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Joe Fairless: Best Ever listeners, welcome to the best real estate investing advice ever show. I'm Joe Fairless and this is the world's longest-running daily real estate investing podcast. We only talk about the best advice ever, we don't get into any fluff.
I hope you're having a best ever weekend. Because it is Sunday, we're gonna do a special segment called Skillset Sunday, where we talk with a Best Ever guest. Today, they're gonna tell us about tax planning strategies for real estate investors. Yes!
The number one expense we have, believe it or not - taxes. That's it. We've gotta pay attention to the expenses, and the income going out the door as a result of taxes, and John Pollock is with us to talk to us about that. How are you doing, John?
John Pollock: I hope I can be the best ever... I'm gonna bring the heat. [laughs]
Joe Fairless: Let's do it! I'm looking forward to it, and especially with this topic. Real quick though, a little bit about John. He is the CEO of Financial Gravity and president of Pollock Advisory Group. He grew his business from his dining room table to 25 employees and 700% growth in one year. He is the author of The Nest Egg Cookbook: Your Recipe For A Comfortable Retirement. He's been featured in Forbes; he's based in Allen, Texas. With that being said, John, before we dive into it, do you wanna give the Best Ever listeners a little bit more about your background for context?
John Pollock: I'm just a guy that started a business and pivoted in that business because I ran into my own problems. And my biggest single problem in my business was the taxes, and I reached out to the people you probably reach out, which is the CPAs, and I found out that they really don't know anything about taxes, and in fact they're not trained on it.
There's not a single question in a CPA exam about taxes, which stunned me... So we built a business model to solve that specific problem, because I thought "Shoot, if everyone thinks the CPA industry solves the problem that they don't solve, if I solve the problem, I'll have a lot of clients." That's kind of the approach I took.
I just started out as a wealth management/financial guy... I started out in corporate sales years ago, and just kind of evolved who I am as a human being, and now we're publicly traded, we went public last year. How we did that without an IPO is a fascinating topic all on its own, but the idea is that every system can be hacked, every system can be made better, and that's what I do right now with the tax arena.
Joe Fairless: I would've answered incorrectly to the question "CPAs are tested on tax questions during those CPA exams?" I had no idea about that, thank you for sharing that.
John Pollock: It's a strange problem too, because the A in CPA says what they do - they're accountants, but what exactly is an accountant? An accountant is a historian; they are a history taker of information - specifically numerical information. That's it. That's what they do. They will record your information like nobody's business. They understand how to depreciate the house, they know how to do all that stuff, but they really don't know how to plan things better. So if you ask a CPA -- typically CPAs are a lot like attorneys, they answer the question you ask. "Can I buy a house inside of my IRA?" The answer is "Yes. Use a self-directed IRA." Most of your listeners probably know that. But the question is "Should you?" They won't answer that, and the answer is "No, you shouldn't. You should not buy a house inside of an IRA." But the reason for it is not because real estate is a bad investment, because the investment quality doesn't change whether I buy it inside of an IRA or outside of an IRA."
In other words, buying real estate and using that as an investment vehicle for my growth of wealth doesn't change. What does change is the net return, and the net return inside of an IRA goes down dramatically... So bad that if you liquidate the IRA, pay the current income taxes, then buy the house, you're better off.
Joe Fairless: Why is that?
John Pollock: And nobody knows that. Well, because [unintelligible 00:06:03.19] double down. What's so great about real estate is this... Let's say I wanna buy - I'll use easy math, so I can do it in my head - a $100,000 house. I can probably buy it with 20% down, so now I'm controlling $100,000 with $20,000. But from an accounting standpoint, I gotta depreciate the entire $100,000. So now I'm depreciating $100,000, but I only really have 20k in, so I'm not depreciating against a number that I don't really have invested. This is how leverage works - I can imagine it's something you spend a lot of time on... If I have 20k but give the deduction of 100k, but I'm getting the return on investment on the full value, which is 100k, but I'm not invested 100k, I'm only invested 20k...
