4 BENEFITS OF DEFERRING TAXES NOW!
By: J Scott
Perhaps the most important lesson I’ve learned over my two decades of investing has been the importance of reducing and deferring taxes. As young investors who are focused on growing our income, it’s easy to think, “Paying taxes is good…it means I earned more money!” And to be clear, I fell into this camp of thinking for a long time.
But, as you get accustomed to earning a decent living, and as your income starts to peak, you begin to realize that saving money is just as important as earning money. And that the easiest way to increase the amount of money you save at the end of every year is by reducing or deferring the amount of that income you need to pay to the government.
And, as real estate investors, there are a lot of great ways to reduce and defer our taxes: Depreciation Benefits, 1031 Exchanges, Installment Sales, etc. And in future articles, we’ll discuss each of these (and more) ways that we can leverage tax laws to reduce and defer taxes.
But first, I wanted to touch on why, specifically, reducing and deferring taxes gives us the ability to grow our wealth faster and more efficiently. And more importantly, why you should be focusing on this sooner rather than later.
There are four primary ways reducing and deferring taxes will make you money:
1. Boost compounded returns.
If you’re familiar with the concept of Time Value of Money, you know that money today is worth more than money tomorrow. Pushing off paying taxes until tomorrow (or, better yet, twenty years from now) allows us to reinvest those dollars today to boost our returns over the long term.
Let’s look at an example. Let’s say that I earn $500 in income this year, on which I would normally be taxed 20% ($100). But, what if I can avoid paying that $100 in taxes this year. In fact, what if I can defer the payment of that $100 for the next 10 years, and in that time, I invest that money into a syndication that generates as 14% compounded return (fairly standard return for a real estate syndication these days).
At the end of 10 years, that $100 has turned into more than $370!
For a six-figure income earner who might pay $50,000 in taxes per year, deferring and growing that money for 10 years would add $135,000 to their net worth. Do this with a $50,000 tax burden every year for 10 years, and that $500,000 in tax deferral will earn you an extra $750,000!
The only work required on your part to earn that extra $750,000 was to make investments decisions that would allow you to defer those taxes and to invest that money passively.
2. Pay taxes in inflated dollars.
Going back to the Time Value of Money concept, thanks to inflation, a dollar tomorrow is worth less than a dollar today. Paying your taxes later means paying less (in today’s dollars).
To put this into real numbers, assuming a rate of inflation of 2.5 percent per year, a dollar today is going to be worth less than 50 cents in the time it takes to pay off a thirty-year mortgage. In other words, deferring your taxes for thirty years can cut the total hit to your net worth from taxes in half!
Even deferring your taxes for 10 years will result in nearly 30% less money paid in today’s dollars thanks to inflation.
3. Wait for more favorable tax laws.
Tax laws are always changing, and there’s a chance that putting off paying your taxes may allow you to take advantage of future tax benefits that don’t exist today. Don’t get me wrong, taxes today are at historical lows, but real estate investors have been fortunate to receive some amazing tax breaks over the years, and I’m hopeful that future tax advantages are even better.
4. Perhaps put it off completely.
Finally, while we may not like to think about it, one day we will die. If we can defer taxes long enough, we may never have to pay those taxes ourselves. And depending on other changes to the tax code and our ability to structure our asset holdings in the best possible way, we may be able to reduce, defer, or even eliminate the payment of taxes on our gains long after we’re gone (or even completely).
In other words, if you can put off paying taxes for the rest of your life, there’s a chance that those taxes will never be paid, by you or your heirs. And even if those taxes are owed upon your death, you still get the advantages of #1-3 above.
Long story short, reducing and deferring taxes can be the easiest way to compound your net worth, and the sooner you start, the more benefit you get thanks to your ability to compound that savings over time.