Unlock the secrets to smart real estate investing and learn how to maximize your returns while minimizing your tax burden. In this episode of the Market Call Show, we uncover the essential strategies for achieving a balanced portfolio by diversifying your assets into business ventures, real estate holdings, and secure reserves like cash or gold. We'll reveal how to strategically rebalance your investments without the heavy tax implications, even if a large portion of your net worth is anchored in real estate. Plus, we analyze the effects of inflation and interest rates on property values and rental income, underscoring the significance of after-tax, inflation-adjusted returns.
Navigate the complexities of capital gains and depreciation recapture taxes with our expert insights on 1031 and 721 exchanges. Discover the advantages and potential drawbacks of these powerful tax deferral tools, which can help you transfer property into like-kind assets or Real Estate Investment Trusts (REITs). These strategies offer not just tax benefits, but also avenues for diversification, liquidity, and improved estate planning. However, be prepared to give up some control over your properties. Listen in to gain a comprehensive understanding of how these tactics can aid in managing tax liabilities and diversifying your real estate investments in today's dynamic market.
Show Highlights
In this episode we'll talk about:
- Diversifying your assets into business ventures, real estate holdings, and secure reserves like cash or gold.
- How achieving a balanced portfolio can help mitigate risks associated with market fluctuations and economic changes.
- Learn strategies to rebalance your real estate investments without incurring heavy tax implications.
- Understand the complexities of capital gains and depreciation recapture taxes and how they affect your net worth.
- Analyze how inflation and interest rates influence property values and rental income.
- Focus on after-tax, inflation-adjusted returns to better gauge the true performance of your investments.
- Explore the benefits and drawbacks of 1031 exchanges to defer taxes by transferring property into like-kind assets.
- Discover how 721 exchanges allow for moving assets into Real Estate Investment Trusts (REITs) for diversification and liquidity.
- Understand that while these tools offer tax deferral and estate planning benefits, they may require giving up some control over your properties.
- Consider how REITs can provide quarterly liquidity and simplify estate planning through unit-based ownership.
- REITs offer a diversified portfolio that may include sectors like multifamily housing, storage, and healthcare, which are more recession-resistant.
- Evaluate opportunities to reduce real estate concentration and invest in other areas like businesses and reserves.
- Implement a low-turnover investment strategy to maximize your after-tax rate of return and minimize costs associated with frequent exchanges.
- Recognize the challenges in commercial real estate post-COVID, such as high vacancy rates.
- Identify resilient sectors like self-storage, healthcare, and education that offer more stability and growth potential- Be mindful of not letting real estate become too dominant in your portfolio.
- Diversify across different asset classes to protect against market volatility and economic downturns.
- Stay informed about quality investment opportunities in both real estate and the stock market.
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Transcript
00:00 - Louis Llanes (Host)
Now I want to talk a little bit about the challenge that we get with capital gains. So now you've got this real estate, maybe you're lopsided and you have a lot of real estate. Maybe you want to retire soon and you want to have, or you just want to get more balance in your situation, or you want to diversify. Maybe you have too much concentration in one piece of real estate, or you might just be tired of renting it out and dealing with all of the issues of being a landlord and you want to have more of a passive approach.
00:30 - Intro/Outro (Announcement)
Welcome to the Market Call Show where we discuss investing wisely and living well. Tune in every Thursday to Apple Podcasts, spotify, google Play or subscribe on YouTube.
00:46 - Louis Llanes (Host)
Hi, I'm Louis Llanes. This is the Market Call Show. Today I'm going to be talking about real estate, mainly because people are talking about real estate all the time and many people are in a particular situation, so I thought I would address that situation. So I was thinking about what the name of this podcast would be. One idea was navigating real estate investments and capital gains tax, but really this is all about maximizing your after-tax rate of return on your real estate and then really meeting your objectives.
01:17
I heard about an old sage saying that is thousands of years old, and the gist of the saying was that every man should split their assets into three categories. One would be business, and then the other one would be land or real estate, and the other one would be reserves, which could be many different things, like cash or money market or CDs or gold things that are more reserve oriented. And I was having a conversation with somebody about this, and I've actually been lately seeing this same conversation over and over again. So I thought it might be something helpful for you or somebody listening to this podcast. And the situation is like this so I've been investing in real estate for a long time and over the years, my real estate has appreciated in value and maybe I put money in my 401k and other investments as well. But my real estate is worth a lot more than my other stocks and stuff because I put most of my wealth there and it is compounded and maybe I had debt on it and been paying the debt off over time. So now I've got this real estate and now if I look at my net worth, I'm kind of unbalanced. Unlike that sage advice that's thousands of years old that said you need you should have balance, I'm unbalanced right now because I've got all this money in real estate. Then maybe the real estate is paying income, but maybe it's not enough or maybe there's other reasons that you want to have less of it. So the question becomes how do I do that without paying an enormous amount of taxes? So that's what I'm going to be talking about today is some strategies on dealing with that can be very effective for you.
