Tax Drag: The Silent Compounding Killer Costing You Millions | Ep. 8

In this episode of The Sage Investor, host Brian Spear unpacks the critical role of tax efficiency, serving as the fifth pillar of the Sunrise C.A.P.I.T.A.L. Strategy. While many investors fixate exclusively on gross generation metrics, the actual durability of long-term wealth depends heavily on capital preservation. Taxes represent the single largest, most predictable drag on investment returns. Because compounding operates as an after-tax phenomenon, every dollar surrendered to annual taxation permanently compromises the ultimate compounding trajectory.

Spear contrasts the structural inefficiencies of active real estate models, such as fix-and-flip syndications, against a disciplined long-term buy-and-hold strategy. Active trading environments expose investors to recurring friction costs, including capital gains liabilities, transaction fees, cash drag, and heightened reinvestment risks. Spear challenges standard real estate industry advice by highlighting structural flaws inherent in the 1031 exchange cycle, illustrating how real-world friction and market-timing errors routinely break theoretical spreadsheet models.

Using evidence from a past mobile home park disposition that limited future appreciation, Spear shares the three-step framework utilized by Sunrise Capital Investors to optimize after-tax returns. Listeners will learn how to leverage accelerated bonus depreciation under current tax codes to create major first-year phantom losses, utilize non-taxable cash-out refinances to harvest equity without triggering capital gains, and maintain tax-shielded distributions. Designed for high-income earners and business owners, this briefing details how to actively manage family tax architecture, utilize the Real Estate Professional Status (REPS), and shift from rearview compliance to proactive tax strategy.

Key Takeaways

• Taxation is a Compounding Multiplier in Reverse: Every single dollar paid in taxes is principal that is permanently removed from an investor’s wealth-building engine, significantly reducing the ultimate scale of long-term returns.
• The Fix-and-Flip Model Inherently Erodes Principal: Active transactional models create severe wealth friction through immediate capital gains liabilities, recurring transaction fees, idle cash drag, and substantial reinvestment risk.
• Spreadsheet Logic Fails in Real-World 1031 Cycles: While 1031 exchanges look mathematically superior on a spreadsheet, they introduce market-timing liabilities, do not shelter depreciation recapture, and create a perpetual game of risk exposure.
• Refinancing Avoids Fiscal Realization Events: Executing a cash-out refinance allows investors to extract equity and send capital back as a non-taxable event, preserving ownership of a high-performing asset while accessing liquidity.
• Strategic Planning Trumps Rearview Accounting: True tax efficiency requires hiring a forward-looking tax strategist to organize family structures and investments proactively, rather than relying on a traditional CPA to report liabilities retroactively.

Key Topics Covered

• Tax Drag as a Wealth Destroyer
• The Philosophy of Capital Stewardship vs. Bureaucracy
• Post-Tax Compounding Mechanics and the Power of Tax Deferral
• The Four Friction Costs of Fix-and-Flip Real Estate
• Structural Limitations and Reinvestment Risks of 1031 Exchanges
• Asset Harvesting Regrets and the Importance of Permanent Hold Horizons
• Accelerated Bonus Depreciation and First-Year Phantom Losses
• Non-Taxable Cash-Out Refinances and Multi-Bite Asset Extraction
• Real Estate Professional Status (REPS) for High-Income Tax Mitigation
• Rearview Mirror Accounting vs. Forward-Looking Tax Strategy

Episode Chapters

00:00 Intro Brian introduces the hidden friction of taxation, illustrating how ignoring tax drag quietly stalls long-term wealth compounding and undermines otherwise strong investment returns.

00:52 T – Tax Efficiency An introduction to the letter “T” in the Sunrise C.A.P.I.T.A.L. Strategy, framing tax minimization as an essential philosophy of wealth preservation rather than a collection of short-term tricks.

01:47 KEEP More of Your Money Brian shares his foundational worldview on capital stewardship, explaining why capital is allocated more wisely when kept within individual families rather than routed through centralized government bureaucracies.

