Tax Adjusted Returns – understanding how taxes impact returns - MBC REI

When comparing investment opportunities, it is very tempting to just look at one of the common metrics, in particular IRR, and pick the investment with the best projected return.

While there is some value in comparing these numbers, you really need to consider other factors about the deal in order to have a fair comparison. The two most important factors to consider are the relative risk of the investment [1] and the tax implications of the deal.

In this article, we focus on the impact of taxes on the deal return. As always, this information simply reflects my opinion, it is not tax, legal, or financial advice. Always consult your own professional advisors before making any investment decisions.

Would you believe me if I told you that you would have more money in your pocket at the end of 10 years with a deal that pays you a 9% cash-on-cash return over a deal that pays you 10%?

That is absolutely possible – if you are in one of the higher tax brackets and the 9% deal provides tax free (or tax deferred) income and the 10% deal is taxed at your normal tax rates.

Let’s go deeper into the details while making some basic assumptions: you are married, file joint taxes, and your total taxable income is $300k/yr, which places you in the 32% tax bracket in 2023 [2]. You live in TX, which has no state income tax (the 9% deal is even better if you have state income tax). You have $100k to invest and are considering two deals of equal risk, both of which return all of your original investment after 10 years. For simplicity, we assume that the tax rates don’t change, your income outside of the deal remains constant over the 10 years, and we won’t consider any other investments or strategies you can use to offset the taxes on income you receive from this investment.

The first deal offers you a 10%/yr return on mortgage notes, so you will get $10k/yr for each of the 10 years. However, this return is taxed at your normal tax rate. That means that each year, you will have to pay $3,200 in taxes and will have $6,800 available to spend or re-invest. After ten years, you would have a total of $168k from your investment (including return of your original principal).

The second deal offers you a 9%/yr return, so your annual income from the investment is only $9,000/yr – which is clearly less than the 10% deal. But this deal is a real estate deal that gives you deprecation to offset that income, making the income tax free in the year that you get it. That means that you can spend the $9,000 freely that year.

“But wait”, I can hear you saying, “if you take depreciation, then you are subject to depreciation recapture and you have to pay taxes on that money when you sell the property. “

And you are correct. In this scenario, when you sell the property in 10 years, you will have depreciated your basis by $90k and will have to pay depreciation recapture tax on that amount. However, the maximum tax rate for depreciation recapture is only 25%, not your normal tax rate of 32% – so you will pay a total of $22,500 in taxes instead of $28,800. That means that you will have a total of $167,500 available to you after taxes at the end of the 10 years.

Now comes the part that is hard to wrap your head around. In nominal dollars (i.e. the specific number of dollars) you are still receiving $500 less with the second deal ($168,000 – $167,500 = $500). However, in the second deal, you don’t pay any taxes until the property sells. That means that you have access to $2,200/yr during the 10 year period that you wouldn’t under the 10% deal ($9,000 – $6,800). Due to inflation, the purchasing power of a dollar in 10 years is much less than the same dollar today. Assuming a low inflation rate of only 2%, your payment of $22,500 in 10 years would be the equivalent of $18,458 in today’s dollars. Compared to paying taxes each of the 10 years (in the 10% deal), you would be gaining approximately $1,500 in purchasing power by deferring the taxes until the deal ends.

As a result, you have over $1,000 more effective purchasing power taking the “lower return” deal. Not a life changing amount, but still significant.

Furthermore, that does not consider any income you could make by investing that additional money during the 10 years. If you invested the $2,200/yr at 2% you would get an additional $2,000 from that money over 10 years, making the investment even better.

It is important to recognize that the relative value of the deals depends greatly on how long the hold period is (ie how long before you get your money back and the deal wraps up). The longer you hold the deal, the better the 9% deal becomes because the taxes are deferred until the property is sold at the end of the deal. As a result, the purchasing power of the dollars continues to decline every year. If you end up holding both deals forever (e.g. until you die or at least your tax rate drops because you stop working), you never end up recapturing the depreciation and end up having the entire $9,000/yr tax free. Conversely, if the deals wrap up in only 2-3 years, the impact of deferring taxes is minimal and the 10% deal would be the better option.

While you should never select a deal based solely on its tax impact, it is important to understand how taxes will ultimately impact your returns. While you can get most of the information required to understand the taxes from a deal sponsor, you can’t always trust them when they say it is a “great tax treatment”, since their tax situation may be very different than yours. If you are considering different opportunities, it is worth talking to your accountant so you can understand the tax implications in the context of your personal situation.

If you have any questions or comment about this post, please email them to me at blog@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.

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This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.