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Gimme Shelter: Help clients leverage real estate's investment clout and tax advantages

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Jim Maher has never been afraid to take the plunge. He grew up on a family farm in Iowa, and that meant getting up before dawn and doing whatever had to be done that day, irrespective of the weather.

This character trait has served him well in his professional life, from beginning his career in the advisory business with Edward Jones in the 1990s, to leaving Merrill Lynch and heading out on his own by launching Archford Capital Strategies in Swansea, Illinois, in 2013.

While Maher had always advised clients on the tax benefits of owning real estate, the impact of the strategy hit home when he took the plunge himself — he didn’t just rent more office space, he decided to buy an entire building in Swansea.

Call it the intersection of pragmatism, shrewd investing and an astute tax strategy.

“We bought the building out of need, but also as an investment,” Maher says. “I just turned 50, and the building diversifies my portfolio with an income-producing asset from rents that will be a great tool to supplement my income in retirement and should also appreciate in value, especially if inflation returns.

“I’ll also be able to depreciate the whole asset, and it’s a good time to leverage capital, with the current low-interest-rate environment,” Maher continues. “Unlike a stock, where you can put 50% down to use leverage on a margin call, with real estate you can put 20% down, but you are starting to depreciate an asset that is worth five times that amount.”

What’s more, Maher plans to use cost segregation on the 20,000-square-foot building.

This allows real property and the components that make up a building, such as electrical and plumbing, to be treated as personal property, which opens the door for accelerated depreciation.

“Cost segregation is a very unique benefit and a wonderful arrow in your quiver,” Maher says. “And it improves cash flow as well.”

With interest rates at extraordinary lows and many clients nervous that the multiyear rise in stocks may not be sustainable much longer, advisers are seeking other options for free cash. Real estate offers myriad ways clients can reduce taxes and grow the value of the property.

“Cost segregation is a very unique benefit and a wonderful arrow in your quiver and it improves cash flow as well.” — Jim Maher, Archford Capital Strategies, Swansea, Illinois

Better yet, savvy planning can help leverage properties that firms or clients already use or live in. To be clear, these strategies go far beyond flipping houses, becoming speculative developers on the side or even digging more deeply into REITs.

For the most part, it’s about smart thinking, and learning which strategies benefit which clients.

Of course, price declines can be punishing (or devastating) as advisers and clients saw about a decade ago. Further, liquidity may quickly evaporate, especially in a declining market, so advisers should counsel most clients against investing assets they may need to tap unexpectedly.
Here are a number of approaches advisers are using to help clients boost gains while also minimizing taxes.

Colorado’s booming legal marijuana business helped one of Martha Awad’s clients identify a niche real estate market that also offers tax advantages.

With cannabis growers clamoring for buildings where they can grow their potent plants, demand has soared for warehouses covering 25,000 to 100,000 square feet. But this size is too big for the small players in the warehouse business and too small for large warehouse storage companies.

Awad’s client and a partner seized on an opportunity for profiting from price appreciation while also receiving tax-advantaged deductions.

They decided to build two new warehouses in Denver’s Commerce City section. Each invested $500,000 and financed the balance through construction loans.

Construction began earlier this year and is set to be completed in March. The partners expect the warehouses to have market values of $2.5 million and $4 million upon completion.

“Current projections estimate an 8% annual cash return, net of all expenses, from the ultimate rental,” says Awad, a founding partner of Cardan Capital Partners, in Denver. “The partners are actively involved in managing the business and will be able to deduct the interest on the construction loans, and later will also be able to deduct the annual warehouse depreciation and expenses for any ongoing maintenance.”

It’s a classic win-win, Awad says. “The partners expect to make a profit if they sell the buildings, and will have received substantial tax benefits while they owned them,” she explains.

Tax benefits are not limited to commercial properties. There are also many ways that clients can harvest substantial tax advantages from residential real estate.

For example, clients who want to give their home to their children but still live in it — and reduce their transfer gift and estate tax cost — should consider using a Qualified Personal Residence Trust, says James Bertles, a managing director and principal of Tiedemann Wealth Management, who is based in Palm Beach, Florida.

“It’s a great strategy for people who want to transfer ownership of their home in the future but at today’s value, reduced by the present value of his or her right to live in the house for the term of residency as set forth in the trust agreement,” Bertles says.

“Current projections estimate an 8% annual cash return, net of all expenses, from the ultimate rental.” — Martha Awad, founding partner Cardan Capital Partners, Denver

The lower valuation for the gift is based on the concept of the time value of money — namely that money or an asset available today is worth more than the same amount in the future.

Under a Qualified Personal Residence Trust, a home is transferred to the trust while the client retains the right to live there for a specified period of time.

Afterward, the client can distribute the home to children, or the house can continue to be held in the trust for them, or even for a spouse.

The gift-tax value for the home is determined by the date in the future that the children are entitled to receive it.

