Are Taxes Crushing Your Gains?

DANO WEIR: I got three statements that just make all the sense in the world. These are very logical. Your brain tells you these things.

DANO WEIR: I have a single stock that's gone up a lot. I'm stuck in it.

DANO WEIR: I have highly appreciated real estate and I can't diversify. And there's actually no way to make a gain while making a loss, right?

DANO WEIR: There's more to that story.

DAREN BLONSKI CFP®: Financial confidence for your hip.

DAREN BLONSKI CFP®: Money is really just energy. If you're checking out, it's all money.

DANO WEIR: Welcome to Sonoma. Daren's right. There is more to that story. Let's tell it right now. My name is Dan O'Weir. I'm the marketing director for Sonoma Wealth Advisors. You're in our conference room right now, and I'm joined by our managing principals. Daren Blonski, CFP, Chris Sipes, CFP. Guys, today on the podcast, we're asking the question, are taxes crushing your gains?

DAREN BLONSKI CFP®: Aren't they always?

DANO WEIR: Those first three things I said make a lot of sense. And that's a good thing to lean on in finance. The things that make sense, things that you understand. And both working at this firm and being a follower of finance. I myself have learned some things in the past year, couple years.

DANO WEIR: They blow my mind.

DANO WEIR: So today we are talking about taxes, capital gains, and what is out there in the universe of investments.

DAREN BLONSKI CFP®: I think we should say first that we're not tax professionals. We're certified financial planners, and we dance a lot in the tax space because of that.

DANO WEIR: Yes, and there are things that your CPA should be doing, and there's things that your financial advisor can be doing. And so today's episode is where... Do the two kind of cross and meet and what is our area of expertise? And Daren, I want to start with a term I've heard you use a lot when it comes to investing and particularly with taxes, lazy money and advisors who lean on lazy money.

DANO WEIR: What is that phrase and what does it mean to a client?

DAREN BLONSKI CFP®: Well, so there's lots of levels of lazy, right? With your money. So really lazy would be just sticking it in a bank account and a non-interest bearing account and letting it do nothing but rot to inflation. That's super lazy money.

DAREN BLONSKI CFP®: Kind of lazy money would be just allocating it to stocks and bonds or ETFs or mutual funds, but not investing it in a way where you're actually able to use the tax code to your benefits and do stuff like tax loss harvesting and make sure that you're minimizing the taxes you pay and only paying your fair share.

DANO WEIR: So if your advisor is not mentioning those phrases to you, that might be something to consider.

DANO WEIR: Chris, I've heard you say the phrase, taxes are the block and tackle of finance. And I'm excited because I found a way to work in football into this episode. Which Daren loves. Daren loves it when I make everything football. Can you put Disney and Nintendo in this episode too, Dan? Come on. Let's not talk about all my passions here.

DANO WEIR: Why are taxes the block and tackle of finance?

CHRIS SIPES CFP®: For those that in your opinion, maybe don't watch football as much blocking and tackling are both football terms. And they're kind of considered like the simple things that are like, it's not, it's not the touchdown pass. It's not the, the sack, but it is the thing that during the game has a huge impact if you don't do them correctly.

CHRIS SIPES CFP®: Meaning that if you kind of make mistakes on blocking and tackling, it causes problems in a lot of other places. And if you get two really good football teams playing one another, a lot of times it comes down to who does those simple things better, who makes fewer mistakes.

DANO WEIR: The boring stuff.

CHRIS SIPES CFP®: The boring stuff, right? The stuff that you and I enjoy. Wow, did you see that block? Right. And I feel like taxes are kind of the same way because we all pay taxes, or most people pay taxes.

CHRIS SIPES CFP®: And there's a code and we for sure say you should pay your fair share and, you know, follow the code. We are not the type that would say, hey, push the envelope here because trust me, you do not want, you know, the IRS is looking to tackle you.

CHRIS SIPES CFP®: But, you know, trying to make sure that you're not making mistakes there. You're not doing things that are inefficient tax tax wise. Knowing about your taxes can be. Can be, you know, accretive to your overall financial picture because it's a part of everybody's financial picture, a significant part.

DAREN BLONSKI CFP®: Let me give you a really simple example, I think that I think will make a lot of sense for the viewers.

DAREN BLONSKI CFP®: In the last few years, money markets have been paying pretty decent interest, right? Cds have been paying pretty decent interest. That wasn't the case for the last 10 years, but they started paying decent interest. And so we had a lot of clients who said, hey, I want to put money in money market.

DAREN BLONSKI CFP®: We put money in money market. And then they got a nice little 1099 at the end of the year. Oh, ordinary income. Now they got this ordinary income coming off their money market account. They're like, Daren, why am I paying more in taxes? Will you the income coming off the money market actually becomes ordinary income.

DANO WEIR: Not investment income.

DAREN BLONSKI CFP®: Not investment income. And that was a big surprise to a lot of clients because for so long, they weren't making any interest. So now we've got an issue. So we have an investor who makes a lot of money and then all of a sudden they have an extra $50,000 income bill. And they're like, where did this come from? Well, here's why you have that.

DAREN BLONSKI CFP®: Because you have that money market over at that bank that some broker talked you into with no idea about your tax situation. And now you stacked onto your income. And guess what? That income that you got, got paid out at the highest tax bracket you have. Not at the low one, at the high one. So you paid a lot more. Well, there's a little thing called a tax-free money market you could use. Whoa, shocker.

DAREN BLONSKI CFP®: So one of the calculations we always run for clients is if they're gonna buy a money market based upon their specific tax, expected tax bracket, does it make more sense to use a tax-free money market or tax... Money markets so sometimes actually makes sense to make less on a tax-free money market fund than it does to make More income on a taxable money market fund.

DANO WEIR: This is why I have these guys a podcast together with these guys But let's let's talk about some more things that maybe are counterintuitive.

CHRIS SIPES CFP®: On that point though. I think it's important for people to understand in the tax code they use it as a way to influence public policy and you know how they want people to to react and So people should know that income is taxed differently than investment type of tax.

CHRIS SIPES CFP®: Capital gains, capital losses. So the way the tax code looks at it is those are two separate things. And income in general is taxed at a higher rate. And the more of it you have, the higher the rate you're going to pay.

DAREN BLONSKI CFP®: But wait, Chris, I'm confused.

CHRIS SIPES CFP®: So you mean if I buy an investment called a money market fund, I'm not paying capital gains, I'm actually paying income? Is that what you're telling me? Right.

CHRIS SIPES CFP®: That interest is income versus other types of investment gains can be taxed at capital gains. And they have short-term and long-term, and the delineation there is a year. So even in today's instant society, long-term is a year and a day, essentially. So there's a benefit to that from a tax perspective if you can manage around that.

DANO WEIR: I just get to see I get to watch this all the time watch these two go at it it's great all right so we're I hope you've gotten value already watching this episode just right off the top let's get into the real meat of what we're talking about today we've got six what we call tax aware investment strategies approaching investments from a tax state of mind you probably didn't wake up this morning dreaming of learning about tax strategies and yet when you're sitting there looking at the bill or the obligation and you tell yourself like wait a minute is There may be another way.

DANO WEIR: Well, maybe there is another way and we're going to dive right into them. The first of the six, let's talk about a 351 exchange.

DAREN BLONSKI CFP®: Let's do that. But I'm going to pass that one to Chris because he's the expert on the 351s.

CHRIS SIPES CFP®: Yeah, this, so the 351 exchange is at a high level. It's a way to take maybe more concentrated positions than you would like to have.

DAREN BLONSKI CFP®: So like you bought.

DAREN BLONSKI CFP®: A lot of nvidia and you're sitting on this massive nvidia or Visa holding right yeah and i can't get rid of this thing because if i get rid of it i'm going to pay insane amount of taxes because i've owned it since the beginning of time right but if i stay in and i'm beholden to the volatility of a stock stock maybe that has topped we're not saying that's necessarily happened but you know i'm riding this wave that i don't like anymore right you want it you want a way to diversify but you can't sell it because if you do.

CHRIS SIPES CFP®: You're going to... Immediately recognize you know the capital gains and have to pay the taxes there so through a 351 exchange you can you are seeding a new fund a new etf exchange traded fund and there are rules to it define the the word seeding because that might be confusing seeding is like it's like if you're planting something it's the beginning stages so it's it's before that fund is available on on the market.

CHRIS SIPES CFP®: Essentially there, they say, Hey, we're going to start this new fund. It's going to have this strategy and you can contribute your positions to become a shareholder in, in this fund. So, you still have the tax liability. You're not getting rid of it.

CHRIS SIPES CFP®: But it allows you to put your positions in with a bunch of other clients' positions or other investors, I should say, into the structure of the fund. And because it has the wrapper of the exchange-traded fund, that fund manager can make changes within that fund to diversify. So now you're taking your shares of XYZ and you're putting it in this fund that's going to give you a more diversified exposure to some. Strategy.

DAREN BLONSKI CFP®: So let me feed that back real quick because I think this is important to understand. So if we've got 10 investors and this investor owns Visa and this one owns Google and this one owns Microsoft and this one owns Walmart and this one owns Starbucks, you can take that highly appreciated stock and we can seed the fund and we can dump it all into the middle of the table, pull it together.

DAREN BLONSKI CFP®: And then what we get out of that is a diversified basket of ETF or an ETF that's diversified. So now I haven't got rid of my tax liability, but what I've done is I've spread my risk. Am I getting that right?

CHRIS SIPES CFP®: Yeah. You're going from the risk of a few stocks, which is a higher risk to a lot of stocks, which is generally lower risk.

DAREN BLONSKI CFP®: So like, this is a good thing if you're thinking about like, hey, mom bought Visa a hundred years ago. It's worth a half a million dollars again. Now I don't want to sell it because at death it's going to get a step up, meaning I'll owe any taxes.

DAREN BLONSKI CFP®: But I also don't want the risk of the concentration of just in visas. So you say, oh, hey, mom, let's use a 351 exchange. And you seed an ETF, create the diversification. You're better off because you're more diversified and you're not on the tax docket.

CHRIS SIPES CFP®: Yep. They've been around for a long time, but only recently kind of become available to, you know, what I would say is investors that. Don't have $10 million or $20 million or more, right?

CHRIS SIPES CFP®: Some of the fund families that I won't mention the exact names have been able to offer this to clients of advisors at a lower entry point.

DAREN BLONSKI CFP®: Well, and I'll add to that point because I get a lot of questions when I talk about these different solutions with clients and they're like, well, Daren, where's the solution been? Like, how come no one's told me about this? Well, it's been around, like Chris said, for higher net wealth people, right?

DAREN BLONSKI CFP®: People with a lot of money who can afford certain private wealth bankers, et cetera, that can navigate Wall Street for them, right? I always tell people there's tax law for the informed and tax law for the uninformed.

DAREN BLONSKI CFP®: I prefer the tax law for the uninformed side of things, right? So, but with the advent of technology and computers, what it's allowed Wall Street to do, because Wall Street is a distribution business after all, it's allowed us to more broadly distribute different financial products and tools.

DAREN BLONSKI CFP®: Because the technology enables the platforms that allow for democratization and utilization of these different strategies. Whereas before it was such a heavy lift to get it to people who just didn't have a lot of money, it wasn't worth the lift.

DANO WEIR: And I think I should say too, as you can tell, we're keeping today conversational. No charts. This seems like a conversation that would lend itself to charts. And the minute I put that up there is you're going to fall asleep. So we're keeping it a couple of guys who, I guess we have one cup of coffee, maybe we can share, having a conversation about these things conceptually. So that's the 350.

DAREN BLONSKI CFP®: Well, Dan, let me also add that like these things are complex, right? So fundamentally, they require someone who understands the nuance. There's no way in this episode that Chris or I could cover the nuance of any one of these given things. Exactly. And so...

DAREN BLONSKI CFP®: What solution you use. Like I think you hit those three. Like if you own a business and you're looking to sell a business, if you've got highly appreciated stock or highly appreciated real estate, any of these tools could make sense for you if you're planning to and you need liquidity. There are ways to get through that liquidity wall and lessen the tax impact by being strategic.

DAREN BLONSKI CFP®: And that's what this is about. Obviously, unless we know your whole financial plan, your whole situation, there's no way I can say, in a very broad way for anybody this is specific advice this is just educational like hey these things are out there you might want to check in and if you have a broker get a real advisor that can do so as a producer okay now.

DANO WEIR: He's taking shots straight over the bow now let's not get a 351 exchange confused with our second solution which is an exchange fund and that difference is what?

CHRIS SIPES CFP®: Well, they, they, are similar in name because it's similar in concept in that the benefit to the investor is that you're taking the concentrated positions and in exchange getting a more diversified basket.

CHRIS SIPES CFP®: The rules around the concentration metrics are different with exchange. They're a little less stringent than the 351.

CHRIS SIPES CFP®: But in exchange for that, you have less liquidity. So an exchange fund typically is going to require like a seven-year lockup.

CHRIS SIPES CFP®: So there's less liquidity to it.

CHRIS SIPES CFP®: That's a downside. And in addition to- Define liquidity, because I think that term, we throw it around like it's- Good point. It, liquidity is like, Hey, I need the money right now. You got to turn it into cash.

CHRIS SIPES CFP®: I got to go buy a car. I got to pay for a house or something like that. You don't want to put money into an exchange fund that you're going to need anytime soon.

DANO WEIR: Because 401k in your thirties is a like what illiquid without extreme penalty. Right.

CHRIS SIPES CFP®: Right. Right. But in this case, it's actually like you, you need to be able to tie it up for at least seven years.

CHRIS SIPES CFP®: There, there is a an element required of private investments in the exchange fund as well. So a typical one is real estate. So you might have like stocks plus a real estate basket in the current environment. Those investments are taking some hits. So there are cons to this. But the pro is that if you can stick with it for the seven years and and in exchange for those concentrated positions, you get that diversification.

CHRIS SIPES CFP®: You still have the tax liability, just like with the 351. You still have that cost basis that you had before. So it's not like you're making the taxes disappear. It's just allowing you to diversify those positions.

DANO WEIR: So that you can gain the diversification. You can lose, potentially, the risk. Correct. Because you don't like that concentrated stock. Position that's teetering at maybe its top and you're riding that roller coaster every day and you're like, I'm going to, I can't take it anymore.

DAREN BLONSKI CFP®: Well, we have two really Fancy words for that. You're going from asymmetric to symmetric risk, right? Symmetric risk is the tides out for everything, right? So you want to use diversification just so you're exposed to the tide going in and out as the markets go in and out.

DAREN BLONSKI CFP®: But asymmetric risk is you have specific a risk to that security. So by using a 351 or an exchange, you're moving from it. Asymmetric risk of that particular security to symmetrical risk. And that's a decrease.

CHRIS SIPES CFP®: That's kind of another principle of the tax code, I would say as well, is there's always a trade-off. There's always a trade-off. And usually that trade-off is time related. Like take your retirement account, something that most people are familiar with. In exchange for tying up your money until you're 59 and a half or older.

CHRIS SIPES CFP®: The government's going to give you the tax deduction now or the tax deduction later, plus the deferred growth. So you're giving up the liquidity, you're giving up the ability to go buy a car with that money. But in exchange for that, they're giving you tax benefits. So that's a common principle you're going to see in a lot of tax situations.

DANO WEIR: Daren, before I move on to number three, could you please define, I've heard this a lot in my feed lately, what is direct indexing?

DAREN BLONSKI CFP®: Yeah, so direct indexing, the easiest way to think about it is a custom fund, right? So when you go out and you buy what we call a 40-act fund or a mutual fund or ETF, they're a basket of stocks or a basket of bonds or a basket of both or a basket of alternatives. It's a basket of some type of financial asset put together by a company, right?

DAREN BLONSKI CFP®: So a company goes and says, hey, we're really good at picking stocks or bonds. We're going to create these different baskets. And then Wall Street, the brokers, will go out and sell them to everybody. That's the distribution model. That's why I always tell people fundamentally Wall Street is a manufacturing business and you just have to understand what's being manufactured.

DAREN BLONSKI CFP®: So when a mutual fund company or an ETF company manufactures a basket of stocks or bonds, they're putting that basket together for you. When you're direct indexing, you're doing something similar. But what you're doing is you're buying those specific stocks or assets in that index. You're tracking an index. So you pick an index to track like, hey, we're going to track the S&P 500, right?

DAREN BLONSKI CFP®: Which is the largest 500 US-based stocks. We're going to index to that particular investment. We're going to buy all those individual stocks that are in that basket, but we might have some variation. So direct indexing is very common for people who are interested in ESG, environmental, social governance where there are specific stocks like tobacco or munitions they don't want anything to do with.

DAREN BLONSKI CFP®: Right? So you could say, because of my Christian beliefs, I don't want to have these type of things. Or because of my Jewish faith, I don't want this. Or because of my belief politically, I don't want that. Direct indexing is really the only way that you can effectively invest for environmental social governance criteria or values.

DAREN BLONSKI CFP®: So when we're doing ESG investing for clients, we will use direct indexing where we can be very selective about what's inside that basket. Now, There's another benefit from direct indexing. That is we get to control how long we own what we own in the basket. And we get to do it in a way that benefits the particular owner of that basket.

DAREN BLONSKI CFP®: Whereas when it's in the mutual fund, they're picking what's going in that basket. They're doing it in a way ultimately that benefits the basket creator, which is the mutual fund or ETF company. When we direct index, we can use value sets to pick and select what assets we have in there.

DAREN BLONSKI CFP®: But we can also do it in such a way where we do it tax advantaged for the client, right? So the client can say, look, Daren, I don't want anything to do with tobacco in my portfolio, but I also want to be very conscientious of what the tax implications are of owning, right?

DAREN BLONSKI CFP®: So for example, if in that basket I own Apple and I say, I only want long-term capital gains on that basket, I could put criteria on that direct index that says I will own everything for 12 months, one day. That has a different tax implication, right? So going back to the beginning, there are tax strategies based upon understanding the rules.

DAREN BLONSKI CFP®: And you could say, I only want long-term gains in my direct index. Whereas in a regular mutual fund or ETF that was built, there might be someone turning that over constantly. They don't care who Dan Weir is and what Dan Weir's tax base is. I know, right? Heartbreaking. It's me.

DAREN BLONSKI CFP®: But. When we're direct indexing, all we care about is Dan. It's very customized investing. That customization allows us to get very dialed in and specific to what your unique tax platform or profile is. And then we can do specific things that allows us to be more tax efficient. So it's not what you make that counts, but what you keep that matters. And direct indexing is a way to achieve that.

DANO WEIR: Okay, so now... If you followed so far, let's take that. And this is the most complicated part of the episode. I'm just going to say this out loud. It's hard for me to wrap my brain around this and I've listened to it a lot. So let's talk about how direct indexing can meet up with a long, short strategy.

DAREN BLONSKI CFP®: Okay. So most people think about when they own investments, they own something, they're owning a piece of that. It could be a bond, could be a stock, and you own that. You own that right to that share of Starbucks or that right to that share of Chevron. That's a long, that's considered long.

DAREN BLONSKI CFP®: You can also short something, which that means that, hey, I'm betting this thing's going down, right? A lot of investors don't do that. Most retailers don't do that. But when you short something, you're saying, hey, I think the stock's actually headed south.

DAREN BLONSKI CFP®: It's possible when you're direct indexing to use leverage on the stocks. Or whatever you're buying, whatever asset you're buying that you're indexing for, right? So let's say the Russell 3000 that you're trying to target the Russell 3000.

DANO WEIR: Which is an index unto itself. Which is an index. Kind of similar to the S&P 500, but a different collection of companies.

DAREN BLONSKI CFP®: That's right. So when you direct index, what you're saying is I'm going to pick an index, could be the S&P, could be the Russell, could be the Dow, whatever it is. Typically when you're direct indexing, you're going to pick an index that has a lot of different positions in it. Why? Because that allows the direct indexing process to have a vast variety of options because you need options in this game.

DAREN BLONSKI CFP®: And the goal is I have to meet the performance of the S&P or the performance of the Russell or the performance of the Dow. That's the index. They're indexing to that. Every index, whenever you're direct indexing, there's what's called a tracking error. I mean, like how close am I to that S&P? That's called tracking error. Ideally, you want a very small tracking error.

DAREN BLONSKI CFP®: Well, you can add leverage so you can make bigger bets on going up or bets on it going down, which magnify the up and magnify the down.

DANO WEIR: Okay.

CHRIS SIPES CFP®: The way I like to think about it is as an analogy, if you own your home, you know, something most people are familiar with, you own the house you live in, free and clear. You could go to the bank and borrow money on that house. And buy more houses, right? Let's say you own a house in California.

CHRIS SIPES CFP®: It's worth, you know, a million dollars. You own a free and clear. You're going to borrow $800,000 out of your house and you're going to go to the Midwest. And buy two, three houses for that extra. So now you've gone from one house to multiple houses by introducing leverage.

DANO WEIR: Okay, gotcha.

CHRIS SIPES CFP®: And so the same means of stock, right? If I own one share of stock, but if I go and get some debt on that stock.

DAREN BLONSKI CFP®: I can go buy two things of Starbucks. Now, here's the thing. If Starbucks goes up really quick, that's great for me. If Starbucks goes down really quick, that's not so great for me.

DAREN BLONSKI CFP®: Now. Here's where one of the beauties of what we call long short direct indexing comes in. I can literally, if I'm taking a loss, so Starbucks goes the wrong way on me. It goes down and I say, I'm going to sell that thing.

DAREN BLONSKI CFP®: I'm going to actually take that loss and bank it. Meaning I'm going to put it over here and say, when I have gains, my loss can go against my gains. That's called tax loss harvesting the gains with the losses. Just part of the tax code. Okay.

DAREN BLONSKI CFP®: Now, I can lose on 60% of my trades. Some say that great traders actually lose 60% of the time.

DAREN BLONSKI CFP®: What happens with all those losses, typically in like a mutual fund chassis or ETF, is they get buried inside the fund company. They get to keep all that stuff. We don't get to keep it. When you're direct indexing, guess who gets to keep it? Dan O'Weir gets to keep that, right? When Dan O'Weir gets to keep it, guess whose taxes it gets to go on? Gets to go on Dan O's taxes.

DANO WEIR: Trying to get some love. I like this. I'm liking this.

DAREN BLONSKI CFP®: So now, because whenever Dan, just by the way of trying to track that index takes a loss, he's banking those losses. They're not awesome, but let's make bad better. And they bank those losses. That goes on Dano's taxes as a net capital loss.

