Retain Before Return
Updated: 4 days ago
Jesse Yeats | Head of Investor Relations & Capital Raising August 1, 2023
Combining tax planning and investments with a focus on retaining income first can maximize portfolio returns more than anything else.
Since tax savings are easy to generate and can reflect a large dollar amount, tax-focused investing should be considered first and viewed as the “lowest hanging fruit”
Reverse engineering how much you should invest to reduce tax liability is the most optimal approach to maximizing retained income and investment return
Real estate investments offer the most compelling tax-focused investment options
Working in tandem with a qualified tax professional is critical in executing tax and investment strategies
RETAIN BEFORE RETURN
Investing isn’t easy. Deciding on how to invest is a multi-variable question that is highly dependent on circumstance. It is truly one of the most impactful, complex, and subjective questions out there. In an attempt to answer this question, wealth advisers often lean on the answers to key questions about liquidity needs, investment time horizon, risk tolerance, ownership structure and diversification, to name a few. Though the answers to these questions are critical in building an investment portfolio, these answers alone do not provide the holistic view needed to maximize the portfolio’s return while reducing its risk overtime. Ultimately, all investors face the same question, “How should I invest?”. Then, while keeping in mind the answers to the questions above, they attempt to wade into the waters of portfolio construction with only risk and return considerations in tow. This article will not (and cannot) answer this question perfectly for every investor, but it will outline the answer to the first question that should be asked before anything else. That question is:
“How should I invest to maximize tax savings?”
Since tax planning impacts both present-day liquidity and is the source for future investment dollars, tax planning and investing are irrefutably connected. Whether the two are considered together, or not, does not change this reality. When holistically assessing a portfolio, tax implications must be considered with every investment decision, or at least to the point that tax liability has been reduced to its maximum.
This article will conceptualize a framework that explains why combining tax planning and investments with a focus on retaining income first can maximize portfolio returns more than anything else.
Most investors focus on an investment’s return above all other points of consideration. This is understandable but flawed. Astute investors may instinctively think that an investment’s risk should be considered in conjunction with return, and they would be right, but there is something that needs to be considered even before that. What is the first thing that should be considered in constructing your investment portfolio? The answer: taxes.
Nothing interrupts compounding interest more than annual tax liability. Many investors feel at a loss (pun intended) each year as they part with 20%, 30%, or 40%+ of their taxable income. This pain compounds, year over year, as taxes inevitably become everyone’s largest living expense incurred overtime.
There is a simple solution to alleviate this annual expense, and at the same time, maximize the portfolio’s value overtime. This solution comes from allowing tax planning to inform investment decisions so tax incentives can be earned and used to offset tax liability. Unfortunately, due to ignorance, lack of strategic planning, or both, many investors miss out on these tax incentives that the government offers freely. Due to the irrefutable relationship between taxes and investments, these incentives should be viewed from an investment lens — as a guaranteed return. If the tax code says, “if you do X, you will get Y,” then the IRS legislation provides backing to the action. Though it is true that the word “guarantee” should never be used when discussing investments, it can be used in the context of tax strategy. Framing tax incentives the right way helps investors accurately value its role in constructing an investment portfolio.
Interestingly enough, tax liability and its impact to an investment portfolio isn’t commonly understood. For example, tax liability shouldn’t be viewed any differently than debt expense and should prioritize its reduction. For debtors, interest accrues until the loan is repaid, so once paid in full, they immediately save on the future interest expense. For example, if an investor is paying 20% interest on a credit card, simply paying off the credit card immediately retains that future 20% interest that would have been required at a future date. Tax liability shouldn’t be considered any differently, but is arguably even more important as 20% of one’s income probably equates to more money than 20% of credit card debt! In short, if your investment strategies and tax planning save you 20% on what you would have paid, then you just retained 20% on your money!
So why Retain Before Return? Simply put, the easiest (and potentially highest) returns available are often those that can be retained through strategic, tax-oriented investments. Referring to it as the “easiest” isn’t an exaggeration either; unlike with investment returns, where active management is required to achieve alpha above a benchmark, retained income through tax shelter strategies are guaranteed and don't require investment performance in order to receive the benefits. From the IRS’s perspective, if you qualify for a deduction or a credit, that’s it. You get the benefit. Done. There isn’t execution risk or a need to outperform. You file your taxes accordingly and it is settled. This is why incorporating a Retain Before Return framework in your investment decisions makes so much sense — it’s the lowest hanging fruit available. Doing so results in significant tax savings and does so without the need for an investor or professional asset manager to outperform the market. There are assets and investment strategies that, in addition to their return profile, provide tax incentives that can be used to offset tax liability. Considering after-tax implications, these assets and strategies provide an unparalleled risk-adjusted return profile.
FOCUSING ON TAX STRATEGY
Less sophisticated wealth advisers focus on an existing portfolio and the after-tax income to determine an investment strategy. This approach leads to overlooking investment strategies that can reduce tax liability. Advisers that don’t include tax strategy as part of their process lack a holistic approach to portfolio construction which profoundly impacts the investor’s risk/return profile. If this describes your wealth adviser and you are a high income earner, then your financial situation has most likely outgrown your wealth adviser. Many wealth advisers today include tax strategy to some degree in their process, but usually without the level of priority it deserves. Most focus on objectives, liquidity, time horizon, and risk tolerance along with other investor preferences to construct an investment portfolio. Espousing diversification to provide what they believe to be the market’s only “free lunch,” they work to create a balanced amount of exposure to asset classes that will hopefully provide the highest return for a given level of risk. Not wanting to expose their investor to too much risk, they aim to not overweight any one asset class with the intent to create an optimal, albeit subjective, balance. Notwithstanding the broad adoption of this approach and the other sub-tenants of Harry Markowtiz’s Modern Portfolio Theory, the priority in any investment decision should begin with capturing the lowest hanging fruit first, and that requires a focus on retaining earned income. Focusing on returns through non-tax specific investments and strategies is appropriate only after an investor has been able to retain as much of their income as possible. This begs the (very appropriately named) “million-dollar question” -
“What asset classes and tax strategies offer investors the ability to retain their earned income by offsetting tax liability?”
This article will summarize a couple noteworthy strategies. Importantly, both share two key features: First, these strategies are not tax avoidance schemes devised to only reduce tax liability. The underlying assets function as standalone investments as the assets can appreciate in value and produce cash flow. Note — it’s never wise to “invest” in anything where it’s clear that the tax tail is wagging the investment dog (land conservation easements anyone?) Second, the investments in these strategies produce depreciation losses that can be used to offset taxable income.
Unsurprisingly, real estate includes some of the most attractive tax incentives in the tax code. While there are some things the government is good at, housing is not one of them. The government knows this and has accordingly put a myriad of tax incentives into legislation for the benefit of anyone that invests their time or money in real estate.
There are numerous ways someone can invest in real estate. The asset types, sectors, and investment vehicles seem to be numberless and many can incorporate a strategy that provides initial phantom losses in addition to the asset’s expected returns. While there are nuances to each asset type and strategy, these are the basic steps that allow real estate to generate significant depreciation losses:
The effect of depreciation in real estate investing became a very lucrative component after the 2018 Tax Cuts and Job Act legislation. Without going into too much detail, this legislation allowed for a larger portion of the building value (the amount is determined by the cost segregation study) to be depreciated in the year of acquisition.
Real estate depreciation is considered by default as a passive loss. This means any investor can use the passive loss against passive income. This is a nice benefit, especially for those with a lot of passive income, but it can be significantly more beneficial to use depreciation losses to offset active income. Why? First, for investors who are still working, the majority of their income is active income (W2, 1099, etc). Second, and more important, active income is taxed at ordinary income rates, which can be the highest marginal tax rate depending on how much is earned. Said another way, it is much more advantageous to offset money taxed at 35% rather than 20%.
Unfortunately, passive losses cannot be used to offset active income. However, it is possible to have the losses recategorized as active losses allowing the offset. This would let an investor offset their tax liability, retain their income, and massively change the trajectory of their investment portfolio. There are a couple popular strategies used to accomplish this. One strategy is to qualify as a Real Estate Professional, which is a special tax designation that offers tax incentives to a household where at least one of the members devote the majority of their time to real estate specific activity. Remember what was noted previously about the government outsourcing housing work to the private sector through tax incentives? This is one of the aforementioned incentives, and arguably the biggest incentive available to anyone that can qualify. It is strongly recommended that investors work in tandem with licensed tax professionals in executing this strategy correctly. For investors interested in leveraging this strategy it is strongly recommended that qualifying for the designation is treated with a level of attention that is commensurate with the potential tax savings. This special tax designation can be so impactful and nuanced that it requires a more in-depth writing outside this brief overview. Another popular strategy incorporates the use of depreciation losses against active income, but rather than recategorizing passive losses into active losses, it changes active income into passive income so passive losses can be used as an offset. This strategy is much more complex and requires an experienced tax professional and estate attorney who would assist in structuring a trust. By using a trust and multiple entities for business and investment interest, this strategy enables active income to be recategorized as passive income. This can be ideal for business owners who pay themselves profit distributions and who can’t qualify as real estate professionals. To determine whether this strategy can be implemented for you, please consult with your tax advisor and estate attorney.
