’re buying of equal or greater value. But the downside to it – or one of the downsides – in my view is that it’s very inflexible, in that if a person wanted out of real estate for example, or they needed to be out, a 1031 exchange does not allow them to do that; it forces them to buy more property.
I’m doing a lot of work with folks who own commercial properties for example, who want to sell. They want to solve the tax problem, but park the money. They don’t wanna buy right now because the market conditions really don’t warrant it. It’s a great time to sell, but a horrible time to buy right now, because the cap rates are being so low. So they’d much rather sell and park the money and wait until the market comes back to a level that is really warranting them to buy more real estate. You can’t do that with a 1031 exchange because it’s a replacement strategy, it’s not an exit strategy.
So we’re able to accommodate that need in that we can demonstrate to them and their CPA’s how to structure the sale in such a way to where we can defer the taxes literally for decades, but have the seller of the asset receive in lump sum cash, tax-free, an amount that’s nearly equivalent to the sale proceeds. That way we’re able to solve the tax problem, maximize what they get at close of escrow, and they’re in a position to where they can wait until the market gets back and then they will find the right property at the right price, without the 45-day declaration rules they have to contend with a 1031 exchange, and that of the 180-day close rule.
Right now in the market nationally – I’ve been told by commercial brokers who are very seasoned, experienced folks, I’ve been told that 50% of the exchanges right now fail in today’s market. Well, this planning approach helps solve that issue as well, because it can rescue a failed 1031 exchange.
Joe Fairless: Are you referring to a land contract?
Bruce Jones: No.
Joe Fairless: How do you structure it then?
Bruce Jones: Well, in that situation we’re utilizing what is called a dealer in the purchase and resale of capital assets. And in law, we actually reach all the way back 99 years to 1918 when the installment reporting rules came into law – what is typically called an installment sale.
Most people identifying an installment sale would [unintelligible [00:14:20].04] financing, but that’s only one way of structuring an installment sale. The very definition of installment sales or installment reporting – it simply says in law “One or more payments made after close of escrow.” That’s it. It doesn’t say how much the contract must be for, it doesn’t say how long it must be or how short. It simply says “One or more payments made after close of escrow.” That’s all.
At the time that the laws were established, the Congress also inserted the term ‘dealer.’ A dealer is simply an intermediate buyer. They buy the asset to immediately resell it. Very much like that of a car dealership – they buy the cars in consignment to sell the cars as quickly as they can and get them off the lot. It’s no different than that.
I’ve been very fortunate that for the last 9+ years now I’ve worked with a dealer in the purchase and resale of capital assets who also is the architect of this planning approach when he was an attorney who specialized in solving tax issues for real estate transactions and business transactions, reaching all the way back to 1967.
He is a Harvard Law School graduate, been in practice for all those years; he transitioned his consulting business and ended up becoming a full-time dealer about 12-13 years ago. He created this as a solution for a client that he had as attorney back in 1995, who actually did a traditional installment sale on the sale of a timber property in the Pacific North-West. He took seller carry back, was actually very happy with the transaction until he got a call from the buyer in 1995, telling him that they were gonna pay him off early. Well, he didn’t like that, because that meant that all the deferred capital gain was then due in ’95 tax year with all the taxes with it. So he contacted this attorney (our dealer we’re working with now), and he reviewed all the agreements and documents and verified that the buyer had every right to prepay if they chose to, and he crafted the very first one of these types of transactions to solve the issue.
There are now 22 years — it was a 30-year tax deferral period; we’re at 22 years of that deferral period right now, and that same program is in effect today for the very same client, unhindered and unchallenged by the IRS.
So all we’re doing, looking at it from sort of a helicopter view, is we’re combining two different things in law. We’re combining a specific type of a loan called an investment business loan, together with an installment sale. On the installment sale side, the taxes are deferred for three decades, and instead of receiving sale proceeds, which would be taxable at close of escrow to the seller, they’re receiving loan proceeds from the investment business loan, which by law are non-taxable. So it’s really a pretty simple thing to do, it’s just not well-known.
Joe Fairless: Yeah, that’s combining a couple strategies that aren’t — well, one of them… What did you say, it’s the installment sale, and what’s the other one?
Bruce Jones: Investment business loan.
