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Alternative Funds Stategies

Alt Fund
Strategies

Please expand on the tabs below to view how various applications of Alternative Funds can be utilized for unique investment & tax strategies.

Strategies

We strongly recommend to our clients that not only should they have a diversified stock portfolio, but also a diversified real estate portfolio. Traditionally that is very hard to do inside a qualified plan like a 401k or IRA, not only because it is expensive to do so, but most qualified plans prohibit ownership of physical real estate inside them. Therefore, investors typically turn to REITs to obtain exposure to real estate inside their portfolios. The downside to this tactic is that a REIT does not provide investors physical ownership of real estate and the benefits that come along with it (i.e. depreciation), just shares of the company that owns the real estate. Therefore, you will see constantly volatility in price and income.

Instead, we advise out clients to carve out a portion of their qualified accounts and look towards alternative investments to achieve diversification in real estate and maintain physical ownership of the assets. Not only is that achievable with a relatively smaller commitment of capital, but many more opportunities and access to high quality properties present themselves.

DEPRECIATION GENERALLY

Real property includes both land and the things we do to improve the land, such as the construction of infrastructure, parking lots, buildings, etc. While the tax law recognize that land may appreciate in value – something most real estate investors are familiar with and have long enjoyed, the law also assumes that improvements (buildings, etc.) depreciate – we consume them, they age and become obsolete. While the assumption that real property improvements depreciate might not always hold true in actuality, it is an established principle in federal income tax laws. 

These competing processes – the appreciation of land versus the depreciation of improvements, is what often results in real estate investors achieving long term gains with low effective tax rates. The income derived from the property over many years is offset by depreciation expenses that effectively reduce the tax burden of their investment – an impact that compounds over time to create a net benefit to investors that few asset classes can match. 

Importantly, appreciation and depreciation do not involve cash, they are paper gains and losses. While the laws do not tax unrealized appreciation, they do allow the real estate investor to depreciate a portion of the improvements each year, offsetting the income produced by the property. 

Depreciation schedules have been set for most property types, broadly classifying residential rental properties (excluding land) as having a 27.5-year useful life and commercial rental properties (also excluding land) as having a useful life of 39 years. Thus, the amount of depreciation an investor can claim each year is most simply the amount of improvement cost (purchase price less land) divided by the useful life each year the investment is held until the entire improvement cost has been depreciated to zero.

LEVERAGED DEPRECIATION

Depreciation, as powerful as it is, becomes even more impactful with leverage. Most real estate is purchased with some form of loan in place – an investor buys property with a greater value than their cash on hand by borrowing additional funds from a lender. The amount borrowed and the increased value because of the amount borrowed, generally increases the investor’s cost basis in the property. If an investor buys property with greater value, the investor typically has more improvements that can be depreciated and thus more income that can be offset.

BONUS DEPRECIATION 

In 2024, an investor can elect to take bonus deprecation of 60% of the improvement cost of certain real property acquired with a scheduled depreciation period of 20 years or less along with certain other property. Otherwise eligible properties acquired in 2025 will only be eligible for 40% bonus depreciation and the benefit continues to phase out annually (20% in 2026) through December 31st, 2026, when it will drop to zero unless otherwise extended by Congress. 

Without making some other elections, most real property will not qualify for bonus depreciation because the scheduled depreciation is greater than 20 years – this is where cost segregation studies are often employed with significant impact as some percentage of every property will have a shorter useful life than the entire property (e.g., site improvements are typically 15-year assets – which include improvements like sidewalks, roads, sewers, fences, landscaping, etc.). 

A relatively small percentage of real estate has been granted a depreciation schedule shorter than 20 years and are therefore able to take 60% bonus depreciation (excluding land) without completing a cost segregation study, if acquired in 2024. Retail Motor Fuel Outlets (gas stations) are one such property class that has a 15-year depreciation schedule and therefore qualifies without the need of further engineering studies or analysis, as provided for in Internal Revenue Code (IRC) Section 168(e)(3)(E)(iii). 

BRINGING EVERYTHING TOGETHER 

In 2024, a sophisticated investor can invest in gas stations, take on leverage, bonus depreciate the non-land portion 60% in the first year and claim depreciation expenses greater than the amount of cash used to acquire the property.

APPLICATIONS 

Since the depreciation in this case is so much greater than a property will reasonably be expected to generate in cash flow over a typical investment horizon of 5-10 years, the investor would ideally be able to use these dramatic depreciation expenses to offset income from other sources – the question then becomes what income can investor offset? Buckets of income used for determining federal income tax liability include the following: 

1. Active 

2. Passive 

3. Portfolio 

Failed 1031 Exchange – An investor that is unable to complete an orderly 1031 exchange would, in many cases, have passive income that is either capital gains or recapture taxes – both of which can often be offset by depreciation expenses. An investor with a failed 1031 exchange should consult with their tax preparer to determine how the gains from sale will be characterized and if this strategy may be applicable. 

Real Estate Investors – Income or loss from rental real estate is, for most investors, a passive activity. Investors with large portfolios of rental real estate, particularly real estate that has been owned for a long time and has significant unrealized potential gains, likely generate significant passive income that is currently being taxed as ordinary income.

While converting to a Roth IRA can provide future tax-free growth and income, doing so creates a taxable event. Investing in a Fund that utilizes a Valuation Discount study can provide a significant tax saving when doing the conversion.

ROTH CONVERSION WITH VALUATION DISCOUNT PROCESS

VALUATION DISCOUNT TIMELINE CHART

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