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Join Josh Guggenheim, our VP of Acquisitions, as he speaks with Michael Johnston on the WealthChannel’s podcast, Tax Efficient Investor. The podcast covers a few key tax-saving topics:
Transcript
Michael Johnston:
Welcome to the show. I'm Michael Johnston. Joining me today to talk about the tax advantages of farmland investing is Josh Guggenheim. Josh is the VP of Acquisitions at Gold Leaf Farming. Gold Leaf is a hybrid investment and farming company that's managing about $350 million of permanent crop land in the U.S. Josh, thanks for coming on the show.
Josh Guggenheim:
Yeah. Thanks for having me.
Michael Johnston:
We're going to talk about the tax advantages of farmland today and there's four points of it that we want to go through. I gave a very quick summary there. Before we dive into the nerdy tax stuff, give us the high level overview of what Gold Leaf is, what you do.
Josh Guggenheim:
Yeah, sure. Gold Leaf is about seven years old, and I'd say the best way to look at us is probably a hybrid investment company and farming operating company. As far as an investment company, we're probably pretty similar to a real estate private equity firm where we're raising capital primarily from family offices and high net worth and then we're buying real assets with it. You guys have other sponsors on your show who take the money and buy apartment buildings or offices, what we do is we buy and develop specialty farm land. Almond farms, pistachio farms, we have a date farm, we have some wine grapes as well.
The way to look at us is like real estate investing, but we're not doing buildings, we're doing farmland. I say we're a hybrid operating company or hybrid farming company is because we do our operations ourselves. Every farm that we buy, we manage. If you look at our organization, we're about 100 employees and about 70 of those are farmers. Why that's important is because we control the farms that we own. We're not leasing it to third parties or hoping that a third party farm manager does a good job. We're doing it all in-house and that gives us better control over the assets and lowers risk.
Michael Johnston:
Great. Good overview there. Let's dive in and talk about the tax piece of this. We spend a lot of time on this show talking about ways that high net worth investors can be more tax efficient. Sometimes that's moves that they can make individually. For example, I do a backdoor Roth IRA. We talk about funding your HSA as an IRA, a mega backdoor Roth, all these things that high net worth investors can do to be more tax efficient. I'd like to also talk about the ways that if you believe that you can generate alpha for yourself essentially by making smart tax moves, all those things I just ran through, 401(k), 529, et cetera, you should believe that companies can do the same thing.
There's a tax code for individuals, there's a tax code of companies, and there's smart companies or smart asset managers who just like individuals can take advantage of the incentives and the tax code, they can take advantage too. That's what we're going to talk about today, is how Gold Leaf is taking advantage of some of the incentives that have been laid out in the tax code to minimize the tax burden for the company and for their investors. Let's dive into it. There's four that we wanted to go through today, Josh. The first one, depreciation, specifically bonus depreciation. How do you leverage this to maximize the tax benefits?
Josh Guggenheim:
Good question. If you think about our strategy, most of the deals that we do aren't really developments. They are buying existing farms, existing permanent farms, and it's a little bit different. I don't know if we have some Midwestern listeners on today, but a lot of people think about a typical farm might be a piece of land with corn or soybeans. In that case, there aren't really that many depreciable improvements. For us, it's different because we're buying farms that have big trees and extensive irrigation, et cetera, on them. It turns out that all of those trees, and irrigation, and equipment, and all that can be depreciated. The way to look at it is if you're buying a multifamily house, the land can't be depreciated, but the buildings and various other things, personal property, can be. When we're buying a farm, all of the trees or whatnot are equivalent to a building which can be depreciated. That's the high level.
In particular, why it's important for us and why we think we're advantaged versus other real estate asset classes really has to do with the TCGA and the Trump tax plan. What that tax plan said is that you can take bonus depreciation, which basically means you can depreciate assets over one year in an accelerated fashion rather than over 30 years. You can take all your depreciation upfront, but according to that plan, you can only do that with assets that have a 20-year life or less. For farming, everything we buy has a 20-year life or less according to the depreciation code. Irrigation is 20 years or less, trees, equipment, farm buildings, et cetera. With general real estate or multifamily, for example, a lot of the depreciable assets don't have 20 years or less. The real property has 27 and a half, so that can't be bonus depreciated. The personal property, like cabinets or whatever, can be bonus depreciated, but most of it can't. Long story short, most of what we're buying can be bonus depreciated and it has a pretty big impact on our investment.
