by Pj de Marigny, DITMo Capital, Newport Beach, CA
For those who consult in the private wealth area and for estate attorneys (some who have turned advisor for the huge insurance commissions), egregious tax loopholes for the global wealthy is the most profitable part of financial services. Consider that insurance products are tax-advantaged and commonly used in all sorts of trusts to protect assets and are coupled with business interests in creative tax avoidance structures.
Financial advisers specializing in this area usually work with favored advanced planning insurance company attorneys and independent attorneys. Some independent attorneys either have switched to an adviser role to share in the insurance commissions, or outright charge by a percentage (typically 25%) of the tax savings. The risk of a tax regime change is laid-off on the client from these “paid upfront” advisers and attorneys.
Here are three classes of tax loopholes that are “under the radar” that many believe unfairly benefit those who receive non-work-related income (investments) and/or avert legal barriers:
1 – 1031 exchanges and depreciation offsets: This is an IRS code that allows an investor in real assets to defer or avert paying taxes on gains. The gains from sale (this can even apply to generators at GE or airplanes) are rolled into a new like-kind real asset investment and for individuals, the assets may be inherited from deceased family with a step-up in basis. Trump has utilized the 1031 vehicle in his family.
Regarding depreciation, many who invest in real estate understand that any cash flow from real estate investments is offset by depreciation on the structures and improvements (not land) over a 27.5 or 39-year period. Therefore, if land is a smaller percentage of the cost of the real estate, it is possible to distribute (receive) non-taxable income until the property is sold at which time depreciation is recaptured at a lower tax rate or exchanged tax-free.
Argument against: Income is income. It’s a basic principle to tax one’s increase so why favor one source of income over another? If one receives dividends from an equity holding, the depreciation of the underlying company does not offset it. Yet, when a property is depreciated, the income flow is offset by depreciation instead of being deducted from the residual value. Add to this special tax credits to induce developers. The result of all of this is to inflate the ROI multiple and to misprice risk.
2 – Long Term Capital Gains: This allows an investor to pay a lower rate on realized gains for longer held investments rather than the rate for ordinary income (from wages).
Argument against: Now, here is where Mr. Kudlow and others are dead wrong who aver that this is double taxation. The principal is not being re-taxed, only the income from the principal. Why should investment income be taxed differently from ordinary income, or even more quizzical, why are there investment income classes that are taxed differently?
3 – Variable-interest entities utilizing BVI or Caymans holding companies or foreign owned entities (WFOE):
Argument against: Using these structures and special attorneys or firms like Milbank and Tweed (the fee often is as much as 25% of the proposed tax savings up front), taxes can be brought down below 10% using loans for the equity interest that also includes bank funded insurance for planning purposes. VIE and other structures are used by foreign nationals to circumvent capital and domicile restrictions.
It is obvious that changing marginal tax rates also affects other bond market sectors:
4 – Municipal securities: Munis are about to flood the market on a lower Trump marginal rate. Though “munis” are not a tax loophole, most highly affluent investors own municipals – and many exclusively invest in munis – to avert taxable income.
The long ratios have been almost non-existent. Municipalities that have been funding budgets using balloon paying, non-accreting Capital Appreciation Bonds (that differ from OID bonds) will now be faced with greater credit risk with less additional issuance in the face of a flooded muni market from prior issuance.
To prevent a rush to alternative non-taxable / tax-deferred sources of income – i.e. real estate – the tax inequalities above should be resolved to avert massive dislocations.
Pj de Marigny
DITMo Capital, Newport Beach, CA