The cost of a college education can run into the hundreds of thousands of dollars, and many parents find themselves financially unprepared for their children’s academic endeavors. One option that can help families get a head start on saving for education expenses is the Coverdell Education Savings Account (CESA).
The CESA is a custodial account established for the purposes of covering the qualified education expenses of a designated beneficiary. It can be opened at any IRS-approved financial institution in the U.S. that offers CESAs.
What’s most relevant to our discussion however, is the fact that CESA funds can be invested in real estate among other types of assets. Before we look at a specific example of how investing in apartment syndications can be used to grow the funds in a CESA, let’s review its most important features.
* Eligible beneficiaries: Any person under the age of 18 or with special needs can be designated as the beneficiary of a CESA. The beneficiary can be changed at any time.
* Contribution limits: Any beneficiary can receive up to $2,000 annually, regardless of the number of contributors or accounts in their name. Any excess contributions in the account at the end of the year may be subject to an annual 6% excise tax.
* Eligible contributors: Anyone with a modified adjusted gross income (MAGI) of less than $110,000 (or $220,000 for joint returns) can contribute to a CESA. The contribution limit of $2,000 however is gradually reduced for individuals with MAGI between $95,000 and $110,000.
* Account utilization: The funds from a CESA can be used for elementary, secondary, and higher education expenses that meet certain qualification criteria. Qualified expenses include tuition, fees, books, supplies, equipment, as well as room and board for students enrolled at least half-time.
* Investment options: In addition to real estate, CESA funds can be invested in stocks, bonds, ETFs, mutual funds, and more. Investment losses in CESAs however cannot be claimed on tax returns.
* Tax implications: While contributions to the account are not deductible, any investment profits generated with the account funds are tax free until distribution.
* Distribution taxation: If the annual distribution amount is less than the beneficiary's qualified education expenses for the year, no taxes are due. Taxable distribution amounts are assessed a 10% additional tax.
* Final distribution: Any remaining balance in the account must be distributed within 30 days of the beneficiary’s 30th birthday (except for special needs beneficiaries) or their death.
* Rollovers: Funds from one CESA can be rolled over to certain family members’ CESAs tax free.
* Education tax credits: As long as they are not used for the same expenses, the American opportunity or lifetime learning credits can be claimed even if a beneficiary receives a tax-free CESA distribution.
Now that we have covered the basics, let’s look at a specific example in order to better illustrate the potential of a well-managed CESA.
Joan has two grandchildren and wants to help with their future education expenses. She opens CESAs for each of them, and diligently contributes the annual limit of $2,000 to each account for 10 years. By the time her grandchildren are 10 years old, the accounts have a combined balance of $40,000.
Joan decides to invest the CESA funds into a multifamily syndication. The syndication purchases a 30-unit apartment building for $2 million with a 25% cash down payment of $500,000 and a 75% loan of $1,500,000. Joan’s equity investment in this case would be 8% ($40,000/$500,000).
After 4 years, the syndication decides to refinance the property, which has appreciated and is now appraised at $2.5 million. Assuming that the new loan on the property is $2 million, there will be $500k ($2 million new loan - $1.5 million old loan) of equity that can be pulled out and returned to investors.
Joan’s 8% equity share would net her $40,000 in tax-free refinance proceeds ($500k x 8%), with $20,000 going into each of her grandchildren’s CESAs.
Not only did Joan make a 100% ($40,000 returned / $40,000 invested) cash on cash return on her initial investment, but she still has an 8% ownership stake in the apartment building. Her grandchildren’s CESAs will potentially receive cash flow from ongoing operations for years to come and gain even more tax-free income upon the sale of the property.
To learn more about CESAs, please review IRS Publication 970, Tax Benefits for Education, Chapter 7 Coverdell Education Savings Account (ESA) or consult with your CPA.
Using a Coverdell Education Savings Account (CESA) to put aside and grow funds can be a great way to prepare for your children’s future educational expenses. Each beneficiary can receive up to $2,000 a year, and the tax free growth of that money can be accelerated through passive real estate investments such as multifamily syndications.
Disclaimer: Actual investment results may vary from deal to deal. All investments involve risk. We’ve intentionally kept the numbers simple in our example. There are other costs to consider in real estate purchase and refinance transactions such as closing costs. Speak to a financial professional before investing.
It all starts with passive income. Join our investor group today!