Why Tax Benefits Shouldn’t Drive Your Investment Decisions with Adam Cmejla (EP.215)

0:28We all need to make smart decisions with our money. money. And the topic that we started with was opportunity zones, basically thinking through the tax impacts and trade-offs of whether that's a good investment idea for somebody who's looking to defer a large capital gain. But the conversation really evolves over time just into how to make investment decisions in general. So I think you're going to really enjoy this conversation. And because we're talking so much about how I think about investing within the conversation, I do want to point out that at the top of the episode, there is a link to a PDF where you can learn exactly how it is that I invest my own money.

1:03You can also go to howpeterinvest.com to find that information. But I am really excited to share this conversation with you. So let's not waste any more time. Here's my conversation with Adam Schmela.

1:18Welcome back to another episode of 2020 Money. Joining me back on the show today is the chief investment officer of PlanCorp, host of the Long-Term Investor Podcast, author of Making Money Simple, and most importantly, my friend, Peter Lazaroff. Peter, good to see you again. Adam, thanks for having me again. You got another project in the works too, don't you? You've been busy. Yes. I just turned in the manuscript for my next book, which will be called The Perfect Portfolio. And it's really just my take on a lot of the investment classics. I know that we don't have video. So no one's watching us.

1:51I mean, I can see you, but I got all these books behind me. And when people ask me for an investment book recommendation, I feel like I'm always giving them three or four books and they're all 400 or 500 pages long. It's all Ben Graham's. It's just copies of Ben Graham's book, right? Yeah. His is back there. But I just realized, you know, I need to be able to hand something to someone that's less than 200 pages that captures all those big ideas in a single approachable way. But let me do say this, because I have a new book coming out, that means I have a lot of making money simple sitting on my shelf.

2:24So Adam, if people go to peterlazaroff.com slash free book, you put in your mailing address, give me a couple weeks because this is airing while I'm on vacation. And I'm personally got a lot of time. Yeah. So go ahead and put in your information. You'll get signed up for my newsletter. It comes out every other Wednesday. It is a small cost to get what is a piece of work I'm really proud of, making money simple. Again, that's peterlazaroff.com slash free book. And we'll get that in the mail right when I get back from vacation. Just to be clear, I said out of office. It is a mixture of both personal and business.

2:57You got a lot on the docket here over the next couple of months. Yeah, I'm going to touch all of the states. You might forget what the inside of your house looks like by the time you get back. That's true. I wish I could travel with my pillow. That's the thing I'm going to miss the most, but that's an unnecessarily large carry-on. So we'll risk my neck and posture for the next handful of weeks and hope that all my information on investing remains intact. Do you have a favorite pillow? Is it like one of those square pillows? I got to know. I can't believe I don't know this about you. So it's a Z pillow, like the letter Z.

3:28I think I probably bought four or five pillows before I finally landed on the one that I loved. there's a Tempur-Pedic pillow that I'm okay having. But if my wife tries to steal my pillow, I will wake her up to take it back from her. I'm like, I'll buy you one of these pillows. I have no issue whatsoever buying a pillow, that same pillow for everybody. It's not that nice. I mean, it was a couple hundred dollars, but if somebody else is trying to use it, they will feel something come out from underneath them while they're sleeping. I needed to go to sleep. So yeah. See, if I could travel or if I could bring something with me to travel, it's even more non-pragmatic, if that's the way to say it.

4:06I would love to, if there was a travel version of eight sleep. So the whole bed sleep system that regulates the temperature, it heats, it cools, it changes elevation slightly throughout the night. If it detects your snoring or changes in your breathing, it has revolutionized the way that I sleep. But I heard it on the Tim Ferriss Show podcast and a couple of other places, but it's a massive, massive system. I mean, there's risers that go underneath your bed, there's a cooling. This might be my next big investment. You've mentioned this in one of our group chats, and I know there's a referral code.