Joe Fairless: Investment business loan. Yeah, I haven’t come across that very often in transactions.
Bruce Jones: Well, probably not in real estate transactions, but actually they’re very commonplace. You can go to any bank and arrange a business loan. They’re very commonplace.
Joe Fairless: Okay, I’m overthinking it then.
Bruce Jones: I think so, a little bit. But all we’re doing is taking what law has said we can do, stretching back to 1918; actually, it was reinforced by the IRS itself in 1980, because they codified into law the ability to monetize installment contracts without losing tax deferral. Then in 2012 the chief counsel of the IRS issues a memorandum in favor of [unintelligible [00:18:05].05] with an installment sale. So there’s a lot there in substance in supporting law for this, but it’s not well-known, that’s all.
Joe Fairless: Alright, so the scenario would be that you don’t want to pay all of your long-term capital gains when you sell, so you do this installment and investment loan hybrid structure. And that structure, if I’m the seller I’m receiving the proceeds from the sale, but it’s not the actual proceeds from the sale, because that would be taxed; it’s actually an investment business loan that the buyer has with me, and it’s paid out over a period of time that’s agreed upon?
Bruce Jones: No. Almost there, but not quite. What is happening is that — let me give a quick example. Let’s say that you’re the seller and I’m the buyer. We find each other, we negotiate price for let’s say a million one. So we enter escrow. Well, while in escrow, you as the seller invite the dealer to come in between us as an intermediate buyer; that’s his function. And you sell that asset in the same escrow that we’ve established, you sell it to him on an interest-only installment sale contract, non-amortized for 30 years. That defers the taxes under law, because you’re not taking constructive receipt of those sale proceeds until this contract is paid off 30 years [unintelligible [00:19:34].04]
You are introduced to a third-party private lender who now for the last seven years has been providing these types of loans for these transactions. So what you’re receiving at close of escrow are not the sale proceeds, you’re receiving those loan proceeds from the investment business loan, and they are non-taxable. They will be for nearly equivalent to what would have been the sale proceeds.
Joe Fairless: You said “I invited the dealer as an intermediate buyer” – who’s the dealer?
Bruce Jones: He is a gentleman who has a company in the Pacific North-West, who has been doing this full-time for about the last 12-13 years, but this is the same gentleman I mentioned earlier, who was [unintelligible [00:20:15].21] Harvard Law School graduate, admitted to the bar in 1967, and the very first one he did was in 1995 to solve that tax issue for that client.
Joe Fairless: Okay, interesting. This is next-level stuff, and I’m grateful that you’re walking us through it. With your experience in tax planning, what is your best advice ever for real estate investors?
Bruce Jones: Never rush into anything, because in most cases you never have to. What one really needs to do is just take their time to find out what all their options are, and there’s a lot in tax law that folks do not realize is there to take advantage of… And be sure that the ones that they do choose really fit their needs, really do fit their objectives and their goals.
Once they identify that and they prove that out, that it really is a fit, then they can move comfortably forward in implementing whatever the choices are that they’ve chosen to make.
But it’s important to take your time. Having a working knowledge of the tax code is really important, and in order to have that, you need to take the time to really see what the various choices in law are, and most people I think don’t do that.
Joe Fairless: Going back to that previous example when you’re basically deferring the taxes until 30 years, are they paid off a little bit at a time where you’re receiving the gains a little bit every year, or you’ve got to pay a big chunk in 30 years?
Bruce Jones: You pay it in 30 years based upon the prevailing tax rates at that time. However, what you’re doing is taking advantage of two things over that 30-year period. The first thing, you’re taking advantage of the time value of money. Let’s take an example – per $100,000 of taxes deferred over three decades, since you’ve deferred the taxes, you now have full use of those tax dollars to invest, don’t you?
Joe Fairless: Yeah.
Bruce Jones: So if you invest those dollars, and let’s say you just average a 5% net rate as an average yield over that 30-year period, you will have over $430,000 to pay the $100,000 of taxes 30 years later. So even at a modest, consistent rate of yield, you will have at least, if not substantially more than what you need to pay the taxes, all originating from the tax dollars themselves. That’s just pure efficiency in time value of money.