So let's do easy math - let's say I can get $1,000/month on a $100,000 house; probably a little high, but let's just use the numbers. So now my $100,000 investment is earning 12%/year. But is it really earning 12%/year? No, it's actually earning more than that, because it's not a $100,000 investment, it's a $20,000 investment. I'm controlling $100,000. So I'm not getting 12%, I'm getting five times 12%. And then when we depreciate the $100,000, I can actually get even a higher rate of return, and then there's some parts of the text code that will allow me to accelerate appreciation. Once you get over about half a million dollars of real estate, you should start to accelerate your appreciation. So don't use the 30-40 year tables, use the 8-10 year tables.
Everything I just explained cannot happen inside of an IRA. I cannot depreciate it. All the returns are not at capital gains rates, they're all 100% at regular income tax rates, so all I'm doing is creating a huge revenue stream that's taxed at the highest level of the entire tax code, which is regular income taxes. So you need to get your investments out of regular income taxes, especially if you're in it for the long haul. If you're in it for more than a year, then you're gonna be taxed at capital gains rates, versus regular income tax rates. And even at the lowest level, capital gains is 15%, regular tax is 25%, so... 10% better returns is better.
You've gotta manage your taxes, and most people don't, and this is a problem I've seen that reaches across all areas. Franchise companies teach their franchises how to make a hamburger the same way over and over again, but they don't help them run their business better. Real investors are taught how to buy real estate over and over again, but they don't take taxes into consideration and don't realize that they can double their rate of returns just by making sure things are tax-efficient.
And if you understand compounding interest, doubling your rates of returns that are tax free is much better than doubling your rates of returns that isn't tax free. And if you get big enough, you can self-ensure, which is another tax shelter. So now you're self-insuring, which means all the insurance you were paying is now going into your own insurance company, which is now an asset which you can borrow against to buy more real estate. All these little things that nobody knows about, and the CPA won't tell you.
Joe Fairless: Let's talk about self-insuring... How does that work, and at what point does it make financial sense to do so? You said there's a certain threshold.
John Pollock: I'd say when you start to cross the $250,000/year in insurance costs. And if you're getting close to that, like 150k, then you still may wanna make the move. The cost of the structure is usually about $35,000/year to build this insurance structure, so obviously if you're not saving enough money, then you don't wanna spend the money. But if you're close, it's still worth it because now instead of sending $250,000/year to a bunch of insurance companies, I'm not sending it to John Pollock insurance company, and if I don't have any claims, I get to keep the money, which is how your insurance company makes money. If they don't have any claims, they keep the money. Well, wouldn't that be better if you didn't have any claims that you kept the money?
The question I always get asked is "Yeah, but if I self-ensure, what happens if the house burns to the ground? I don't wanna pay for the whole $200,000 house. I may not have saved enough in the insurance company yet."
Well, first of all, insurance companies don't pay the $200,000 either when it burns to the ground. They have reinsurance. They'll ensure up to, say, $25,000, and then they hire a reinsurance company that covers the bigger cost; this is how health insurance works, by the way, and you can do this exact same thing with health insurance. So if your health insurance costs and your property [unintelligible 00:10:28.09] on your real estate are above a certain threshold, which 250k is usually the low end (but if you're getting close, you may still wanna look at it), it makes sense to self-ensure, because now you get to keep all those dollars. And even if all the dollars went out every year, you're still in the same position; I paid 250k, and 250k went out. But if I pay the insurance company, 250k goes in, 250k may come out, or 250k may not come out, and I get to keep it. So all I have to do is have one good year and you get to keep all the money.
The tax code allows for this, it encourages it. You can ensure for stuff that you can't ensure for in a regular insurance company. What if my commercial building burns down and I happen to own the Subway in it? Yeah, I get the commercial building replaced, but what about all the income from the Subway while I'm waiting for the commercial building to be replaced? Most insurance doesn't cover for that. You can actually make your own insurance company cover for that, so the money goes in tax-free - as tax-free premiums, because premiums are a business expense - and then when you have a claim against your own company, which is loss of income, the money comes out tax-free. So it actually grows the capital gains.
