In a meeting the other day, I was asked a question that made me stop and think. We were discussing upcoming proposed changes to tax laws that would increase the federal tax for high net-worth individuals. Anyone with an income of more than $1 million could be charged up to 43.4%, plus any applicable local taxes.
The question seemed simple.
“Will these possible changes scare investors off of investing in real estate or funds?”
My first answer is something I heard from a college tax professor and often repeat. You should never do anything solely due to tax reasons. If you were going to invest in real estate or a fund before those tax changes, you should still invest after those changes take place.
Investors will still look for whatever rate of return they want, and consider tax implications later. To me, this seemed obvious: a good deal is a good deal. My answer was so convincing that even my acquaintance was swayed.
I kept mulling over my response. While I still believe it was the right answer, it wasn’t as simple as I originally thought. What I said was true, but only if those investors had no alternatives with different tax implications. Comparing apples to apples with similar taxes on gains and returns, the answer stands. However, these new changes may make it harder to find options outside of real estate with more favorable terms. Will real estate investments and funds need to compete for investor capital with lower nominal return investments because of these new taxes?
Right now, there are different strategies that can be used to defer tax liability. There are even investments where you won’t pay any tax on income and gains. One of the most popular strategies to defer capital gains tax is the 1031 Exchange, where investment properties are swapped. These may no longer be possible with the proposed changes. Other strategies for deferring tax liability usually only allow much smaller amounts to be deferred, and only in the future. Other options are limited, and the best I found are municipal bond ETFs. While high-yield municipal bond ETFs carry a high rate of risk, they can also garner 3-4% returns that are virtually tax-free.
If the new changes are passed, this could be a possible scenario. An investor from California earning over $1 million a year could have a taxable investment comparable to an 8.1% return. This takes into account the 3.5% return with 43.4% federal and 13.3% local tax for a total of 56.7% total.
At face value, the above example can be problematic for investments that offer higher nominal returns, like real estate funds. However, the bonds in this example carry higher risk, and while they’re often marketed as “tax-free investments”, higher net worth individuals may still be subject to a federal Alternative Minimum Tax of up to 26%. This means those municipal bonds may not actually be such a great option.
While my final answer may not be as straightforward as I initially believed, ultimately, I still believe investors will chase the higher nominal fees in real estate, despite the tax laws that may pass.
That being said, investment managers should be ready to field more questions about the implications of these higher tax rates, and how they’ll impact investors. Educating investors, knowing the tax implications of investments, and connecting the dots are critical to building lasting relationships.
Arturo Cepero is the CFO of Novello Financial Group.