We could talk a lot about the tax code or whatnot, but some simple map might help. If you think about our typical farm, the typical farm we're buying is about $10 million. Of that 10 million, about 5 million is land and about 5 million can be allocated to depreciable assets, trees, et cetera. When we buy this $10 million farm, what we're generally doing is we're using 5 million of debt and 5 million of investor equity. What we end up getting is 5 million of the 10 million is depreciable or will be depreciated, and then we have a $5 million equity check. What you end up getting is for basically every dollar that you invest, you get a dollar of depreciation. Most of that, I guess now this year it's 80% in 2023, can be depreciated upfront. If you write Gold Leaf a check for 100 bucks, you're going to get probably 80 bucks or so, give or take, of depreciation back within the first year.
Michael Johnston:
Let's talk about why that's really valuable for someone. I'm guessing when you say you're going to get it back, I'm guessing that means it's coming through on a K-1.
Josh Guggenheim:
Exactly. Exactly.
Michael Johnston:
Their partnership and they're getting K-1. They've got this loss coming through because depreciation is a non-cash expense, so your investors can use this depreciation expense that's coming through on the K-1/ if they have other passive income, say they own another business that's spitting off some passive income, they can essentially use depreciation to offset other passive income that they've got coming in. Is that right?
Josh Guggenheim:
That's right, yeah. You can either use this tax loss to offset future income generated by a Gold Leaf investment or you can use it to offset other passive income. That's right. Every individual, every situation is different. People should speak with their CPA. I'm not a tax advisor, but the interesting thing here is you can take a big Gold Leaf loss, and then like you said, if you have a bunch of income from multifamily or office or other partnerships, you can shield that using the loss generated by Gold Leaf. A lot of our investors have big passive income streams or big really real estate investment portfolios, and they love the fact that they can take a paper loss from us and use that to offset something that they've had for years before.
Michael Johnston:
Yeah. Paper loss is music to the ears of any kind of tax focus investor because it means you've got a loss that you can use to offset income, but it's just on paper. It's not actually money going out of your pocket but you can use it to offset taxes. It's fantastic. You mentioned, of course, you should talk to your advisor. Everyone's circumstances is different. For the most part, this is going to be able to offset passive income. If you're thinking, "Oh." You can't use it to offset your W, typically you're not going to be able to use it to offset your W-2 income or active layered income, but you can use it to offset passive income. If you can't use it all this year, typically you're able to carry it forward so you'll be able to use it eventually.
PART 1 OF 4 ENDS [00:09:04]
Michael Johnston:
... forward, so you'll be able to use it eventually. But that's pretty powerful, being able to get potentially up to 80%. I know that's going to kind of taper down here over the next few years, but that's a huge chunk of the upfront investment that's coming back to you, and a loss that you can use to offset other income.
And I'm glad you mentioned, Josh, there might be some Midwest listeners. I grew up in Ohio. I live in the West Coast now. I live in Oregon. So you're right, if you have this flyover country, Midwest, I say that affectionately, I love Ohio, of what farmlands are there, it's different as you get out west. I think a lot of your properties are a little further west, but yeah. There's a lot more of the trees, the irrigation systems, these kind of depreciable assets. So I'm sure a lot of people's minds, when they think farmland, they think in Nebraska and Indiana and Ohio, but a lot of different types of farms in this country.
Well, I know you mentioned that I think you guys have done some calculations about one of the metrics that a lot of investors will use, whether it's real estate, any type of private equities, IRR, the internal rate of return. I think you all have done some calculations about essentially how much of an IRR lift investors can get just from the depreciation piece of it?
Josh Guggenheim:
Right. So thanks for mentioning that. Talking about the tax benefits is all great, but unless you can quantify it, it's maybe less impactful. How we think about it is we look at our returns on kind of a net kind of pre-tax basis, and then the net post-tax, which post-tax is essentially including the depreciation benefit.