So the money goes in tax-free, grows the capital gains and comes out tax-free. It's literally the best place from a pure tax strategy. The companies I help set this up will wag their finger at me... "John, this is not a tax strategy, this is an insurance strategy." Yeah, but the tax implications are staggering, so I've gotta mention it. But they feel like they'll get in trouble from the IRS if they mention that the tax strategy is being tied to it, but insurance premiums are 100% deductible, that's the law. But if the insurance premium is going into MY insurance company, then that's even better because the money starts to stockpile.
[unintelligible 00:12:05.20] if you need 250k/year to put in it, so there's not that many people that can do it, I suspect that a few of your investors are probably spending more money on insurance... Maybe spending the second biggest line item - taxes being number one, number two is insurance. They can solve both problems with one product and one strategy. Then you can throw in your cars into that... If you've got enough houses and you've got employees that are going out and fixing the houses, you can ensure that to that; your health insurance I've already mentioned... If you have health insurance for your staff, you put in that.
I have a friend of mine that owns an outsourcing business that has huge worker comp insurance costs. He's spending $150,000 for workers comp, and I said "Dude, you're right on the threshold. I think we should set this up now. Yeah, it's $35,000/year, but right now you spend $150,000 and you don't have a claim, you're out $150,000. If you spend $150,000 and $35,000 in fees, you don't have a claim - you still end up with money." So we're working on him right now to set that up, because he's probably two years out from being at the 250k threshold, but we can see the trajectory and it's still better. And we didn't even talk about throwing his company's health insurance plan into this product.
So it's one of those things - it's there, but most CPAs don't know about it, because they're not taught. The way we explain it to people, there's four basic tax strategies. Shifting, which is moving from one entity to another; shifting out of an IRA into non-qualified money is a taxable event, but I can make the case that in the long run you're better off.
Number two is timing. If I pay you on December 31st, you've gotta recognize that revenue, but I get to recognize the expense. If I just waited a day, then I wouldn't be able to recognize the expense, and you would have to recognize the revenue at the end of the day, so that's a timing strategy. 401k is and IRAs are timing. They're saying, "Let's split the taxes off till later."
Then there's code, which is just pure code. For instance, here's a real estate strategy... If you run your business out of your house, which most real estate investors do; I assume you're probably doing this podcast out of your house... Well, that means you're doing business out of your house - so are you writing the house off? Are you writing your pool off? Are you writing your yard guy off? Did you know you can rent your house to yourself 14 days/year, tax free? 14 days you can rent it to yourself. Why 14? I don't know; it's in the code, I don't care where it came from. It's 14. It's not 15, it's 14. So we rent our house to ourselves 14 days a year. We've gotta do paperwork - it's the IRS - but the paperwork is remarkably easy.
So we'll do the paperwork for you, and then you add $1,000 in expenses to your business, so it's $14,000 expenses. You write $1,000 out of your business to yourself. You do not have to recognize the revenue to yourself, so it's $14,000 I pulled out of your business tax-free, that went to yourself tax-free. Well, if you're in the 25% tax bracket, that's $4,000-ish. So that's another thing.
And real estate, with the depreciation schedule, the ability to accelerate depreciation - all those things are built-in. Real estate is one of the best areas from a tax planning standpoint. It's almost magical, and this is one of the things that has made Trump very wealthy; he's played the real estate game very well, but he's played the whole game. He didn't just play part of the game. And part of the game is leverage, buying the right properties, up selling it... The Trump Tower is really not in a great location, but they marketed the heck out of it, they built a brand around it, so now it's very popular. But it's not in the best location... So "location, location, location" is not always right. Sometimes you can make the location the best location by marketing it as a better location. Keep that in mind in real estate.
But with that said, he knows how to play the tax game. When one of his projects lost a billion dollars, he took that as a write-off, which means the next billion dollar in income was tax-free - which he got criticized for, which is nuts, because no one wants to lose money for a tax write-off; that's not good planning... But since he did, he was able to use that against his future revenues. So you can actually take a little bit more risk in real estate knowing that if one out of then sucks, at least that one that sucked is gonna help you write down the other nine that didn't. So that's why real estate investing is one of the most powerful forms of investing in the marketplace, because you can create cashflow, you get to write off more than you're actually spending, you get to make money on more than your actual amount of money that you have invested, and all that compounds very aggressively. None of that happens inside of an IRA.