4:38So we'll see if Adam's ready to monetize his podcast by sharing his eight sleep number referral. Yeah. So the most indirect way for someone to actually monetize a show would be to put something completely unrelated to the show as a referral link in the show notes and now say it's monetized, but it makes you more important. Right. I don't even know how to segue into the actual topic that we're going to talk about. So I'm not even going to try and just dive into it. Opportunity zones. Or rather, opportunity zones, I think, are the numerator in the equation in which the denominator is letting the tax tail wag the investment dog.

5:17You and I have been around the block long enough in this profession where inevitably we will either have a conversation with a potential relationship or you're working with a client for an extended period of time and they see something on social media, they see something on TV, they have a friend talk to them about filling a blank concept and almost completing the sentences. There's awesome tax advantages to this. Why aren't we doing this or should we be doing this? and the challenge. And again, I think this is why I'm excited to have this conversation with you from an investment standpoint. I think we're both in violent agreement that investing is a fairly simple concept, but that doesn't always make it easy.

6:01And one of the things that can make it difficult is being distracted and getting outside the comfort zone and letting the tax tail wag the investment dog. And so I wanted to use opportunity zones as the kickoff point for our conversation. We'll just kind of see where it goes as we talk about this concept of reconciling prudent investment decisions with the tax benefits that come along with that. So let's just start giving the basic kind of high level 30 ,000 foot view of what is an opportunity zone and then we'll go from there. Well, I like the way you teed that up because opportunity zones when they were first created in 2017.

6:38It was part of the Tax Cuts and Jobs Act. It was designed to incentivize investment in these economically distressed communities, but it created a lot of buzz for people who were selling a valuable piece of real estate or selling a business. Adam, I know you work exclusively with optometrists. And so I'm picturing you're an optometrist. You've built your practice over the last few decades. You get approached by a private equity group interested in buying your practice. And you decide you're going to sell and you have a capital gain of, say,$3 million. And so that's going to be a big tax bill. And when you're doing a financial plan and you're thinking, man, even if I sold it for, I don't know,$5 million and the gain is$3 million, it doesn't feel like you really got all the money that you earned over the time building up that practice.

7:27And so what you can do is you can put that$3 million capital gain into a qualified opportunity fund. So basically, you're going to defer paying$3 million on the taxes currently until December 31st, 2026. And then if you continue to hold this fund for 10 years, you can make any appreciation in that opportunity zone fund go away. If you only hold it for five years, you get a little bit of a step up in basis. But here's the thing, you're basically trying to defer the capital gain, and there's some value in that. But you owe taxes on that capital gain, no matter what. Eventually, right? Yes. At the end of 2026.

8:06Now the one big, beautiful bill act, or as I'm going to try to get it to catch on the ABBA, or the OBBA. OBBA. I wish there were two O's so we could go OBBA. That has changed some of the rules and we can get into those nuances, but basically high level. I'll just kind of repeat back even simpler. You defer your capital gains by investing into these opportunity zones. They're typically economically distressed. It's trying to create incentives for people to put money in areas that could benefit from a capital infusion. If you hold on to that investment for five years, you're going to get a partial step up in basis.

8:41And so like that$3 million capital gain you put in, you'll get a partial step up in basis. So any of the gains happening in that fund are minimized. And then if you hold it for 10 years, you're not going to own any gains on the appreciation. Of course, this assumes that there is appreciation in that fund. So let's pause there, see where you want to take us. Now, you teed it up perfectly. Again, we're teeing each other up here. This is great. It's almost like we like golf. Because that's what I really want to draw out in this. You still owe taxes on the original gain that gave you the principle to be able to put into this opportunity zone.

9:18I just want to clarify that because I feel like that's where maybe this can get lost in the weeds where people think, oh, use the opportunity zone as a way to offset the gains on the sale of the business. To your example, on the$5 million gross$3 million net of selling my optometry practice, the tax man is still going to come. You still will end up paying taxes on that. To your point, we're just hoping that if there is any gain in this opportunity zone, that it's either partially or totally tax free. To your point, the huge asterisk there is, if there is a gain. Before we dive into that a little bit, my thought on this is, okay, why would somebody do this?

