2. The Tax Advantages of Owning Real Estate
Maybe you've heard that real estate is great for taxes. Or maybe you haven't. Here, the crew discusses the multiple ways the IRS gives you a tax advantage for owning real estate.
-Hey Dan, let’s talk about all the tax advantages we get for investing in multifamily real estate.
-Disclaimer about not being CPA. Not tax advice. Everybody's tax situation is different
-If you’re a high-income earner can you reduce your current tax obligation by investing in real estate? Not really. But you can increase your income without increasing your tax burden.
-Real Estate is tax-advantaged. That means the government gives you a tax break for participating in the activity. Why do they give you a tax break?
They want to encourage the activity since the private sector can accomplish it more efficiently than the gov. This is how the gov encourages certain behavior within the private sector-- tax breaks are incentives. A few examples include: Starting a business, employing people, exploratory drilling for oil and natural gas, farming pistachios(?)
-Unlike our W2 income, where our employer takes out all our taxes before it even gets to our bank account, our rental income comes into our bank account first, then we get to deduct our expenses, and at the end of the year we pay any taxes we owe on the remainder. WE get to keep our hands on the money before the government does!
-In real estate, we benefit from depreciation which reduces the net income that the IRS taxes us on. This means you get to keep rental income without getting taxed on it. It’s untaxed income.
Let’s talk about all the tax advantages we get:
-Depreciation. The IRS allows us to account for the asset to have wear and tear during normal use and make deductions from our passive income to allow for that. We can depreciate the cost basis of the residential property over 27.5 years and commercial property for 39 years.
-We can also depreciate certain improvements we make to the property. Install a whole new HVAC system? Or all new windows? We can depreciate those as well instead of just counting them as an expense in the taxable year they occurred. These will add to the cost basis of the building.
-Accelerated Depreciation- IRA allows us to depreciate certain items faster than the straight line 27.5 or 39-year appreciation. Certain improvements or personal property can be depreciated on a 5,7, or 15-year timeline. We need a cost segregation analysis to do this. We can’t do this ourselves! Utilizing this service will allow us to reduce our tax liability and taxable income further.
-Bonus Depreciation - The laws on this just changes with the new 2017tax cut and jobs act. In some cases, we are now allowed to depreciate 100% of the cost basis of certain items in the year they were placed in service.
-A cost segregation analysis will outline what can be depreciated on what timeline. However, if you just own a single-family home or two, the cost of the study will probably negate the benefit of any tax advantage. This is only used on larger more expensive properties like apartment complexes and commercial properties.
-Opportunity Zones- If you click through real estate listings for any length of time you’re bound to come across listings advertising their property is in an opportunity zone. Again, this is the government trying to encourage and activity by giving a tax break for it. Specifically, they are trying to encourage capital investment in distressed areas. However, you have to invest more in the building that it cost to purchase it and do that within 30 months of purchase. If you meet that threshold and hold that investment for at least 5 years you can get a discount on your capitals gains tax liability by 10%. You can defer more if you hold longer.
-1031 exchange- You can defer your capital gains tax when you sell your property by buying another property of equal or greater value of the one you sold. Sounds pretty awesome, right? Theoretically, you can defer these taxes indefinitely if you keep scaling up to larger and larger properties. You have to meet some requirements though. You have to solicit the services of a 1031 intermediary, identify the property you want to buy in 45 days, and close on that property within 180 days from selling your exchange property. Also, the taxable entity that sells the property for exchange must be the same one that buys the subsequent property. Remember that depreciation recapture tax we talked about? Yup, that gets deferred too!
-Passive losses and gains.
-Most likely, you’ll pay no or very little tax on your income derived from real estate. Whether you own it directly or invest with a partner or in a syndication for the first few years. If you have positive net income after accounting for depreciation from your rental activity, you’ll owe some tax at your marginal tax rate. HOWEVER, if you show a passive loss then any losses from real estate won’t carry over to your earned income. However, you can carry forward that passive loss for many years.
-the only way for your passive losses from real estate to offset your earned income is to be classified as a Real Estate Professional.
-So why does everyone say real estate is great for your taxes if you can’t reduce your earned income from investing in real estate? Because we can increase our income dramatically over time while paying little or no tax! If you keep acquiring real estate, theoretically, you can replace the income from your W2 job and pay far less tax as a result!