213: Ask Buck Part 2

Buck: Welcome back to the show everyone. Let’s get to it. First question is a written question from John Cho. John writes what is the outlook for Conservation Easements for Tax Year 2020? Okay so let’s back up a little bit. John is referring to something called a Conservation Easement. So let me explain what that is and let me just say that I’m going to simplify this for ease because it tends to be a little bit more complicated than this, but for explanation purposes, say we have a piece of land that we acquired for a hundred thousand dollars right, and say we were planning to develop it you know, and again hundred thousand dollars you know in reality these are multi-million dollar acquisitions, but say we paid a hundred thousand dollars for this piece of land and we decided you know what we’re going to develop something on this and then we realized hey you know what there is a mine on this property and it’s full of valuable stuff that we can mine and solve for a whole bunch of money so then we decide well should we do that? Should we mine that thing and sell all this or should we just you know conserve this land in this mine? Which one should we do? Well which one is the highest and best use for the property? In other words where can we make the most money? So an independent valuation can be done on the land and the mine and you can have somebody say well you know you’ve got this mine’s output, it’s worth a certain amount and if we do that, we have a certain amount of money of value that this mine has. So if we forego mining by calling this a Conservation Easement we can deduct the theoretical value of the mine’s output instead of just the value of the land that we paid for it. So as you can imagine this could be a very profitable situation you know, so for example you might have paid a hundred thousand dollars for the land but the mine might be worth you know or valued at five hundred thousand dollars because of the output so and if you don’t develop potentially you could take a deduction of not the one hundred thousand dollars that you develop you know that you actually purchased land for but five hundred thousand dollars which is the value. As you can imagine that is pretty you know significant when it comes to tax savings. So the issue is though that this is you know it’s a way you can do with these and what have been done with these. They were designed for farmers primarily right, but what’s happened is that there are large syndications of these things where you can put certain amounts of money in etc. and then you vote on the development, if you want to develop it or conserve it and if you want to conserve it, you get these kinds of deductions. Sometimes you know like I said five to one etc. Now as you can imagine, the IRS absolutely hates these things right. So congress makes the laws right, congress makes laws and this is legal. There’s nothing illegal about this but the IRS as you can imagine looks at people making five to one deductions. It’s like we hate these things and they have hated these things for years and years and years and years, yet they have continued and people have taken those deductions. Now John brings up the issue of you know legislation this year. Every year there’s talk about legislation and it just seems like it never quite gets you know changed and you know there’s clarity so that the IRS stops like you know be you know threatening people. You know to date basically the only thing that they’ve been able to do is if like you find an operator who doesn’t do it properly, they can go back and disallow those. So if you’ve found an operator who does things properly and doesn’t get caught with technical footfaults, you’ve been in pretty good shape. So this year though I will say that given the tax revenue hit that the government has taken, that there probably will be some resolution on this issue this year, according to my sources including lobbyists on Capitol Hill. And the most likely outcome, according to them, not to me, will be that there will be limitations on valuation sometimes right. Now you know typically sometimes people are seeing four or five X of the amount that they’re investing and most people tend to think that these will get limited to maybe two, two and a half, you do the math in there to see if it’s still worth it or not, but most people tend to think that any retroactive laws applying to people who’ve invested in these things is highly unlikely, but you know anything is possible. So I’m not going to tell you it’s not possible. Well I’ll tell you that I’ve participated in these things, so it’s not like I’m telling you you know that this is something that you know I would never do because I have, but part of the problem with Conservation Easements right now frankly is that we are in limbo and you know we need congress to make some decisions to let people do something that is you know ultimately lawful or not right so they need to clarify the law and to get the IRS off of everybody’s back. So like everything else whether or not you participate has to be a calculated decision. You know I talked to one guy who said you know any sort of again a lobbyist who said that you know the law could change but the chances of there being any retroactive stuff would be fought tooth and nail by any conservatives and republicans out there so that would be a highly unlikely scenario of anything happening that would affect people who’ve already invested. So his take was go ahead and invest now before any laws are changed so that you get grandfathered in. I don’t know. I don’t have an answer for you, but again we do some updates on this type of stuff within our Accredited Investor Club. So if you’re involved with that you know stay tuned and I’m sure we’ll be talking about it again.

