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investment property

Frugal Living, Lifestyle, Taxes and Investing

The Hidden Tax: Transaction Costs

Living a frugal lifestyle sometimes lends to a false sense of security. We take all the financial precautions to increase our savings rate and invest in broad-based index funds. Before long the net worth starts reaching for the stars and we feel good about ourselves.

Now, we decide, might be a good time to get a second car or trade for a new one. Moving to a smaller home, across town or to another state or country, sounds tempting and easy to do with your nest egg growing faster than you are spending.

Your habit of caution is well defined. There will be no stupid tax in your future! Careful planning leads to good decisions. You look before you leap.

Then it happens and you never even saw it coming. You paid a stupid tax without even realizing it was there.




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The Mistake Obama and Trump Both Made

Eight years ago Barack Obama was hitting full stride in his first term as President. The economy was in tatters. The banking industry was only beginning to come to terms with the level of bad loans they had on their books. The largest insurance company (AIG) required a bailout to survive; the largest domestic automakers needed a bailout to preserve jobs; nearly every bank required assistance and every money center bank actually took assistance to weather the storm. This easily could have been another Great Depression.

So what did President Obama do in this desperate environment? Why, tackle health care reform, of course.

Every President has a short window of opportunity to build a coalition at the beginning of their Presidency to pass a key piece—or if lucky, several pieces—of legislation. These are the tough issues, things like major infrastructure investments and tax reform.

President Obama chose health care reform. The country needed, and still needs, major health care reform. The country also needed economic stimulus. Badly! Unemployment was high, income inequality was expanding at a rapid pace, while the nation’s bridges, roads, sewer lines and water works crumbled.

It was an honorable effort, but a tactical error that prevented any additional large, and necessary, legislation. (Yes, I am aware banking reform was passed along with other legislation. This will all become clear in a minute as I illustrate why the most pressing legislation never happened.)

And President Trump is making the exact same mistake.



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Living with a NIMCRUT

Recently I discussed my net worth and how I went from a poor farm boy to an eight figure net worth. To keep the discussion moving I glossed over a few issues, most notably some of the vehicles I use to invest and protect my net worth from taxation. My sole mention of using trust instruments to protect net worth and save taxes caused several requests to hit my email inbox. People wanted to know more about trusts and how they can be used to super-charge net worth, provide guaranteed income, reduce taxes and protect against lawsuits stealing your hard earned money.

To which I mentally replied, “Is that all?”

A tax discussion on trusts turns into hard core tax planning quickly. Discussing all trusts is beyond the scope of a simple blog post and even beyond the scope of an entire blog. Too many variables are involved. What we can do in a single blog post is cover one trust topic enough to help you decide if it is right for you and get you to the right people to facilitate the process.

Today we will discuss an animal called the net income makeup charitable remainder unitrust, or NIMCRUT. It sounds like a derogatory name you would call someone in the heat of battle. Instead, the NIMCRUT, or even her sister the CRUT, is the perfect tool to get a massive tax break now, avoid paying capital gains on highly appreciated assets, help the charity of your choice and get a nice income stream—some of which might be tax free—for your entire life or a set number of years. Sound like fun? Then read on.

The Problem

Highly appreciated assets face a large capital gains tax rate, currently topping out at 20% for federal, plus more in many states. To make matters worse, the alternative minimum tax is calculated using a 22 ½% capital gains rate.

Moving money from a long-term, highly appreciated asset to a higher income producing asset requires a serious tax haircut. The reason for the transfer of investments frequently revolves around income. The old asset has appreciated several fold, but has a low or no current income distribution. To access your net worth requires sale of a portion of or the entire asset, triggering a taxable event.




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Investment Commercial Real Estate Profits and Pitfalls

Residential investment property is forgiving for the most part. Professional managers exist in most markets and except for the very worst of conditions it is possible to fill most apartments even if it is not at a profitable rate.

The number of residential properties available is large and unloading a single family home or duplex is fairly quick and simple. Many economists consider a six month supply of homes on the market a healthy balanced market.

Things get slightly less forgiving when you graduate to multi-unit apartment complexes. There are fewer to select from, they cost significantly more, there are more tenants to manage and it usually takes longer to sell the more expensive buildings. Not as many investors can swing a multi-million dollar deal or even finance one.

It might not be intuitive, but the more expensive the property the more likely it will be purchased as a cash deal. Big buildings carry big responsibilities and risks, but also are coupled with larger rewards.

Generally the rules are straightforward with residential rental properties. Lease contracts are generally standardized in most states and the landlord/tenant rules are clearly defined. The laws tend to protect the tenant more than the landlord. Still, the landlord, if she bought right, should turn a tidy profit.

Real estate investors usually start small, a single family rental or duplex, moving up to multi-unit buildings later. Most landlords stop at the duplex level with maybe a 4-plex or so tossed in for good measure.

