Before I started QFS, the founder of a $1B+ RIA gave me a piece of advice.

He said certain client profiles were consistently more difficult for financial advisors to work with than others.

And in his experience, one of the most difficult profiles was real estate professionals.

It makes sense. Some of the stereotypes are:

• They want to invest almost exclusively in real estate, making diversification conversations difficult.
• Their wealth is often illiquid. Someone with an $18 million net worth might have only $2 million in brokerage assets and the remaining $16 million tied up in real estate.
• Their tax situations can be complex: depreciation, cost segregation studies, 1031 exchanges, K-1s, LLCs, partnerships, and entity structuring.
• They're usually very engaged investors who ask a lot of questions and want to understand exactly what's happening.

I completely understand why many advisors shy away from that profile.

However, they've become some of my favorite people to work with because there are additional tools/levers that are exclusively available to them.

They come to us to build customized portfolios that take advantage of those opportunities.

One of the best opportunities we’ve seen are professionally managed manufactured housing community investments because they offer some of the most attractive depreciation profiles we've seen.

Unlike many other property types, a significant portion of the value is often attributable to land improvements (roads, utility infrastructure, pads, drainage systems, lighting, sidewalks, and similar assets) which generally have much shorter depreciable lives than the buildings themselves.

Combined with agency financing, these investments have recently been producing approximately 1.6x-1.8x first-year depreciation deductions relative to invested capital.

For clients who qualify as Real Estate Professionals and are able to materially participate in their grouped rental real estate activity, those deductions can become incredibly valuable.

As an illustration:

A $1 million investment that generates approximately $1.7 million of depreciation deductions could produce roughly $629,000 of federal tax savings for someone in the 37% marginal bracket, assuming they are able to fully utilize those deductions.

And that's before considering any cash flow from the investment or long-term appreciation of the underlying real estate.

Those dollars can then be invested in more tax-advantaged investments that compound while passing deductions, whether it’s tax-aware hedge funds, tax-aware long/short SMA, or more real estate.

One comment I hear fairly often is:

"Depreciation doesn't avoid taxes. It merely defers them."

In many cases, those deferred taxes will ultimately become due when the property is sold unless another tax-deferral strategy is used. But every year you can legitimately defer taxes is another year that capital remains invested and compounding on your behalf.

And if you can continue finding legitimate opportunities to defer taxes over time (through depreciation, tax-loss harvesting, 1031 exchanges, Section 351 exchanges, trader funds, etc.) you allow more capital to remain invested for longer.

And that's exactly why I enjoy working with real estate professionals so much.

Most advisors see complexity.

I see opportunity.

 

Quantitative Financial Strategies, LLC is an investment adviser registered with the U.S. Securities and Exchange Commission. This material is for educational purposes only and is not tax, legal or investment advice. Investing involves risk, including possible loss of principal.

Private market investments are illiquid, may not be redeemable for extended periods, involve substantial risk including loss of the entire investment, and are available only to investors who meet applicable qualification standards.