And generally, what we'll see is every farm's different, but generally, we'll see kind of a 3 to 5% IRR lift when you include depreciation. So if we're seeing a farm that might be yielding, let's say, a 13% IRR, net IRR, it's fine, it's good. But when you consider the depreciation benefits, it might be 17, 18%. And these are long-term holds, right? So if you think about 13 versus 18% over a one-year hold, it's not a huge difference. But if you think about a 13 versus 18% IRR over a 10 or 15-year hold, it really matters a lot.
So generally, that's what we'll see, is maybe low-to-mid teens in our returns before thinking about depreciation or anything else. But then with depreciation, you're kind of in a higher teens-type investment, which is, in our opinion, attractive for more of kind of a value-add or a core-plus real estate play. Not something with development risk.
Michael Johnston:
Sure, sure. Yeah. And I love that you guys quantify that. That's something that I always harp on is sometimes people talk to me about tax strategies, and I say, "Well, I'm sure you're saving here," and you're tripping over nickels sometimes is the phrase that I like to use. But if you're talking about a 3 or 5% list, lift, excuse me, that's pretty substantial. So I always tell people it's important to kind of understand the trade-off here of how much are you potentially saving here versus how much complexity are you adding? So it's good to understand what the potential benefit here is.
Let's go on to the point number two, opportunity zones. We just did an episode on opportunity zones. I'll link to that in the show notes, but I think some of your farms are in OZs. So for folks who aren't familiar, who haven't listened to that episode, talk about the tax benefits of opportunity zones.
Josh Guggenheim:
Sure. Yeah. So as your listeners probably know, to qualify for an OZ or to qualify for these types of projects, you really have to have a development angle. So I'd say 70 or 80% of our farms are actually not developments. We're buying existing farms, and there's not an angle. However, the 20 or 30% that are developments are often in opportunity zones, and we often structure them to take advantage of the benefits.
For folks out there, basically, what opportunity zones are or do is they identify areas of the country, it's by census-tracked, but they identify historically kind of underinvested, underdeveloped areas of the country, and they give you tax benefits to invest in these areas. The whole idea behind it is to bring capital away from places like, let's say, parts of Manhattan or something, and into areas of the country that historically have been underinvested. Actually, as a side note, I think it's a great idea and a great thing to develop, less-focused areas of America.
But anyway, how you would qualify for this opportunity zone and how it works is if investors invest, they can invest capital gains, realized capital gains, into opportunity zone projects, and then the benefit of that is a few things. One, they get a deferral on the capital gain due. So let's just say you bought a stock for $100 and you sold it for $200, you have $100 capital gain, you can reinvest that $100 capital gain into an OZ project, and you won't have to pay tax on that until 2026. So that's benefit number one.
And then benefit number two is if the opportunity zone project or the QOF holds the asset for at least 10 years, there's no capital gain on that leg of the investment. So there's really two benefits, so yeah.
So anyway, with the opportunity zones, there's a bunch of rules. I won't get into it, but to qualify for an opportunity zone investment, not only does your project have to be in an opportunity zone, but you have to hit two tests, either a original use test or a substantial improvement test, which essentially makes sure that the money that you're investing is used to build something new or improve something in the opportunity zone.
So for us, what we do is we raise a bunch of opportunity zone capital, so deferred capital gains, and then buy bare land in one of these opportunity zones, and then build a farm on it. So we're basically taking lower-value land, putting it on a higher-value orchard, and then hold it for 10 years and sell it for appreciation, and that appreciation will be tax-free. No capital gains on that.
Michael Johnston:
Yeah. And this is potentially huge. My partner, Jimmy Atkinson, says OZs are the greatest tax incentive ever created. Maybe that's a bold statement, but he's not far off. I mean, it's near the top of the list. I like to say that the two best times to pay taxes are later and never, and the OZ checks both of those boxes.
If you've had a capital gain in the last 180 days, there is a window on it. It can be a gain from anything. It can be a gain from, you sell Tesla stock, you sell your company, you sell real estate, you sell Bitcoin. Anything. If you've had a capital gain or if you have a capital gain upcoming, the OZ benefit can be incredibly powerful.
