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How to Leverage Your Real Estate Portfolio Without Forgetting Taxes

By Ian Grimbleby, CPA

March 4, 2020

How to Leverage Your Real Estate Portfolio Without Forgetting Taxes

If you’re a typical real estate investor (asset rich, cash poor) trying to figure out how to finance your next investment opportunity, you could try looking at what cash is available from your current investments.

Many times, the easiest way to obtain cash is to pull equity out of one of your current properties by refinancing or obtaining a loan. Additionally, it’s often the cheapest way to go because the interest rate and risk might be lower than on a bank loan. So, what are the drawbacks?  

“Investors are normally focused on their short-term cash needs and not thinking about tax considerations,” says Principal and CPA Ian Grimbleby. “I try to discuss future tax implications as soon as possible so my clients can make the best long-term decisions possible.”

Here are the questions we get asked most often:

I owe Capital Gains taxes even though I don’t have cash from the sale?

Yes, it can happen. If you have already taken out the cash on the gain from a property to invest in another opportunity, you will still need to pay taxes on that gain when the time comes. But because you invested the cash in another opportunity, you may be caught short when you sell the property and need to pay the taxes.   

Why can’t I deduct the loan interest?

The IRS has “tracing rules” on the deductibility of loans. Under these tracing rules, the interest on a loan can only be expensed against the business or asset the loan was used for. For example, if you obtained a loan on a commercial property for $100,000 and then used that money to buy land in another entity, the interest on the $100,000 loan would be deductible against the rental income on the new land purchase – not the commercial property’s rental income. Aside from general tax and reporting complexity, a new investment might not be in service or have income for a few years. Thus, the interest may not be deductible for a few years, i.e., tracked on a carryforward schedule.

Why does the IRS care about this? Well, what if you took the $100,000 to buy a personal asset, such as a ski boat? Would it make sense to deduct the interest against the commercial property’s rental income? No.

Cash flow? These investments are part of my retirement plan

“The most common discussion I find myself having with clients in these situations is this: How leveraged (in debt) are you on your real estate investments? What is your 5 or 10-year goal? How can the team help you achieve those goals?” Ian tells us. “Many times, people want to reduce their leverage or borrowing as they head toward retirement. It’s a good idea to talk this through with your advisors, especially if there is a real estate investment you are considering, and you do not have sufficient cash to make the purchase.”

To stay on top of your portfolio, it’s important to keep track of the key performance indicators (KPIs) that are critical to you, such as market values, debt, and/or leverage ratio.

“Our team is here to advise you on how much leverage (and risk) you want in your portfolio,” Ian says. “We then help you stay on track with those goals in mind. Sometimes it’s just about having the conversation and talking through the pros and cons of an investment.” We believe it’s important to take a holistic approach and look at the whole portfolio, not just the individual investment opportunity.”

Wondering how you can make your investments work for you, not against you? We can help. Count on us to give you perspective on how to evaluate your financial and tax implications. For additional information, contact Ian at igrimbleby@gccpas.net or 209-527-4220.