Listening to an experienced accountant explain a tax situation sounds like easy work even when the words and numbers sound strange. It is rarely so easy connecting the dots, however.
The Tax Cuts and Jobs Act (TCJA) passed December 22, 2017 changed how you are taxed in ways we haven’t seen in over a generation. New opportunities to reduce your tax liability were opened, but the real advantages are hidden from plain view. It takes an experienced hand to ferret out the unexpected connections that can make or break your financial condition.
Today we are going to explore a thought experiment where we outline how the TCJA can super charge your tax savings. But first we have to tell a story.
A Chance Encounter
I spend my days researching the tax code for ways to help clients (that’s you, kind readers) reduce or even eliminate their tax liability. Some ideas are old and well-known. Others are somewhat unique in their application to the specifics of a client’s needs.
Our story starts with a longtime client and a real estate agent.
In my office there is a family limited partnership with several pieces of commercial property. One of their leases was coming up and I was unable to determine an accurate lease rate. Market rates are changing as real estate values climb.
Since it was my job to advise my client on an accurate lease rate I had my assistant call multiple sources around town to get an appraisal. My client was also interested in selling if the price was right.
After serious vetting we settled on a real estate agent with a history of success in the local commercial real estate market.
I was pleased the agent was wiling to provide a market analysis (a quasi appraisal) without fee. The agent provided the service and hoped to get the business if he did a good job.
My client also had a mini-mall with a vacancy. The current listing agent wasn’t able to sell or lease the unit in years. I convinced my client to get an assessment on this property as well.
The agent preparing the market analysis was fast, efficient and informative. The tenant of the first building we needed to update the lease with also wanted to buy. There was no need for the agent (or the fee) to sell or lease this property.
As luck would have it the tenant of the first building wanted to buy. My client was happy.
I felt it was fair to list the second property with the agent as a gesture of goodwill for his work assessing both properties. The agent did good work, followed up and was professional.
My client dragged his feet. The second building had one vacant unit with nobody working it now. I had to light a fire under my client.
After weeks (it was really a few months) of pleading my client finally relented and decided to let the agent offer the property for lease and sale.
The agent sent his assistant to pick up the paperwork the same day it was signed.
It Pays to Talk with People
It was getting to be 4:30 when the agent’s assistant showed up. I explained we sold the first building and didn’t need his services for that building. The assistant was good with that and understood our reasoning.
I then explained a unique tax strategy (a cost segregation study) that I shared with the buyer of said property. I mentioned to the assistant the buyer would save over $100,000 in taxes even though he was closing on the last business day of the year. These tax saving would be the result of a $300,000 first year deduction for owning the property a single day of the year!
People who know me understand how quiet I tend to be (dad, stop laughing). You can’t pry a word out of me.
Okay, I enjoy deep conversation that leads to massive results.
As I talked with the assistant I explained how the TCJA made it easier than ever to never pay income tax again. As we talked I kept building a bigger and bigger pyramid of tax savings strategies involving real estate. Many of these strategies would help the agent’s clients.
Needless to say, he took several of my cards. I reduced taxes for local businesses by several million dollars in less than one and a half hours. That short conversation opened a can of worms that will benefit this accountant’s communities for years to come.
And it was only possible because of the chance encounter with the agent. I knew all these things, but until that moment I hadn’t put the pieces together. Months of relentless research gave me the tools to excel at helping my clients in their tax matters as it pertained to the new tax laws.
And this is where you come in, kind readers.
The Gift that Keeps Giving
What I am about to share is merely a thought experiment. I will use large and round numbers because it is easier to understand that way. Many of these ideas will work for people with lower incomes. But in the end I will show you how you can have a million dollars in gains, pay no tax on said gain and end up with a $400,000 loss on your tax return you can use to offset other income.
Do I have your attention yet?
I hope so. This is new; this is novel, but it will work. The tax law is clear. What I am proposing can reduce your income tax to zero with extra deductions is case you have other income you need deductions against!