DAREN BLONSKI CFP®: Now Dano's portfolio is still going up because we're still doing a good job and winning 40% of those trades, but we're losing 60. So we're banking that loss here. The index is going up and you're making money, but now you still got a loss. So Dano, it turns out you can make money and lose money at the same time.

CHRIS SIPES CFP®: Which is important because it's very important because the primary goal of the long short strategy or any is not like losing money for taxes. Like that's not the primary goal. The primary goal is to track the index, hopefully do better than the index. You know, that's the primary goal and the losses are, are a. A byproduct of that because nobody can be right all the time.

DANO WEIR: Let your winners win and your losers run, right?

DAREN BLONSKI CFP®: No, it's let your winners run and you cut your losers short.

DANO WEIR: Right.

DAREN BLONSKI CFP®: So you lose trades. If you lose a bunch of little trades 60% of the time, but you win big time on 40%, you end up positive. And then you capture all those little losses as you go. Again, you're not doing it to get the loss. The losses are just like a byproduct.

DANO WEIR: Right it's like it's going to happen it's going to you're going to happen so you can either let the etf eat them or you can keep them for yourself and bank them as a net capital loss that can help you when it comes to tech stuff that's right so scenario possible scenario Dano wants to sell his business he's had his money invested and it's been generating net capital loss just by way of i'm very profitable apparently i'm doing a lot of stuff for my portfolio in this episode.

DAREN BLONSKI CFP®: So Dana wants to sell his business, and he's going to have this. Big capital gain coming at him, but he's been investing in a long, short direct indexing strategy, generating a net capital loss for years. That's going to help Dano on his capital gain because he's going to have a capital carry forward loss that then he can use against that capital gain. And so that is the rest of the story.

CHRIS SIPES CFP®: Just like when Daren mentioned the bank of losses before, where you put those losses into your bank to use them against your gains. Well, If you use them against, you know, your, your, your business sale or your house sale or whatever it might be, you don't have those in the bank anymore.

DANO WEIR: Right. They're gone.

CHRIS SIPES CFP®: So then the rest of your portfolio, that's got all these gains, they're still there. It's not like the gains disappear.

DANO WEIR: Right.

CHRIS SIPES CFP®: It just is allowing you to kind of use those, those banked losses along the way. But once you lose, use them, just like your checking account, like once you've written that check out, they're gone.

DAREN BLONSKI CFP®: But going back to the concept of lazy money, now go back to just a regular stock and bond portfolio. Your stocks and bonds make money. You're going to pay taxes on that. It's no different than the situation you're now in with bank losses that you used against your business, but you've got appreciated stock.

DAREN BLONSKI CFP®: So you would end up paying capital gains on that, and you would want to strategically manage those gains so that you were selling them at an advantageous time for yourself.

DANO WEIR: Let's talk about real estate. Which is not what someone would necessarily think of first thing. We're financial advisors. We're a financial advisory firm. So you would think... Not necessarily the first people to talk to about real estate. And yet, as we look at your entire financial picture, your holistic approach to finance, real estate for a lot of people is going to be a large chunk, 50%, somewhere around there.

DANO WEIR: So you own real estate that's grown significantly in value since you bought it. You want to exit ownership and management. You're done with that, but you're concerned about the capital gains impact. So what can a 1031 exchange into a DST and a 721 upgrade. Into a REIT do? Let's start with the DST.

CHRIS SIPES CFP®: Okay. So I think- Define DST first. DST stands for Delaware Statutory Trust, but I think the concept is important, which most people are familiar with the 1031, which allows you to defer taxes on an investment property as long as you're going into another investment property.

DAREN BLONSKI CFP®: A like and like.

CHRIS SIPES CFP®: Right. It has to be like, and like there's rules around it as without all of these, there's a lot of rules. So you got to do it correctly using an exchange agent, et cetera, et cetera.

DANO WEIR: I've got a, a apartment complex. I've got a hundred thousand dollar gain on it. When I sell it, if within a certain timeframe, I go buy another apartment complex, the gain, it basically moves over to that, that building. That's right.

CHRIS SIPES CFP®: That's, that's kind of a simple example. So That's basically what you're doing here, except for instead of.

CHRIS SIPES CFP®: That new apartment complex that you would have to take care of and manage and deal with the maintenance or hire somebody to do that you're going into a privately run real estate project so it's probably still an apartment complex or student housing or or you know data centers think of commercial properties mcdonald's property or yeah they're commercial properties but it's run by someone else.

CHRIS SIPES CFP®: The finances, the maintenance, et cetera, et cetera. It's more passive essentially. So it's still a 1031.

CHRIS SIPES CFP®: You're still deferring the taxes. You still have the deferred tax liability, but you're giving it to someone else to manage on that property or properties because you can go into more than one, which is nice.

DANO WEIR: And that's the Delaware Statutory Trust.

CHRIS SIPES CFP®: That's the deletion. Delaware Statutory Trust. Right. Now think of those as single properties, right? Which leads to why would you want to do the up read?

DAREN BLONSKI CFP®: Well, what's the risk of the single property? Cause I think that's really important that we outline the risk of a DST.

CHRIS SIPES CFP®: Well, we, so we've experienced this for clients.

CHRIS SIPES CFP®: Like any real estate, you can have unforeseen issues, right?

CHRIS SIPES CFP®: There was a property, it was an apartment complex that had a water main break. And we're talking like 500 rooms apartment complex, the main water main broke. Everybody's got to leave, they can't collect rents. It's like a $50 million insurance claim, et cetera, They can't pay their distributions to the investor. So there's risks, just like if you're in an individual stock or an individual.

DAREN BLONSKI CFP®: That wasn't a DST that we provided to a client. By the way, this is just a real estate example of a client who owned a commercial or apartment building in the water main broke. Correct. They're not getting rent for a while. Right.

CHRIS SIPES CFP®: Even though it's managed by a professional, you know, maintenance, all the things still happen. So there's more risk. So, again, there's rules. You got to be in the DST for a certain period of time, et cetera. But you can.

CHRIS SIPES CFP®: Transfer that property into an up-REIT, which is essentially a collection of properties. It might be a hundred or a thousand or more. And so it's the same concept of spreading your risk across a lot of different positions instead of just one or two or three.

CHRIS SIPES CFP®: And so it reduces the risk by going into one that holds multiple properties instead of just one. And me, jump in there for a Zach, what's interesting about 721, though, so...

DANO WEIR: A client who was selling an island right and they had this island the family inherited the island you can't just as families do you can't just say that you just inherit an island i know it's wealth advisors can we laugh at least for a minute so they inherit this island right but the island has like 12 people that inherit the island.

DAREN BLONSKI CFP®: This is a horror movie i've seen this right they're all trapped has nothing to do with that person that shall not be named but so this island that is going to be inherited. There's 12 different inheritors. All the kids are looking at this thing going, oh my gosh, this is a nightmare. We don't want to own this island.

DAREN BLONSKI CFP®: Right. So they transferred the property into an up-rete. So what that allowed to happen is the island got sold into the up-rete. And went and diversified it. But the other thing that the up-REIT eventually, there's a period of lockup time. Once it goes into an up-REIT, you actually own shares of a REIT, a real estate investment trust.

DAREN BLONSKI CFP®: And when you own shares of real estate investment trust, now you can sell parts of that property, right? In the sense that you can sell shares of the REIT. Whereas before they own this island, you either sell it all or nothing. Like, what do you do? You get the beach.

DANO WEIR: You get the mountain, right? You can't break it up into little parsecs.

DAREN BLONSKI CFP®: So it's a great way to create partial liquidity, which is kind of nice with an up-REIT. So an up-REIT's when you've got mom and dad, they've owned the commercial building forever. They don't want to be landlords anymore. They want to get away out of the professional management of it, but they have a massive gain. They don't want to take the gain.

DAREN BLONSKI CFP®: They know there's going to be a step up at death in that game. They want to put it into the Delaware Statutory Trust or multiple properties in the DST. So you can take one property, make it multiple properties. You can use an uprete and it creates less risk because it's spread out and there's still risk and you can preserve that capital gain until it's more beneficial from a tax standpoint.

CHRIS SIPES CFP®: Liquidity's a little bit more, but it's important as with most real estate, you should think of it as illiquid money.

CHRIS SIPES CFP®: Illiquidity is the, again, where you can't turn it into cash. You can't just go sell it on your phone like you're used to with your regular stocks. This is money that's going to be there for a while. Now you can still go in from one property to another property. So as long as you're staying within the real estate asset class, you have some options.

CHRIS SIPES CFP®: But if you said, I want to get out of real estate and give me my cash, that's going to be an issue. And so that's the downside. So again, that that time element, as long as you're exchanging the time, the government's willing to give you some tax benefits for that.

DANO WEIR: And I think it's appropriate to say here in the episode, because you might ask, why would these guys bring up downsides to some of this stuff? I mean, you just told a story of something bad that happened, right? We're supposed to be talking about all the upside, right? That's what someone, I guess, who's trying to tell you about something new would be telling you about all the good things.

DANO WEIR: We're fiduciaries. Which means that we are obligated from many levels to tell you advice in your best interest. And that includes both up and downside and talking about the risks of certain things. So what these strategies can bring to you, but also the risks that are inherent with them. And then determining based on consultation how it's going to work with your situation.

DAREN BLONSKI CFP®: Yeah, so let me just expand on that relationship. It's really important you have an advisor that... The conflicts of interest are minimized because there's always conflicts of interest, right? Like a baseline advisor wants your business.

DAREN BLONSKI CFP®: That's a conflict of interest, but they minimize the conflict of interest in a way that they can take their knowledge of how Wall Street works, how investments work, how planning works and advise you and say, Dan, this is a good tool for you. This isn't a good tool. There's, I don't care which one you do. Cause it doesn't matter to me.

DAREN BLONSKI CFP®: You pay me a fee for my job and I give you the best interest advice to you. Yeah. I think that's a really important delineation. And what I always tell clients, if you don't understand the trade-offs, because every investment has a trade-off. If you don't understand the trade-off, you have not done your diligence.

DAREN BLONSKI CFP®: And you need to ask more questions. Because there is no such thing as a silver bullet investment world. Everything has a trade-off. You just need to know it. The more money you're going to make, the more risk you're going to take. And that's just a reality.

CHRIS SIPES CFP®: There's always risk. And there's always someone getting paid. You should as an investor feel empowered to ask, how are you getting paid on this? How are the other individuals getting paid on this? Because if there's a sense of nobody's getting paid on this and there's no downside, you should run as fast as you can.

CHRIS SIPES CFP®: You don't understand.

DAREN BLONSKI CFP®: And if the guy's selling to you, his last name's Madoff, you should probably make off and run.

DANO WEIR: Yeah, we don't ever use the G word around here, do we?

DAREN BLONSKI CFP®: The G word's the guarantee. If you hear a guarantee in our business, you're about to get sold an insurance policy.

DANO WEIR: All right, well, let's start, let's end with something really great. Let's put something that was information. I was, I'm not surprised to find this, but it was cool to see it really verified. We're in Sonoma County, Sonoma Wealth Advisors, where there are 3,000 plus nonprofits in Sonoma County.

DANO WEIR: And did you know, confirmed based on a study from the IRS, the most volunteerism in all of California, Sonoma County, people donating their time to give back to the community, which is pretty cool. It's from a 2023 study.

DANO WEIR: Charitable options are also a tax strategy and they are our sixth strategy we want to talk about. So Chris, Darren, donor advised funds, for example, how can that be a part of a tax strategy?

DAREN BLONSKI CFP®: So we call these DAFs for short, right? So if you look at the tax code, we all get a standard deduction. And so the idea is that you can contribute to a DAF more than your standard deduction, and then you can have an itemization on your taxes is just a real simple way to do it.

DAREN BLONSKI CFP®: Advice Fund's nice because I don't know about you, Dan, but I get invited to different charities throughout the year. You always got to pull out the checkbook when you go to the charity, whatever.

DAREN BLONSKI CFP®: And so what I have is I have a DAF. I use a DAF, a donor advised fund that I can write checks to various charities as I'm going throughout my year. But I can take the deduction for it all at once.

DAREN BLONSKI CFP®: And so i might give this year and then i might spread it out over next year maybe going to the year after just depending on what the you can float the deduction across you can't float the deduction the deduction comes once in the year in which you make the gift to the DAF okay but you can float the gifting oh okay right okay so it's like oh i'm gonna go to the baseball fundraiser and then i'm gonna go to the soccer fundraiser and then i'm gonna go to the united angler fundraiser and then i'm gonna go to whatever and i've got that banked up charitable deduction into the DAF and then I can gift out as I go.

DANO WEIR: Interesting.

DAREN BLONSKI CFP®: So that you're not forced to gift a big chunk in any one year. We were just talking to a client. She's inherited all this money. Her mom was a professor at a big university. They want to do a gift to the university in her mom's name.

DAREN BLONSKI CFP®: I said, well, you might also consider it a DAF because charities don't always do what you want. And then you can start doling out the money over years. If you feel like it's still in alignment with your values.

DANO WEIR: Interesting.

CHRIS SIPES CFP®: Yeah. So going back to the blocking and tackling, let's say you're going to have a year where you're selling your business and you're going to have a lot more tax than normal, right? And you also are charitable in some way.

CHRIS SIPES CFP®: Maybe you're give to your church or you give to your favorite charity or both. Well, you can take, you can take some of the extra money you're going to be making that high tax year, put it in the DAF all at once, kind of front load it so that those two tax things happen in the same year.

CHRIS SIPES CFP®: And then, as Darren was saying, actually pay the money out of the DAF over the coming years.

DAREN BLONSKI CFP®: You know, you don't have to do it all at once. So you can kind of give it out as you prefer.

DANO WEIR: Do you want to get into CLATs and CRTs or do you want to roll?

DAREN BLONSKI CFP®: No, I would say there's lots of other strategies that lawyers like CLATs and CRATs and what, I mean, there's so many of them. There's more complex strategies that there's no way we could handle on this show. But that's why you need professional advisors, right? So what I would just say is super biased on this, but you need an advisor because there's lots of things we understand in our trade.

DAREN BLONSKI CFP®: You know, I think a lot of times everyone's like, Oh, I just put my money at blah, blah, blah, low discount broker. And I don't worry about any of these other things. And what you're missing out is on these more strategic. Planning things. And that's where an advisor creates value.

CHRIS SIPES CFP®: That's a big key for an advisor too, is like, just like we don't give tax advice because we're not tax professionals. That's not what we do. We have a tax firm that does, but Darren and I don't give tax advice. Just like we don't give legal advice on how to set up, you know, a trust or whatever.

CHRIS SIPES CFP®: But our job is to recognize these options for the client and know enough to know, hey, now it's time we need to bring that attorney in and talk about. You're trying to create income and give money to this charity. What do you suggest and have this set up?

DAREN BLONSKI CFP®: So it's really the job of the wealth manager to kind of understand the options that are available and then bring in the correct professional when it's time to set up the structure that you need.

DAREN BLONSKI CFP®: So it's really important, even if you have an attorney who's setting up all these CLATs and CRTs and blah, blah, blah, that you have a financial advisor that's doing the modeling behind it because the Lawyers are not modeling it most often.

DANO WEIR: Just as you wouldn't go to trial with your legal advice for me, you know?

CHRIS SIPES CFP®: Going back to the football analogy, you kind of need a coach that oversees everything, right? Because like the running back is going to see things from a running back's perspective and be like, well, I run up the middle or I run to the side. And like, these are the things that I do. And so all those professionals have their specialty that they're doing.

CHRIS SIPES CFP®: You know, the wide receiver does wide receiver things. You need a coach that's like, here's how the whole game is. Being played. And here's how we should, how we should do that strategically, right? So as the coach, we're not the one throwing the pass or running the ball blocking, but we're, we're kind of overseeing the overall game.

DAREN BLONSKI CFP®: Again, why the relationship is so important and making sure that the conflicts of interest have been mitigated to the extent possible. Because if you have a coach that has a conflict and they're sitting there only telling you to run the ball because they get paid more just to run the ball, you got a problem.

DAREN BLONSKI CFP®: Right. That's the problem with hiring an insurance agent as your financial advisor. That's the problem with hiring a broker as your financial advisor, because they're paid to do specific things, not to use the entire field. That's their winning strategy.

DANO WEIR: That's right. Can you, speaking of, because I know sometimes you give second opinion reviews, or even just when you're sitting with a client for the first time. Can you look at a portfolio and see immediate red flags for tax issues?

DAREN BLONSKI CFP®: Look, I can tear my portfolios apart, right? Like no portfolio is perfect, not even mine. And the reality is I can take any portfolio and show you what the trade-offs are. Okay, so that's the key to show what the trade-off. We're not talking good and bad. Sometimes there is legit bad and legit good in this business.

DAREN BLONSKI CFP®: And if it has a guarantee on it, it's usually probably bad. But... We won't go there in this episode. What we can absolutely do is look at and say, here's the trade-offs of what you own. Are these the trade-offs you're okay with? And that's what often happens more. It's not, they've got sold some junk or something like that.

