The Tax Case for Real Estate
Many financial advisors try to help clients avoid whatever taxes they can minimize while satisfying IRS rules. This might begin with tax bracket management, but there are more things you can do, especially for higher-income clients.
The Net Investment Income Tax, enacted as part of the Affordable Care Act and in effect since 2013, imposes a 3.8% tax on investment income, not W-2 income, for clients whose income is already high enough to trigger it. For many married couples that threshold is $250,000; for single filers it’s $200,000. The good news is that its original goal, to reduce the number of Americans without health insurance, has been achieved. Nevertheless, to do our job we should all remember that once a client is in NIIT territory, the question stops being “How do we get a better gross return?” and becomes “How do we keep more of what we already earned?”
Real Estate Is One Of The Best Answers To That Question
It gives you two of the most powerful tax tools in the code: interest deductions, if the property is financed, and depreciation. Think of it this way: depreciation plus mortgage interest plus charitable contributions should be greater than capital gains. That’s an oversimplification, and I’ll defer to your client’s accountant on depreciation recapture when a property is sold and on 1031 exchanges when one property is swapped for another. But as a rule of thumb to keep in your head during client conversations, it holds up. Real estate gives you more levers than a plain vanilla stock-and-bond portfolio does.
Even better, if your client does not deal with NIIT, use those depreciation benefits against their capital gains. One of the most prolific problems I see these days is with clients who passionately bought index funds, held them for twenty years, and now have a large unrealized gain problem. Good for them, yes. But also: now what? You don’t just want gains; you want the right gains, at the right time, in the right account. I won’t rant on this; I have written about it before and I will probably do it again.
Real estate also can serve as an inflation hedge. Before you buy a commercial building, look at the tenant rental contracts. Many will have inflation adjustments you can put into place as the years go by. And if they don’t, when a tenant leaves, you can touch up the property and raise the rent. This becomes your shield against inflation, and it is a lot more tangible than hoping your dividend will grow exactly when you need it to. Raising rent is not the same as raising a dividend, but at least it is something you can actively work on.
Consider Losses, Gains, And The Index Problem
I have spent lots of ink writing about capital gains management, and I will probably write about it again. One of my favorite aspects of the U.S. tax code right now is the ability to carry losses forward. You really add value to your client’s tax situation by taking losses. Then, in those years when you take gains, those gains might be shielded by the loss carryforward. For the client who spent two decades buying index funds and now has a significant embedded gain problem, this is not a minor point.
Are the U.S. markets, along with their foreign counterparts, going to have bad years? Of course. This is why I advocate complementing your client’s stock and bond investments with real estate. If there is a downturn in the U.S. markets, maybe I should say when there is a downturn, your client can use both the dividends from stocks and the income from bonds, as well as the money coming in from their real estate rentals, to support their income needs. They don’t have to sell anything at the wrong time and can sidestep the sequence-of-returns risk that derails so many otherwise reasonable retirement plans.
Depending on the type of property your client buys, there will be a choice of how to maintain and manage the property. I am certainly no expert here, but two things I have seen work: help your client find a trustworthy property manager, or consider being the single point of contact yourself. You can always outsource some of the responsibilities, but keeping that relationship close deepens your engagement and gives you expertise that pays dividends, if you’ll forgive the expression, in future client relationships.
Don’t Outsource The Tax Levers
Fight the urge to delegate clients’ assets to a GP (general partner). For decades I have attended investment meetings where private real estate investments are a fixture of the agenda. I have also noticed, every time, that the economics of those conferences depend heavily on the private equity firms sponsoring them. These private companies showcase their portfolios—scores of apartments, big warehouses, huge industrial buildings. None of those asset classes are inherently bad. But what’s in it for your clients? When you hand a client’s money to a general partner, you are giving up control of decisions on depreciation and interest income. Someone else is controlling the investment. The firms you hire to manage assets are also controlling when you get documents, when they buy or sell their properties, what capital investments are made, and finally what your tax advantages will be. Our profession values keeping control of client assets, and in this context, that instinct is exactly right. Perhaps it’s time you took these benefits into your own hands.
Charitable Planning Belongs In The Toolkit
The equation I referred to as a rule of thumb above is depreciation + mortgage interest + charitable contributions should be greater than capital gains + charitable contributions. So let’s not forget the charitable piece. With standard deductions at their current levels, clients are either making very large one-time gifts or, more likely, setting up donor-advised funds. Financial planners and advisors are generally really good about promoting these strategies to clients, so I don’t want to dwell on them. But charitable giving belongs in the same conversation as depreciation and loss carryforwards. It is working toward the same goal: keeping more of what your client earned.
End With The Fee Model
All of this brings me back to a favorite subject of mine: flat fees. Set the fee based on your hourly rate and the time you expect to spend. Or dictate the hourly rate by your normal asset‑based fee and their asset size. Tell the client upfront that if they hit a certain milestone, it will be time to renegotiate fees. And don’t hand their assets to a GP and take your fee from that investment; you have no control over depreciation or interest income decisions if you do. It is the epitome of objectivity because asset‑based fees incentivize the asset, in this case private equity real estate investments, and not after‑tax client success. A flat fee incentivizes the outcome.
