By Scott Melbrod
As our American financial system gets more and more complex, financial planning is growing in importance. There are over 300,000 financial advisors in the U.S. (1) now offering services to help people manage their money and get ahead financially but a large percentage of them just want to manage your money and charge fees on that money. Frankly, we feel they care more about the fees they charge and less about what “advice” you need.
Financial planning is not a one-size-fits-all service, as some advisors would like you to believe. There are fine nuances and stark differences in the needs of people depending on their family situations, industry participation, and life goals.
In our practice, we have found that real estate investors, developers, and landlords have very unique financial planning needs. They don’t care about the latest investment product or fad and more than anything, they need forward-looking, tax-focused planning. Here are some important financial planning considerations for real estate investors.
Are you a risk-taker? You’ll probably answer that question positively. After all, everyone knows that real estate investing is a higher-risk, higher return activity. What about your other investments, though? Do they need to reflect that higher level of risk?
What we have found in our years working with real estate investors is that, while eager to take on risks with real estate, many are very conservative with their non-real estate assets. Most hold a lot of cash and shy away from stocks because you don’t feel the same sense of control over a fluctuating stock market as you do over your real estate investments. This approach does balance things out somewhat, but it’s still not optimal with regards to taxes and long-term returns.
Because of these tendencies, the first step in financial planning for real estate investors and developers should be investment planning and basic diversification.
In order to better utilize their non-real estate assets, we usually have our clients slightly decrease their allocation to cash while increasing the yield on the cash in their “emergency/liquidity/next deal” fund. We often advise them to add a diversified allocation of global stocks to increase the overall household diversification.
Real Estate Diversification
Diversification is important among real estate holdings as well, especially in relation to sector or type and location. Rather than having a lot of multi-family properties, it is better to add holdings focused on commercial office/industrial or forest and timberland.
Many investors own properties close to where they live. While this is convenient, it can increase risk exposure to a local economy. Institutional real estate funds can offer instant geographic diversification to the global real estate market. Again, we don’t want to change or alter your day job. Making money in real estate but taking some of those gains or money you make and investing them in “other” real estate can really help lower your risk in the long run.
With our clients, we don’t just look at their investments. We help them with business decisions, especially the tax ramifications as well. This is essential for real estate investors as they look at things like entity selection, structuring or deals and capital commitments. We ask questions like: How can landlords solve for concerns regarding liability and mitigate risk pertaining to investment properties?
All real estate investors should consider having a limited liability company and/or umbrella insurance. Both are cost-effective solutions to provide peace of mind and protect personal wealth in the event of litigation in connection with a property.
Every real estate investor should consider the advantages of being characterized as a real estate professional. Investing sufficient time in the management of your properties allows property owners to offset income with rental losses and to avoid net investment income tax of 3.8% on rental income, as well as possibly qualifying for the “Qualified Business Income” tax deduction under the most recent 2017 tax law change.
It is also important to review all cash management solutions and business lines of credit and/or property-level or portfolio financing. In addition, self-rental strategies for your office space may be enticing opportunities to look at as well.
When it comes to real estate, tax planning is vital. Buying and selling properties can have significant tax consequences and that “tax cost” can be greatly reduced with proper planning.
For property sales, you should think about:
- 1031 exchanges
- Installment sales
- Monetized installment sales
- Qualified opportunity zone funds
- Deferred sales trust
- Using outside tax loss-harvested losses
- Taking advantage of low tax brackets (10% and 15% brackets)
- Donating appreciated assets
- Donor-advised fund or foundation
- Charitable remainder trust
- Upstream gifting
- Holding until death for step-up in basis
Reviewing cost segregation is also useful in minimizing income taxes. Owners and developers who have made real estate acquisitions made within the past decade may benefit from accelerated depreciation and greater tax deductions. A full analysis is required to understand the best cost segregation strategy, which we can provide for our clients.
Whether you want to or not, you will likely have to retire someday. While most people simply throw some money into their employer’s 401(k) plan, real estate investors have more options. As a business owner, you are able to establish your own retirement plan, designed to meet your personal needs.
Some retirement plan options include:
- IRA’s/Roth IRA’s
- 401(k) profit sharing plans
- Safe Harbor 401(k) profit sharing plans
- Non-qualified deferred compensation plans
- SIMPLE IRA
- Solo 401(k) or SEP for owner-only firms
- Personal defined benefit plans
It is important to work with a qualified professional to not only determine which plan is best for you and your company but to design it in a way that complies with all applicable laws and still meets your objectives.
Everyone needs to do estate planning because no one will live forever. A well-thought-out strategy goes much further for real estate investors, however, because of the nature of and laws regarding real property.
Instead of gifting low-basis property, you can use a depreciated property as leverage to secure financing. That can provide liquidity to fund a transfer of wealth while also allowing you to preserve the step-up in basis by holding the property until death.
Using a family limited partnership as a real estate holding company is also a commonly used strategy. Family limited partnerships are multi-purpose entities that can consolidate the management of real estate investments, enhance liability protections, and facilitate wealth transfers to the next generation.
Don’t forget about life insurance! Life insurance, often sometimes with a Irrevocable Life Insurance Trust or ILIT, can be a tax-free tool to provide readily available cash to pay for estate taxes, fund a cross-purchase agreement, or facilitate property acquisitions between family members.
As you focus on your business and investments, it’s important not to forget your own household. You should develop your own personal balance sheet and cash flow plan, outside of your business. Review your spending and saving habits and make sure that what you are doing accurately reflects your personal values. Making sure all business related expenses are being taken by the business so they are deductible are huge opportunities for real estate owners/developers/professionals.
How We Can Help
Financial planning is complex and it gets even more complicated if you invest in real estate. Those complications make it even more important to work with an experienced professional who not only understands traditional investments and planning, but the unique needs of real estate professionals like yourself.
If you would like to discuss your specific financial planning needs with someone who already understands them, our team at Taxable Wealth is here to help! Call our office at (858) 221-7521 or email me at [email protected].
Scott Melbrod is the founder and CEO of Taxable Wealth, an independent wealth management firm in San Diego, CA. Working with a wide array of clients and focusing on real estate professionals, investors, and business owners, his mission is to provide impactful and targeted financial advice at a transparent cost to people who want to reduce their tax burden and minimize investment and insurance-related fees that eat away at their savings. With more than 15 years of industry experience, Scott uses his knowledge to develop solutions and structured, tailored financial plans designed to guide his clients toward financial freedom.