And again, as Josh mentioned, the incentive here is to drive investment into the low-income census tracks, the parts of our country that have historically been underinvested in, so a good incentive that seems to be working pretty well. This is also a relatively new program. Part of the Trump Tax Cuts and Jobs Act in 2017 driving a lot of investment. So would recommend anyone out there, if you have a capital gain, if you have a capital gain coming up, learn more about OZs. It can be a tremendously powerful tool.
And then I think there's kind of a combination of these first two. So we're talking about depreciation. Josh, when we were talking about opportunity zones, you mentioned there's kind of two benefits of opportunity zones. You can defer your capital gain, and then at the end of the 10-year hold period, there's no capital gain tax on that investment. And there's kind of a third hidden benefit too, which is no depreciation recapture. So we're getting a little into the weeds here, but if you want to maybe give a high-level summary of what that means, that would be helpful too, I think.
Josh Guggenheim:
Yeah, sure. So when you're taking depreciation with a project, with a building, or with a farm, if you sell later on, you may have to pay depreciation recapture, which basically means all the depreciation you've already taken, you'll have to basically pay that back to the government. So if you...
PART 2 OF 4 ENDS [00:18:04]
Josh Guggenheim:
You'll have to basically pay that back to the government. So if you took $10 of depreciation and then you sell at the same value a few years later, you'll have to basically repay the government. Some OZ deals can be structured so that they are exempt from that recapture, which is a big deal.
Michael Johnston:
Yeah, potentially very big, so it's undersold with the OZ thing, but it can potentially be a nice little boost for opportunity zones as well, not having that depreciation recapture.
Josh Guggenheim:
Yep. Certainly Two other interesting things I'd say, and thanks for bringing that up, your listeners probably have heard about other opportunity zones, but in our view, we're pretty excited about OZs for farmland in particular, for a few reasons. I would say number one is that it turns out that some of the best farmland in the country, or at least in California, happens to be in an opportunity zone. The best soils, the best water rights. A lot of rural areas of California are unfortunately poorer than some of the coastal or urban areas [inaudible 00:19:12] qualify for opportunity zones, and they have the best growing conditions in the state. So long story short, we don't think that we're sacrificing asset quality for a tax benefit.
Sometimes I feel like other sponsors might buy something or develop something in an opportunity zone, which could be a great tax deal, but it might not be a great underlying business case. Not all of them, by the way. As a side note, I'm personally invested in a few real estate developers who are doing work in OZs, so not everyone, but with OZs, you don't want to do a bad deal to qualify for an OZ. You still need to have good asset quality. And with farmland, we can do that.
And then the other issue that is kind of interesting is a lot of other real estate investors have kind of figured out about opportunity zones and have taken advantage of them. And as a result, in certain areas, there may be a price premium actually, for land that's in an opportunity zone. Folks will sell and they'll know that there might be more investor capital out there willing to buy because of the great tax incentives. That doesn't really exist in farmland at all. There's no price premium, whether it's in an OZ or not. Frankly, most of our brokers have no idea what an OZ is.
And one of the reasons I would say that that's the case is because a lot of people buying farmland are farmers and not investment groups, and the farmers have ordinary income. And to take ordinary income, it doesn't matter if you buy in an opportunity zone, it has to be deferred capital gains. So they don't really have this capital gain that they need to reinvest and defer. If we had a bunch of investment groups in this, we would have that problem. But long story short, there's not a lot of buyer appetite out there that cares that it's OZ or not. So as a result, there's no price premium.
Michael Johnston:
Yeah, it's a couple of great points you make there. I mean, certainly anecdotally I've seen that. In some hot markets, the opportunity zones in say, Phoenix, Arizona, or Nashville, Tennessee, kind of that smile sunbelt part of the country, the big cities there, tremendous competition among different groups looking to buy up land and throw up, a lot of times, multifamily. So you do get a lot of competition [inaudible 00:21:40] the prices.
It's good a point too about, I like to say that the tail shouldn't wag the dog. You shouldn't just make it an investment because the tax part of it sounds good. That's especially true with opportunity zones because the big benefit is that if you hold it for 10 years, there's no tax on the capital gains on the backend. Well, there better be capital gains, right? There better be an increase in value or else what's the point of not paying taxes on it? It's easy to not pay taxes on nothing. It's a lot harder to not pay taxes on a big capital gain. So there better be a capital gain, or else it kind of really diminishes the point of an opportunity zone. Okay. Let's move on here and talk about, we've got a couple more to get through, the Williamson Act. I think this is something California specific, so I don't know a ton about this.
