buy-borrow-and-die

“Buy, Borrow, and Die” – A Real Estate Tax Planning Framework

When someone I have met for the first time finds out I am a tax consultant, they often ask me for a good tax reduction strategy. I sometimes respond with “buy, borrow and die”[1] . Initially, they think I am being flippant. However, there is a lot of meat behind this concept; especially for the real estate investor and operator.

Buy –

A basic principle of tax planning is to buy and hold assets as they appreciate tax-free. An added tax benefit of owning improved real property is the tax depreciation[2] deduction. The owner of the property uses the depreciation deduction to shelter the taxable operating cash flow from the property. There are techniques available to maximize and accelerate the depreciation deduction. First, the property owner wants to maximize the cost allocable to depreciable improvements and minimize the value allocated to non-depreciable land. Usually the IRS looks to the property tax assessment records. However, other valuation and allocation methods can be used to maximize the depreciable cost. Second, cost segregation[3] can be employed to accelerate the depreciation deduction.

Borrow –

Debt is a powerful tax planning tool. However, leverage should always be employed with an abundance of caution. There are different types of debt and a variety of ways to utilize leverage.[4]  Used in the right way, debt can be a powerful tool to reduce or eliminate income and estate taxes, and maximize after-tax wealth accumulation. Debt has the following tax advantages:

  • Less “after-tax dollars”[5] are required to acquire the property.
  • Leverage can be used to acquire more real estate that appreciates tax-free.
  • Interest expense is generally a current deduction that can offset income taxed at ordinary rates. If property held for investment is eventually sold, the gain is normally taxed at lower capital gains rates.
  • As the property appreciates in value, debt can be used to monetize the asset without creating a taxable event.
  • Debt can be used to reduce the taxable estate.

Die –

Okay, so most people are not as enthusiastic about this part of the plan. The good thing is, they were able to legally avoid income taxes during their lifetime. As an added income tax benefit, when a taxpayer dies, they pass on a “stepped up” basis to heirs wherein the tax gain miraculously disappears. In other words, there is no income tax on the real estate appreciation accumulated during the owner’s life, and their heirs can sell the property with no taxable gain. If the heirs decide to keep the property, they get to depreciate the property all over again based on the stepped up tax basis.

Buy, borrow and die is one conceptual approach to tax planning. In our next blog we will discuss the “SAVANT” system. SAVANT is an acronym for how tax planning fits into business and investment decisions.


 

[1] I first heard this provocative phrase from Edward McCaffery, a tax law professor at the University of Southern California Law School

[2] Depreciation is the gradual charging to expense of a fixed asset’s cost over its useful life

[3] A cost segregation study identifies and reclassifies personal property assets to shorten the depreciation time for taxation purposes, which reduces current income tax obligations. Personal property assets include a building’s non-structural elements, exterior land improvements and indirect construction costs. The primary goal of a cost segregation study is to identify all construction-related costs that can be depreciated over a shorter tax life (typically 5, 7 and 15 years) than the building (39 years for non-residential real property).

[4] For Example, Donald Trump has filed for corporate bankruptcy four times, in 1991, 1992, 2004 and 2009. All of these bankruptcies were connected to over-leveraged casino and hotel properties in Atlantic City, all of which are now operated under the banner of Trump Entertainment Resorts. He has never filed for personal bankruptcy — an important distinction when considering his ability to emerge relatively unscathed, at least financially (“Fourth Time’s A Charm: How Donald Trump Made Bankruptcy Work for Him”, Forbes 4/29/2011). I am not recommending this as a strategy. However, note that Mr. Trump may not have had such a favorable result if he personally guaranteed the casino debt. Also he may not have had to file corporate bankruptcy if he used less leverage.

[5] “After tax dollars” is the amount of money that an individual or company has left over after all federal, state and withholding taxes have been deducted from taxable income.

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