You will also seriously consider selling income properties you currently own to use this information. In fact, you may want to pass on like-kind exchanges (the old, and still usable, way to defer taxed on real estate) in the future. But I’m getting ahead of myself.
The best way to understand my strategy is see it in action step-by-step. Because there are several ways to apply this strategy I will provide multiple solutions to the word problem.
Before we start I need share a few things that have changed in the tax code. Like-kind exchanges are a way to defer the gain on business or income property you sell by transferring the gain to a replacement property. While this tax strategy is still available for real estate, it is nixed in 2018 and after for business property. Capital gains from other investments are always taxable, until this year.
I sometimes get complaints that my tax strategies don’t apply to everyone. This is true. Not everyone can benefit from every strategy. The goal is to provide a framework that is understandable and modifiable for personal needs. While this works best for property owners with large gains, it can be tailored to lower incomes as well. It also assumes you have capital gains as that is our starting point. Wages and business income are not the driver of this strategy. If you want to reduce business income taxes you can read this. Wage earners should probably focus on retirement plan first as these provide significant deductions.
We start with capital gains since real estate and the stock market have been climbing for a good decade now. The gains in these investments are huge and a real problem to diversify without incurring a large tax bill.
Real estate might seem easier since like-kind exchanges (sometimes known as 1031 exchanges) are still available. But a like-kind exchange requires a replacement property be identified within 45 days and closed within 180 days. And all your money stays in the replacement property to receive the tax benefit. (You can borrow against the equity of the replacement property after closing, but this costs you interest.)
With this in mind we need to deal with either large unrealized stock market gains or a piece of real estate with a large gain over basis (purchase price plus improvements minus depreciation).
For our example we will consider a stock investment (mutual fund, ETF, index fund, individual stock or other asset with an unrealized gain) with a $1 million unrealized gain and/or a piece of real estate with a large gain if sold.
The good news is that ALL capital gains are now super easy to avoid with a Qualified Opportunity Fund. I will not get into all the details of Opportunity Funds since I published recently on the topic in detail, available through the link.
For our thought experiment we can realize a capital gain from a real estate or investment sale and avoid reporting of the income currently. A million dollar gain can be deferred to 2026 and only 85% is taxed at that time with deflated dollars.
But Opportunity Funds are more than deferred taxes with a small tax reduction enhancer! All the gains within the Opportunity Fund (not the original gain, but gains on the capital gains invested in the Fund) are tax-free if held for 10 years or more.
Another benefit of Opportunity Funds over a like-kind exchange is how much needs to be reinvested. With the like-kind you need to buy a replacement property of equal or greater value to defer tax on all gains. Under the new rules only the GAIN needs to be reinvested in the Opportunity Fund within 180 days. The basis you can do whatever you want with.
Example: You have a duplex you bought for $200,000 and depreciated $50,000. You sell the property for $500,000. You can pocket your remaining basis ($150,000) and invest the taxable gain of $350,000 in an Opportunity Fund, avoiding any tax on the gain until 2026. (We will disregard depreciation recapture in this discussion so the examples don’t get muddy.)
Example: You bought $100,000 of Apple stock and now want to diversify without tax implication. Your Apple stock is now worth $1,000,000. You sell the stock, invest the capital gains in an Opportunity Fund and use the original $100,000 for whatever you want. Only 85% of the $900,000 capital gain will be taxed after 7 years and all the profit the $900,000 generates is tax-free after 10 years in the Opportunity Fund.
A Better Idea:
Selling your appreciated assets (investments or real estate) is only the starting point on your journey to tax-free freedom. Remember, you only deferred most of the gain. And if you have other income (business income, wages, dividends, interest or rental income) in need of deductions to avoid income taxes currently, you need another step.
Enter, real estate.
I assume you are not adverse to income property ownership in this stage of our game.
