Qualified Plan / Real Estate Presentation

This is a concept tool. It does not present tax advice or calculate accounting entries. It is intended solely to compare and contrast attributes of real estate and qualified plans.

This tool demonstrates that assets subject to capital gains tax (such as a Condo) typically provide greater overall return (and usage benefits) as compared to assets subject to ordinary tax (such as a 401k). This is because:

•Assuming an affluent client, assets subject to capital gains tax are typically taxed lower than ordinary rates.

•Real estate investments provide a true tax advantage or shield. That is they generate return of cash to the investor. Contrast this to the tax deferring of a qualified plan where taxes are simply deferred and may or may not provide any tax advantage.

•The Condo cash flows or tax advantages occur early on the time line and thus improve the Condo’s internal rate of return.

No script is provided for this screen.

Assumptions:

•Both the 401K and the Condo are funded with the same before tax cash outlay.

•The Condo Mortgage is an IOL (Interest Only Loan).

•The Condo fees, property taxes, insurance and cost of maintenance are equal to the pleasure derived from the Condo.  Mathematically, this is the same as neglecting these costs.

•The Condo is not a rental property.

•The Condo appreciates to the same value as the 401K fund during the term of the mortgage.  More detail on this assumption appears in the Clarifications section below.

•The tax advantage occurs monthly. Actually it occurs once a year at tax filing time (about April).

•The limitations on investments in a 401K are not exceeded. Think of the first alternative as any Qualified Plan, not just a 401K.  You may think of the second alternative as any capital asset (a Condo, stocks, mutual funds, insurance, etc.).

•That the client is in a high marginal tax bracket.

•For every month, the entire monthly payment is subject to the marginal tax bracket.

•There are no expenses, fees, or closing costs associated with the IOL (mortgage).

•Mortgage Life insurance is not required.

•All payments occur at the end of the month. Since we are working with a mortgage which has payments at the end of the month, this assumption keeps all payments at the end of the month (to match mortgage payments).

•Compounded is monthly, again; this is to match mortgage calculations.

•The cost basis of the Condo can be imputed from the 401K inputs.

•The 401K is taxed at death.  This is not necessary true.  It is a simplifying assumption.

To help articulate the calculations used in the presentation the following assumptions are used for this help file example:

•Monthly Contribution or Condo Payments Before Tax = $600.00

•Assumed 401K Interest Rate = 8.00%

•Ordinary Tax Bracket = 33.33%

•Capital Gain Tax Bracket = 20.00%

•Time span = 30 years

401K Plan

The 401K alternative is a simple calculation or projection.  The client contributes a specified amount each month. Since all taxes are deferred, the entire amount is added to the 401K account and earns interest in future months. Compounding mode is monthly. The contributions are repeated each month. Finally, at the end of the projection, the client pays ordinary tax on the entire balance in the 401K.

For example, the client contributes $600 before tax at the end of the first month. Since taxes are deferred, no taxes are paid each month. At the end of the second month, the client contributes $600 more. In addition, the 401K fund receives interest on the balance each month. This process repeats each month until the end of the projection. At the end of the projection, we assume the client withdraws the funds and pays 33.33% of the funds in ordinary tax.

The Condo

By contrast, the Condo is a complex investment. The following cash flows and calculations occur each month during the life of the mortgage:

The client starts with the same $600 before tax cash flow. The client then pays $200 in income tax. That leaves the client with $400 remaining that is spent on a hypothetical Condo IOL (Interest Only Loan) mortgage. Since the $400 Condo IOL payment is all interest, the total mortgage payment is assumed to be fully tax deductible. The $400 tax deduction creates a tax advantage of $133.33 ($400 times the 33.3333% tax bracket). We assume this tax advantage is returned to the investor monthly (as opposed to annually in the real world). Thus the monthly cash outlay after taxes is reduced from $600 to $466.67 ($600 - $133.33). This process repeats each month. Finally, at the end of the projection, the tax due is one of the following cases:

1.The profit on the Condo is taxed at the capital gains rate.  (See next paragraph.)

2.The Condo is not taxed because it is inherited and the cost basis is marked up to the current market value.

3.The Condo is not taxed because it is (or has become) a primary residence selling for less than $500,000.

To calculate the capital gains tax on the Condo, a cost basis is required.  We impute the cost basis using the following simplifying assumptions:

•The cost basis is equal to the original IOL amount.  That is, we made a 100% loan.

•That the IOL (or cost basis) is equal to the Present Value of the following payments, interest rates, and term.

•The IOL is assumed to have the same interest rate as the 401K.

•The IOL monthly payment is assumed to be the same as the 401K Before Tax times (1 minus the ordinary tax bracket).  This just adjusts for the fact that we have to pay the mortgage with after tax dollars.  In our current example, this is $466.67.

•An assumed mortgage term of the entire length of the projection.

For the help file example, the cost basis is $54,513.67. After 30 years and with typical input assumptions, the cost basis is not very significant. With the above inputs, the 401K will have grown to $894,215.66. And by assumption, the Condo will have grown to the same value. The $54,513.67 cost basis is only about 6.1% of the assumed Condo market value of $894,215.66.  Thus we use this simplification to avoid additional inputs and calculations.

In the final cash flows for the Condo, we deduct the IOL balance which by assumption is the same as the condo cost basis.

The two questions concerning rate of return are solved by iteration.  We start with a guess about the required 401K rate of return.  We run the spreadsheet solutions and calculate the IRRs.  We test to see if the current guess makes the 401K IRR equal to the Condo (either with or without capital gains) IRR.  It the guess is too large, we lower it.  If the guess is too small, we increase it.  We continue this process until the two IRRs are the same (within several decimal places). At that point, the guess is equal to the answer of the question.

The two questions concerning IRR on the condo are solved by changing an assumption. The question specifies that we are assuming the final market value of the condo is the final balance of the 401K after taxes.  Previously we has assumed the condo final market value was the before tax balance of the 401K. To solve for these two questions (the top question with capital gains and the bottom question without any taxes); we just modify the last month’s cash flow in the cash flows spreadsheet. There are two columns of cash flows. One column is for the condo with capital gain taxes. The other column is for the condo without taxes. The modification is to change the final market value to the final balance of the 401K after taxes for both sets of cash flows.  Then we repeat the calculation of the IRRs. This provides two Condo IRRs. The first IRR is with capital gains. The second IRR is without taxes (of any kind). These IRRs are the solution to the questions.