Josh Guggenheim:
Yeah, this is California specific. A lot of people say, oh wow, you guys are invested in California, taxes must be high. The income tax is high in California. But fortunately, there's a great program called the Williamson Act, which lowers our property tax in California. Basically what it is, it's a act that was passed in 1965 and what was happening is that a lot of farmland was increasing in value because some of it was becoming parts of urban centers, so areas like Fresno or Orange County, et cetera, now, pretty big cities, used to be a lot of farmland.
So as farmland became more developed, prices went up. And what ended up happening is that a lot of farmers were sitting there and they were like, this is before Prop 13, by the way, which regulates property tax increase in California. But what you end up happening is that, or what you had was that a lot of farmers couldn't pay their property tax bill because prices were going up, but the economic output of the crops was not necessarily growing and matching it. So the state passed a rule that limits property tax and ties it more to farm production and economic value of the crops, rather than the value of the land. So at the end of the day, what we end up paying is something like 70 basis points of property tax on average. In California in general, it's about 110 basis points. So we get something like a 30 or 40% reduction in property tax because we're in this Williamson Act and we're ag focused.
And that's important to think about. You don't want to buy a property, especially if you're going to hold it for a long time, to have uncontrolled, really high property taxes. It can really eat against your returns. And we fortunately don't have that issue in California.
Michael Johnston:
Yeah. And it's what you'd be doing with the land anyways, right? You're buying it for agricultural purposes, so you're essentially getting a tax benefit. I looked it up, the California Department of Conservation, their estimate is that agricultural landowners save 20 to 75% on their property tax liability each year. Sounds like you're right in that ballpark if you're saving about 40 basis points on 110, so free money, essentially, right? If you're going to be doing it anyways.
Josh Guggenheim:
Yep, definitely.
Michael Johnston:
Yeah. Okay. Let's talk about, there's an export angle of this too, that I knew nothing about. So let's hit the last bullet point here of the tax strategies you're using.
Josh Guggenheim:
Yeah, so one example would be, it's called IC-DISC. And what IC-DISC does is incentivizes companies to export goods. And the reason the government wants that is to help fix our trade balance.
And essentially, income that's generated by these exports qualifies for a lower tax rate, so it qualifies for the same tax rate as qualified dividends. So that's probably 20% plus 3.8 of net investment income tax, rather than ordinary income tax, which is much higher. And for us, that's important, because something like 80% of California almonds are exported. So on our almond farms we can say, "Hey, 80% of our income is generated by products that are exported." This, of course has to be proven by processor records, but by proving that and showing that we're exporting a lot of these goods, we end up qualifying for a significantly lower income tax rate, which is a nice program from the government to incentivize, export and fix our trade balance.
Michael Johnston:
Yeah, that's great. I always think it's nice to understand why these tax incentives exist, so I love that you kind of touched on that and yeah, it's essentially tax arbitrage. It's a way to move some income out of the ordinary income tax rates, move it into the lower dividend and cap gains rate, so the ordinary income rates can be upwards of getting close to 37%.
If you're able to [inaudible 00:26:47], if you're able to move, shift some of that tax burden to a 23.8% bucket, that's arbitrage. We won't go into all the mechanics of how it works. I'll put a link in the show notes if anybody really wants to dive deep. But essentially, it's setting up a separate entity and then the parent...
PART 3 OF 4 ENDS [00:27:04]
Michael Johnston:
But essentially it's setting up a separate entity and then the parent company, the operating company, is paying a commission to that entity and it's capped at a certain percent of the export sales. So you're shifting some of that income. The operating entity gets to write it off because it's a deductible expense, and you're shifting it into an organization where there's a lower tax rate. So, kind of a neat little incentive there that you're able to take advantage of.
So Josh, that's great talking through these. I mentioned earlier the tail shouldn't wag the dog. You shouldn't invest in something just because it's got some nifty bells and whistles from a tax perspective. So make the case for us, what's the investment case for cropland in the US outside of the tax advantages of it?
