Consider a real estate investment over a 10 to 20 year time horizon to diversify your investments for the long term.

The following spreadsheet shows the costs and tax advantages that can be gained through a real estate investment.   Press Right Click on your mouse, select Open in New Tab or New Window.

We identified a home in the suburbs of Chicago that sold for $235,000. For illustration purposes, the home and mortgage was acquired on January 1, 2011.

The purchaser placed a down payment of 20%, $47,000, on the property and financed the remaining $188,000 at 4% for 30 years. An amortized, 30 year mortgage would require annual total payments of $10,872. An interest-only mortgage, at the same rate, would cost just $7,520 annually. Since we would expect price appreciation over time and are not averse to paying mortgage interest (as it is a tax deduction), we would favor the interest-only mortgage if we could obtain it.  In this case, we will show the interest only mortgage.  We can pay down principal if and when we wish.

Assuming taxes and maintenance expenses as listed in the spreadsheet, along with the interest on the mortgage, our annual expense is $17,390. Rental for the property is estimated at $1,735 per month or $20,820 per year.  Our net income is $3,430.

Rental residential real estate is depreciated over 27 ½ years meaning that you can write off an additional $8,545 for 27 ½ years as a cashless depreciation expense (note: you cannot depreciate land.  The numbers here are just estimates). Your Schedule E tax form would include interest, maintenance, depreciation and a number of other expenses to arrive at a net gain or loss for the year. In this case, the depreciation expense of $8,545 eliminates the net gain (for tax purposes). You have a net loss of $5,115 for the year.

If you have an income of less than $100,000 and actively participate in the management of the property, you can write off up to $25,000 of losses against your gross income.
With this in mind, it’s important to see that developing a comprehensive financial plan is often important in order to manage your taxable income to take advantage of tax breaks that phase out as your income increases.

Assuming that you are able to rent out the property and that you reinvest net profits as well as tax benefits, line 44 shows the net cost of your investment. You start in year 1 with an investment expense of $235,000 The first year shows a cash profit of $3,430 (line 36). Yet with depreciation, you have a tax loss and your taxes are reduced by $1,279, nearly $5,000. This could be the money that funds your IRA.

After 26 years, based on this scenario, you have recouped your entire investment through rental income profits and tax reductions.

Based on a modest 3% growth rate, your property is now worth $506,000 and your mortgage balance remains at $188,000.  If you continue to hold the property in retirement, it should continue to provide you with a steady income stream.  Should you wish to sell the property at that time, again consult your fee-only financial planner to determine tax-efficient ways to sell the property.

Traditional Investments Fail to Protect Against Long-Term Dollar Devaluation

Home prices, as measured by the SP/Case-Shiller index rose in 16 of the 20 major regions surveyed.  Only Detroit, Las Vegas and Tampa continued declining.  Boston and Washington DC led in price increases with 2.6% and 2.5% gains.  Minneapolis also posted strong results. The data lags by three months.

The US Dollar also showed a moderate increase from April to May but did little to cut into the 36% devaluation experienced over the past 10 years.  Only Washington DC, New York and Los Angeles home prices protected one from the devaluation of the dollar.


1 month
1 year
2 years
5 years
10 years
Ten City Composite

Las Vegas
Los Angeles
New York
San Diego
San Francisco
$US Dollar
Source: Asset Design Center

Is Real Estate Being Overlooked as an Important Investment Class?

When it comes to saving for retirement, investment advisors generally recommend that one contribute regularly to an Individual Retirement Account (IRA) or a company 401(k) plan.  Steady growth can be achieved, they suggest, by diversifying one’s portfolio with a mix of stocks and bonds.  Rarely, however, do they recommend adding real estate to the investment portfolio.  By neglecting to invest in real estate, one could be missing out on the many benefits afforded by this asset class.

Advisors and investors may shy away from real estate for many reasons.  Advisors might avoid this possibility because they are not licensed to sell it.  They have no incentive to decrease the amount of money that they have under management.  Also, investors often avoid real estate because often they don’t understand it.  Even if they do, they don’t feel that they have enough capital to make an initial investment.  But if they became better educated in the benefits of real estate, they would find that it offers some advantages not seen in other investments.

Often, advisors recommend utilizing investments such as mutual funds to achieve risk-adjusted, long-term appreciation when saving for retirement.  By utilizing qualified retirement vehicles such as an IRA or 401(k) accounts, investors can often receive a tax deduction to offset income, reducing their current tax bill.  They may also use Roth accounts to forego the upfront tax deduction enabling them to receive retirement account distributions tax free.  Real estate may also provide long-term appreciation, as seen in stock and bond mutual funds.  In addition to receiving up-front tax advantages just as qualified plans do, real estate investments may add other tax advantages when the property is liquidated.