04:47 This is Costing You Millions A deep dive into the mathematical reality of tax drag, showing how a $1 million investment compounding over 40 years loses tens of millions in absolute value when returns are reduced by annual taxation.

08:08 Fix and Flip Kills Compounding An analysis of why active real estate models fail over time due to four distinct friction costs: taxes, transaction fees, cash drag, and severe reinvestment risks.

10:44 The 1031 Exchange Trap An examination of why the popular 1031 exchange strategy introduces dangerous market-timing liabilities and exposure to depreciation recapture that standard pro-forma spreadsheets completely ignore.

15:41 Real Example (This Cost Me Millions) Brian shares a personal case study of selling a high-performing North Carolina mobile home park in 2014, explaining why harvesting the profit ultimately destroyed massive future cash flow and appreciation.

18:02 Step 1. “Phantom” Losses An explanation of how to leverage accelerated bonus depreciation under the tax code to generate substantial first-year passive paper losses that protect investor principal.

21:38 Step 2. Tax-Free Cash-Out Refinances A breakdown of extracting equity through strategic refinances, which adds non-taxable debt to the balance sheet and returns capital to investors without triggering a tax realization event.

22:45 Step 3. Tax-Advantaged Cash Flow How a long-term buy-and-hold strategy ensures that ongoing operational distributions remain entirely shielded by asset depreciation, maximizing after-tax cash-on-cash returns.

25:34 Erase Your W-2 Income Tax A real-world example of an Indiana physician leveraging the Real Estate Professional Status (REPS) via his spouse to offset high W-2 earnings with fund-generated passive losses.

29:09 What’s Coming Next Brian summarizes tax efficiency as an active family design constraint and previews the next episode on building an assurance of outcome.

Full Transcript

[Transcript begins]

Brian Spear: Most investors focus on how much they make, but very few focus on how much they keep. $45 million. Just remember that number. I’ll revisit the significance of that number in a bit, but just bear with me here, bear with me. Taxes are the single largest, most predictable drag on long-term returns. But most investors, they treat them like a footnote. And this is a substantial differentiator in the wealth building equation. Every single dollar that is paid in taxes is a dollar that never compounds again. Today we’re talking about T, tax-efficient structure. We’re going to talk about why taxes quietly decide which investor keeps compounding and which one of them stalls out over time. And how the smartest investors, they structure their wealth so that time works with them, not against them. This is part five of the Sunrise Capital Strategy, and it’s where good investing ultimately becomes durable wealth.

Taxes are one of the tools in the tool belt. There’s a lot of different ways you could ultimately maximize your returns over long periods of time. And minimizing your tax burdens is one of those ways. My business partner, Kevin Bupp, recently just interviewed Kim Lochridge on his podcast, Real Estate Investing for Cash Flow episode 974, where he goes super deep in terms of cost segregation, one of these really detailed tactics on minimizing your tax bill. So if you want to get super granular, you can go ahead and check that one out. Today we’re going to focus on the philosophy associated with creating a tax-efficient structure and investing all of your capital in such a way that you’re keeping more of your hard-earned money in your pocket over long periods of time.

We’re going to dig into the math behind tax efficiency in just a bit, but I wanted to start off by just providing explicit clarity in terms of my worldview. Okay, my worldview, so that you understand and don’t misinterpret what we’re trying to achieve, or what I’m personally trying to achieve on behalf of my family and all the partners that ultimately join our team over here at Sunrise. I personally believe that you should keep more of your hard-earned money in your pocket, not because of greed, but because no massive centralized bureaucracy can possibly know more about what you and your family need better than you do yourself. Capital that is allocated closer to the family is almost always allocated more wisely than capital that’s ultimately routed through some massive bureaucratic organization.