All right next question is an audio question from Terry and here it is.

Terry: Hey Buck. My name is Terry and I own an ecommerce business. I recently stumbled upon the Wealth Formula Podcast on Youtube and love your content. So here’s an income shifting strategy I want to run by you. I have a cash balance defined benefit plan which I’ve been maxing out with pre-tax contributions around 150,000 per year for a few years. Now at some point I may want to convert the defined benefit IRA into a Roth IRA and was thinking about pairing up a Conservation Easement investment to offset the Roth conversion taxes. What do you think about this idea? Thanks. Terry.

Buck: Well as you can probably tell I planted that particular question from Terry to follow John’s question so we didn’t have to re-explain what Conservation Easements are. But you know, listen, the math on the strategy you talk about Terry in fact works and I will tell you that multiple people in our community have used you know easements exactly for the strategy that you’re talking about, and again the only caveat is of course the controversy and you have to figure out whether or not you want to get involved in these types of things. I have again invested in Conservation Easements multiple years. They’ve even been audited in years where I’ve had them and since there was nothing clearly wrong with what I was doing and it was not lawful or against anything they’ve not been an issue, but again I can’t advise you to do it or not. I’m just saying beware of the issues. What you’re talking about has been done by several people in our accredited investor group. I know if you want to you know talk to some of those people you may want to join Wealth Formula Network and talk about it some more.

Okay let’s go to the next recorded question. This is an old one, you can tell by what he says at the end.

Samir: Hey Dr. Buck. This is Samir Shah. I got your information from another investor group I’m a part of and got a chance to hear some of your podcasts. I’m an ophthalmologist, high wage earner. I love your strategies or at least the thoughts that you put behind the ideas of how to save from taxes and grow wealth I just wanted to touch base about a couple of different things that my accountant is recommending right now, just to get your perspective on it because I’m sure you’re also a very high wage earner that had to go through this before as well. The first is captive insurance companies and if you have providers or referral sources or whatnot that I could interview at least and compare them to the one my account recommended along with Conservation Easement opportunities which was another one that one of my high earning plastic surgeon friends also recommended. I’d love to talk to you. Thanks so much and hope to hear from you soon Merry Christmas.