Many might be surprised to learn that over the past ten years, despite the “real estate meltdown,” real estate prices have outperformed the Standard and Poor’s 500 stock market index by a wide margin.  As of May 2011, data provided in the Standard and Poor’s Case Shiller index (CS) showed that real estate prices, based on a 10-region composite, advanced 30.1% over the latest ten year period.  During that same time the Standard and Poor’s 500 (S&P500) stock market index advanced just 7.1%.  This is despite the fact that over the past two years, stock prices nearly doubled off of their March 2009 lows. During this same period, bond and commodity prices have also moved dramatically higher, causing many to worry about future market corrections.  Only real estate prices have not performed and remain 32% below than their peak. The S&P 500 was just 13% from its all-time high based on May data.  This is a value that an investor might look upon as a good opportunity based on current prices.

Both qualified retirement plan contributions and real estate investments offer tax incentives.  When one contributes to a qualified retirement plan, the investor can usually deduct the contribution from gross income, reducing the income tax liability.  Real estate, even when purchased outside of a qualified plan, offers tax deductions, sometimes as great as a qualified plan contribution.  Individuals who own their own home can deduct mortgage interest and property taxes paid if they itemize their tax deductions.  If they don’t itemize, they can still deduct their property taxes to receive some tax relief.  Investors who purchase real estate investment property do even better.  In addition to the mortgage and property tax deduction that home owners receive, real estate investors also receive deductions for property maintenance and depreciation.  If this investor is not generating positive cash flow on the property and the investor has an income of less than $100,000, he or she can write off up to $25,000 for losses against their gross income. 

A residential real estate also receives a special capital gains tax exemption not offered to other investments.  If one had lived in the home as a primary residence for two of the previous five years, the individual is allowed a capital gains exemption of $250,000.  This amounts to a $37,500 tax savings based on the current 15% Long Term Capital Gain tax rate.  Not so with distributions taken from a qualified plan.  These are taxed as ordinary income, at your highest tax rate.  If the investor owned a primary residence along with a rental property, the investor could sell the primary residence at retirement, take the capital gain, and move into the rental.  The tax-free distributions from the liquidation of the primary residence could be used to pay off any remaining mortgage on the rental property and provide extra funds for retirement expenses. 

Real estate offers many positive benefits that may be important to a person planning for retirement.  Like stocks and mutual funds, real estate has the potential to appreciate, preserving purchasing power.  Adding real estate to one’s holdings increases diversification and reduces overall portfolio risk helping to ensure a financially successful retirement.  Residential and investment real estate often provide tax benefits not found in other retirement investments.

Dynasty Trusts Let U.S. Wealthy Duck Estate, Gift Taxes Forever - Bloomberg

Dynasty Trusts Let U.S. Wealthy Duck Estate, Gift Taxes Forever - Bloomberg

Dynasty Trusts Let U.S. Wealthy Duck Estate, Gift Taxes Forever

Jeffrey Thomasson, 52, may pass on more than $100 million to heirs using an estate-planning strategy for avoiding gift and estate taxes.

Thomasson, who lives in Indianapolis, said he’s funding a so-called dynasty trust set up in Delaware with $8 million of equity from the expanding financial advisory business he owns, Oxford Financial Group. Putting the assets in a trust, which he figures could be worth more than $100 million by the time he dies, means the money should go to his heirs without triggering federal gift, estate or generation-skipping transfer taxes.
“Why would I want to pay estate taxes on some really, really big number 30 years from now, if the IRS is giving me this opportunity?” Thomasson said.
A dynasty trust is used to pass money on to multiple generations of descendants while paying as little in taxes as possible. The trusts have no expiration date and there are no required minimum distributions, meaning their assets may grow for an unlimited number of future generations. While the trusts can be set up in many states, Delaware offers extra breaks, including stronger protection from creditors and potential exclusion of assets in divorce proceedings.
“It’s an astoundingly powerful vehicle for generating long-term family wealth,” said Neal Howard, chief fiduciary counsel for Philadelphia-based Glenmede, which manages more than $20 billion on behalf of individuals, families, endowments and foundations.

Gift Limits

Interest in the trusts has risen because of the higher individual lifetime gift- and estate-tax exemptions of $5 million available this year and next, which means clients can put more tax-free money into the trusts, said Carol Kroch, head of wealth and financial planning for Wilmington Trust Co., a unit of Buffalo, New York-based M&T Bank Corp. (MTB)
That limit will drop in 2013 to $1 million and the top federal tax rate on gifts and estates will rise to 55 percent from 35 percent, unless Congress acts. Gifts that skip a generation, such as from a grandparent to a grandchild, follow similar rules.
Northern Trust Corp. (NTRS), based in Chicago, has set up several dozen Delaware dynasty trusts on behalf of clients in 2011, compared with almost none in 2010, said Daniel Lindley, president of the Northern Trust Company of Delaware, who declined to provide more specific figures.

