Most of you have heard the saying “It’s not what you make. It’s what you keep.” The difference between what you make and what you keep is predominantly found in taxes. We know this all too well as W-2 wage earners when we look at our paychecks and see 30 to 40% withheld for state and federal taxes. Taxes are the largest single expense for most people.

When evaluating investments, it’s critical to consider the effect of taxes. Most investment returns are discussed in terms of the returns before considering taxes. Most of the time there is hand waving, and you read or hear…“everyone’s tax situation is different so one should consult with their tax advisor or CPA about your investment returns after taxes.” Most of us are not CPAs or tax advisors, but it is worth considering taxes, at the very least, on a basic level.

Is a stock investment that gets a 10% annual return better than a real estate investment that gets a 10% return? At a glance, most people would say these investment returns are the same. For this example, let’s consider the real estate investment as a direct investment in a single real estate asset and not a REIT. Refer to the May blog post for a discussion of the differences between REITs and direct investments. To answer this question, the first thought should be regarding the riskiness of these two investments (i.e., a stock versus a direct real estate investment). For simplicity, let’s assume the risk level is the same between these two investments. The second thought should be about how these investment returns are assessed. Are we talking about investment returns before taxes or after taxes? We should be talking about investment returns after taxes. After all, taxes can be the largest expense that erodes true investment return if you are not careful. As the saying goes…It’s not what you make. It’s what you keep.

For stocks held for less than one year, investment returns are short-term capital gains, taxed at the ordinary income tax rate (up to about 40% for the highest tax rate when considering federal and state taxes). For direct investment in real estate, the income will be more than offset by the depreciation. With depreciation as a tax shield, the income received as cash flow distributions throughout the year will be tax free. The power of depreciation in direct real estate investments is incredible. Tom Wheelwright, CPA in his book Tax Free Wealth referred to depreciation as magical. He called it the King of All Deductions. The below example illustrates why…Let’s put numbers to the example above to see what this looks like over a five-year period with a $50,000 investment. How is the return on investment (ROI) affected by taxes for these two investment options?

Comparison of Return on Investment (ROI) when considering taxes

Looking at the table above, the direct real estate investment yielded the same return in three years ($67,409) that the stock returned in five years ($67,442). Put another way, the direct real estate investment has nearly double the ROI as the stock over a five-year period (1.85). If these two investments have the same level of risk, then you can absolutely say that the direct real estate investment has a much better risk-adjusted return after taxes than the stock.

Tom Wheelwright in his book Tax Free Wealth does a great job explaining the many strategies available to reduce your taxes by simply following the tax code. I recommend buying this book ASAP.