From my personal perspective, this country was founded on a principle of no taxation without representation. For most of the entire history of this country, income tax was not even a function of the country, truly. I mean, the Boston Tea Party, it was a part of the gigantic revolution that ultimately led to the founding of this phenomenal country. Income tax kind of slipped into our country back in like 1913, the early 1900s, and the idea was it was under the guise that the only individuals that were ultimately going to be taxed were going to be the most wealthy individuals in this country. A few short years, the government had the ability to go ahead and just tax everybody in that middle class and that eventually trickled down to every single individual in this country who now is susceptible to that income tax. Over time, it just quietly expanded to include everyone.

And the sad state of affairs is, you know, most people don’t even realize that they don’t even feel it. Taxes are your largest single expense every single year, and most people will spend an inordinate amount of time, clipping coupons, trying to save 20 cents here and there at the grocery store, but never even contemplate tax strategy and minimizing their largest expense. And if you went around the street and you were surveying a lot of different folks and asked them, hey, you know, how much in tax did you pay last year? I can promise you that a large percentage would say, I actually didn’t pay anything in tax last year. I received a refund, but that is false. You know, if people had to write a check and we were in a scenario where the government hadn’t been so sly in the way that they’ve structured taxes, people would feel it in a much more significant manner. If people had to write a check after the year, let’s say that they go to work in January, they work the entire year, they make $50,000. At the end of the year, they have to write a check for $10,000. I could promise you that they would feel it. Instead, the government has created a very sly way to ultimately peel that capital out of the individual’s accounts. Taxes are removed before the money ever hits their account through payroll taxes. So most people think, look, I didn’t pay any taxes. I got a refund without realizing they gave the government an interest-free loan every single year.

So when we talk about tax efficiency, this is not a loophole conversation. It’s about stewardship. It’s about stewardship of your work, about your time, and your family’s future. I believe that nobody’s going to know more about your family than you, and you should do your best to keep more of your hard-earned money in your pocket so you could spend it on yourself and your family better than the government would if you provided that capital directly to them.

So let’s just zoom out for a second and look at what is the overall objective of T, tax-efficient structure? What we’re trying to drive home in this respective episode is that taxes are a drag on compounding. The truth is you never let the tax consequences wag the investment dog. We’re on part five of the capital strategy. We’ve talked about cash flow first, add value, protect the downside, invest don’t speculate, but once you’ve done all those things, once you’ve found a great investment, a durably wonderful business that’s throwing off quality free cash flow, once you’ve done those things, you need to optimize for tax efficiency because taxes are a drag on compounding. Taxes compound in reverse. Every single dollar that you pay in taxes is a dollar that never compounds again. Compounding is an after-tax phenomenon. It’s not about what you make, it’s about what you keep, which is why I love this quote. The most powerful force in the universe is compound interest. And the second most powerful force is tax deferral. Tax deferral is a version of compound interest. You’re simply allowing a larger base of capital to compound for a longer period of time. Let me give you a simple example. Earlier I said $45 million. $1 million compounding at 10% for 40 years becomes roughly $45 million. But if taxes reduce that return to 8%, that same million dollars becomes about $21 million.

Charlie Munger, one of the greatest investors of all time, said something that perfectly captures the essence of this idea. He said, we don’t pay taxes, we defer them indefinitely. And that sentence, it’s not about tax evasion, it’s about behavior. Charlie wasn’t talking about tips, tricks, right? He was talking about structure and patience. So you have low turnover of your investments, you have long holding periods, you have minimal forced selling. He understood something that most investors miss. The system rewards inactivity. Fewer trades mean fewer taxes, fewer fees, fewer mistakes. And Charlie also said the most important thing is to keep the most important thing, the most important thing. And the most important thing is compounding, just continuing to keep that base of principle as large as possible so that compounding continues to affect over very long periods of time. Anything that leaks it, anything that minimizes that original principle base, including taxes, must be minimized legally. And Buffett makes the point even clearer, right? He says our favorite holding period is forever. And that’s not branding, that’s not tax strategy, it’s a behavioral strategy and how you need to manage money. And it’s a compounding strategy. Buffett has literally never sold his shares of Berkshire Hathaway. He has deferred capital gains on his unrealized gains for more than 60 years. And that deferral has functioned as an interest-free loan from the government. If he’d sold every single decade, right, like every 10 years, he sells a portion of his shares, his net worth would be a fraction of what it is today. A lot of the great fortunes in time, right, in history weren’t built by kind of clever tax tricks. They were built by owning really phenomenal engines, great, durably wonderful businesses that throw off exceptional amounts of cash flow and refusing to interrupt the compounding.

Now let’s talk about why the fix-and-flip method of real estate investing breaks down over time. Over at Sunrise, we’re massive proponents of a buy-and-hold philosophy. And the reason is there’s really, I would say, four different friction costs that compound against you when you’re operating in a fix-and-flip business model. I don’t care if you’re doing a fix-and-flip on a single-family home or a car wash or a multifamily property or a gigantic syndication, doesn’t matter. If you’re doing a fix-and-flip business model, you’re minimizing the amount of principle over time through a litany of friction costs. First is taxes. Most importantly, you’re going to get crushed by capital gains on the back end of that even if the fix-and-flip does well, right? You buy low, you sell high, you make a bunch of money. Congratulations. You’re going to get crushed by capital gains tax and depreciation recapture along the way. Second, every single time that you sell a deal, you’re going to have transaction costs. You’re going to get crushed by broker fees. You’re going to get crushed by legal costs. There’s loan fees, mortgage brokers. There’s a lot of different transaction costs on the way that ultimately minimize the amount of principle that would otherwise be put into your pocket. It’s not about what you make. It’s about what you keep. I can promise you that the disposition price is not the amount of capital that ultimately gets inserted in your bank account after the transaction occurs. The third friction cost that you’re going to experience when you do that buy-fix-and-sell model is cash drag. Between the time when you sell deal A and when you buy deal B, you’re going to experience cash drag. You’re going to have capital that’s sitting idle between deals. So you’re stopping the compounding and Charlie Munger would just absolutely crush you for stopping compound interest over long periods of time. But what I’d say is one of the most important aspects here is the fourth piece, the fourth friction cost, which is reinvestment risk. From my perspective, probably the most important. If you’re going to operate that buy-fix-and-sell model, when you sell it, you have to take those proceeds and do something else with it. And every time you’re making a new investment, you’re introducing an additional level of risk, right? You’re going to be forced to find the next deal. And sometimes you’re going to try to find it at the wrong time. The only time that you’re really going to sell a deal is when you’re getting a nice multiple on the back end, right? If you’ve done a great job, you’ve sold the deal. It’s a nice time in the market to ultimately sell and try to capture some of those gains. Congratulations. But what do you do with that principle at that time? If you’re in a hot market, that’s a beautiful thing because you might be able to sell for a high price. But now you’re going to go buy in at a massive basis on your new property. That’s a very tough spot, right? Every time you sell, you don’t just reset taxes. You reset the momentum. And the sad state of affairs is spreadsheets ignore friction. But in real life, we don’t. We don’t live in a spreadsheet. Real life multiplies friction, real life multiplies risk. You know, these are a lot of reasons why we despise that fix-and-flip philosophy. We’re obviously massive proponents of buying and holding over long periods of time.