DAREN BLONSKI CFP®: It's the person doesn't even know their plan and they've got some tool over here that's not going to get them to the finish line just because it's not the right application because someone didn't do their plan to begin with. Now that you understand the trade-offs, we look at the plan and say, let's build a plan for you and see if we're going to get where you want. You want to go.

CHRIS SIPES CFP®: And part of the plan is just knowing the tax picture. There's been many times where clients are really stressed out about taxes and you go in and you look at their tax situation and you're like, you're in a very low tax bracket. Like you're causing yourself a lot of brain damage for nothing. Right.

CHRIS SIPES CFP®: And vice versa, where the person's all stressed out about getting an extra 1%, you know, gain on their, on their investments and they're not doing anything from a tax perspective and they're paying 50% in taxes combined. Right. So part of it is just knowing what affects that client the most. And that's all part of the planning process. Not necessarily something, you know.

DAREN BLONSKI CFP®: In the very first meeting, but you know, that's something that your advisor should, should be working into the overall strategy for the game. The perfect example is just client. And I would see him walking around town.

DAREN BLONSKI CFP®: He never, he didn't make a lot of money. He didn't spend a lot of money, but he was absolutely convinced all he could own was tax-free California muni bonds.

DAREN BLONSKI CFP®: But he was in like the 6% tax bracket.

DAREN BLONSKI CFP®: It made zero sense, but he was absolutely obsessed about that muni bond and that's all he would buy. And he was giving up so much interest because he was buying those muni bonds at a lower interest rate, but he didn't have the right tax bracket for it to make any sense for him.

DANO WEIR: So we've talked about six strategies, 351 exchange. Exchange fund, long, short, direct indexing, 1031 exchange into a Delaware Statutory Trust, 721 up read into a real estate investment trust, and charitable options. Chris, is there a threshold? Is there a dollar amount?

DANO WEIR: We typically, minimum is a phrase that gets thrown around sometimes and it can cause a lot of consternation for people. What is the asset? Range where you would start to think about these tools really making sense? I think it's the way I want to ask that.

CHRIS SIPES CFP®: Oh, I'd say first and foremost, the most important part is that when we just talked about, which is knowing your tax situation, are you in a high tax bracket? Do you have a lot of income or not? That's, that's a good place to start. Because to Darren's point, if you're in the 6%, like you probably don't need to cause yourself all this complexity, right?

CHRIS SIPES CFP®: But then as far as the actual investments themselves, a lot of them do require, you know, like a status as an investor that you're sophisticated enough and you have enough liquidity to go into these strategies. And usually that minimum is somewhere around a million.

CHRIS SIPES CFP®: And so it can be different income levels and such. That's another thing you got to kind of look into. But I would say a million is a good kind of rule of thumb liquid, not including your house.

CHRIS SIPES CFP®: For some of these strategies that would be required.

DAREN BLONSKI CFP®: Well, like I mentioned earlier, right? Technology's allowed to, it made these options more available to people at a lower and lower threshold. It's still fairly high.

DAREN BLONSKI CFP®: But what I would say is if you think you're in a high tax bracket, talk with an advisor, talk with a fiduciary advisor, get some feedback on what you think. And if that's accurate, because at the end of the day, you might be lost in the realm of some possibility that's not a probability, right?

DAREN BLONSKI CFP®: There's a low probability of what you think is going to happen, but you're in that possibility space. And so the advisor's there to be that behavioral coach, that financial coach for you and to support you and find the right tools to get you on the road to your whatever goal you've got.

DANO WEIR: And for our clients who are watching this, thanks for making it this far. We love you. For someone who's just meeting us for the first time.

DANO WEIR: You can start at SonomaWealth. Com. That's where you can book your wealth analysis. Chris, Darren, if you're having a first meeting with a new client, what's something someone should know about Sonoma Wealth Advisors? What could that experience be like in your first Zoom call or in-person meeting?

DAREN BLONSKI CFP®: I think come as you are. Right? Like I think all too often people get intimidated. I have to have all my ducks in a row. I have to have all my paperwork put together. I have to fully understand things, but come as you are and then let us guide you down that road to figuring out the complexities to your financial situation.

DAREN BLONSKI CFP®: Don't be intimidated, right? If you walk into a financial advisor and they feel like they're talking down to you and they're not breaking down things into simplicity, then walk out because that's not a person that's going to be a good long-term relationship for you.

CHRIS SIPES CFP®: Yep. We value education and a consultative approach and we're not high pressure. We want it to be a good fit for both parties in order for it to make sense.

DANO WEIR: We look forward to long-term relationships.

CHRIS SIPES CFP®: Yeah.

DANO WEIR: We hope that you've enjoyed today's episode, learned maybe six things at max, maybe just a couple, something stuck. My name is Dan O'Weir. I think you know that by now because I own a business and I have several portfolios that have been discussed. I guess I'm selling it soon.

DANO WEIR: I'm the marketing director. This is It's All Money. Wherever you found the show, however you found the show, subscribe. We've got the video here on YouTube. We've also got audio on Apple Podcasts and Spotify. Darren Blonsky and Chris Sipes. You can learn all about our firm at SonomaWealth. Com. And we have many more episodes for you to check out.

CHRIS SIPES CFP®: Thank you so much for your time today.

CHRIS SIPES CFP®: Thanks for watching and listening.

DANO WEIR: To It's All Money. We hope today's episode shared information to increase your financial confidence. Now is the time in the show for the voiceover with a bunch of words at the end. Listen close, though. You might find out something you didn't know.

DANO WEIR: It's All Money is powered by Sonoma Wealth Advisors. Sonoma Wealth Advisors helps individuals and families in Northern California and across the country with building, managing, and sustaining wealth.

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DANO WEIR: Information presented on this program is believed to be factual and up to date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Discussions and answers to questions do not involve the rendering of personalized investment advice.

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