In our above examples we have large capital gains we deferred gains on and either $100,000 or $150,000 of basis we could do whatever we want with. I suggest buying a good piece of income property.
By good income property I mean a property that cash flows. You may need to buy something further from home base and utilize a property manager. This is probably a good thing regardless.
Without the necessity of replacing a property with an equal or greater value you have more choices. A half million dollar property doesn’t need to be replaced. Instead, with your basis from the sale, you can buy an income property that cash flows right out the gate and get more tax benefits.
Let’s jump to the cost segregation study again. You can read more with the link, including who I refer my clients to for a cost segregation study.
For a cost segregation study to work the property involved needs to have an original basis (generally the purchase price) of $300,000 without considering the value of the land.
The basis from the original sale in your pocket is perfect for a down payment on the property we are eyeing.
Example: Assume we buy a new income property (or properties) for $700,000. Under current tax rules a cost segregation study will turn approximately $300,000 of the purchase price of the building into a deduction the first year!
What this means: Think about this for a second. You sold a stock or rental property with a massive gain. You deferred/avoided tax on the complete capital gain by investing said gains in an Opportunity Fund. Then you decide to use the basis from the original investments as a down payment on an income property and conduct a cost segregation study. This equates to a $300,000 deduction on your tax return while avoiding tax on the capital gains! If you are a real estate professional or use grouping you can use this deduction against other income still being taxed.
If you buy right now we will include this free pocket calculator. Keep it even if you return the product. It’s our way of saying. . .
Okay, I got carried away.
But I’m not done. there is even more!
Why You Want to Sell NOW!
Up till this point we played with big numbers with a focus on real estate. Deferring capital gains from any source is simple under current tax rules. A $30,000 mutual fund gain is easily deferred/avoided just as easily.
But what about landlords. If you own real estate now you might want to consider selling!
Remember our thought experiment above where we defer gains and apply cost segregation studies on new properties? If you already own real estate with gains you have an additional tax planning tip.
Cost segregation studies are possible on properties you held for years. The tax benefits are still tremendous.
However, unleashing gains on existing properties is a powerful way to spike cash flow!
More isn’t always better so I always recommend property managers for the day-today tasks of property management. Your job is to buy the right properties at the right price. Rinse and repeat. The manager/s should handle the rest.
Example: In this example we will start with three income properties you owned for 10 years. We’ll assume you have a combined basis of $500,000 on these properties with a market value of $1 million. A cost segregation study on each of these properties is inadvisable (each property is less than $300,000).
If you keep the properties your cash flow grows only as fast as market rates for the three properties. You pay tax on all the profits after expenses.
Unless you sell!
That’s right. Sell the three properties. Invest the capital gains in a Qualified Opportunity Fund and use the $500,000 basis as the down payment for a larger value property where a cost segregation study will work well.
Assume we find a multi-unit complex for $1,000,000. The half million capital gain is in Qualified Opportunity Funds avoiding tax while the other half million is available for any use you want. Whether you use all the excess money from the previous sale or borrow more funds to purchase the complex, you will realize around a $400,000 deduction under current tax rules due to the cost segregation study. This massive deduction is available to reduce your other income property profits or income from other sources in many cases.
If the three income properties were throwing off $4,000 a month, the complex should be doing the same or more and the cost segregation study will generate a deduction to eliminate the tax on these profits. (Your taxes would be low or zero in this example if you had no other reportable income so other factors must be considered before you proceed.)
Example: Here is another example worth considering. Let’s say you’ve owned a property for decades and depreciated the property to the land only. The property is throwing off oodles of cash flow, but it is all taxed because there are few deductions (mortgage is paid off,too) and no remaining depreciation.
Capital gains from the sale would go to a Qualified Opportunity Fund to defer/avoid taxes once again. Buying another property to replace the lost cash flow opens the opportunity for a cost segregation study.