“The catch is that, the longer the retained term, the lower the amount of the taxable gift, but the person making the gift has to survive the term to make the strategy work,” Bertles says.

“Under IRS rules, if you die before the end of the term, the house goes back to the donor’s estate and is taxed at its then fair market value. If you establish the trust when you’re younger, a longer term makes sense; if you do it when you’re older, it’s the opposite,” Bertles adds.

One of Bertles’ clients, a retired businessman who’s 67, had a home in Connecticut worth around $6 million. The client and his wife wanted to move to their second home in Florida for tax purposes, but still use the Connecticut house part of the year.

Using a QPRT, they transferred the Connecticut home to their children for a term of eight years.

After the term ended, the home was worth $8 million.

But the $8 million home was distributed to the children at the earlier gift tax value of approximately $4 million (the home’s worth when the trust was created and funded) for an estate tax savings of $2 million, according to IRS tables, compared with what would have been owed if he hadn’t created the QPRT.

The volatility can be painful, but these funds are often used to diversify portfolios and generate alpha.
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“The client, who was in a high tax bracket, received two benefits from using the trust: the amount of the taxable gift was significantly reduced, thereby saving on future estate taxes, and, as a Florida resident, he was no longer subject to Connecticut’s much higher state income and estate taxes,” Bertles explains.

The depreciation deduction that comes with income-producing real estate can also produce a tax arbitrage for some taxpayers.
“It’s a situation that’s unique to real estate,” says Mark Blumenthal, partner and leader of Chicago-based Plante Moran’s family office practice. “The client has a deduction at one rate and can recoup the deduction at a different rate.”

Blumenthal cites the example of a client able to deduct $5,000 per year of depreciation who was able to offset ordinary income at her federal tax rate of 39.6%.

If the client sold the property after four years, she would realize a long-term capital gain of $50,000. The IRS would tax the previous depreciation deductions of $20,000 ($5,000 for four years) at a 25% rate, and the balance of $30,000 at 20%.

“The client has a deduction at one rate and can recoup the deduction at a different rate.” — Mark Blumenthal, partner and leader of Plante Moran’s family office practice, Chicago

The depreciation, Blumenthal explains, produced a tax arbitrage of 14.6% (39.6% less 25%) and put an additional $2,920 ($20,000 times 14.6%) in cash into the client’s pocket.

The ultimate economic benefit to the client, he points out, will vary based on the time value of money, taking into account the year that the client can take the deduction and the year she can recapture the income.

Tax advantages alone are “not a reason people should invest in real estate,” Blumenthal cautions. “People should buy real estate because it’s a good investment and to diversify their portfolio. But the fact that real estate is tax favored certainly makes it more attractive.”

Clients interested in philanthropy can also put the tax benefits of real estate to work.

Donor-advised funds, for example, can give clients a double tax break: Contributing appreciated real estate to such a fund could potentially eliminate the capital gains tax liability when the property is sold and allow donors to take a current-year tax deduction at the property’s full fair market value.

Donating to a private foundation, by contrast, is deductible only at either the cost basis of the property or the market value, whichever is lower.

A donor-advised fund is best suited for clients who have owned a property for more than a year that has appreciated significantly in value, says Kim Laughton, president of Schwab Charitable in San Francisco.

Ideally, the property should be easily marketable and debt-free, she adds, and the owner must be willing to transfer it to the donor-advised fund.

“A DAF is a really smart vehicle for clients who want to transition out of ownership of a property, but want to see the asset go to charity,” Laughton says. “The donor-advised fund provider manages the sale, and the donor gets the tax benefits and also will be able to determine which charities will receive money from the fund.”

Given the tax benefits of investing in real estate, there is one pitfall that should be avoided, cautions Awad, the Denver adviser.

“A lot of people ask us about buying real estate in an IRA,” Awad says. “They think they can flip homes, make a quick profit and shelter the gain or use the IRA to shelter the income from rental properties.”

A donor-advised fund is best suited for clients who have owned a property for more than a year that has appreciated significantly in value, says Kim Laughton, president of Schwab Charitable in San Francisco.

While it is true that the gains and income will be tax-deferred, any related tax deductions will be lost. For example, you can’t deduct property taxes or mortgage interest, or take advantage of depreciation.

In addition, “you can’t put property you already own in an IRA,” Awad explains. “You must purchase new property directly for an IRA, but you won’t be able to get a traditional mortgage, and so you will likely have to pay cash. And there are rules around how much you can participate: You can’t live or work on the property, and you can’t pay for upkeep outside of the IRA.

“If you use funds from your taxable accounts to pay expenses like repairing the roof or replacing a dishwasher,“ she adds, “you can jeopardize the tax-deferred status of the IRA and trigger immediate taxation of the entire value of the IRA, plus a 10% penalty if you are under age 59 ½.”

Clients ask Awad and her colleagues about the strategy of investing in real estate through an IRA “all the time,” she says.
Her answer is unequivocal: “It is just not a good idea.”

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