Protection in Divorce

Delaware is one of several states, along with New Jersey and Pennsylvania, that allow so-called perpetuities, or trusts that may never expire, Lindley said. It’s also an appealing state because it’s easier to modify existing trusts there, said James Bertles, managing director of New York-based Tiedemann Wealth Management, which oversees more than $6 billion on behalf of families with $20 million or more. Delaware allows trusts greater flexibility to invest in certain assets, such as hedge funds and private equity, he said.
The state also offers stronger protections from creditors and civil litigation, including divorce proceedings, said Ted Cronin, chief executive officer of Manchester, Vermont-basedManchester Capital Management, which directs $1.9 billion and provides tax- and estate-planning services for families with $25 million or more in assets.
“In effect, it acts as a prenup,” Cronin said.

State Taxes

Most Delaware trusts set up by out-of-state residents don’t owe state income or capital-gains taxes on accumulations within the trust, and pay these taxes only when distributions are made, Bertles said. Some states do tax the undistributed gains and income of dynasty trusts set up by residents, including Pennsylvania and Illinois, according to Glenmede’s Howard. The trusts owe federal income and capital-gains taxes on distributed and undistributed investment gains and income.
Dynasty trusts have gained popularity since 1986 when Congress overhauled the generation-skipping transfer tax and since then several states, including Delaware, have eliminated their rules against perpetuities. In New York, by comparison, trusts may last no longer than the lifetimes of people currently alive, plus 21 years, said Bertles, who’s based in Palm Beach,Florida. Connecticut allows for the greater of 90 years or current lives plus 21 years.
Thomasson said his Carmel, Indiana-based business, which provides investment-management and financial-planning services to families with $5 million or more, has been growing at a double-digit pace in recent years. Assuming that continues, and assuming he lives until 80, his trust could provide more than $100 million for heirs by the time he dies, when the shares would be redeemed.

‘Whimsical’ Minds

“With the whimsical nature of the minds we have in Washington D.C., whenever you get an opportunity to do something from a tax standpoint, you really need to consider taking advantage of it,” Thomasson said.
A dynasty trust funded with $10 million from a couple today could be worth as much as $184 million in 50 years, assuming no intergenerational transfer taxes and a 6 percent annual return, and before subtracting any federal income or capital-gains taxes paid on the trust’s investment returns. By comparison, assets not placed in a trust and taxed twice as an estate in that period could be worth $39 million at the end of 50 years, assuming a $1 million exemption and 55 percent top rate.

Potential Growth

The Standard & Poor’s 500 Index returned 9.6 percent annually over the 50 years through December, with dividends reinvested. A $10 million investment in the index over that period could be worth about $975 million before taxes.
, stocks or other assets, said Kara Talbott, a family office services technical adviser with Oxford. Securities such as stocks and bonds are generally valued at their current market value at the time they’re placed into the trust.
Clients may fund a trust with cash
Costs to set up a dynasty trust may range from about $3,000 to more than $30,000, depending on the complexity and attorney’s fees, said Adam von Poblitz, head of estate planning at New York-based Citigroup Inc. (C)’s private bank.
While there’s no minimum for setting up a dynasty trust, clients with about $20 million or more in assets have expressed the most interest in taking advantage of the full $5 million exemption, said Joan Crain, a family wealth strategist in Fort Lauderdale, Florida, for Bank of New York Mellon Corp. (BK)

Boosting Gifts

Some clients increase their gift to the trusts by using the initial contribution to take out a loan, Bertles said. An individual can gift a trust $5 million, for example, then sell the trust $50 million in assets, using the initial $5 million as a down payment. The trust would issue a promissory note to the individual for the remaining $45 million.
The notes are treated as intra-family loans and must follow U.S. Internal Revenue Service rules on repayment and interest rates. As of July, the rates were 2 percent for loans of three to nine years. Any appreciation of the purchased assets above that interest rate pass on to the trust without triggering the gift tax, Bertles said.
One client used this strategy to transfer partial ownership of the family’s growing winery business to his children, Lindley of Northern Trust said. The client funded a trust with $4 million, which it used to purchase a $40 million share of the business, he said.

Family Business

The strategy is appealing for families with a closely held business because they may be able to sell a portion to the trust at a discount of as much as 40 percent, said Laura Zeigler, a Los Angeles-based senior vice president for Bessemer Trust Co., which provides investment-management and financial-planning services for families with $10 million or more in assets. That’s because the stakes might be difficult to sell on the open market.
The trusts are irrevocable, meaning the person starting the trust has minimal control over the assets once it’s set up, and generally may change the trust only by going to court or getting approval from all beneficiaries, said BNY Mellon’s Crain.
“The word ‘irrevocable’ doesn’t always resonate until they suddenly want the money,” she said.
Individuals who feel hesitant to give such a large sum away permanently can choose to structure a dynasty trust as an asset- protection trust, in which case they can name themselves as beneficiaries in order to take withdrawals under certain circumstances at the trustee’s discretion, said Northern Trust’s Lindley.
“If it turns out they’re in dire need of financial resources they can turn to us and request a distribution,” Lindley said. If they never need it, the trust’s assets will pass on to heirs as planned.
To contact the reporter on this story: Elizabeth Ody in New York