Josh Guggenheim:
Yeah, thanks. So it's really pretty, I'd say pretty simple. One, I think the big thing driving this is there's a great macro opportunity here. The specialty farmland that we're buying is a really supply constrained asset. So, that basically means there isn't a lot of land in the world where our crops can grow at all, and there isn't a lot of water. And that's actually decreasing every year as cities grow. So, you basically got this very supply constrained market, and at the same time you've got a bunch of demand growth. So if you think about the products that we're growing, almonds and pistachios, these are kind of high-end healthy plant-based proteins. There's a lot of demand for it in kind of the western world as people eat healthy. But there's also a ton of demand in new markets. 40, 50 years ago, people in China and India, frankly, the average person didn't have the income to afford goods like this, and to be able to buy really, I'd say high-end fresh, sustainable, healthy proteins from other countries. That's totally changed as those countries have matured. India's actually the largest growth market now for California almonds.
So the exciting thing here and why we're investing and spending all this time in it is really similar to other thesises that you've seen in other real estate. When the supply can't grow, but there's a bunch of demand for the product, there's good returns to whoever owns that asset.
Michael Johnston:
Yeah.
Josh Guggenheim:
So that's probably a high level. A few more things I'd say, this is a very inefficient market. So, if you think about farmland in the US, it's probably about, it's a $3 billion asset class. But only something like 30 to 60 billion of it is owned by institutional investors. It's very underinvested. If you looked at offices or multifamily, I think those are both like 3 or 4 trillion each. Those are much more institutionalized. So as a result of being in a place that doesn't have a ton of investor, or I guess institutional investors or professional investors yet, you can pick up good opportunities. The last three deals that we bought or something, one was like a nine and half percent cap rate. One was a ten and a half percent cap rate, and the most recent one was about 11% cap rate. So our view is that because it's an inefficient market, you can find these great deals that are at higher cap rates than other real estate assets, where you might have been able to find those types of deals in, let's say, self storage or manufactured housing 20, 30 years ago.
It's really hard to find those now in those markets. In our market, those opportunities still exist. From an operational perspective, I'd say we're at an interesting inflection point as well with agriculture. There's all kinds of interesting automation, technology, water technology, genetics technology, that are making it basically easier for farmers to have better margins. So it's an interesting time, kind of operation to invest as well. And last but not least, I'd say what I like about this asset class is that there's a lot of ways for it to go right. If you think about what's driving our returns, a lot of it is cash from crop. We farm a crop and then we sell it. That's what we already talked about, there's a great supply demand dynamic there. But we've also got a bunch of land appreciation going on. Farmland in the US has appreciated about 6% per year historically. Our assets also have really senior water rights. Oftentimes they're actually senior to local cities.
So there is an option in the future where we could actually... Well, we just think our water will appreciate as water becomes perhaps more scarce in cities grow, there's a big appreciation angle. Last but not least, there's obviously a development angle too. If you think about, we're buying in land when it's low use in farmland. These central Valley cities, Fresno, Bakersfield, stocked in Modesto, et cetera, continue to expand. And there's a good chance that a lot of those, the farmland that we have now could be used in the future for different development purposes, and trade for a much, much higher price, right? The best farmland now might trade for 20 grand per acre, 30 grand per acre with the best water rights. Housing development in California, bare land in those types of cities might be 150 or 200 grand an acre. So there's a big upside there.
Michael Johnston:
Always good to have options. That's a great summary of the investment case. Josh, my last question for you, if folks are interested, they want to learn more, they want to see what funds or deals you have open. Where can they go to connect with you or to find more about Gold Leaf?
Josh Guggenheim:
Yeah, so we are Gold Leaf Farming. You can find us online at goldleaf.ag, or you can reach out to me directly at josh@goldleaf.ag. And any of your listeners we'd love to talk to. So really would be happy, and no question is a dumb question. So happy to do that.
Michael Johnston:
Yeah, great. Well, I appreciate you coming on here and letting me ask some dumb questions about the tax nuances of this. I learned a lot. I think this is fascinating. I didn't know a ton about the tax benefits of farmland coming in. So, this has been a great conversation. Josh, I want to thank you for coming on today. I really appreciate it.
Josh Guggenheim:
Thanks very much.
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