May 24th 2011
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By Al Prentice, vice president, strategic firm development, 1st Global
As CPA wealth managers know, the foundation of a holistic financial plan requires tax-optimized planning. Although tax planning incorporates traditional tax reduction strategies, such as use of IRAs, 401(k)s and tax-free investments, the real power of tax planning comes in the utilization of tax reduction tools inherent in direct participation programs (DPPs). Strategic use of these tools can provide tremendous differentiation from traditional financial advisors. Three of the most effective are real estate investment trusts (REITs), 1031 exchange programs offered by real estate providers, and oil and natural gas limited liability partnerships (LLPs) offered by energy providers. These programs provide either upfront tax reduction solutions (oil and gas LLPs), or current tax deferral (1031 exchanges), or tax-advantaged income (all three). Let’s take a closer look at each type of direct participation program and explore how they can be used to solve the issues relevant to the comprehensive financial tax planning.
REITs provide investors exposure to the benefits of real estate investments without the disadvantages of direct ownership, such as active management. REITs also provide benefit by using leverage and depreciation. Leveraging a portion of the purchase price provides a boost to potential returns because the actual upfront investment is only part of the purchase price. Then, if everything goes according to plan and the investment is sold after several years after appreciating in value, the return on the actual amount provided by investors is enhanced by the leverage of the borrowed amount. This is, of course, after the remaining debt has been repaid. The depreciation expense and the interest paid on the note are tax-deductible and provide a tax- advantaged return, which allows the investor to retain a greater portion of the cash received from the property.
1031 exchanges are a great way to provide tax deferral for direct owners of real estate. 1031 exchanges normally fall into one of two categories. The first is when the owners of active real estate, such as rental homes or strip malls, have reached a point in their lives where they no longer want to deal with the hassles of active management, but still desire current income. The second usually involves the heirs to such property. These inheritors may have no interest in the ongoing management of real estate, may live in a different part of the country, or have no expertise or ability to manage these properties. In all of these cases, a common theme is that the investors want to minimize or defer any current taxable exposure. It is possible to maintain 1031 exchanges until death and receive the benefits of a stepped-up income tax basis in the real estate property without having to ever pay capital gains tax under today’s estate tax legislation. In these cases, a 1031 exchange may be a good solution. Essentially, the owners work with our real estate partners to identify a buyer of the current property, while also identifying a replacement property. Once this exchange is identified and implemented, the sales proceeds from the original property are held in escrow with a qualified intermediary while the purchase of the second property is completed. Then the sales proceeds are finally transmitted to the 1031 provider to complete the transaction. The new property is usually held in the form of a Tenant in Common (TIC), which provides limited liability and no management responsibilities for the investor. In addition, the investor is entitled to receive a periodic income stream from a portion of the rents. These income payments are tax-advantaged due to the leverage and depreciation benefits discussed earlier.
Oil and Gas Limited Partnerships
One of the most important ways to help clients maximize tax-optimization in their portfolios and actively manage their future tax liability is through the use of oil and natural gas limited liability partnerships (LLPs). These LLPs are one of the few tax shelters that survived the Tax Reform Act of 1986. Since then, their status in the Code has grown only stronger as Congress strives to find ways to make the U.S. less dependent on foreign sources of energy, which now account for up to 66 percent of our daily consumption (up from 50 percent only 15 years ago).
These energy LLPs, by reducing taxable income as a deduction in the year of investment, provide tax benefits up front, and on a continuing basis, are designed to provide long-term (10-25 years) tax-advantaged return of principal and subsequent yields for as long as the wells produce. The tax advantages flow from the intangible drilling costs (IDC) on the initial investment, and the depletion allowance (DA) on the subsequent return of principal cash flows. The depletion allowance works much the same way that depreciation works with real estate.
The tax benefits provide passive losses to offset passive gains (if the investor enters as a limited partner), relief from high marginal tax bracket exposure (ordinary loss if the investor enters as a general partner), and from exposure to the alternative minimum tax (AMT) up to certain investment limits. In addition, the subsequent cash flows are tax-advantaged due to the benefits of the DA as described earlier.
Proper use of these tax-advantaged direct participation programs can provide investors with solutions that they would probably not be able to find outside of a tax-centric wealth manager working with the right partner.
To learn more about direct participation programs and how you can become certified to offer them to your wealth management clients, or to learn how to add wealth management to your practice, contact 1st Global at: (800) 959-8461 or LearnMore@1stglobal.com.
This is not a solicitation to sell the aforementioned program types. Please note that there are special risks of investing in Limited Partnerships and REITS such as lack of liquidity and potential adverse economic and regulatory changes. For this reason, there are minimum suitability standards that must be met. Investors should read the prospectus carefully before investing. In addition, an investment in real estate will fluctuate with the value of the underlying properties, and that the price at redemption may be more or less than the original price paid.
This article and its content has been provided by 1st Global. With more than 500 firms affiliated with 1st Global, it is one of the largest wealth management services partners for the tax, accounting and legal professions. 1st Global delivers the required capabilities essential for wealth management excellence including progressive ongoing education, which places the firm in a unique position to offer wealth management knowledge.
1st Global was founded by CPAs on the belief that accounting, tax and estate planning firms are uniquely qualified to provide comprehensive wealth management services to their clients. Each affiliated firm is provided with education, technology, business-building framework and client solutions that make these firms leaders in their professions through dedicated professional client relationships built around wealth management.
1st Global Capital Corp. is a member of FINRA and SIPC and is headquartered at 8150 N. Central Expressway, Suite 500 in Dallas, Texas,(214) 265-1201. Additional information about 1st Global is available via the Internet at www.1stGlobal.com