02:51
So the real issue that comes to play here is the balance right. Why should you have the balance? Well, it's kind of self-explanatory, but back thousands of years ago the sages were basically saying you should be prepared for any type of situation that is going to happen around you and you know nothing has changed. You know you have booms and busts and you have changes in government regimes. You have all sorts of crazy things that can happen, and that's why having reserve makes sense.
03:22
You know, if you want to have some gold, some hard assets, some assets that are, you know, really sound and steady, but you also want to be in business too, because business has the growth aspect and you know business can adapt to whatever is happening in the world. So you know, like, for example, right now in artificial intelligence, there's some businesses that are making a tremendous amount of profits. It's not just and that's just one example, but it could be many different businesses. It could be a private business, your own business, or an investment in private businesses, a portfolio of private businesses, which I'm also a proponent of doing as well, because then you can take advantage of other businesses that are doing well, that are in the private markets. It could also mean public businesses, and so that would be stuff on the stock exchanges, where there's tremendous amount of opportunities that come to play there. So you've got your business, you've got your real estate.
04:13
The beautiful thing about real estate is that you have rental income, hopefully from your properties, and then that rental income can hopefully go up over time. One of the challenges that happens, though, is that if inflation goes up, interest rates go up faster and inflation can go up faster than your rents, and the actual value of that real estate cannot be as attractive as it seems, and this is something that I've been noticing happening a lot, in fact. This morning, there was an article in the Wall Street Journal talking about how the average rental increase has been much lower than the inflation rate, and so you're really seeing that keeping up with inflation isn't always there. So, and typically, when you look at the valuation formulas for any asset, it's the present value of the cash flows of that investment, and that present value has a discount rate which is tied to interest rates, so if interest rates go up, then your hurdle rate goes up. That means that you need to have a higher rate of return to justify owning that asset at a particular price, so that could actually hurt asset values, and I know that sounds counterintuitive to some people, but that is kind of how it works. So what really matters is what happens after tax, right? What is your net worth increase after tax and inflation, which is kind of the silent wealth killer that is really affecting everybody right now due to many different factors which we won't go into right now.
05:37
So the other stool on that right, we talked about the reserve, gold, cash, things like that, and then we talked about real estate and we talked about business. Actually, I covered all three, so that's good. So so we wanted to. I want to talk a little bit about why you want to have balance there. Now I want to talk a little bit about the challenge that we get with capital gains. So now you've got this real estate. Maybe you're lopsided and you have a lot of real estate. Maybe you want to retire soon and you want to have, or you just want to get more balance in your situation, or you want to diversify. Maybe you have too much concentration in one piece of real estate, or you might just be tired of renting it out and dealing with all of the issues of being a landlord and you want to have more of a passive approach with real estate and maybe bring down the amount of real estate that you have, maybe increase the reserve or increase the stock or business orientation of your portfolio.
06:30
Okay, so capital gains is the big issue. There's really two main parts of that tax situation. Again, it's capital gains, and you probably have a long-term capital gain in your real estate, but you also have this nasty little thing called recapture of depreciation that comes into play. So recapture depreciation is just simply, you know, as you've been depreciating that asset over time, you've been getting a tax break on it, most likely, and now when you sell it, you have to kind of re undo that basically, and so there's a reversal of that. You recapture that depreciation and that generally hits income taxes rate, income tax rates. That can be ugly.
07:11
So many people know about what's called a 1031 exchange. A 1031 exchange allows you to go from one piece of property to another piece of property. They call it a like-kind exchange. They don't have to be exactly alike, it doesn't have to be like an apartment building to an apartment building or residential real estate to residential real estate. It just needs to be like-kind. There's some definitions and I'm not going to get into the details of all the definitions, but you basically go from one property to another and you defer that tax.
