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Like everyone we have ever worked with, you likely want to reduce your taxes as much as legally permissible. While most consider tax reduction as their #1 or #2 financial concern, few take full advantage of the two commonplace tax-favored assets that have enjoyed advantageous tax treatment under our tax code for decades – real estate and permanent life insurance.

How real estate and permanent life insurance and are similar tax-wise

In our books, videos and podcasts, we discuss the similarity of real estate and cash value life insurance from a tax perspective.  While our tax code changes somewhat regularly, both have enjoyed superior tax treatment over recent decades.

With real estate, you can write off depreciation on business real estate, deduct interest payments on home mortgages within limits, write off local property taxes against your federal taxes (this was limited by the most recent tax law), and enjoy up to a $500,000 capital gains exemption on the sale of the primary home (for a married couple filing jointly), among other benefits.

With permanent life insurance (also called “cash value” insurance), you can enjoy tax-deferred growth of gains within the policy, and with proper management, access such value tax-free in retirement.  In addition, policy death benefits generally are paid to beneficiaries free of income tax and — for those focused on estate planning — you can even structure the death benefits to be paid estate tax free within certain types of trusts.

Further, both asset classes offer a powerful tax benefit that few others provide: the ability to move from one piece of real estate or life policy to another using a tax-free like kind exchange.  These exchanges are controlled by tax code sections 1031 and 1035, respectively.

How real estate and permanent life insurance are similar as investments         

Interestingly, from an investment and asset class perspective, these two assets are relatively long term.  While there are certainly professional real estate developers or fix-up flippers who do well in the short term, most real estate buyers should think longer term when buying a home, rental, or other real property. Because of the real estate business cycle and the previously mentioned tax benefits, thinking longer-term is often savvier. The same is true for permanent life insurance, where the longer term allows time for the tax benefits to outweigh the upfront costs.

Most Utilize Only One Tax-Favored Asset Well

Not surprisingly, most clients we have worked with have utilized real estate as a significant part of their balance sheets. This is not surprising, as many investors own a home and it is often one of their most valuable assets.  Some also own second homes, rental properties, and even raw land.  Further, many business owners purchase real estate, rather than renting offices or other facilities for their companies.

It is typical for the physicians and other individuals with whom we consult to have anywhere from 20% to 50% of their net worth tied up in real estate.  Over the years, they have taken full advantage of some real estate tax benefits – most notably the interest deductions and property tax write-offs.  A few have also utilized the depreciation benefits and like-kind exchange tax opportunities.

Despite their interest in building tax-favored wealth for retirement, relatively few investors have taken advantage of the significant tax benefits of cash value life insurance.  While we do encounter some individuals with substantial cash value policies as key assets for their retirement, most have little, if any, invested in this asset class.  This is unfortunate, as the tax-free growth and access of this asset class fits well within a long-term “tax diversification” strategy for most high net worth clients.  Let’s look at an example of how this can work.

Case Study: The Power of Tax Advantages of Cash Value Insurance

Dan is a 45-year-old in good health who wants to invest in either a taxable investment account or a cash value life insurance policy for his retirement.  Keeping rates of return equal at 6.00 percent annually, Dan wants to see what relative advantages the life policy will produce due to its favorable tax treatment.

Let’s assume Dan invests $25,000 per year for 10 years before retirement and then withdraw funds from ages 65 to 84.  Let’s also assume Dan’s tax rate on investments is 29.4 percent (80 percent coming from long-term gains and dividends, 20 percent from short-term gains, plus 6 percent state tax).

With these assumptions, if Dan invests in mutual funds on a taxable basis, he will be able to withdraw $27,103 per year after taxes. If he invests in cash value life insurance, he will withdraw $46,416 per year (no taxes on policy withdrawals of basis and loans) and will still have over $200,000 of life insurance death benefit protection at age 90. This is a substantial difference based primarily on the tax treatment of the cash value policy.

Conclusion

Real estate and cash value life insurance are two everyday asset classes that can be leveraged to optimize your tax planning.  We encourage you to explore both and see how they may help you achieve your long-term financial goals.