Buck: Well of course since it’s now May somehow that question got lost, but Merry Christmas to you too. Listen, we’ve hit the Conservation Easement question pretty hard already. The big thing is there if you’re going to do it, make sure you do it with somebody who dots their I’s crosses their T’s, knows the law et cetera et cetera et cetera. Now captive insurance, okay what is that? Well let’s back up. The law provides that people are allowed to have their own insurance companies and why you might ask would you want your own insurance company? Well think about all of the stuff for which you and I have been paying insurance on through our businesses or practices for years and years but have never filed anything right think of all that money it’s a lot of money I mean seriously it’s a lot of money. What happens to that money? Well when you pay it from your business or practice of course it is the tax deduction for you but for the insurance company it is a premium on which it is not taxed it goes into a pool of money that sits there in case there are claims. Now insurance companies can of course use excess money to buy assets like real estate and that’s why much of the country’s most expensive real estate is held by insurance companies and why insurance companies as we mentioned in the context of Wealth Formula Banking are so darn stable. So what if you had an insurance company yourself right, and you pooled that risk with other people who had their own businesses and practices and so that you could mitigate the risk? By the law of large numbers yourself right what would that look like? Well your premiums for your business, your primary business would then be deducted from your income, from your revenue and when that income went into your insurance company as a premium, well it’s not income right that’s a premium. So the excess over time could then be used the way other insurance company uses that money. Maybe it could be given out as dividends to shareholders you which would be then taxed at capital gains, long-term capital gains, instead of ordinary income tax rates. Would that benefit you? Maybe, right, or maybe excess income over time could be used to acquire assets the same way insurance companies do it right? In other words maybe loans or the acquisition of of real estate etc. Bottom line is that this is the concept called captive insurance and it along with Conservation Easements is used frequently by wealthy business owners or people with medical practices etc to reduce exposure right because it is an insurance company and there are things that you may want to insure or maybe do reinsurance to complement your current insurance and finally because you do this you have the additional benefit of potentially huge savings in taxes and if you look at this and you think well gosh how’s that legal well it is legal the law in congress created says that this is legal. But guess who hates it again? Yep the IRS. Because people end up paying a lot less taxes so again this is an issue that is scrutinized I would say probably maybe less so than Conservation Easements but you gotta do this right right. You have to make sure that you are with a company that does this in a manner that, it’s real risk, it’s a real insurance company. The trouble comes with a lot of these captive insurance companies when you know they kind of don’t really even pretend to be insurance companies right they discourage any claims etc, but if you’ve got a really big captive with lots of money pooled you know you can have losses and still really not lose much of your money right, so you can really come out ahead. So it is really important that you do this right, and again I’ll tell you that there’s scrutiny here and I have had a captive in the past by the way. In fact with regard to the scrutiny both Conservation Easements and captive insurance companies as we’ve talked about are on the list of you know IRS listed transactions in other words they want you to admit you’re using these strategies so that they could be tax shelters right? Does that make it illegal? No it does not. It’s a scare tactic. In fact this year, the supreme court is going to hear a case on captives that challenges the idea that the IRS can even put a label on anything it’s a listed transaction you know because the question is do they have the authority to do that or is that lawful for them to do that, and again for me captives are one of those things that I know for this for captives in particular when they are done properly, I mean I will tell you that a lot of people had business interruption insurance through captives that they couldn’t get through their primary providers and it and then many cases save their businesses. As for companies, again I’m not going to give you advice. If you are in Investor Club though, you did see us do a webinar recently with Oxford. I really do think they are above board. They are the biggest company in this space so the huge risk pools and if I were going to do this myself again, I would trust them. Again they’re the biggest provider, largest pool, and they function like an insurance company should. You can look them up or if you’d like you can certainly just connect, you can just shoot me an email at [email protected] and I will make you an introduction to Eddie Wunderer who I know over there.

kay so next question okay next question is from Kornell and this is an audio question.

Kornell: Hi Buck. I’ve been investing in syndications real estate for the last bunch of years and I had this one big question and concern and yet I never really hear anyone talking about it. So here it goes and I’ll phrase it just as an example to hopefully make it easier to understand. So if I buy a multi-family building, let’s just say for a million bucks and we do front load depreciation and a cost segregation study and that’s how we can take 300,000 depreciation right away and then we sell that building in five years we may have to do 200,000 of depreciation recapture, but instead of paying tax on that 200,000 of depreciation recapture, we go ahead and buy another building. It’s the same thing, take another 300,000 depreciation and use 200,000 of that to offset the tax liability we had from the first building. And we keep doing that by buying more and more buildings we’re kicking the can down the road of that tax liability but to me it just seems like it’s a snowball effect that’s going to start getting bigger and bigger and you have to keep buying more and more and more at an accelerated rate just to keep up with your tax lives to avoid having to pay that tax liability and kicking the can down the road. So I look at that and say instead of defer, defer, defer and then die I mean there be a point when I’m in my 70s and 80s I don’t want to be buying real estate and yet I can’t afford not to because of the tax liability. So I just wonder how that plays out or what I’m missing if I’m not thinking about that right. Thank you.

