Summary: You’ve all heard about the current inflation problem. You’ve also experienced it when you buy groceries or fill up a tank of gas. But what you might not realize is that this “problem” is far worse than you realize. In this article, we show you just how damaging inflation is for your financial health, using an illustrative example. We also give you our thoughts about what real estate investors can do about it.
[Disclaimer: We are not accountants, lawyers, or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
You’ve all seen the headlines about inflation. Inflation is now approaching levels we haven’t seen since the 1970s. Most look at inflation as the cost of goods going up.
While the cost of goods is going up, that’s not the real issue. That’s just the symptom of the real issue. The real issue is that the value of the U.S. dollar is going down.
Since 1970, the value of the dollar has declined by a whopping 98%! This is one reason something like a McDonald’s Big Mac, which used to cost 65 cents, now costs $4.95. While this is an issue, the situation is worse than you think.
Not only is your buying power going down, your wealth is also declining.
What’s the Issue With Inflation?
Some of you might be thinking, “I’m investing and getting a 10% return per year from my index funds!”
If inflation is above 10%, you’re actually losing money over time. What you might not know is, that even if inflation is at 10%, you’re still losing money because of taxes.
Let’s explain this using an example.
Let’s assume inflation is 10% per year for the next 7 years. During this time, your buying power gets cut in half, so prices double.
Let’s also assume your investments double over this same time period. Did you make money?
No, you have no net gain.
But it doesn’t end there.
You’re taxed 23.8% on your investments. So in the end, after taxes, you lost money on your investment.
You see, taxes don’t care about inflation. Just because there’s inflation, doesn’t mean the government will tax you less.
If taxes were indexed to inflation, in the above example, you wouldn’t pay any taxes because there was no net gain.
This is why inflation is so damaging, and the situation is worse for you than you think….
Here’s another example. This time, I’ll use a real estate example.
Let’s say that your parents bought an investment property for $100,000 in 1970 and they sell that property for $700,000 in 2022.
You might say to yourself, they made $600,000!
But is that true? No.
If you adjust the purchase price for inflation, the $100,000 in 1970 is worth $753,340 today. When you adjust for inflation, they actually lost money!
But from the government’s perspective, they had a gain of $600,000.
At 23.8% capital gains rate, the tax is $142,800!
So after all of that time holding onto this investment property, they didn’t make anything and in fact, they lost money.
What Can You Do About Inflation?
Instead of making you wait, I’m going to give you the answer and the key takeaway of this article: you need to invest your money and achieve a rate of return that beats not only inflation, but also the taxes we mentioned above.
For the rest of this article, I’m going to focus on solutions for real estate investors. Real estate investors have unique advantages because they have access to various tax incentives and loopholes to reduce their taxes. Which we’ll discuss more below.
If You Sell, Always Use a 1031 Exchange
The above example illustrates just how important a 1031 exchange is for preserving wealth. If your parents used a 1031 exchange, they wouldn’t have to pay taxes on the $600,000 gain.
Far too often, I hear investors say, “it’s too hard to find a replacement property, so I’ll just pay the tax.” Just remember that every time you pay the tax, you’re not preserving your wealth and in fact, your wealth may go down.
We have personally done numerous 1031 exchanges. We have been fortunate to make the deadline every time. One way we do this is by finding our replacement property before we sell our relinquished property.
Another thing we like to do is have a backup plan. One backup plan that is available to anyone is a DST 1031 exchange. While this comes with some downsides, for us, the upside of preserving our 1031 exchange usually far outweighs the downsides.
The other benefit of preserving the 1031 is what some people refer to as “swap until you drop.” In other words, you can keep using the 1031 exchange until you die. The benefit is that your heirs inherit your properties. However, they don’t have to pay any of the accumulated capital gains or depreciation.
Your heirs get what is called a “step-up in basis.”
This is a huge benefit to you if you want to pass on your wealth, tax-free, to your heirs.
Make Great Investments and Stay Way Ahead of Inflation
If you want to beat inflation, your investments will have to far out-pace inflation. It’s just math.
Don’t think saving is the answer. If you save and you don’t invest, the value of your money declines with inflation. You’re getting poorer over time.
Don’t think the stock market is the answer. When inflation is low, for example, 2%, your index funds at around 10% are outpacing inflation, but when inflation is at 10%, you’re losing money because of the taxes on the gain.
Even worse, some are predicting another “lost decade” for stocks. For those who don’t know what that is, the lost decade was the period between 2000 and 2010. During this time, the annual stock market returns were actually negative when adjusted for inflation.
So good luck if most of your wealth is in stocks. A decade with no wealth growth and in fact, wealth destruction is a disaster.
For real estate investors, continue to invest for cashflow and forced appreciation. Many in our community make greater than 10% cashflow and they force considerable appreciation in their properties. When you add up the cashflow, appreciation, debt paydown, and tax savings, you can do far better than 25% annual return.
Lower Your Tax Burden
The other thing you can do to beat inflation is to become more tax efficient.
However, for many high-income doctors and professionals, you’re in the highest tax bracket with very few options for sheltering income.
To make matters worse, the trend is declining reimbursement and declining salaries. Add inflation on top of that and you’re actually making way less than the actual decline, but let’s assume you’re one of the lucky ones and your salary goes up over the next 10 years. Keep in mind that if the rate of increase in your salary doesn’t outpace inflation, you’re actually making less.
So what’s one potential solution? You have to become more tax efficient. In other words, if you could pay zero taxes on your salary, that’s the same as a higher salary. If you assume your effective Federal tax rate is 25%, then you’d be giving yourself a 25% salary increase.
How do you do that?
Real estate has some unique advantages. Using tax strategies like real estate professional status or the short-term rental tax loophole, you can shelter your income and pay zero in federal income taxes.
Click HERE for a list of CPAs that can help you with tax savings with real estate
Consistently Do the Above, Year After Year
If you want to stay ahead of inflation, it’s not enough to shelter your income one year, but not the next. You have to be consistent and do it year after year.
Anytime you fail to shelter your income, it’s like a double tax. You are not only taxed on that income but you are also hit on top of that with inflation.
As one tax expert said at a talk recently, “inflation is taxation without legislation.”
The same with your investing. You have to consistently invest your money. Whenever it sits there, the money is losing value.
You also have to do it well. Having a year where your rate of return falls behind inflation means you’ve lost money that year.
If all you’ve been doing is saving money in your 401(k), it’s simply not enough in an inflationary environment. As you saw above, the cost of doing nothing is not a smart alternative.
If you want to fast-track your real estate journey, our Zero to Freedom course will show you how to combine cashflow, forced appreciation, debt paydown, and tax savings to beat inflation and lower or eliminate your taxes.
The bottom line is, the sky is not falling. It’s not time to panic. It’s time to make smart decisions and ACT.
Have you found a way to creatively fund your real estate portfolio and achieve financial freedom? Join the conversation! Follow our Semi-Retired MD Facebook page and join our Physicians (for MDs or DOs only) or Professionals group!
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