Answers To Tax-Efficient Investing Questions From Advisors Hot

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This blog entry answers questions raised by advisors in the recent Introduction to Tax-Efficient Investing webinar. Advisors4Advisors members can see a free on-demand replay of the webinar, which is the first of a four-part series. The other three sessions can be viewed on demand for $20 each for A4A members and $30 each for non-members.

1.  What do you think of investments in Real Estate Investment Trusts (REITs) in the current economic environment?

REITs are companies that buy, manage, develop, and/or sell real estate such as shopping malls, office buildings, apartment complexes, or housing developments. They make money from rental income, profits on the sale of property, and fees for services provided to tenants. REITs are traded on major exchanges and investors can buy ownership interests in them in the same way they could buy shares of stock in a corporation. They have both advantages and disadvantages.

Advantages of REITs

  • Make it possible for the average investor to invest in a diversified real estate portfolio
  • More liquid than a direct investment in real estate because they are traded on major stock exchanges
  • Tend to have low correlation coefficients with stocks and bonds, making them an excellent asset to diversify a portfolio
  • Professional management
  • Provide current income (at least 90% of income must be distributed)
  • Also create capital gains, providing a hybrid return that may appeal to some investors

Disadvantages of REITs

  • Vulnerable to declines in the real estate market (either lack of renters or low sale prices)
  • Vulnerable to rising interest rates that affect borrowing costs
  • Limited use as a tax shelter because they are not allowed to pass losses through to their investors
REITs invested to produce rents from apartment buildings and professional offices are generally doing reasonably well and may be a good addition to a portfolio because of their diversification potential. REITs invested in rental buildings that are more sensitive to economic downturns like retail and office buildings may not be doing so well. Sale prices for buildings are also depressed.

2.  Are low-income housing tax credits a viable tool for long term tax planning?

The Low Income Housing Credit (LIHC) is an economic incentive to produce affordable rental housing. The credit rate is approximately 9% per year for new construction and 4% for either rehabilitation projects or federally subsidized buildings and is claimed over a 10-year period. The calculation is complicated by the fact that the tax credit rate is not actually 9%, but the rate necessary to make the present value of the payment stream equal to 70% of the eligible basis. As interest rates drop, the amount of the annual credit could drop significantly below 9%.
The economic effect of the LIHC is to lower a taxpayer’s opportunity cost of capital (OCC). Whether taking advantage of the credit makes sense depends on the taxpayer’s opportunity cost of capital (OCC). The OCC for a project is the rate of return an investor could earn on the next best alternative investment having comparable risk. Suppose, for example, that a taxpayer (T) is thinking of investing $100,000 in Project X and could otherwise invest the $100,000 in Stock Y, having comparable risk and producing an expected return of 6%. Given the 6% OCC, it would only make sense for the taxpayer to invest in Project X if the expected return was at least 6%.
The effect of the LIHC is to reduce the OCC for the eligible investment because, in effect, the taxpayer needs to invest less capital to get the same return. Consider the following simplified example.
T is thinking about investing $1,000,000 in a low-income housing project. T believes it can earn 3% ($30,000/year) on the project. T’s opportunity cost of capital is 9%. This means that T would only invest if the return from the project was at least $90,000/year. Without the LIHC, T would never invest in the project because the expected return is far below T’s OCC. But, with the LIHC T, in effect, needs to invest only $300,000 to get the $30,000 return. T keeps the other $700,000 because of the tax credit. This makes the effective rate of return for the low income housing project 10% ($30,000/$300,000 invested). Because the expected rate of return now exceeds the OCC, T might consider investing.[1]
The answer to the question, then, is that the LIHC might make sense if the return on a project exceeds the taxpayer’s OCC after the LIHC is taken into account. To make this determination, the taxpayer will have to estimate both its OCC and the expected return on the low income project.  

3.  How is estimated tax affected by selling a low-basis, concentrated stock position late in the year?

Recognizing a large gain at the end of a tax year would generally create no estimated tax problems. To avoid an underpayment penalty, an individual must make quarterly installment payments based on the amount of the required annual payment. This required annual payment is the lesser of (1) 90% of the tax shown on the current year return or (2) 100% (110%, for high-income individuals) of the tax shown on the previous year’s return. Thus, provided the annual payments were at least 90% of the prior year’s tax, there would be no penalty regardless of how large the year-end gain was.

For more guidance on tax-efficient investing, see the replay of my recent webinar, Introduction to Tax-Efficient Investing.
After that, check out the other three parts of the Tax-Efficient Investing Webinar Series:

[1] The simplified example may understate the effect of the LIHC on the OCC. The Congressional Research Service estimated a 79.1% reduction under similar facts. For a more comprehensive calculation of the OCC see Congressional Research Service Report RS 22917, February 2, 2009. 


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