The other thing that we’re taking advantage of with this is actually inflation. Now, inflation is normally viewed as our enemy, because as inflation goes up, costs of goods and services go up, which means we pay more to get less. That’s true, but in this case the inverse is true – it actually becomes our friend, and the reason it does is because inflation will deteriorate the value of those tax dollars over that 30-year period in terms of today’s value.
Inflation over the last 30 years, for example, has been just shy of 3% as an average. So if we take 3%, projected out over the next 30 years, but apply it on those taxes, by the time the taxes have to be paid 30 years from now, in today’s dollars they’re only gonna be worth 40 cents on the dollar, assuming that 3% rate. So what the seller is doing is using tax dollars to grow, likely make a profit on top of that on the deferred taxes, pay off the taxes in 30 years at a very steep discount in real dollars in terms of today’s value… That’s an effective tax reduction cost of 60%.
Now, it’s important to understand however that what we’re doing is locking in the taxable amount. We cannot lock in the current tax rates. But if you take the current tax rates we have now, the 20% capital gains, 3.8% net investment tax, in real estate a 25% depreciation recapture, then state on top of that, here in California that can be as high as 13.3%. So if you combine all those tax rates and then project it out at 3% inflation, they’re going to have to go up by more than 250% above what they are today in 30 years to equal what they are today. In California, that would thrust us up over an 80% tax hit. It just isn’t going to happen.
It hasn’t been one CPA or tax attorney I’ve spoken with on that topic who disagrees with me. Government can allow that to happen, so it leaves the seller in a very, very good position, doesn’t it? You’re using tax dollars to grow, to pay the taxes at a very steep discount in 30 years, likely make a profit, and this is over and above all the other money that they’re getting at close of escrow tax-free, that [unintelligible [00:24:54].25] That only represents a very small portion as a whole, that reflects what the tax dollars would have been.
Joe Fairless: You know, next time we have a conversation I’m gonna make sure that I have not one but two fish oil pills, that way my brain is working at some level that it needs to be in order to have a conversation with you. This is great stuff, practical and also next-level… It’s a unique combination.
We’ve gotta move on to the lightning round – are you ready for the Best Ever Lightning Round?
Bruce Jones: Let’s go right in.
Joe Fairless: Alright. First, a quick word from our best ever partners.
Joe Fairless: Best ever book you’ve read?
Bruce Jones: Good To Great, by Jim Collins. The profile is how to approach structuring a very effective, lasting company.
Joe Fairless: Best ever way you like to give back?
Bruce Jones: Actually, we’re working on an internship program for college students to give them real business experience. That’s one way that we’re looking at that.
Joe Fairless: How can the Best Ever listeners get in touch with you or learn more about your company?
Bruce Jones: Well, I would suggest they go to our website, at CapitalGainsTaxPlan.com. The phone number to reach out at is 949-627-8724.
Joe Fairless: Thank you, Bruce, for being on the show, talking through tax planning and a scenario where if we are selling and we want to defer the gains and we don’t wanna do a 1031 because we don’t want to buy something right now, then we use a combination of an installment sale and an investment business loan, and I will let the Best Ever listeners listen to that section where we recap the buyer/seller scenario, the 1.1 million dollar transaction, and you’ll hear the play-by-play for how to do that. I have it in my notes, but I don’t wanna recap because I’m probably gonna miss one aspect of it, and it just won’t work.
I’m gonna re-listen to it myself. From a macro-level I understand it, it’s just the specifics is what I think would trip me up. And that’s why you’re involved – so if you’d like to talk to Bruce, then reach out to his company. Any last words you wanna mention, Bruce?
Bruce Jones: Yeah, I would, and thank you for that. I would encourage your listeners to create a team. Have a CPA involved, have your attorney involved. Any other financial advisors that you have available, have them involved… But bring in a proactive, trained tax planner as well. Don’t rely upon the CPA’s and accountants of the world to do tax planning, and the reason for that is because they’ve never been trained, in most situations. They’re great at accounting, they’re great at compliance with the law, but usually they’re pretty ill-equipped in how to delve into law proactively to find solutions.
So develop a team, and let each of your team members do their very best in what they do for you, and collaborate together in a synergistic fashion for your best benefit.
Joe Fairless: Thanks for being on the show. I hope you have a Best Ever day, Bruce, and we’ll talk to you soon.
Bruce Jones: I appreciate it very much, thank you.Follow Me: