Transaction and Taxation Costs are The Enemies of Great Returns

I want to illustrate a recent example of how I looked at a particular real estate holding of mine to show the ruthlessness of transaction costs and taxations to one’s investment returns. I will later try to tie this concept over to how I manage my equity portfolio.

I have a rental property that I purchased back in 2013 for $162,500. The current market value is $384,000. I have a loan against the property at $148,000. So my equity in the house is at $236,000. The question is, can I get $236,000 by selling the house? The answer is no.

First, let’s dive into transaction costs. I would have to pay about 5% transaction costs (2.5% realtor commission + 2.5% in transfer taxes, title companies etc). I get to save 2.5% more because I’m a real estate agent myself. As a result, transaction costs would come out to about $19,200.

Next, let’s look at taxes. You can expense depreciation against a rental property annually. But once you sell, however, you would have to pay for a depreciation recapture, which is 25% of the total depreciation you ever took. The amount is counted as ordinary income. I have depreciated the house for about $42,000 over the years. 25% of $42,000 comes out to be $10,500, which would be counted as ordinary income.

In additional, because I’ve depreciated about $42,000 over the years, the property basis is now at $120,500 ($162,500 original basis – $42,000 depreciation). As a result, the long term capital gain is at $244,300 ($384,000 sales price – $19,200 transaction costs – 120,500 current basis).

Let’s say at the moment the taxation at the short term ordinary gain is at 37% and long term capital gain is at 23.8%, we would multiply the STCG ($10,500 x 37%) and LTCG ($244,300 x 23.8%) and arrive at  about $62,028.

At the end, I would net about $154,772 [$384,000 (sales price) – $19,200 (transaction cost) – $148,000 (existing loan) – $62,028 (taxes) = $154,772]. The original equity of $236,000 has been cut by 34%. In fact the transaction costs of selling this house in total would have been about 21%.

In conclusion, to extract an additional $236,000 in equity would have cost me $81,228. It would have been an extraordinary waste of capital.

On the other hand, if I were to refinance the property, I can take out in loan 60% of the property value. By doing that, I would be able to take out a loan of approximately $230,400. The loan will replace the existing loan at $148,000, leaving me an extra $82,400 in capital. While this amount is not a lot, I would not have to pay any significant transaction costs other than maybe a couple thousand in mortgage fees. At the same time, I maintain an exposure to real estate, I can continue to collect rental income and lower my tax exposure by depreciating against the property and paying interest. The value in simply not selling is actually quite significant.

In the longwinded illustration of such example, I would say the same can apply to how I invest in my portfolio. Ideally, I want to be like Buffett – own every stock or index for as long as possible. While I admit we all have liquidity needs in some place or time, the most important thing is not to sell anything in the portfolio to get additional liquidity. Every time you have to sell a stock to pay for something, you’d most likely end up paying some form of capital gain tax on the position. There is no reason to incur taxes if you don’t have to.

I use margin loans for any liquidity needs. Instead of liquidating a position, I just take on additional debt. While most see this as risky because there is a possibility of getting margin called, I’d say it would be even more risky to sell a stock at the wrong time (and incurring transaction costs and taxes along with it). Interactive Brokers offers extremely low margin rates. I don’t know how other brokerages have been charging usury rates on consumers. But I’d say if you can get portfolio margin and uses Interactive Brokers to draw out capital when you truly need it, it is a much better way to increase your returns in the long run.

Now for one more tie in. I use LEAPS to purchase an equity position – this is almost like putting a down payment for a house. Just like a house, I am really putting down just 20% to own a position for a couple of years while paying interest. Like a house, if the stock drops, I can only really lose what I have put down. But if the stock goes up, my returns multiply because my initial investment is highly levered. Furthermore, if the value goes up by the exercise date, I can exercise the option and buy the stock instead of selling the option for a profit. Because remember, if you sell it, you’d have to pay taxes on your gains. By just buying it, I may have to take a margin loan to hold this position – but now I’d avoid taxes and transaction costs while at the same time the margin interest is tax deductible. The only risk difference is that while a bank can’t call your loan if the house falls in value, a brokerage can make a margin call. Nevertheless, like what I do, it is all about managing risk while increasing returns.

The moral of the story is to do your best to avoid transaction and taxation costs. These twin evils can shave away your returns and it can compound to a terrible monster over long periods of time. Keep that in mind every time you buy or sell something.

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