When a prospective client is considering a Tax Deferred
Cash Out (TDCO), we inform them that we are looking
at 3 criteria to see if that particular tax strategy is a
good fit for them. While we do not provide legal advice,
we do take a close look at the numbers, goals, and
personality so that we can give them a thumbs up to go
to their legal counsel to get advice in regards to the
legal value and application of the TDCO strategy.
NUMBERS. Doing the TDCO strategy is not
inexpensive up front. It costs the seller between
6.5-6.8% of the net sales proceeds (NSP), depending
on the closing costs. The NSP is defined as contract
price minus closing fees, BEFORE deducting the
mortgage payoff if there is one. In many cases, the
capital gains tax bill is not much more than the cost to
do the strategy. We’ve seen scenarios where the tax bill
will be around $100K and the cost of the TDCO is
around $85K. If that’s the case, there is no real value to
using the tax strategy. There may be other options
available that better fit the need.
On the flip side, when the tax bill is much larger than
the cost to do the strategy, then there is a fantastic
opportunity to leverage a large part of the monies that
would have immediately gone to the IRS. Leveraging
that money for 30 years can do amazing things!
For example, let’s look at what can be done with just
the money that would be sent to the IRS for capital
gains and straight line depreciation recapture taxes.
Let’s say that the property sells for $1.8M and the tax
bill is based on $1.2M of gains. That would be about a
$444K capital gains tax bill (in CA) plus recapture taxes.
The cost to do the strategy (contract price minus
closing fees) is about $114,000. Now, that is worth it
based on the numbers because there is $330K of tax
money (plus depreciation savings) that you now can
invest. In 30 years, if you don’t touch the growth and it
grows at an average of 7% per year, you or your
beneficiaries would have about $2.5M to pay the
$440K+ tax bill. That’s significant leveraging! If you paid
the tax the following April at tax time, there is a lost
opportunity to grow the estate with a larger starting
base. Of course, the amount of taxes paid on the
growth will be determined by which tax bucket the
investments are in: tax now, tax later, or tax never. That
makes for an incredible numbers fit.
As a side note, many people have been heard saying,
which would you rather pay: 6.5% (for MIS) or 37% (to
IRS)? That would not be a proper comparison. The
6.5% could turn out to be higher than the 37%!
Why is that? The 6.5% is based on the total value of the
sale after paying closing costs and the 37% is based
only on the capital gains portion which is, in many
cases, significantly smaller. Also, the top rate of 37% is
based on a sale in CA where we have to pay a state tax
as well.
Goals. This is also a very critical criteria. The loan
proceeds that the seller receives are technically called
an Investment Business Loan. That means that the
seller is required to use the money for any kind of
business transaction or to place the funds into
investment vehicles of their choice. This makes for a
great exit strategy for those wanting to no longer own
investment properties while deferring the capital gains
and straight line depreciation for decades.
However, if someone needs to use the funds for
personal use to buy a primary residence, a boat,
immediate retirement money, etc, then that can
potentially create an annual income tax bill that would
negate the value of doing the tax strategy. Our team
includes financial services professionals so that we can
take a look at the client’s goals to see if they can be met
without creating extra income taxes each year. It is
important to take a deep dive into this area to make
sure that it is a good fit. We want to make sure the
strategy is good for the client and good for the
economy!
Personality. This might seem like an odd criteria but it
is a very critical one. Our team always takes this into
perspective when working with a prospective client.
Once someone sells an asset and employs the strategy,
it begins a 30 year journey of tax reporting of the tax
strategy on an annual basis. Starting the 3rd year, it’s
primarily copy and paste on the tax returns if used
properly and if the tax reporting forms stay consistent.
There is also an annual bill of $300 (currently) to keep 3
funding escrow accounts open. For some prospective
clients, they are very excited about the opportunity to
leverage tax money for their estate. This is a little thing
to deal with each year. That is a great personality fit. For
others, they will always feel like they are carrying a
burden while waiting for the taxes to be paid in 30
years. That is not a good fit, even if the #’s work well for
them.
The above example in the numbers criteria applies here.
If the prospective client gets excited about the
opportunity to leverage $330K that would have gone to
the IRS and turn it into $2.5M for their estate over 30
years at 7% return, then that makes for a great fit!
BTW, there is a difference between personality and
maturity. It’s best to not conflate the two. One person’s
great decision is another person’s bad decision and it’s
often due to personality and not maturity.
Wrap up. There can be a lot to determining if a tax
deferred cash out is a great fit for a perspective client.
Most of the time, prospective clients don’t know until
they have met with our team. Our team would be glad
to take the time, for free, to look at your case and see if
it is a good fit. It’s always worth it to have the
conversation. It’s never a waste of time!
Disclosure: While this is general information about capital gains tax
strategies, it does not constitute legal or tax advice. The best way to get
guidance on your specific legal issue is to contact a lawyer.