9:59If we know that we're eventually going to have to pay the gain, we're assuming that we're part of the plan here is, all right, there's a chance that potentially long-term capital gains rates are lower than what they are right now. With history as our guide, I think we could say that the chances of them being lower, I mean, we just had a huge piece of tax legislation come through 800 some pages long, which was in large part, the permanency and extension of a lot of tax cuts and jobs act. Nowhere in that legislation were tax were long term capital gains rates even discussed at being lowered. So it didn't happen with this administration and this Congress.

10:38I can't even really think of the combination of legislative actions that would cause capital gains rates to be even lower than what they are right now. So if we take that off the table, what are some of the other reasons that people would do this? Because again, you're going to pay the taxes eventually. What's the other angle that people are thinking? It's a really good question. I think anytime someone feels that they've found a loophole, everyone wants to get rich quick and find the easy button. And I do think that there's this idea that the quote rich have access to loopholes like the mega rich, like the 10th of a percent, the people on the Forbes 100 list or Fortune 100 list, whatever it is.

11:24They feel like there's access and they know all the tricks of the trade. I think with something like opportunity zones, you have to be overweight liquidity to have it make sense. And let me explain a little bit more of what that means. basically, let's go back to our optometrist who sells their practice for$5 million and has a $3 million capital gain. And let's assume this individual has been saving in to a 401k and profit share, or maybe they even had a cash balance plan. But let's just kind of say, I guess they have... Actually, let's say they have$5 million of retirement savings also. So after the transaction, they're going to have$7 million of net worth of liquid net worth.

12:05and that$3 million capital gain is going to be taxed. So whatever the tax rate is on that. The question is, can you go without 10 years without that$3 million of the capital gain that you're sinking into the new investment? And if you can, is investing in a single real estate project in an economically distressed area in a single geography by a single manager, is that a bet that you can afford to take? What I have seen with our clientele, we saw a lot of this come up in 2017. And I think we're talking about this at the right time because there were some changes to the rules of how it's going to work starting in 2027.

12:47And so this will come up as a question, but I've only seen one family do it. And for whatever it's worth, their net worth isn't quite$100 million, but it like touches up against that. Yeah, it's a really big thing. So let's say you put$3 million into something, you're already overweight liquidity. And I think that's a really important concept. When you had the practice, this hypothetical practice owner, they were probably underweight liquidity because some of this stuff is in retirement savings that they can't tap and a big part of their net worth is in the business. But once you liquidate, you might feel more liquid, but then you really have to think about it.

13:24So let's say instead that the opportunity zone allowed you to invest in a globally diversified portfolio. Well, this would be a slam dunk. Assuming that you can live without that$3 million of capital gain that's growing, the likelihood of catastrophic loss is bad. The likelihood that the tax benefit will be worth the squeeze is going to be pretty good. But when you're investing in basically one real estate project, and there can be opportunity zones with multiple projects in the fund. The problem is, yes, you are saving money on taxes, but what if you paid the taxes and then just took that liquidity and put it in a diversified portfolio?

14:02That is sort of the trade-off that you're trying to evaluate. And so this is a very roundabout way of asking your question, why would somebody else do this? I think you do it because you have more liquidity on your balance sheet than you could possibly need over the next 10 to 20 years. And you feel that if this sleeve of your balance sheet were to not grow at market rates, that it wouldn't hurt your overall plan. Obviously, if you thought it was a great real estate deal, you might do it. But I got to be honest, Adam, and most of what my experience is coming from is pre 2020. I've only personally looked at one opportunity zone fund since the pandemic.

14:41So pre 2020, though, when we looked at them, the deals did not look good. And if you're familiar with the geographies where some of these are, then you're like, really? That has no chance of working. Investing is all about trade-offs. I think that the trade-off that sometimes happens, at least when people are asking you or I or their advisor questions about this is, they overvalue the tax benefit and don't think about total return and don't think about the entire balance sheet in the entire portfolio. I think it's an all too common and to your point, everybody wants to get rich quick and it's been amplified with access to information and the reels that we see online and the short videos like your tiktok your instagram everybody is claiming to have the next best thing right the swiss army knife of investing and this can be one of those arrows and the quiver so to speak that people think of as being sexy and to your point again people are listening to this on video right now when you talked about oh putting in a diversified portfolio, I almost did the yawn motion because that's so boring, Peter.

