Benjamin Franklin famously wrote that there are two certainties in life: death and taxes. Most investors accept that statement at face value. Taxes are inevitable, so we plan for them, pay them and move on.

Of course, we would strongly prefer to delay both of those events for as long as possible!

In real estate investing, there’s an important nuance to Franklin’s observation. While taxes may be certain, the timing of those taxes is not. And when it comes to investing, timing can make a meaningful difference.

At Pathfinder, we spend a lot of time thinking about timing – when to buy, when to sell, when to refinance and when to hold. One of the advantages of investing in real estate, particularly multifamily properties, is that the tax code and capital markets provide several ways to defer taxable gains and keep capital invested longer. That additional time can dramatically increase the power of compounding.  Our Pathfinder Income Fund is a good example of our decision to hold properties, defer taxes and allow the value of investments to compound.

Another smart guy, Albert Einstein, called compound interest the “eighth wonder of the world.” The principle is undeniable: Compounding is powerful. A challenge is that taxes interrupt it.

When an investor sells an asset and pays taxes on the gain, a portion of their capital leaves the investment ecosystem permanently. The government becomes a “partner” in the transaction. Unfortunately, Uncle Sam is a partner who never attended the investment committee meetings, didn’t help with the late-night underwriting sessions, never participated in any of the value-add strategy sessions or even helped collect the rent.

That reduction in capital as a result of capital gains tax payments can have a significant impact over time.

A simple example helps illustrate the point. Assume an investor sells a property with a $1 million gain. In high-tax states like California, combined federal and state capital gains taxes can easily reach 35%. After paying taxes, the investor may have roughly $650,000 remaining to reinvest.

Now compare two scenarios over ten years:

Scenario I: $1,000,000 invested at a 10% annual return grows to approximately $2,590,000.

Scenario II: $650,000 invested at a 10% annual return grows to approximately $1,680,000.

The difference is roughly $900,000, attributable solely to tax drag.  To reach the same ending value, the after-tax investment in Scenario II would need to generate significantly higher annual returns. An investor would likely have to invest in a significantly riskier investment to make up the difference.  (See my partner Mitch’s article this month about investment risk…)  Achieving those higher returns consistently is much easier said than done.

This is where real estate investing becomes particularly interesting.

Unlike many other asset classes, real estate often allows investors to access capital without triggering a taxable event.  One of the most common ways this happens is through refinancing or recapitalization. As a property increases in value and income grows, owners can often refinance the property and return a portion of the equity to investors. Because the distribution of loan proceeds is not generally taxable, investors can receive liquidity while the property continues to operate and generate income.

This approach allows investors to continue to own a strong asset while still accessing capital (by borrowing on the appreciated value of the property) for new investments or other opportunities.

But what about liquidity?  Investors may be able to use their real estate holdings to secure lines of credit or other financing arrangements. These tools provide flexibility and liquidity while keeping the underlying investment intact and continuing the miracle of compounding.

These strategies are widely used by institutional real estate investors and are why many long-term investors are reluctant to sell high-quality properties unless there is a compelling reason to do so.

Another option available to real estate investors is the Section 1031 like-kind exchange, which allows an investor to sell one investment property and reinvest the proceeds into another property without immediately paying capital gains taxes. A 1031 exchange can be a useful tool when an investor wants to reposition their portfolio (by selling older properties and exchanging for new properties or selling smaller properties and exchanging into larger properties, for example) or move capital into a new opportunity while preserving their entire equity base.

Over long periods of time, these strategies can create an outcome that looks somewhat like a Roth IRA, where investors contribute after-tax dollars and their investments grow tax-free. With real estate, the mechanism is different, but the effect can be similar. Investors defer taxes while their investments continue to grow and compound over long periods of time.

In some cases, investors may refinance properties or exchange into other properties multiple times over the life of an investment. If properties are held for very long periods and passed on through an estate, current tax law provides for a step-up in basis to market value at the time of inheritance. In practical terms, that means years –and sometimes decades –of deferred gains may never be taxed.

This dynamic becomes even more meaningful for investors in high-tax states such as New York or California. Between federal capital gains taxes, state taxes and the Net Investment Income Tax, the combined tax burden can exceed one-third of an investment gain. Losing that much capital to taxes significantly reduces the amount available to reinvest.

Deferring those taxes allows investors to keep a much larger capital base working for them over time.

At the end of the day, tax deferral strategies are really about one thing: TIME. Time allows:

Rents to grow.
Properties to appreciate.
Loans to amortize.

Every dollar that remains invested continues to work. Every dollar paid in taxes stops compounding forever.

Which brings us back to Benjamin Franklin’s quote about life’s two certainties. Taxes may indeed be inevitable. But for real estate investors, the timing of those taxes can make a meaningful difference in long-term investment outcomes.

At Pathfinder, we focus on acquiring and operating multifamily properties in markets with strong fundamentals and long-term housing demand. We understand the sensitivity our investors have to taxes, and continually evaluate opportunities to refinance, recapitalize or exchange properties in ways that maximize long-term value for our investors.

Because…while death and taxes may be inevitable, good real estate investors spend a lot of time figuring out how to delay them.

Brent Rivard is Managing Director and COO of Pathfinder Partners. Prior to joining Pathfinder in 2008, Brent was the President of a national wealth management firm and CFO/COO of a one of southern California’s leading privately-held commercial real estate brokerage firms. He can be reached at brivard@pathfinderfunds.com.