Thanks to the appreciation gains we’ve seen in the past few years, a lot of Colorado investors have a ton of equity in their portfolios. What’s the best way to use that equity and maximize their investments? Lon Welsh, founder of private equity company Ironton Capital is here to go over some options.
We’re going to look at four investing strategies and measure the returns over the long term. Some of the scenarios involve paying capital gains tax. While many people’s knee jerk reaction is to find ways to avoid paying this tax, that’s not always the best outcome.
- Listen to the podcast “#416: Can I Make More Money by Paying Capital Gains Tax?” Denver Real Estate Investing Podcast
- Watch the YouTube video (at the bottom).
- Read the blog post. Note, the blog is an executive summary. Get the in-depth breakdown from the podcast or video.
Setting Up the Scenario
In this scenario, the investor has two or three single family homes they bought several years ago for $300K that are now worth $600K. We are assuming they have $1MM in equity and that cash flow has increased since purchase.
Remember that every time you renew a lease, you’re buying the property from yourself at the current market value. You always have the choice to sell the property and use that money to do something else.
Our 4 scenarios for using equity are:
- Option 1: Do nothing and evaluate the properties as-is, which brings about a 9% return annually thanks to the four ways you make money in real estate.
- Option 2: Sell the properties, pay capital gains tax, and invest in a passive investment fund like Ironton Capital’s Fund 5. This fund is anticipating 14%-20% returns, so we’re using a 17% return in our calculations.
- Option 3: Sell the properties, pay capital gains tax, and invest in a stock and bond portfolio. Stocks tend to generate 10% returns while bonds historically generate 5.3% returns. Combined, we’re expecting 8.1% returns.
- Option 4: Use a 1031 exchange and put the money in a Delaware Statutory Trust, which is a form of passive investing. This allows the investor to avoid paying capital gains and averages 5% returns.
What are the Returns?
When we look at the returns over 10 years, we can see that paying capital gains tax allows the investor to pick a higher return investment and make more money!
- Option 1 generates $2.3MM
- Option 2 generates $4.3MM
- Option 3 generates $1.9MM
- Option 4 generates $1.6MM
Why Isn’t It Always Bad to Pay Capital Gains?
In these scenarios, the investor makes an extra $2MM in wealth by paying taxes. While avoiding taxes may look more attractive at first, what you choose to do with the money makes the biggest impact over the long term. By paying taxes and investing the money in a fund that yields a higher return, the investor can make more money over time even with some of the money initially going to the IRS.
The true key to generating wealth is the Internal Rate of Return. Compound interest over a long period like 10 years can make a huge difference in wealth building.
Potential Changes to Capital Gains Tax Rules
It’s important for all investors to pay attention to the news and see how rules regarding capital gains tax and 1031 exchanges change. There’s talk about increasing the capital gains tax and eliminating 1031 exchanges, which means investors may have fewer options down the road.
If you’re thinking about making a move similar to the ones you’ve seen today, it could make sense for you to act now.
Remember, always talk to a financial advisor or tax professional before making any moves.
Learn more about Passive Investing Options
Ironton Capital’s Fund 5 just closed, having raised $10.5MM in 6 weeks. Fund 6 will start soon; it’s similar to Fund 5 and is expected to have comparable returns, too.
Set up an appointment with Lon to learn more.