15:47Why would anybody want like, oh my gosh, I could do that myself. You could and then you'd save fees on the opportunity zone. And yeah. Yeah. And all of the headache that comes with tracking that. I keep going back to what we talked about in the beginning, if it makes money and the liquidity event that has to happen in order for somebody to get their capital. Because if we follow the dollars in this, right, not to mention to what you had just said, you've got layers and layers of organizational structure in these things read fees, because everybody's going to want a cut off of the deal in return for the hopeful, supposed potential value that they're delivering.

16:25And so what is the investor's net return after all said and done after cost? Yeah, I know after taxes, it's like, okay, so there's an after tax gain, but this is real estate, there has to be a liquidity event. So now we're talking about kind of ironically and almost, I guess ironically is the only word, as an investor in an opportunity zone, you are in the exact same situation that you were as the owner of your existing business. Your business is worth zero until you have a willing buyer and a willing seller coming to terms on the same day and a check and agreement is exchanged. And so if we fast forward 10 years, I don't know where I heard this, but what's the best way to make God laugh, tell him you have a five-year plan.

17:10We're talking about a 10-year plan and having something like this work out. One of my favorite phrases here, we mentioned the tax tail wagging the investment dog, is the juice worth the squeeze. And I just have a hard time. Like you said, investing is all about risks. And if this is money that, dare I say, you're okay losing, or at the very best case scenario, not being liquid, sure, scratch the itch. But I just have a hard time finding the pragmatic reason why somebody would take this amount of investment risk for, again, you got to pay the taxes on the original source of funds. Anyway, all you're doing is kicking the tax bill down the road.

17:50You're not eliminating it. Yes. I mean, like that example that we painted that was sort of off the cuff where somebody had $10 million liquid pre-tax, post-tax, even though they're going to get to maybe eventually defer something on the growth of that other$3 million. It's just a tough sell. And here's what's going to happen, in my opinion, at least. So I'm the chief investment officer of a large RIA. And we do some private investing. We do some all-term investing. I will tell you that what's really important, I think this is worth calling out, the why is super important. And it differs from client to client.

18:24And the education is super important. Because the degree of certainty versus uncertainty that one of these things will actually add value, it's pretty unclear. In general, for me personally, I view the world through the lens of I am more worried about implementing a bad idea than I am missing out on a good one. And that does color how I choose to invest my own money. But it also means that when I do this research and I meet with managers, I probably say no 10 ,000 times every one time I say yes. And that's what's going to inform what I'm about to say is that we're going to get to the 10-year mark on some of the first opportunity zones very soon.

19:02And the rules for these, according to the OBAA or the One Big Beautiful Bill Act, I'm going to keep calling it OBAA. It's going to catch on. Everyone's going to pick up on it after this podcast episode. So what's going to happen is there's these 2027 rules where it used to be that like, hey, you had to pay your taxes by December of 2026. So like deferring your taxes in 2018, all the way to December 2026, that was a good deal. Doing an opportunity zone right now would be insane. Like there's no reason to do it because you're going to owe the taxes in a year. It's going to be a rolling five-year period starting in 2027.

19:38And what's going to happen is we're going to have these mature funds, these managers who did really well. They're going to be the survivors. That's what we call survivorship bias. And they're going to say, look what happened to this fund over the last 10 years. And all you're going to see is the winners. And if you hear about it from one of your friends who is in a winner, that was great for one of your friends. But what you don't hear are the losing stories because your friends don't brag about the losers. And, oh, the fund companies don't pitch me the losers because they don't exist anymore.

20:07And so I think it's really important to realize what we're talking about. I think you don't want the tax tail to wag the dog. But also because of the new law, because of what you're going to see in back performance of previous funds, it's going to look good. You're going to see stuff that's going to look good. And you're going to have to apply this framework that we're talking about. Do you have enough liquidity? Do you have enough diversification to make this type of a concentrated bet? And then what I'll say lastly, I mean, there's a lot of what goes into evaluating a sponsor, but let's just talk about it at a deal level.