Gas Stations and Truck Stops
Unsurprisingly, another asset type that offers significant tax incentives comes from a sector that the government considers to be very important, namely, energy. Oil and gas tax incentives are available through a number of strategies including exploration, development, and operations. Similar to the real estate strategy referenced previously, after an asset is acquired a cost segregation study is performed to enable accelerated depreciation. However, unlike the real estate strategy, substantially more depreciation can be realized due to extra incentives offered to the oil and gas sector. Here’s a simplified example of how it works:
Acquire a gas station with cash $10M
Receive building depreciation $7M Tax savings at 35% effective tax rate $2.45M Principal at-risk post acquisition $7.55M
In this example the investor bought the gas station with $10M in cash and retained $2.45M in tax savings. The risk and return becomes even more meaningful when the asset is financed:
Acquire a gas station with cash $3M Receive building depreciation $7M Tax savings at 35% effective tax rate $2.45M Principal at-risk post acquisition $550K The above examples are simplified approximations meant to highlight the massive tax savings available through tax incentives offered to oil and gas investments. Importantly, these examples factor in the after-tax reality of the investments. The initial return from these investments (expressed as retained tax savings) provide three incredible benefits: 1. The tax savings don’t require an asset manager’s investment prowess (no execution risk) outside of the property acquisition 2. The tax savings immediately de-risks the investment by reducing the principal at-risk 3. The tax savings offer an immediate return before the underlying investment has even performed
MEASURING THE IMPACT
Below is a simplified example of how a Standard Portfolio that does not implement a Retain Before Return framework, would perform against one that does. This example includes the following assumptions: 1. Annual taxable income is $1M for each of the 5 years 2. Effective tax rate is 33% 3. Both portfolios invests $300k each year 4. Unlike the Standard Portfolio, the Retain Before Return Portfolio invests in assets that generate a 100% depreciation loss which results in $100k in tax savings that is invested each year 5. The investment portfolios grow at 10% per year
Retain Before Return Portfolio
After five years the Standard Portfolio reaches $2,014,683 in value and the Retain Before Return Portfolio reaches $2,686,244 (includes $500k in extra contributions from tax savings) equating to a total difference of $671,561 over five years. It goes without being said that the 10 year and 20 year difference on these two portfolios would be even more dramatic.
DEATH & TAXES
Over two centuries have passed since Benjamin Franklin famously quipped, “Nothing is certain except death and taxes.” While undoubtedly true, what is not certain is how much taxes are required. The amount due is fully determined by one’s life and investment choices. Readers of Robert Kiyosaki’s “Cashflow Quadrant” already know that the most favored taxpayers are investors. The numerous tax incentives made available in the tax code make it clear — nothing can reduce an investor’s tax liability more than tax-treated investments.
The Retain Before Return framework is simple conceptually, but its application should involve the oversight of asset managers, CPAs, and other qualified professionals. As is hopefully evident by now, depreciation losses can massively reduce investor’s tax liability by combining investments in tax-favored asset classes, individual tax designations, and strategic tax planning. Many investors are not aware that these tax incentives even exist. Of those that are aware of these strategies, many fail to allocate their capital appropriately. Once a holistic, after-tax view is considered when assessing one’s portfolio, it becomes clear that tax-treated asset classes deserve an allocation
in proportion to the tax liability. Once understood, the Retain Before Return framework highlights the first question that should be asked to any wealth adviser or CPA, which is,
“How should I invest to maximize tax savings?”
When asking this question, if your wealth adviser only talks about deductible IRA contributions, 529 plans, and tax-loss harvesting — this is a sign that you have outgrown your wealth adviser. If you pose this question to your CPA and they only ask about business expenses, business use of a home office, and miles driven for business — this is a sign that you have outgrown your CPA. It is unrealistic to expect advisers to specialize in everything, but those who serve high income earners need to understand these concepts since they alone have the largest impact on an investment portfolio's growth over time. Additionally it’s critical that there is incentive alignment; don’t expect an adviser to suggest strategies that negatively impact their bottom line.
Focusing on Retain Before Return strategies prioritize the lowest hanging fruit in investment returns — tax savings. It maximizes returns by redirecting tax dollars into an investment portfolio. Whether an investor is a high-income earner or is a business owner that experiences a cash windfall due to a liquidity event, this framework can have a life-changing impact on an investor’s tax liability by retaining their realized income and thus immediately providing a return to their investment. Retaining 20%, 30%, 40% in tax savings can have a significant effect on an investor’s portfolio for any year it is implemented. However, as demonstrated in the tables above, it is when these strategies are utilized every year that the largest gains can be achieved. Coupling annual tax savings within an investment portfolio maximizes compound interest and overtime will outperform any level of expected market return.
JESSE YEATS Head of Investor Relations & Capital Raising
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