Is tax-free investing a myth or is it possible? In this article we will answer that questions and put the controversy to rest.
One of the big things a lot of investors miss when analyzing their portfolios and making decisions based on that is the after-tax performance of their investments. This could potentially be huge as the ROIs will be significantly affecting when viewed as compared pre- and post-tax. And if the overall goal of your investing in higher returns (no one can deny that that at least makes up a large chunk if not the majority of the objective of the activity of investing) then we ought to pay attention to this point and to its results.
Check out this article where we give a run-down of how taxes can impact your overall investing returns.
Scenario #1: Conservative
Let’s think of a scenario where you’re investing $200,000 USD into the stock market with an annual return of 9%. That would get you $18,000 a year in profit.
But what about taxes? Let’s say that with state and federal combined, you would be subject to 20% capital gains rate. That would skim $3,600 off your profits and leave you with $14,500.
Stock Market Vs. Real Estate
Now let’s take those same $200K and put them into a real estate investment. Let’s say the total value of the rental is $400K and you’ve put in half as a down payment. The annual return on your $200K is 6% which gets you $12,000. Now you might want to say to me – “hold on, you gotta be fair! Where is the after-tax return like how you did with the stocks?” The beauty of it is, the 6% is based on the cash return, which is before considering accounting deductions that will impact the tax situation. Because of depreciation, you payed $0 on taxes on the $12,000.
Even then, the stock investment looks like it might fare better overall – $2,500 more or a 1.25% advantage – but let’s examine what happens when we factor in the full implication of accounting deductions.
In addition to paying $0 in tax on the $12,000, depreciation will get us a total deduction of $23,500 for the year.1 That’s an additional $11,500 to use against your salary or business income which will reduce your tax liability.
On an average tax bracket of 30%, that would mean a $3,450 savings on taxes you would have otherwise had to pay without the deduction, for a total of $15,450 or 7.7% return on your real estate investment.
Now even though the numbers might not be that dramatic, you can start to see how considering taxes in your investing decisions could make a huge difference and we ought to include these considerations within our investing analyses.
Scenario #2: Aggressive
Now let’s entertain a scenario with a little more leverage in it – which will also give us more risk, of course, which we must also be mindful of!
Let’s say that we invest $100,000 in stocks and get an 11% return for $11,000.
Under the same capital gains tax as last example of 20%, we would get an after-tax return of $8,800.
Now let’s saw that we purchase a $400,000 rental real estate property with $100,000 down and we get a 8% return of $8,000 annually. Again, depreciation makes it so that the $8,000 would be tax free.
Then, the total depreciation for the property would come out to $23,500 a year, which gets us an additional $15,500 in depreciation deduction which you can use to offset income.
On a typical 30% tax bracket on income, that would give you $4,650 in tax savings that you would otherwise have to pay on your income.
Final result: a $12,650 or 12.65% return on your real estate investment. In pre-tax profits, the stock investment would not be as far from the real estate, at 11%, but considering the after-tax return of 8.8%, that’s a considerable advantage of the real estate over stocks.
Leverage Adds Rewards - Magnifies Risks
Of course, the higher return from the real estate is largely due to a higher amount of debt being taken out to purchase the property, which in turn creates a larger depreciation deduction and a lower initial cash investment. Risk must also be a factor within your investment decisions.
One of the greatest investors of the 20th century, Benjamin Graham, suggested that businesses with low debt have a higher margin or safety than businesses with moderate or high leverage. He further suggested to invest in businesses with 50% or lower debt to asset ratios.2
The bottom line: YES, TAX-FREE INVESTING IS POSSIBLE.
We would be wise, though, to take into account multiple factors within our investment decisions, including taxes, debt and leverage, and our appetite for risk vs. a more conservative approach, as well as the important role of diversification, before we start jumping the gun!
References & Notes:
1. Based on an accelerated depreciation strategy using a 30% cost segregation with those assets depreciated over 15 years on a double declining balance schedule and considering 10% of the value of the property going to land. For more information on the topic of a cost segregation study go to this video were we go over that strategy in more detail. For more information on the double declining balance strategy check out this article.
2. Graham, Benjamin. The Intelligent Investor. New York: 2003, HarperCollins Publishers Inc.