Joe Fairless: You said there are four tax strategies, and I wanna make sure I wrote them down correctly: shifting, timing, code, and what was the fourth? Was it depreciation schedule?
John Pollock: It's product. Pure product. The reason we use product is that like a Roth IRA, if the government decides that only rich people have Roth IRA,] it's a part of the tax code; that's a code strategy, so they can change the code and say "Okay, from now on, money coming out of [unintelligible 00:16:59.25] stroke of a pen.
But life insurance - if I have a million dollar life insurance policy and I die and that goes to my spouse tax-free, let's say they decide "Hey, I want [unintelligible 00:17:11.26] I think since John's spouse got that million dollars tax-free, she didn't earn it - we should tax it." Well, what's gonna happen? The life insurance industry will go, "Hey guys, do you have any ideas the size of the checks we're writing to you? No, you're not gonna do that."
So sometimes products have a little bit more gravitas and protection than pure code, like a Roth IRA, which by the way, you can buy real estate using [unintelligible 00:17:38.08] life insurance policy. There's whole strategies around that that are very impressive. Talking about doubling down, you build an asset, you borrow from that asset to buy another asset, which you're borrowing and leveraging up, and then you're paying that money back into an asset that grows tax-free and comes out tax-free, but yet you still get to depreciate outside the asset. That's another strategy.
Joe Fairless: Which one is that?
John Pollock: It's life insurance. It's almost impossible to explain the complexity of it in an interview, you kind of have to draw it on a whiteboard... But when people see it, they're like "I wanna do that! I wanna do that! So you're saying that when I die, all my money goes to my heirs tax-free. Well, I'm alive, I can borrow money from it tax-free. I can use the borrowed money to grow something that has a depreciation schedule and has the ability to grow." Yes, you can do all of this inside this wrapper that is called life insurance, and if you get big enough, you can build your own life insurance companies. That's a separate strategy from the strategy I already mentioned.
So there's like these recipes where you're mixing three or four tax strategies, so look at real estate as the steak. You can make steak a lot of different ways and a lot of different flavors. Some are better than others. Steak by itself is great, but in a fajita it can be better.
The idea is that you have this raw material - in your case, most of your listeners are real estate investors. So the raw material is the real estate investor, but there's these satellites that surround the real estate investing community that real estate investors aren't talking about. It's ironic that I do public speaking and I can't get into a real estate conference, and I will do more for that real estate conference than any of the other people there that are teaching you how to hire a pool guy.
It's strange, but since my topic isn't real estate investing, it's tax planning, they're like "Well, we don't want you in our real estate investor meetings", when I can double everybody's returns in the meeting just by eliminating the taxes. But that's the problem that I'm working through, that's why I do shows like these. I'm kind of an evangelist, to get out there and say "Everything that you're doing, we can do it better." You may be making 75 cents when you can make a whole dollar.
Joe Fairless: Let me ask you a couple questions, because we don't have a lot of time, and I'm enjoying this thoroughly, but I gotta get in some questions. Number one, which of these strategies do you personally invest your own money in?
John Pollock: The insurance one is the one that we do as a company, and we have a ton of clients in it. It's a tax strategy; it's not really an investment, because I'm doing the same thing differently. Everybody that's listening has insurance premiums, so what if the insurance premiums went to you instead of the insurance company?
Joe Fairless: So you created your own insurance company... And you were spending over $250,000 in insurance?
John Pollock: Yeah, we're a big company. We're publicly traded. That's 30 offices, I've got -- I don't know how many employees.
Joe Fairless: Got it.
John Pollock: I'm bigger than you knew.
Joe Fairless: How does that work? Because I was just doing some rough math, and I'm probably spending $360,000 a year on insurance across my properties. How do I go about creating my own insurance company?
John Pollock: You call Financial Gravity and we help you do it. That's what we do. It's our business, this is what we do, so we will help you set it up... Because you wanna set it up right. There's lots of companies out there that do this strategy but they do it wrong. In fact, the strategy is on the dirty dozen of the IRS list. The IRS hates it. They target it, because everyone does it wrong. They put them offshore, because the capitalization requirements are lower offshore... It's like $5,000 and you can set up a company, whereas in the United States it's $50,000. My attitude is for $45,000 I'd rather my insurance company be in North Carolina than Turks and Caicos. It just looks better. So for $45,000 - that's a small price to pay - I'd rather have it in North Carolina.