20:37What do you even know about the region? And if you could visit the region, I mean, it's a big amount of money. Would you not book a flight to go like walk on the ground of where you're about to put your money? Some people might argue that's an advisor's job, and I wouldn't disagree with that. However, it's still your money. Do you think that your advisor is good at picking distressed real estate deals? Again, remember, these are economically distressed areas. And so it sounds like I'm not in favor of these, broadly speaking, and that's a fair judgment. I have been a part of one implementation where I felt like the liquidity, they're so overweight liquidity.

21:15It was early in the days when it was a project that was going to happen anyways. So any Opportunity Zone fund that's come about in the past couple of years basically is raising money from people who are looking for a tax break. Whereas initially, there were some real estate deals getting done that then they applied to be an Opportunity Zone in the process. And it's like, hey, we were going to put shovels in the ground anyways. And now we have this tax benefit. So it was a little bit of a different situation. I sort of feel like that's going to be part of the pitch going forward is, hey, so we were going to do this all along, but now there's these dollars, which are finally getting going.

21:50Yeah. So I think those are the kinds of things to keep in mind for people who are hearing about this for the first time or the umpteenth time. Just approach with caution. Can you go back? I love the way that you phrased that, your rule. Can you talk a little bit more about that? I'm more worried about implementing a bad idea than missing out on a good one. Can you talk a little bit more about that? Sure. That's what they call a Peterism at PlanCorp. There's like a handful of things that I just say over and over. So think about the FDA when they're approving a drug, risk approving a drug that they thought was going to be beneficial to society, but has really harmful side effects.

22:27So like in the 1960s, the FDA didn't even have that many standards. And there was a woman, I'm blanking on her name. I think it's Frances Kelsey, who basically she was supposed to approve talmatide, which was to prevent morning sickness in women. It had already been approved in Canada, all over Europe. And she just wouldn't approve it. She's like, there are no actual tests. Every time I ask questions, I don't get responses. And several months later, there are all of a sudden all these birth defects and all these deaths. they're being directly tied to the drug. Yeah, yeah. And so basically, that's when they developed an evidence based process.

23:03And so for any of you who remember your high school or college statistics class, you have type one error and type two error. And if you eliminate one, you introduce the other and type one error is a false positive, meaning in the FDA's case, they approve a drug that isn't actually helpful, or just has such bad side effects that even if it's a little bit helpful, it would have been better off not being approved. Type 2 air is failing to approve a drug that would be useful. The same thing exists with investments. And with investments, as much as we want everything to be black and white, it is shades of gray.

23:38We are all looking at the same data sets. And despite looking at the same data sets, an investment decision maker can arrive at a different place based on their preference for minimizing type one versus type two error. So when I say something like I am more concerned with implementing a bad idea than I am missing out on a good one, what I'm saying in statistical terms is I would prefer to minimize type one error. Now, Adam, let me tell you, if I were to fully minimize type one error, what that would mean is owning a single total market index fund and nothing else. And you know what, I have no problem with anybody owning index funds.

24:17I think index funds are the greatest. I do think that you can enhance returns without being a traditional active manager of trying to predict where the market's going. Index funds are just super low cost. They're very diversified and transparent and they're rules-based. The most important thing, they are rules-based. And so when I'm evaluating investments, I do come with the perspective of, I know that most investing success, given how great the market return is, comes down to minimizing success. And I think you said somewhere in the introduction that a lot of this stuff is easy in theory, but it's hard in practice.

24:52And so you already have enough human emotions working against you. If you're working with a professional, that does a lot to take out the emotions, assuming you're working with a good professional. I'm not blind to the fact that hiring a bad advisor can be way more costly than just doing it yourself. But I think in general, with any investment, you try to take a probabilistic approach and think, hey, like, do you expect a positive return in the first place? You know, so for example, kind of going way off the beaten path, like gold or crypto, it's not a productive asset. I'm not going to get into a big debate of whether you invest in gold or not, but or crypto, but it's not a productive asset.