But the people that are on the other side of the debate that are going to argue in favor of the fix-and-flip are going to point out the idea and the concept that ultimately you can leverage the tax code and implement a 1031 strategy and be able to create quote-unquote better returns over long periods of time. Why? Let’s walk through the logic associated with that. When you buy a deal that is a quote value-add transaction, typically the most value that you’re going to create is during the first few years of ownership of that asset. Usually when you look at the pro-forma and you’re implementing a value-add plan from the moment that you buy that deal and you’re looking to stabilize that asset, there’s a higher internal rate of return because you’re adding the most amount of value during that period of time. Then oftentimes on the fix-and-flip business model, what you’re going to do is when you stabilize that transaction, the NOI incremental increases slowly dwindle off, they slowly begin to plateau. So the acceleration of the growth dwindles after stabilization, and it is at that point when the fix-and-flipper would say, “This is when we should sell the asset.” You buy low, you implement the fix-and-flip business model, you add value, and you sell it. You have quote-unquote stabilized the transaction, and the logic is that if I do that, I’m going to have a higher internal rate of return as opposed to watching the internal rate of return slow down over longer periods of time. We take that higher internal rate of return and then we sell it and we buy another deal, we roll the proceeds into a new transaction that is yet another value-add deal and we retain that same higher internal rate of return which would, over long periods of time, accelerate your cumulative amount of compound interest that you create. And I tell you what, the logic behind that argument is absolutely ironclad, 100%. You could show me a spreadsheet that says when I buy low, I stabilize the deal, and I sell high, I do a 1031 exchange, I buy low again, I sell high, I do another 1031 exchange—you could show me inside of a spreadsheet the math that would ultimately tell you that that strategy is going to outperform a long-term buy-and-hold strategy. What I can promise you is that we don’t live in a spreadsheet, we live in the real world. And in the real world, never, ever is a single individual transaction going to perform exactly to pro-forma. Even if the first one does pretty well, at some point, somebody, somewhere, they’re going to mis-time the market because that strategy is inherently risky. It is a game of hot potato, and at some point, somebody, somewhere is going to mis-time the market and they’re going to hurt investors dearly. I do not care how big that original principal base gets. Let’s say you take $1 million, you implement that fix-and-flip, you turn it into $2 million, you do it again, you roll the proceeds forward in a 1031, you take $2 million, you turn it into $4 million, congratulations, you keep going. I can promise you no matter how big that dollar amount gets, if you ever multiply that number by zero, the cumulative number is zero. And I’m unwilling to take that amount of risk with my family’s money.

In addition to that, people don’t realize that a 1031 doesn’t save you. It will allow you to minimize the amount of capital gains that you’re going to have along the way, but it does not save you from depreciation recapture tax. So you are inevitably minimizing the amount of principle that you’re rolling into the next transaction regardless of whatever 1031 tax code that you might have. Folks often don’t even realize that they’re not able to roll all of that principle forward into the next transaction. So for all these reasons and more, all these friction costs, all the additional incremental risk associated with taking that next leap on the next deal, it is not the most prudent long-term strategy to maximize compound interest over exceedingly long periods of time. History has proven over and over with the world’s greatest investors, the world’s greatest businessmen who’ve created the best fortunes over time, that deferring capital gains, deferring taxes, and holding assets over exceedingly long periods of time provides a significantly higher assurance of outcome than a very quick fix-and-flip philosophy. We would much prefer to buy durably wonderful businesses that throw off exceptional cash flow and hold on to them forever. It’s a much easier path to the promised land than the amount of additional incremental risk that you’re going to get by virtue of having that fix-and-flip model. The reinvestment risk is massive in that respective model.

