One of the predictions that are beginning to pick up steam in the investor community is the notion that coming disruptions in government policy will further suppress investment activity and create deflation over the short-run, with inflation expected over the long-run because of high government debt levels that can only be dissipated by printing money. This has left many investors befuddled, as deflationary times frequently result in large contractions for the stock market, while inflationary times erode the purchasing power of income and savings. On top of all this is the impact of taxes, which are already on the rise and likely to continue escalating as the government attempts to attach ‘band-aid’ solutions to its runaway spending problem.
The most difficult part of optimizing your income and investment portfolio for economic uncertainty is the fact that many investments and activities that perform well against inflation are subject to great danger during deflationary times . . . and vice-versa. There are many late-night infomercials that claim to have a ‘system’ for predicting exactly when market booms or disruptions will occur, but nobody has the ability to accurately predict market movements every time. Some people get lucky, but luck is not our preferred method for creating a strong financial future. If it were, we would recommend taking your money to Las Vegas.
Over time, markets always regress back to fundamentals. The journey to fundamentals can be very bumpy as demonstrated by John Maynard Keynes’s observation that “The market can remain irrational longer than you can remain solvent.” In keeping with these two observations, it is optimal for our income and investments to align with fundamentals, but be sufficiently robust to withstand significant volatility and provide adequate protection against the impact of taxes to sustainably build long-term wealth.
The first factor for analysis is the impact of inflation. Sustained inflation is caused by an imbalance in the amount of currency in circulation relative to the amount of goods and services produced. During times of inflation, there are some investments that perform especially well while others perform more neutral or poorly.
The two strongest investments for fighting inflation are gold, a fixed-rate mortgage, and real estate value. The reason for this is because gold holds a stable value during inflation, and the fear of inflation frequently sparks investor speculation that drives-up gold prices disproportionately. On the other hand is a fixed-rate mortgage contract that is paid back in progressively devalued dollars. A mortgage defends against inflation by providing a fixed cost of capital. In addition to this, we have the value of a real estate holding. The physical nature of real estate makes it a very strong hedge against inflation, as demonstrated by the fact that real estate frequently holds constant purchasing power throughout inflation and typically ‘leads’ inflation by increasing in advance of consumer prices.
Next, we shift to income and investment categories that are more inflation-neutral. Income from a job, rental income, rental income, and stock market investments are all neutral, as increases in the cost of living frequently inflate all of these income categories after a time lag.
The weakest income and investment categories during inflationary times are cash, bonds, pension income, and taxes. Cash, bonds, and pensions all have their real value eroded by inflation. The nominal amount of capital and income will still be there, but the amount you can buy with it will go down. Taxes are especially destructive during inflationary periods, because the government does not recognize inflation in its tax code. This means that if the nominal value of your investment doubles while the real value stays flat, the impact of taxes will produce a negative ‘real’ return on your investment. The nominal value will go up, while the real (after-tax) value goes down, leaving you with less wealth while incurring more risk.
The next phenomenon worth explaining is deflation. Deflationary times are when a reduction in money or a slowdown in the velocity of monetary circulation drives down prices. Typically, deflation occurs when credit gets tight and many people are simultaneously selling assets. By and large, deflation is concentrated in assets and luxury items while price contractions for necessities tend to be much smaller or nonexistent. During times of deflation, cash, bonds, and pension income becomes highly valuable as their purchasing power increases while the price of things available to buy goes down. Deflationary times are also more advantageous from a tax perspective, because losses can be offset against other income to reduce your total tax burden.
Income from a job and rental income are both relatively neutral during deflationary times, as they tend to be ‘sticky’ downward, reflecting a general tendency for these types of income to lag the movement of market prices in setting a new equilibrium. Stocks also tend to be neutral vs. deflation, since the decrease in value of your property is accompanied by a decrease in value of everybody else’s property.
Assets like gold, mortgage loans, and the value of real estate are very weak against the effects of deflation. At times, gold has held value on the backs of speculators but is highly prone to large price collapses when economic conditions shift. During times of deflation, gold has the potential to burn investors who purchased it during a speculative bull market. Mortgage loans and real estate value are also very weak against deflation, because a reduction in the real estate value will leave you owing more than your asset is worth, forcing you to take a loss if you need to sell or absorb negative cash flow if you do not. However, the advent of loan modifications, short sales, and the implicit option to ‘walk away’ from troubled properties gives the mortgage potential for moving up into the neutral category.
The third vector of analysis is the impact of taxes. Many people stop their investment analysis before the impact of taxes is added-in. The large government deficits and expected tax code changes are going to make tax efficiency an item of increasing importance over the coming year. The income and investment categories with the greatest tax efficiency are your real estate value and the mortgage. Real Estate is subject to section 1031 of the Internal Revenue Code, which allows for indefinite deferral of capital gains taxes for ‘like-kind’ exchanges of real property. In addition to this, the mortgage interest use for financing real estate investments is tax deductible.
Rental income and cash are relatively neutral in regards to taxes since cash is not taxed, and rent income is taxed at ordinary income rates, but is offset by legitimate expenses. On the bottom of the tax efficiency scale are Gold, job income, pension income, stocks, and bonds. Gold is considered a ‘collectible’ by the IRS and is taxed at a flat 28% capital gains rate. Furthermore, it cannot be owned in an IRA unless it is in the form of a government sponsored coin. W-2, pension, and bond income is taxed at ordinary income rates, and there are a limited number of deductions available to ease the tax impact. Stocks are subject to either ordinary income or capital gains taxes by the government. In addition to this, mutual fund investors can be subjected to a tax liability if the fund manager turns over the fund portfolio too frequently and triggers taxable transactions.
When using all of this information to paint a holistic picture, it quickly becomes apparent that some categories of income and investment possess more attractive characteristics than others. Despite its great appeal to speculators in the recent economic environment, gold represents a risky long-term investment because of its weakness against deflation and the punitive taxes that are levied on collectibles. Pension income and bonds are both subject to considerable risk as wealth building vehicles since their value can be quickly eroded by inflation, and they do not offer any particular tax advantages. Cash is a viable option for short-term capital holdings while waiting for market cycles to unfold, but cannot be relied upon to build a wealthy financial future. The stock market has a historical precedent of holding value relative to inflation, but has produced very little in terms of long-term value outside of dividend payments. Gold and stocks can both be vehicles for speculation with a small portion of your portfolio, but long-term wealth building requires a more robust solution.
Business income can create an advantageous situation, as it is relatively neutral against inflation and deflation (similar to income from a W-2 job), but possesses superior tax efficiency. Many people develop business income while engaged in a job that produces W-2 income. This allows them to create an additional stream of income that is more tax favored. For many people, this strikes an ideal balance of stability and growth where the W-2 income pays for your living expenses and income from your business ventures can fund investments for retirement.
The final category that carries the greatest holistic benefit is income property investing. The reason for this is because income property represents a multi-dimensional asset that allows you to benefit from inflation, protects you from deflation, and minimizes your tax burden. Most people mistakenly think of this as “real estate” when the truth is that real estate simply serves as a vehicle for the real value drivers of income property. These value drivers are rent income, depreciation, and the mortgage used to finance your property.
Since real estate and a fixed-rate mortgage are both strong against inflation, you can lock-in your cost of capital while the price of your property rises during inflationary periods. During this time, you will be able to deduct the interest expense and depreciation from your cash flow to minimize your tax burden. During deflationary times, it is possible that the value of your property will fall below your mortgage balance. In the case of people’s homes, this can be catastrophic if it forces people into default because they can’t pay the mortgage and can’t sell the home for enough to cover the loan. However, income property produces rent revenue that is less subject to deflationary pressures than asset prices. The reason for this is because ‘shelter’ represents one of life’s necessities and is a top financial priority for most families. This means that a prudent investment where the rent revenue covers your mortgage payment will give you ‘staying power’ during deflationary times that prevent a forced liquidation and allow you to capitalize on strengths of income property during inflationary times.
On balance, a complete income and investment portfolio will consist of many categories that we have discussed. However, for people interested in producing long-term wealth, it is optimal to make efforts to shift your personal portfolio toward business income and income property investments for the foundation of your wealth plan. Once that foundation is built, it may be advantageous to speculate on stocks or precious metals to capture the movements of market cycles. When constructing your personal plan, it is important to plan for both inflationary and deflationary times while keeping the impact of taxes in mind. This will allow you to create a holistic solution that generates a lifetime of wealth and happiness.
Action Item: Actively shift the composition of your income and investments toward a base of business income and income property investments. This will allow you to speculate on instruments such as stocks or gold with a small portion of your portfolio while the baseline is poised to take advantage of inflation and defend against deflation so that you can strategically purchase speculative instruments at suppressed prices. (Top image: Flickr | rptnorris)
The Jason Hartman Team