Buck: Great question. And what you have described is what we have referred to in the show several times now as the golden hamster wheel. To summarize what you said, you can essentially defer taxes in perpetuity by continuing to reinvest in real estate to offset long-term capital gains and depreciation recapture. Okay every time you invest in a new property, you replenish your reserve of losses so that future profits and recapture can be offset right. so then you’ve created this wheel and where you’re constantly you know buying divesting and then using you know losses from other acquisitions to offset those gains etc, it’s a hamster wheel, but it’s a beautiful hamster wheel and that’s why we call it the golden hamster wheel. So the question is that you have is how do you get off the hamster wheel? Well let’s review something first. Okay the classic paradigm for the real estate investor is to buy a property and then eventually sell it and then the profits and depreciation recapture can be avoided by an exchange called a 1031 exchange right, eventually the investor gets bored of managing assets has built up a huge amount of money and does a final 1031 into some triple net assets that are hyper stable but have very little management responsibility. So maybe they buy triple net walgreens right for 30-year leases that might you know be highly stable and produce maybe five percent returns but the accumulation of equity over the years allows that person to take these relatively modest returns and turn them into a huge amount of cash flow that they can live on forever and when that real estate investor dies and leaves those walgreens to his or her heirs, all of that depreciation washes away and you start over. That’s what we call buy, borrow and die, right? What happens when you die is your heirs get those assets and they don’t have to deal with the recapture because the cost basis is then reset, you know your heirs don’t have to pay any recapture on the depreciation you have accumulated over the years okay. So here’s the thing, bonus depreciation because limited partnerships typically you cannot with major operators. You’re not going to be able to get involved with the 1031 exchange if you’re a limited partner in a syndication, but the good news is now there’s this bonus depreciation that sort of lets you do the same thing as a limited partner and can be as powerful as a 1031 exchange in many ways. So let’s take one of our investor club opportunities from last year, Sedona Ranch for example. If you had invested in this property and if you invested a hundred thousand dollars in that property, you know we did a cost segregation analysis we did bonus depreciation all of our investors received a K1 for about 100 for 106, in other words if you invested a hundred thousand dollars in that property you would have gotten a loss of a hundred and six thousand, so more than your actual investment. Not a bad deal right? Now eventually we will sell this property and limited partners will be on the hook for long-term capital gains and then depreciation recapture. Now the thing about depreciation recapture is even in the worst case scenario it’s not that bad right because what you’re able to do is on recapture, you’re taxed on a 25 tax rate. Now if you were using income that was going to be taxed at ordinary income rates of and you’re a high wage earner, you’re paying 40 you know 40 whatever, you’re paying on recapture, you’re paying 25 on that instead of the 40. So in and of itself it’s already a good deal, but it’s even better if you have a bunch of other losses waiting in the wings from other syndications you’ve invested in because then you offset the recapture and the long-term capital gains and you go in to the next hamster wheel and we have lots of people using this strategy on Investor Club and again this is what we call the golden hamster wheel . So in this scenario what if you wanted to get off of that wheel for some reason right? Well I should point out you know again you could just you could just sell and then take profits and then you know pay the tax that’s one option. Another another thing is you could just you know if you happen to die during the holding, although you don’t want to plan that necessarily, but say you died during the holding of this you know there is something called a section 754 that most partnerships have that will allow the cost basis of your errors to actually you know go back to to to baseline so that they wouldn’t have to pay recapture, so that’s another possibility. But say for example now you’re living and you don’t want to buy anything more and you don’t want to do any more syndications. Another option might be okay well once we sell it, sell and we get some profits. Let’s buy some of those triple net walgreens like those 1031 guys did and now you can do a cost segregation analysis on those you know triple net properties that don’t require any management. Hold on to those assets until you die and then of course now you’ve got the advantage of the buy, borrow, die thing again right? So that’s one of the ways you can get off if you really don’t want to buy those properties maybe you buy them and then you know you 1031 exchange into something called a delaware statutory trust and that’s sort of like a syndication for 1031 exchanges that buy real estate and give you the same you know benefits but you know the frankly I have yet to find one of these funds that looks anything worth investing in but you know listen I have also haven’t looked at them very seriously because the concept of just kind of you know putting something in a fund and not trying to grow it is not really appealing to me right now so maybe there’s some other options. Anyway suffice it to say when you get to that point, there are lots of options and the reality is that the more money you have the greater options there will be. In the meantime, I would just say hey, man ride that hamster wheel. Well I don’t know about you but I think I have had enough of answering questions for this episode. So what I am going to do is finish off the Ask Buck questions from all of those that were sitting back from episode 200 and I guess even christmas and finish them off in the next episode. So we’ll be right back.