Let me share an example of why we dislike the fix-and-flip business model. I mean, we’ve learned the hard way. I’ve gone full cycle on 16 different mobile home parks over time to great effect, average internal rate of return north of 40% on those respective transactions. It’s kind of like been there, done that, got the t-shirt. One of these transactions we’ll talk about today, we bought a deal in 2014 in North Carolina—exceptional mobile home park, about 130 spaces, bought for a song off-market, direct to owner, and with massive seller financing. Didn’t put much equity down in the deal, ended up quadrupling the value of the mobile home park in a few short years. This thing was throwing off business or inordinate amounts of cash flow every single month, every single quarter, every single year without fail. We’d been on an infinite cash-on-cash return for multiple years. But when interest rates decreased, we had massive private equity ultimately come in, a lot of different people willing to pay absurd numbers, compressed cap rates, big numbers. You can walk away with multiple seven figures. Felt pretty good about getting a nice big seven-figure paycheck on disposing of that individual investment. It’s difficult to say no when somebody floats a lot of cash in front of you. But after we ultimately sold that investment, we now regret it terribly. Why? One, we stopped the compounding. This was a durably wonderful business—durable in that it had safe, predictable, recurring income streams every single month, every single quarter, every single year like clockwork. And wonderful in that the same-store NOI growth increased precipitously, more than any other real estate sector that we could possibly fathom over time. It was a compounding machine, and we stopped the compounding. We received the principle back, and it felt good to cash a check and put a big check in your bank account for about a month, and then that feeling fades. And what happens is you get a gigantic tax bill at the end of the year, massive depreciation recapture tax hit, and ultimately the capital had to be redeployed in a different investment, and ultimately that investment didn’t perform as well as the one that we had previously been operating. Now if you fast forward a handful of years, this is really where you insert the salty sword and twist it. It is exceedingly painful to admit that that property is now worth double what we sold it for yet again—multiple millions of dollars over and above that which we sold the property for. And how much incremental work would have been necessary to benefit and take advantage of that massive compound interest? It would have been negligible. How much more risk would we have had to take to receive all those additional millions of dollars from the compound interest? It would have been negligible. That asset is worth far more today than it was when we sold it. It’s still throwing off unbelievably predictable income. We didn’t lose money per se, but we lost the future massive amounts of free cash flow over many decades into the future. A sure thing, great businesses should be held, not harvested. And that’s why we’ve evolved our investment philosophy over time. We’ve done a lot of fix-and-flip deals over time, we’ve gone full cycle on 16 different individual mobile home parks over time with an average internal rate of return north of 40%, but this lived experience of understanding the benefit of buying and holding assets, durably wonderful businesses over exceedingly long periods of time—I now know deep in my bone marrow that that is a better way to ultimately manage my family’s money over very long periods of time to generate the best risk-adjusted returns for my family. At the end of the day, that’s what we’re looking to do: generate cash flow and build legacy wealth in a tax-efficient manner, and we’re going to help as many people as possible do that as we can along the way.

So if the fix-and-flip model isn’t the best strategy, how do you actually structure your business and your real estate investments in the most tax-efficient manner to optimize after-tax returns? Again, you don’t let the tax consequences wag the investment dog, but once you find an amazing asset, an amazing investment that is durably wonderful, then you optimize for tax efficiency every step of the way. And you start when you first buy the transaction. The very first year that you buy the transaction, you have the luxury given the Tax Cuts and Jobs Act of 2017 and now the big beautiful bill, the big beautiful bill of 2025, you have the luxury of leveraging accelerated bonus depreciation. We just happen to be involved in one of the most tax-efficient real estate sectors on the planet. Commercial real estate has a depreciation schedule of 39 years, residential real estate like multifamily has a depreciation schedule of 27 and a half years, but many different types of investments are known as capital improvements, of which a mobile home park—the vast majority of a mobile home park is known as a capital improvement, and that’s depreciated over the course of 15 years. And with the advent of the Tax Cuts and Jobs Act of 2017, which was then permanently instituted into the code in 2025, anything that is depreciated on a 20-year horizon or shorter can be accelerated through accelerated bonus depreciation and accelerated into the very first year of ownership. What does this mean? It means that you’re taking advantage of the time value of money.

I’ll give you real cold hard math on what that means from a perspective of a mobile home park. Let’s say you buy a mobile home park, it’s worth $10 million. About 20% of that mobile home park is land, so you can’t depreciate the land, but the other $8 million, what are you buying when you buy a mobile home park? We don’t like to buy the actual homes in and of themselves; we like to have the residents own their units, we like to operate the mobile home park like a parking lot. So when you buy a mobile home park, what are you actually buying? You’re buying the underground infrastructure—you’re buying the roads, the curbs, the gutters, the utility lines, the water lines, the sewer lines. All of those are known as capital improvements, and the vast majority of that $8 million depreciable basis is allocated to capital improvements which, given the tax code, can be accelerated into a passive loss in year one. That means by way of example, if you buy a $10 million mobile home park and you put down $4 million, i.e., a 40% down payment, and you have an $8 million passive loss, it means that you’re writing off twice the amount of your original investment in the very first year. It means that when you get a K-1 back at the end of the tax year, if you invested $4 million, you’re actually reporting to the government that you lost $8 million on that respective investment. This is a massive passive loss and a phantom loss that allows you to keep more of your hard-earned money in your pocket, that allows you to offset other areas of income that you might have inside of your portfolio, it allows you to offset other passive income that you might have inside of your portfolio.

