Real estate, permanent life insurance provide tax benefits
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In any year, most physicians would like to reduce their taxes. This goal may prove even more important in 2021, and beyond, as it is expected that Democratic control of Congress and the White House will result in new tax legislation.
A review of President Biden’s tax proposals clearly establishes a policy goal to reverse the prior administration’s tax cuts and increase taxes on high-income taxpayers, a category that includes most physicians. Thus, tax management will likely become more important this year.
To that end, doctors will want to take full advantage of two commonplace assets that have enjoyed advantageous tax treatment under our tax code for decades: real estate and permanent life insurance. In this article, we will discuss these two asset classes and their tax benefits.
Tax similarities for both assets
Real estate and permanent life insurance are similar tax-wise. In our book, Wealth Planning for the Modern Physician, we discuss the similarity of real estate and permanent life insurance from a tax perspective. While our tax code changes somewhat regularly, both of these asset classes have enjoyed superior tax treatment for decades.
An owner of real estate can deduct interest payments on home mortgages within limits and write off depreciation on business real estate. Other tax benefits include a deduction for local property taxes against federal income taxes, a benefit that was limited by the last tax code change and may revert to more generous rules under a Biden tax act, as well as a capital gains exemption of up to $500,000 on the sale of the primary home for a married couple filing jointly.
Tax-deferred growth
With permanent (also called “cash value”) life insurance, one can enjoy tax-deferred growth of gains within the policy and, with proper management, can access the accumulated 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 — one 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, which is 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.
Assets have investment similarities
Interestingly, from an investment and asset class perspective, these two assets are relatively long term. Although there are certainly professional real estate developers or home 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 a longer term allows time for the tax benefits to outweigh the upfront costs.
Both assets not used well
Most physicians utilize one of these tax-favored assets well. Many already use real estate as a significant part of their balance sheet. This is not surprising, as many doctors own a house, which is often one of their most valuable assets. Some also own second homes, rental properties and even raw land. Furthermore, many medical practices purchase real estate, rather than renting office space for their practices. In this sense, most physicians may not need to “reconsider” real estate as much as cash value insurance.
In fact, it is typical for a physician to have anywhere from 20% to 50% of their net worth tied up in real estate. Over the years, many have taken full advantage of some real estate tax benefits, from interest deductions and property tax write-offs to depreciation benefits and like-kind exchanges.
Despite their interest in building tax-favored wealth for retirement, few physicians take advantage of the significant tax benefits of cash value life insurance. 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. Moreover, this asset class is likely going to improve in 2021 and beyond because of a new law passed at the end of 2020 as part of the Consolidated Appropriations Act, 2021.
A section of this law impacted Section 7702 of the tax code, which governs life insurance. Essentially, the law will allow insurance companies to re-price their policies using more favorable internal interest rates so that consumers will be able to contribute more to permanent policies and enjoy more tax-free growth and access. In short, this new law makes an already tax-favored asset class even more favorable in the future, and perhaps more attractive to physicians.
Case study
Let’s look at an example of how a cash value life policy can work as a tax-favored accumulation vehicle even without the new law’s potential impact. Dr. Owen is a 45-year-old doctor 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% annually, Owen wants to see what relative advantages the life policy will produce due to its favorable tax treatment.
Let’s assume Owen has $25,000 to invest per year for 10 years before retirement and will withdraw funds between age 65 and 84 years. Let’s also assume Owen’s tax rate on investments is 29.4% (80% coming from long-term gains and dividends, 20% from short-term gains plus 6% state tax).
With these assumptions, if Owen 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 still have more than $200,000 of life insurance death benefit protection at age 90. This is a substantial difference (assuming the same 6% rate of return) 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 tax planning. Given possible tax increases in 2021 and a new law’s positive impact on cash value life insurance, it makes sense for doctors to re-evaluate these asset classes to see how they fit in their wealth planning.
Reference:
Wealth Planning for the Modern Physician and Wealth Management Made Simple are available free in print or ebook formats by texting HEALIO to 47177 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
For more information:
Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon at Northwestern Medicine in Warrenville, Ill. He can be reached at: sanjeevbhatia1@gmail.com.
David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group www.ojmgroup.com. You should seek professional tax and legal advice before implementing any strategy discussed herein. He can be reached at: mandell@ojmgroup.com or 877-656-4362.
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