07:41
And there's some things that you have to avoid. You have to avoid what's called boot, which is, you know, if you have debt on it after you've sold it. You have to, you know, look at the total value of that real estate. You cannot benefit tax-wise from the leverage. You have to make sure that those values are in line. So, anyhow, that's a great way to do it, but the problem is that you're just going from one piece of real estate to another single piece of real estate most of the time. So what a lot of people like to do is to one great strategy is to actually put yourself in a situation where you can take the real estate that you have right now 1031 exchanges into another property, but that property then gets contributed into through a 721 exchange, an up REIT or a REIT, and this is a great way for you to transfer that property into a diversified portfolio of real estate. That may be more attractive, and this is in today's environment that is probably advisable for a lot of people actually. So you know, obviously everybody's situation is different, but it could make some sense to do that, because here's the benefit to this If you 1031 exchange into a single property and then that property is actually being put into this REIT, if the REIT has a sound investment strategy for the environment, then now you have access to a larger portfolio, that is, you're diversifying that across different types of assets multifamily home, maybe storage or medical and other types of areas that are doing well or maybe are more recession resistant.
09:19
A lot of the commercial real estate property. As you well know, after COVID and after all the changes that have happened there, they're not as attractive and a lot of people are avoiding that. There's a big shift happening there in that area, in the commercial real estate. But there's other areas where they're actually more recession resistant and they have steady rents that can go up. For example, recently in Arizona there's a student housing off-campus student housing where the students that go to universities they need to have a place to stay and they stay off campus. Typically the parents who are the ones who take these rents out are very well capitalized. Their average income is high somewhere around the range of $300,000, very low defaults and you have reasonably good yields and safety there. Storage could be another area Medical facilities obviously medical is stronger. So, having those alternative areas and diversifying a single property most people I've been running into either they have residential real estate or maybe they owned a business. They're selling their business and they need to sell some land or some other things and they just really need to get into income producing property because they have a big part of their network tied up into that.
10:32
There's many situations that can happen, but the concept is exploring that option to go from a 1031 exchange of your existing property, selling it 1031, exchange it into another property that is slated to go into a REIT and the REIT is in a solid situation to benefit over time and is more conservative. That could be a good way for you to do that, and here's the other kicker with doing that is you can also generally get more liquidity Once you're in that REIT. Oftentimes there's quarterly liquidity, so that you can basically peel some of your money out of real estate in general and maybe get less lopsided and invest in other things, in business and in reserves and other things that you need to do, still generating an income stream with that portion of your capital, but slowly moving your way out, and then thus you are paying less in taxes longer term because you're spreading it out. There's other strategies, too, that you could do, where you're doing a deferred sale and basically you're realizing that gain and recapture over time. That's another way to do this, but I do like this concept of 721 exchanging into an upread.
11:42
It is a difference. There is a difference from that than a 1031 exchange, and there's pros and cons there. The pros are you get the tax deferral. The pros of 721, you get the tax deferral. You get the diversification. You also get liquidity. There are some estate planning benefits. You could more easily parse that out in units, because you're basically getting units of this REIT. When you do this, you can, you know, in an estate planning scenario, you could easily divide that across your heirs, rather than having a situation where you have this asset and it's not easily divisible.
12:19
Some of the cons, though, is you do lose some control over the property. So if you really feel like you have to have total control over a particular property or something like that, or all of your property, then you will not like this strategy, because you're basically delegating some of the management. So it's really important to have good, vetted out REITs that you're dealing with, but these you know. If you're, if you understand that you maybe you don't know everything. If you're in a situation where you're not that savvy or you don't feel like you have the time to do all the research and all the everything else. This is a good way for you to actually, through using professional managers who this is all that they do that allows you to get their expertise as well. So, but that is a downside if you have to have a lot of control.
13:02
I mean, I'm thinking of one person. I know, a friend of mine, and I just feel like she wants control so much that at least at this stage in her game she's younger that maybe this wouldn't work for her. But you know, as you age, you know you may not have as less of a desire to do this, or you may just realize that, hey, I need to be smart and delegate some of my money to other people that know what they're doing and diversify, and maybe I need to use this as a way for me to diversify into more businesses, especially if we have more opportunities developing. You want to have, which I believe is going to happen. It just, you know, the probabilities of opportunities in business being higher is, in my mind, always great, even with all the stuff that's going on in the global economy. But then again, you know, if you have reserves too, you can also put money there. You just want to be prepared Anyhow.