The next leap takes courage. Financing a large deal is more difficult. Only a select number of banks are willing to fund a seven figure project. You need good credit, experience and a documented plan. At the end of the day the multi-unit complex is still a forgiving animal in the real estate world.

Then there is the commercial property.




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Fighting the Profit Train

One of the mantras of the FIRE (financial independence, retire early) community is the owning of income property. With rare exception, investors do it all wrong, taking on extraordinary risk for no reason.

Side gigs are handled the same way. Whether you run a full-fledged business or a side gig, you probably make the same mistake real estate investor’s do.

Americans love to invest at home. There is a tendency for people from all countries to focus their investment dollars in the domestic market. The comfort of understanding the local business climate clouds the investor’s judgment. American’s are the worst. For decades I have recommended 70% S&P 500 index fund/ total market index fund and 30% international index funds for my American clients. This is still weighted heavily toward U.S. companies. The diversification in broad-based index funds with a third of the portfolio in international is a good mix in my opinion. Small business owners and real estate investors rarely make such a sound decision.




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Applying Cost Segregation on a Tax Return

A few weeks ago I wrote about the massive tax benefits to investment property owners and business owners who also own commercial real estate using a cost segregation study. Some of you took me up on the offer and now are up for a significant tax reduction. Then the problems started. I didn’t anticipate the large number of tax professionals who didn’t know how to handle cost segregation studies on a tax return.

Before you call your tax preparer bad names, know most tax professionals rarely, if ever, see a cost segregation study in their office. When the rules changed a few years back I doubt 1 in 100 accountants handled their client tax returns correctly as it pertained to the repair regs and tangible property rules. The good news is the changes only required certain actions in the first year of accounting method changes. The bad news is that most tax professionals don’t know how to handle a cost segregation study on the actual tax return when a client comes in with one. Not to worry. Your favorite accountant will spill the beans on how to get it done right.  No picking on your accountant either. This is advanced tax planning and tax law can be miles from tax application at times.

Tax professionals will find this helpful; taxpayers should find value, too. Knowing of a tax advantage is only worth something if you can apply it. There are two major issues surrounding cost segregation studies: tracking the components/elements listed by the study and taking full advantage of the additional depreciation allowed.

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Get a $100,000 Gift from the IRS Using Cost Segregation

In the past I shared ideas that saved you $10,000 or more per year. I also shared numerous other ways to reduce your tax burden by smaller amounts. And, of course, retirement accounts and the Health Savings Account provide plenty of tax reducing power, too.

That is all small change compared to what I share today. Today the gloves come off. Today you will learn how to peal massive amounts off your tax bill. I am talking about taking six figures and more from the IRS and putting it into your pocket legally. No jail required.

This program applies to investment properties and businesses with a building. All other can safely skip today’s post. Or you can read it and share it with someone who owns rental properties or a commercial building. You will make a lifelong friend if you do.

What is Cost Segregation?

The risk I take is getting too technical. You don’t need to understand all the deep tax terms to use this strategy so I will avoid technical jargon as much as possible.

The first thing you need to know is that cost segregation only works on buildings with an original cost basis (purchase price, plus additions) of $250,000 or more. Residential income properties, commercial properties, additions and build-outs all work. This does not include the value of the land. Example: You but a property for $450,000. Land value usually comes in around 20% of the purchase price. Therefore, $360,000 is for the building. Cost segregation works on the building portion of a property only. Also note, the higher the value of the property, the more tax benefits cost segregation provides.

The IRS says you have to depreciate a residential rental property over 27.5 years and commercial property over 39 years. This means you put a lot of money down upfront without a tax benefit.

The IRS says you can use cost segregation to separate the components of the building for faster depreciation. A typical building under cost segregation may have about half the value reclassified as 5-year property, 20-25% as 7-year property, and the remainder as either 27.5- or 39-year property.

Pictures around this post show some illustrations of tax savings with cost segregation.

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Deal Breakers for Investors and Business Owners

The most dreaded words a salesperson can here are, “I need to talk it over with my accountant.”

Accountants have a reputation for breaking deals. Behind the scenes we are actually called ‘Deal Breakers’ as a derogatory term. But the name isn’t fair. What we really are doing is protecting our clients.

The investor or business owner already thought of all the things that can go right. Accountants throw cold water on the deal by examining the numbers. They don’t always stand up to the hype.

And then there is my last blog post where I play a Sad Gus with robo-investing and Betterment. I think a lot of people really believed the tax benefits were much higher than they really are. There are real benefits, just not as many as some would have you believe.

That is where accountants shine. If you are going to serve your client you had better have the stomach for laying the truth on the line, even if the client doesn’t want to hear it.Continue reading

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