I didn’t use numbers in the last example for a reason. The idea is to provide a framework you can tweak to your personal needs. The idea is to keep cash flow pouring in while reducing or eliminating income taxes from any and all sources. The only way to do that is with a new piece of property.
Taxes are complicated and getting worse. Today’s thought experiment is not meant as a definitive guide to eliminate taxes. Rather, my goal was to help you think differently about taxes and strategy.
The tax code may seem straight forward, but the real benefits come from putting the pieces together. I asked my Facebook followers if they would like a program to reduce their taxes to zero. The response was overwhelming. I asked the same group what taxes they wished they could avoid taxes on this year. Capital gains came up often.
We didn’t cover every type of income or every income level. The idea is to plant a seed in your brain so it can grow.
The TCJA is a massive piece of legislation. The advantages are hard to grasp in the basics and putting the pieces of the jigsaw puzzle together in a way that benefits you is even more difficult.
What I provided above should have been a pleasant exercise. You can see how the new puzzle pieces have increased the opportunities to reduce your tax liabilities.
It might be a good idea to read this a few times and even save it. Share it with friends (enemies don’t deserve this level of tax savings). You might even want to use a highlighter on key points:
- Sell with no current capital gains tax using Qualified Opportunity Funds and
- Buy quality real estate where a cost segregation study works well to eliminate all other income taxes.
Below I include the regular list of additional Wealth Building Resources I attach at the end of posts over the last half year or so. You can find cost segregation links easily there from all current posts.
Finally, don’t be afraid to think outside the box when it comes to taxes. Now is the easiest time to reduce your tax liability in over 100 years. Use this opportunity to fuel your net worth.
These good times are unlikely to last forever.
More Wealth Building Resources
Credit Cards can be a powerful money management tool when used correctly. Use this link to find a listing of the best credit card offers. You can expand your search to maximize cash and travel rewards.
Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?
Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.
Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.
QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.
A cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregations studies work and how to get one yourself.
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.
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.
Basics of a NIMCRUT
A NIMCRUT is really a charitable remainder trust with a unique income makeup feature.
Once a NIMCRUT is established, assets are transferred into the trust. The trust sells the asset/s and since it is a charitable trust pays no tax on the gain. You personally did not sell the asset so you also pay no tax on the gain, nor is there anything to report on your personal tax return.
Because you donated to a charitable trust (a qualified nonprofit organization (the beneficiary) gets the remainder at some point in the future) you also get a tax deduction on your personal tax return. The tax deduction has to be discounted for the present value of the future gift. In the old days we used tables provided by the IRS to calculate our deduction; today we have handy online calculators linked at the end of this post.
Example: A 53 year old donating $1 million of stock to a NIMCRUT with a basis of $100,000 would avoid paying capital gains tax on $900,000, plus get a current tax deduction on Schedule A (subject to limitations) of $239,894. Any unused charitable deduction is carried forward up to five years.
The tax avoided and the additional deduction is a great start. BUT, you also get an income stream from the trust. Remember, this is not a straight forward donation to a charity. The charity gets the remainder at some point in the future. You choose how much income per year you want before the charity takes possession of the gift. The Tax Code requires at least a 5% rate with higher amounts allowed (up to 50%). A common rate is 7% and is used for our example above.
You also choose the term, either life or up to 20 years. The longer the term the lower the tax deduction on Schedule A.
CRUT or NIMCRUT
There is a difference between the two. Generally, a NIMCRUT only pays you from income, excluding capital gains. A CRUT can dip into the corpus to fund payments. The NIM part of a NIMCRUT means you can catch up, if you will, the missed portion of past payments.
Since many investments do not throw off a 7% income available for distribution, two investments rise to the surface: real estate and annuities. The rent is available to distribute to the annuitant (you).
An annuity inside the NIMCRUT can control the flow of funds. Income must be distributed up to the rate listed in the trust document. Previously missed payments are “made up” in years when the income supports the payment.