Actually, what's interesting is there's some competition among the states as to these types of products, and a lot of states are starting to prop up in their insurance departments. So you're gonna see more and more states that are gonna want this. North Carolina is the best right now, but Tennessee is getting very good at it, so we've got a couple in Tennessee now... But North Carolina is right now the best. The state is the most friendly towards it, and their costs are the lowest. We've worked with the insurance commissioner there to make sure that our investing guidelines are met.
One of the challenges with insurance is you can't take all the money that goes in there and invest into real estate, because as an insurance company you have to be liquid enough to pay claims. If you have to sell a house to pay a claim, that's bad. 50% of all the money that goes into that has to be in something that's liquid, so we've developed portfolios that meet the insurance commissioner's requirements, but still get a little bit more growth than a CD would. Then the rest of it, it's fair gain. But from a banking standpoint, the whole thing is an asset.
So if you have a million dollars but you can't spend it because you need to have it available for claims, but you show this on your balance sheet, banks will just love that kind of stuff. Banks love assets that look like assets, whether you can use them or not. They think an oven in a restaurant is an asset. It's really not, because you're not gonna sell it to get to the cash, but that's not how banks work. This is another game that a lot of people don't play very well, because they've gotta design what they're doing around the rules of some other entity that can help them. Well banks, one of their rules is they love assets. So what if you can build a big ass asset that's just a big pile of cash that's yours, and then you can sell all the properties and all the cash in the insurance company is still yours, and then you close down the insurance company and you keep the cash. It's pretty powerful.
Our model uses what's called a tax blueprint. We're actually gonna look at your entire cash situation first, and then determine whether or not adding this makes more sense now, or doing some other things. If I can save you $100,000/year in taxes, we may shelf the insurance strategy while we focus on getting the $100,000 saved. Then we can move to the insurance strategy. But we always go where the tax code leads, we don't go where the products lead. Products are sexy, so that actually gets people excited, but we kind of have to back people away from the products; "Look, we're not gonna sell you this product. We're gonna do a blueprint. If the blueprint says the product is a fit, we'll add it. But let's focus on tax strategy first, products second."
Joe Fairless: For the Best Ever listeners who wanna get in touch with you, what is the next step and how do they get in touch with you?
John Pollock: Several ways. You can go to financialgravity.com, which is our corporate website. We have LowerTaxHigherProfit.com, which is a free video series on some of the stuff that we talked about. There's also a book on the 10 Biggest Mistakes Small Business Owners Make. Ironically, real estate investors are all small business owners; they don't see themselves that way, but you can use all the small business tax strategies that are available to you. So the 10 Biggest Mistakes you make is an eBook. So you text the word "taxbook" to 33444 and you'll get a link, and you just put in your e-mail address and you'll get a copy of the eBook, too.
There's lots of ways to get to us, lots of information out there that's free, so take advantage of it.
Joe Fairless: I've enjoyed listening to you and talking to you a bit about this. I took a lot of notes, that's for sure. Creating your own insurance company is something I hadn't come across, that's really interesting... And then using that to build a balance sheet to then go impress banks - that's really interesting, especially for people who are raising money and bringing on sponsors for their deals; perhaps as they get about medium-sized, they can use this strategy to not have sponsors and then sign on their own loans because they have a balance sheet.
Also, the life insurance example... I've heard a little bit about this from different people, and that's certainly something I'm personally looking into. And lastly, the self-directed IRA - we've had Tom Wheelwright on the show, I know you've had him on your podcast, too... He talked about that also.
John Pollock: By the way, his book "Tax-Free Wealth" - without question the best book on taxes ever written, bar none. And I've read them all.
Joe Fairless: Great endorsement. I've learned a lot from that one also, and I highly recommend it. John, thank you for being on the show... Fascinating conversation. I took a lot out of it, that's for sure, and I know the Best Ever listeners did as well. I hope you have a best ever weekend, and we'll talk to you soon!
John Pollock: Thank you.
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