Dollars & Sense: Tax Planning
Dramatically Increase Project Net Profit & Create Decades of Wealth
by David Albin, wealth advisor, Wealth Building Now
(Editor’s Note: To best serve high and ultra-high net-worth families, David Albin embraces a holistic analysis of their entire circumstances. He has assembled specialty experts who help contain taxation and who select, vet, and implement financial tools to economically meet client objectives, ensure liquidity, maintain family harmony, and keep wealth in client families. He can be contacted at david@wealthbuildingnow.com and (855) 451-0500. To learn more about his services, please visit www.wealthbuildingnow.com.)
Architects utilize marvelous methods and resources to create today’s landmarks and development wonders throughout the nation and around the world. As they create the projects, architects frequently encounter opportunities to financially participate in further developments. By utilizing exceptional tax planning strategies and structuring, architects may greatly increase both the net after-tax profits they earn from their projects, and the long-term wealth and income they create.
An architect in our area was asked to acquire a project from a landholder who had been unsuccessful in obtaining an approved tentative map by himself. The price to the architect was $7.5 million, with most of the acquisition price seller financed. The architect obtained an additional $1.2 million in outside-investor financing to carry the project through the tentative map. Under the terms of the investor-owned note, the project would be sold upon tentative map approval. The architect was to receive a success fee, and a priority return would be due to the investor.
The project had significant upside potential, and the architect planned to in fact obtain approval for a portion of the land, take out the seller and investor notes, and to later continue with additional mapping and development of the remainder of the parcels. By the time the first portion of the project was mapped, graded, and ready for sale, the all-in costs were around $11.3 million, and the mapped value was $30 million. Taking out the acquisition and investor financing and assorted other costs left $19,700,000 to divide with the architect’s portion coming to $7,880,000, a very heady return. Some of those proceeds could be applied to the second phase of the project.
Somewhere along the way, most individuals creating assets like these will be confronted with capital gains taxes. Various organizational and tax-minimizing structures will be used by different individuals. Let’s look for a moment at the capital gains tax impact on the original owner that sold the property to the architect, and let’s also take a lay person’s look at the capital gains tax impact of the $7,880,000 gain to the architect. Please regard all amounts as hypothetical for discussion purposes and not as tax advice.
The original owner had held the property for a very long time, and his cost basis is unknown. We’re assuming a $3 million basis and an annual income of $150,000. When he receives his $7.5 million cash out, his federal capital gains taxes would be around $1,047,838. That would be his total capital gains tax if he’s in Texas. However, if this is in California, he owes the State of California another $593,306 for a total of federal capital gains and California ordinary income taxes of $1,641,144.
Controlling Taxation of Gains
On the architect’s gains of $7,880,000, his federal capital gains would be about $2,166,958, or 27.5% of the profit, assuming the transaction qualifies as a long-term capital gains transaction, and that would be his total tax bill on this project in Texas. Move this situation to California, and the Golden State takes out another $1,265,546 for taxes that in California are ordinary income taxes. That makes the tax pain out West a total of $3,432,504. That comes to taxes of 43.56% of the gain going to your silent and non-contributing taxation partners from the state and federal governments.
Just as architects control the vitals of design, building, safety, comfort, and utilization, it is vital to consider how to control the portions of taxation that are controllable. Any expense item that comes in between 25% and 43% certainly needs to be reduced whenever possible. While everyone should pay the taxes they legally owe, it is prudent to harness the many powerful and legitimate means to help control the amounts of taxes due and when they are due. Understanding how this can be done using solidly legal asset-ownership vehicles and implementing the proper solutions can provide enormous current and long-term financial benefits to professionals.
Controlling Taxes: Where Wealth Begins
The rate at which anyone’s income and assets can grow is directly related to net after-tax profits on distributions. Losing 25% to over 40% of the profits on a particular transaction right as we earn it is very destructive, as the asset value upon which we build future earnings and growth is badly hit.
Let’s look at the impact of taxation on $100,000 of capital gain. If we can defer the taxes and achieve simply a modest net growth with continued tax planning of 6% annually over ten years on what we continue to control, the $100,000 will grow to $179,000. On the other hand, if we lose 43% right away to taxes, we only start growth with a net after-tax amount of $57,000. Also, if the yields are perhaps 4% after tax without proper tax planning, then after ten years we only have $84,000, not even what the principal could have been ten years earlier if effective tax planning had been used.
Structuring for Asset Growth
Carefully evaluated and solidly legal ownership structures can frequently be set in place, so that you and your family can enjoy the maximum current and future benefits from your professional work. Some of the structures can increase the net after-tax income from your practice. Some of them will increase what you keep from your ownership in various assets and projects. Others will even allow you to benefit by being able to convert appreciated assets to another class of assets without incurring current tax liabilities. You or your clients may be hemmed in by the probability of having to recapture accumulated depreciation if you were to try to move out of certain real estate portfolios, and even those taxes can be handled. Some of the techniques available can drastically lower current taxes and/or defer taxable events for years.
The very best tax reduction results will be obtained when tax structures are examined and selected before entering LOIs or contracts. Because not all structures fit for all individuals or situations, most people will need assistance to determine, implement, and operate the proper structures for their circumstances.
It is important to wealth-plan through teams that understand tax planning and its impact on asset growth. Essentially every professional utilizes CPA services in conjunction with reporting and with filing their taxes. In many cases, additional tax planning resources can be very important, especially because, according to the American Institute of CPAs, only 3% of CPAs are engaged in tax planning. Hence many professional advisors that we commonly turn to cannot help structure the optimum taxation structures. Additionally, many tax structures demand ongoing specialized accounting that in turn requires particular expertise in meeting IRS reporting standards for the required tax structures.
Earliest Tax Planning Critical
Implementing tax containment at the earliest time is essential. Once implemented for a particular project or calendar year, then tax control should be practiced for all future projects and in all the coming years. Even when you only achieve tax deferral, the difference in your total assets can be very large. In the cases of the landowner and the architect at the beginning of this article, each is confronted with over $1,000,000 in current taxes due. The difference over time of being able to maintain that amount of money can be staggering. If the money is merely invested for a modest return, it will grow to a significant amount. If it is perhaps leveraged to control and develop other projects it can create much larger close-in profits. If the professional then again uses tax structures properly, the leveraged growth can make great long-term improvements in assets and income. Repeating this process over the years propels asset growth to new levels. Consider what it would mean to your plans and achievements if through tax planning you could generate hundreds of thousands or millions of dollars of working cash to use for ten or 20 years.
Please understand that the very best results are obtained when you establish tax-related structures before you enter transactional agreements or even LOIs. While tax-reduction help is often available after documents are signed, it likely will not match the levels available when tax structures are put in place prior to document execution. The greatest variety of excellent alternative strategies and the best results always come when planning is done before entering contracts. Just like you start every building with a solid foundation, your financial structures will reach the greatest heights and have the best stability if you start with tax planning. Tax planning is certainly the foundation where wealth begins.