Since tax is due on all or most distributions, your personal tax situation might require more control over when you get paid and hence pay tax. The annuity inside the NIMCRUT can delay paying out; therefore, no income is available for distribution. When you need the money you can take your distribution by having the annuity pay out income to the NIMCRUT. (Special thanks to Putnam Investments for presenting the annuity strategy at a H.D. Vest Financial Services conference during the mid 1990s.)
Assessing the Benefits
Let’s add up all the benefits of a NIMCRUT before disclosing a few negatives.
First, you avoid capital gains on a highly appreciated asset. Most taxpayers will avoid 15% to 20% long-term capital gains tax with a NIMCRUT, plus state capital gains taxes. In our example, $900,000 of avoided LTCG adds to a $180,000 tax reduction at the 20% LTCG rate.
Next, you get a present value charitable deduction on Schedule A subject to normal limitations for the future charitable contribution. Our example shows a $239,894 deduction.
Assuming a 7% rate and no increases in value of the NIMCRUT investments, you will receive 140% of the original investment over 20 years. If the investments inside the NIMCRUT increase, your payment will too. Our example should generate $1.4 million over 20 years.
Normally you are the trustee so you determine the investments inside the NIMCRUT.
You control in a limited fashion when and how much you get paid. Most income from a CRUT or NIMCRUT is taxable. A portion of a CRUT might be exempt.
At the end of the term your named charity receives the remainder.
To keep the kiddos happy you can purchase a single premium term life insurance policy for the amount of the charitable gift with the tax savings from avoiding the LTCG tax. This is done with an irrevocable life insurance trust (ILIT).
If you die while the NIMCRUT is in effect the remainder goes to the charity, is added to your estate, but your estate takes an equal amount as a charitable deduction.
In sum, you avoid LTCG taxes on unrealized asset appreciation, get a deduction up front, receive income over your lifetime (single or joint) or a set number of years up to twenty, support your preferred charitable causes and give the kiddos a healthy legacy to boot.
Every strategy has pros and cons. A NIMCRUT is irrevocable. This means you can’t later change your mind. Well, you can change your mind, but there is nothing you can do about it. You must plan in advance for a NIMCRUT. The issues and process is complex and set in stone once in effect.
There are annual reporting requirements. At minimum a Form 5227 is required. Sometimes a Form 1041 or other tax forms are required. Few tax professionals are versed or experienced in preparing complex trust tax returns. You will need to find one who is.
You must have an attorney to draft the trust documents. No shortcuts here. An experienced estate attorney will smooth the process and inform you of issues pertinent to you while avoiding IRS scrutiny.
Large investments are required and large unrealized LTCG increase the tax benefits of the NIMCRUT. Realistically, anything less than $100,000 of asset value or $50,000 of unrealized gain to transfer to the NIMCRUT is inadvisable. $1 million of highly appreciated assets and greater put into a NIMCRUT yield excellent advantages to many high net worth taxpayers.
A CRUT usually allows corpus to be used to pay the annuitant, but yields fewer tax benefits. A NIMCRUT must have income from which to pay the annuitant (you). Many NIMCRUTs exclude capital gains from income in the trust documents.
The Next Step
It’s not all roses when planning a trust. Trusts are nor for everyone. They are powerful estate planning tools to carry out your wishes and serve your needs. It takes time and there are legal fees.
I intentionally left out a massive amount of information to keep to this post’s story line brief. Additional research is required even before you contact your estate attorney.
Here is an interesting article on NIMCRUTs you might find valuable.
Here is a NIMCRUT calculator. You can play with the numbers to get an idea of the tax benefits available. The same site has excellent calculators for a variety of CRUTs and CRATs as well.
You can read a bit more from the IRS on the issues discussed.
Finding a qualified attorney is an issue for many readers. Here is an article by a company that helps people set up charitable trusts. (Not an affiliate.)
Finally, if you want to read extensively before committing to a discussion with an attorney, here is a good book on the subject from Amazon.