13:51
So we talked a little bit about pros and cons and I want to address some of the liquidity and income needs issues. So when you go into a REIT, typically there's quarterly liquidity, like I said, and when you're moving that real estate in there, you're going to have more, more liquidity that you could take from it and you also have an income stream that you're getting. Typically, that income stream comes in monthly, which is nice, and the structure is different in terms of how it's taxed. And we're not going to go into all the differences, but suffice it to say that it may be a situation where you could save a lot in taxes, maybe even millions of dollars. I mean, I had a little conversation recently and it became clear to me that this literally means at least a million dollars in tax savings for this person over time.
14:32
So the current real estate opportunities that I wanted to discuss is you know, I kind of touched on it a little bit, but you know, given the current state of the commercial real estate, you know, vacancy rates is an issue post COVID and alternative real estate sectors show more resilience, like self-storage, because that's driven by life events such as downsizing and relocation or dislocation, and we're likely to have more relocation, dislocation, given technology, ai, differences in demographics and where people are moving in the economics of real estate in general being expensive in other areas. So you're likely to see a strong demand there. Healthcare is the other area we have growing demand due to the aging of population and that gives you much more stability. If you're doing your homework, potentially you could have better, more stable returns in the healthcare sector. And then on the education side, it's stable demand.
15:27
It's supported by increased college enrollments. We've literally been seeing, even though you know a lot, you hear a lot of people talking about how you know you shouldn't go to college. College isn't worth it. It's not a good investment. You know colleges are adapting. Right now. You're seeing new colleges that are coming up to adapt, to change and you know, just to make kind of highlight, that I've got 17 year old twins and they just recently went to a particular meeting of a university, the University of Austin actually, which is they're not accredited yet but they have some really sound, smart people there and they have an incredible program that they're developing there. You're just seeing a lot of adaptation and the other more traditional schools are going to need to adapt because you know, we know there's some needs that are going to be changing there. So we are seeing increasing enrollments and education is always important and you know the parents that are paying for this are usually good credit quality.
16:19
Now recession resilience sectors. You know I kind of explained why self-storage healthcare and education are more recession resistant. There are REITs that specialize in that and they have opportunities sometimes where you can invest in a particular property that is slated to go into those REITs and that allows you to do what I'm talking about here 1031 to 721 and help you get less lopsided, get more diversified, better return risk profile for your overall wealth, save a lot of taxes. That's a good thing to do. Speaking of taxes, I want to talk a little bit about compounding returns over your costs. So one of the things that you see some advisory firms do is they tend to 1031 exchange properties and then they roll them over and roll them over and if you look at all the fees and costs of doing these types of things the 1031s it actually hurts your compounded rate of returns because the costs really impact you. So a lower turnover investment strategy can maximize your after-tax rate of return estate component of your portfolio and then, you know, going into the stock world, which is always, in my opinion, equities are.
17:32
You know, I teed on stocks and in business, so I have a little bit of a affinity to that relative to real estate. But I recognize that real estate has benefits as well, and I've often tell people there is no perfect asset class. That's why we diversify, so we want to have diversification in strategies and asset classes and, given the current environment right now, where people have made a lot of money in real estate and they're basically in a situation where they need to, or it's advisable for them to, get more balanced and to save on taxes, this is a great way to think about doing that, and we have ways that we help our clients do that. So I want to just recap the key point here. You know, don't let real estate become too out of whack in your portfolio. You know there is no perfect asset class and there are some significant downsides to real estate.
18:24
Real estate does not always do good in an inflationary, rising interest rate environment. Only certain types of real estates do does, and you may or may not have that type of real estate. So if that's the case, maybe it might make sense to think about a change. And then don't forget stocks. A lot of people are down on stocks, but you know what business it's about. Businesses. Don't think about the stock market. Think about companies within the stock market. So I always talk about focusing your attention on the quality, valuation and sentiment or technical conditions of a particular each company, and you can find opportunity out there, especially for long-term investment and getting your income needs done if you're about to retire. So, anyhow, I thought this might be interesting because it just seems like I'm running into a lot of people right now who are in this situation. I hope you find this valuable and thank you for joining me and we'll talk to you later.
19:23 - Intro/Outro (Announcement)
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19:37
If you enjoy the content of this episode, please share it and comment. The information in this podcast is general in nature and does not take into consideration the listener's personal circumstances. Therefore, it is not intended to be a substitute for specific, individualized financial, legal or tax advice. To determine which strategies or investments may be suitable for you, consult the appropriately qualified professional prior to making a final decision.