So on the front end of the investment, you want to leverage accelerated bonus depreciation, take advantage of the time value of money, and you want to continue to optimize tax efficiency throughout the entirety of the holding period. And what that means for us is we operate a light value-add business model where we buy an asset, we want, we need to be able to materially impact the NOI of the investment in the first few years of ownership. So we buy an asset, we increase the NOIs over time, we actually add value in the first few years, we control the outcome of that respective investment, and then when you do that, you have the luxury after you stabilize that asset—let’s say in year three you stabilize that asset, at that point, a lot of different individuals sell. From our perspective, that is now foolhardy. We’ve seen further than others, we’ve been there, we’ve done that, we’ve got the t-shirt, and we’ve got crushed on the back end—I’ve got the scar tissue to prove it. And we know that the better option is not to sell because at that time you’d pay massive capital gains, you’d pay depreciation recapture, 1031 doesn’t save you, and you have massive reinvestment risk if you’re going to use 1031 exchanges. Instead of doing all that, dealing with all the friction costs, we would rather simply do a cash-out refinance because a cash-out refinance, you take all of that retained earnings that you have on the balance sheet—the value of the property has increased, you now have retained earnings on the balance sheet. How do you tap into that? You do a cash-out refinance and you send that capital back in a non-taxable event. Why? Because what you’re doing is you’re adding debt to the balance sheet, and debt is not something that is taxed. So you’re borrowing against the value of that respective asset, and that is non-taxable. In this manner, in the first numerous years of the ownership of this respective property, the vast majority of income that you’re receiving—distributions, cash flow that the deal’s throwing off—is non-taxable, it’s shielded by the depreciation, and the cash-out refinance proceeds are non-taxable along the way. It is not about what you make, it is about what you keep. And at the end of the day, maximizing the after-tax cash-on-cash return along the way is the best way to ultimately generate the best compound interest and create the best risk-adjusted returns in an investment, period, end of story.

And if you do that, not only do you have the ability to extract that retained earnings, all that additional equity through a cash-out refinance, you are able to continue to own that asset—a durably wonderful business that you know, that you like, that you trust, that’s thrown off exceptional cash flow. And what we’ve now come to realize is it provides the opportunity for you to have multiple bites at the apple. We’ve got numerous deals where we’ve ultimately gotten all the chips off the table, where we do a cash-out refinance, send that capital back to investors in a non-taxable event. They now have an infinite cash-on-cash return but still own the original asset. And if you fast forward another three years, four years, five years, what happens? High-quality same-store NOI growth increases durably wonderful businesses, NOI increases, the value of the properties continue to go up, and you get an opportunity years down the road to take yet another bite at the apple. You have another cash-out refinance where you take more equity out of that respective property, send it back yet again in another non-taxable event. Everybody’s tax situation is unique, and I’m not going to get into super granular nature associated with having a negative tax basis, etc., but the point is this buy-and-hold strategy is by far the best way to generate the highest-quality after-tax risk-adjusted returns, period, end of story. At the end of the day, you want to buy wonderful businesses that throw off exceptional free cash flow and optimize for tax efficiency along the way, and this is the most optimal way to ultimately do that.

So obviously we prefer the buy-and-hold structure. I’m not saying we’re never going to sell, right? I’m stating that our favorite holding period is forever. There are a few times when it might be prudent to what we would consider prune the portfolio, sell an asset. There’s a few reasons why we might do it; we don’t have time to dig into that today, we’ll do so in a future episode, but generally speaking, our favorite hold is forever.

