Jake Carpenter | Cash flow vs. tax flow

What does this mean for you? It means that if your tax flow is not managed you have much less cash flow available to spend. It is a matter of efficiency and coordination inside your financial world.

The situation of a couple that I recently worked with is a good illustration of what I am referring to. This couple had worked hard over the years on their farm. They followed the advice of their tax professional and put most of what they earned back into the farm. And, following the advice of their financial planner, they put the rest into a retirement plan that kept their taxable income lower because the monies they put in were not subject to income tax for as long as they remain in the retirement account.

Now, years later they are meeting with me because they want to create an income stream from their assets so they can slow down, retire and travel around the country spoiling their grandkids. They have no debt on their farm, which is now worth $5 million, and they have $2 million in their retirement accounts.

Now, don’t get me wrong, they have done a great job accumulating some cash and assets. However, they are faced with a potentially huge “tax flow” issue that must be addressed and managed before the assets are repositioned to produce passive cash flow.

Let’s look at the farm asset. The farm needs to be sold to reposition the asset. But if they sell the farm, they will owe capital gains tax on approximately $4 million of the $5 million dollar sale. This will create a huge “tax flow” event.

You may be wondering, “Why don’t they just use a 1031 exchange?” Mainly because they don’t want the headache of owning and managing a farm, they want to slow down. A 1031 Exchange provision requires that the proceeds from the sale are used to buy a “like-kind” property. That means if you sell a farm, you must buy another farm. The solution here is to find a way to repurpose the capital gains tax bill and put it back in their pocket to create more cash flow and growth, without using a 1031 Exchange.

Can this be done, you ask? The answer is yes! However, it does depend on each individual situation and the strategy does need to be set up prior to the sale.

Now, let’s consider the tax flow issue with their retirement account. The good thing about the way their retirement accounts were set up is that it kept them from paying taxes on some of their income while they were working, but the bad news is, now 100% of their retirement account is subject to ordinary income tax. And those tax rates could be even higher in the future.

Another consideration is if we leave all this money in stocks, bonds and mutual funds, how is it going to perform from month to month, for the next 30+ years? Unfortunately, there is no way of knowing.

The rules a financial planner uses to grow your account when you were working and contributing no longer work when you are retired and need to draw income off the account. When you reach retirement, rules like diversification, dollar-cost averaging, focusing on average returns and asset allocation no longer apply.

The fact is, if you set up systematic withdrawals from a diversified portfolio it is generally doomed to fail. That’s because it requires you to do the wrong thing at the wrong time, like buying high and selling low! It can turn dollar-cost averaging into dollar-cost ravaging.

It is important to work with an adviser who has the resources to help you reposition your cash and assets into a position that creates tax-efficient cash flow that keeps up with inflation.

Jake Carpenter is vice president of investor relations for real estate investment company Equilus Capital Partners LLC. He has professional expertise in estate planning, business succession, wealth transfer and asset management. He works out of the Wenatchee and Tri-Cities offices and can be reached at (509) 665-8349.