So how does this strategy actually play out in the real world when we’re investing in this manner in our fund structure? How do our investors that join our team actually feel the impact of this tax-efficient structure? I’ll give you an example. You know, everybody’s individual tax situation is different and unique, and there are different tools that you have in your tool belt that you can leverage to optimize tax efficiency, but I’m going to give you an example of the real estate professional status. If you’ve not been able to dig into that, please do. Not going to go into the definition and what it means today, but please do dig into the idea and the concept of the real estate professional status. It’s one of the best tools in the entire tax code that you could do to leverage your family situation to minimize your tax burden over time. And I’ll give you a real cold hard example of how several of our partners are leveraging this to great effect over time.

We’ve got a phenomenal partner that is in Indiana. Great guy, is a physician in Indiana. He actually owns multiple practices in Indiana and is very successful, makes multiple seven figures in W-2 income on an annual basis. As you can imagine, he’s got an enormous tax bill. He sends a huge amount of money to the government every single year, and he’s trying to find ways to minimize his tax burden. One way that he’s found to be exceptionally successful is the fact that he’s got a beautiful wife that has become the individual who is the real estate professional inside of their home. She manages the family’s finances and the real estate investments inside of the house. And for this reason, when she makes investments, any of the passive losses deriving from those investments can actually offset the earned income that he has on an annual basis. So when you pair her real estate professional status with investing in funds like ours, the results are extremely powerful. This individual basically invests, let’s say, roughly a million dollars inside of our fund every single year. Now, on average over the last seven years, an investment of a million dollars inside of one of our funds has received on average a passive loss on their K-1 of $900,000. Again, on average over the course of the last seven years, this is a phantom loss because of the accelerated bonus depreciation due to the Tax Cuts and Jobs Act of 2017. Now, what does this mean? It means when he invests a million dollars, in the very first year, he gets to report to the government that he is losing $900,000. So if you take his income tax bracket, he’s basically paying 50% of his income directly to the government. And if I’m able to write off a $900,000 passive loss for an individual that makes multiple seven figures annually, that means we’re saving him the equivalent of a $450,000 after-tax cash-on-cash return immediately out of the gate in year one. And we haven’t even begun to send him outbound distributions from cash flow, we haven’t even begun to increase the value of the properties over long periods of time. As you can imagine, this is exceptionally powerful. You have the ability to help him retain more of his principle, keep more of his hard-earned money in his pocket so they can reinvest it into high-quality, durably wonderful business and continue to compound his wealth over exceedingly long periods of time.

So tax efficiency, it’s not just about assets, it’s a philosophy. It’s about how your family is organized. Too many people focus on trying to save a buck or two here or there, you know, focusing on coupon clipping, but very few folks ultimately end up hiring a tax strategist to oversee the entirety of their family situation and focus on forward-looking financial planning and analysis tax strategy as opposed to simply going to a CPA, which is basically at the end of the year going to the CPA and saying, “How much tax do I owe?” That’s not tax strategy, that’s looking out of the rearview mirror, and there’s nothing that that CPA can do to help you moving forward. You have to find a tax strategist who can help you structure your family’s affairs for the betterment of the future so you’re looking through the windshield as opposed to the rearview mirror. It’s about how your family is organized, optimized for tax efficiency.

So as we close out part five, which is T, tax-efficient structure, just remember this: taxes are not just a cost of doing business, they’re a design constraint. If you ignore them, they quietly drain momentum. You design around them, and they become part of the compounding engine. In the next episode, we move to A, the second A, which is assurance of outcome. We’re going to talk about how disciplined investors think about risk, they think about probability, they think about predictability, and why great outcomes are rarely accidental. If you’re finding value in this series, make sure you end up following the show so you don’t miss out on what’s coming next. Guys, as always, we appreciate you being here, but until next time, you be great.

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