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Tax Smart Real Estate Investors Podcast
362. The Quiet Strategies High-Income Investors Use Instead of REPS or STRs
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In this episode of the Tax Smart REI Podcast, Tho…
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You're now listening to the Tax Smart REI Podcast, the number one tax podcast for real estate investors, your source for.
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All things real estate accounting and tax. Here we reveal our secrets that can save you thousands in taxes, streamline your accounting process and help grow your business. Stay tuned to hear insightful interviews with industry experts, successful real estate investors, and current clients on what strategies they use to grow their business and how they steer clear of Uncle Sam.
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Thanks for tuning in to this week's episode of the Tax Smart REI Podcast. So today we're going to be zooming out and talking about why real estate is such a tax advantaged asset class. Even without strategies like short term rentals, the real estate professional status, oil and gas things that allow you to take losses against your W2 or active business income. Just investing in real estate in and of itself, it can be quite advantageous from a tax perspective. I think a lot of people do lose sight of that when they're just looking at non passive losses. So that's what we're going to be talking about today. We're going to go back to the basics. So if you're not able to take advantage of the short term rental loophole or the real estate professional status, or you just want a refresher on why real estate is one of the most tax advantaged asset classes out there, this episode is for you. I'm going to be diving into all that in just one minute. You've probably never found a real estate newsletter worth reading, and that's because we hadn't created hours yet. The REI Daily is a newsletter you actually want to read whether you own one property or 100. We created this for you. Each issue delivers crucial tax saving strategies, legislative updates, as well as real estate market insights. Everything you need to stay sharp and ahead of the game. Get the real estate and tax news that actually matters straight to your inbox. Subscribe to the REI Daily newsletter today@therealestatecpa.com subscribe. That's it for now and right back into today's episode. All right, and we're back. So again today we're going to be covering the bigger picture of why real estate is such a tax advantage asset class even without the real estate professional status or the short term rental loophole. Even though those are very powerful strategies and if you can take advantage of them, you should absolutely do so. So we're going to start with a crash course. We can go back to the basics on the US Tax system. Then we'll cover shifting earned income into passive income and and then why that is so powerful. And then we're going to talk about tax efficient investment and exit strategies and how you can really turn up the jets here. All right, so let's start with the US tax system. So going back to the basics, earned income or ordinary income. So income that you generate from a job or a business can be taxed up to 37% at the federal level. Then in many cases you're going to have state income taxes up to 13.3% in California, plus FICA, which is a 7.65% or the self employment tax, which is double FICA. You pay both sides if you're self employed of 15.3%. And if you live in some locations like New York City or other areas of the country that have local taxes, it could be even more than that. So when you add all this up, if you're a high income earner, it is not uncommon for you to be paying somewhere between 40 to 50% in taxes on your earned income. And we all understand that can be quite painful, which is why many people seek strategies like the real estate professional status or short term rentals to help reduce that tax rate. And certainly that is one way to do it. But let's continue because we're going to have some eye openers here. Okay, so this is where real estate becomes so powerful. The first thing is, and all the business owners tuning in already aware of this, when you invest in real estate versus say a W2 job, like if you have a W2 job, you are paying your taxes on your W2 income. And then whatever expenses you have, you're paying those expenses with after tax dollars. Whereas when you have a business, there's certain operating expenses that it costs to operate your business and you're able to deduct those against your revenue or against your income prior to paying taxes on it. So that's kind of one of the first things here. And when you're dealing with rental properties, for example, or investment properties, you're typically dealing with things like advertising, repairs and maintenance, property management expenses, property taxes, mortgage interest, utilities, so on and so forth. These are the actual operating expenses it costs to have you operate your property, able to deduct those against your rental income and not pay taxes on just, you know, your raw rental income. Right? So that's one of the first things that we're dealing with here. Now one of the other advantages of real estate, which I know we're all very familiar with, is the non cash expense called depreciation. And depreciation can give you a loss for tax purposes, despite the fact that you could be generating positive cash flow. So that's the first unlock here, right? If you, let's just say you're in the 40% effective tax rate when you add up all of the taxes that you're paying between federal, state, local, fico, all that, and let's just say you wanted to earn additional $100,000. I'm keeping the numbers simple here. You want to earn another $100,000, right? So you go, you work a few more shifts, you take on some more stuff, you go close some more deals, wherever you get a bonus, you earn another $100,000. Well, 40% of that or $40,000 would be paid to the government before you even realize it. However, with rental real estate, you could very well be generating positive cash flow, putting money into your pocket from your rental property operations, despite the fact that you're telling the IRS, hey, I lost money thanks to depreciation. Okay, so that's the first unlock here, is that you're generating income from your rental properties, but you are not paying taxes on it. And by the way, rental income, if you did have net rental income, is taxed up to 37% plus state taxes and local taxes if you're subject to those in the location which you live. Now, the good news is on rental income, you're not subject typically to the self employment tax to FICA taxes, but it's still tax ordinary income tax rates. But you're getting the benefit thanks to depreciation and the other operating expenses you have of oftentimes, if you're doing everything correctly, not paying taxes on that income. Let's take a look at, at an example of what this might look like. Okay? So if you just generate $100,000 of income in this very simple example here from your W2 job and you were at the 40% effective tax rate. So that's what you're paying all in. You're going to pay $40,000. But let's just say that you generate $100,000 in rental income and then you have $45,000 in operating expenses again, property taxes, property management fees, repairs, utilities, so on and so forth. Well, that's leaving you with $55,000 of net income. Okay? Now in most businesses, if you have $55,000 in net income, and for all my accountants out there, I know I'm oversimplifying this a little bit, but I think we're getting the point here. If you have $55,000 of net income in Most businesses you're going to pay taxes again up to 37% the federal level, state, local and then self employment taxes on it, right? So if you were at the 40% effective tax rate in most businesses, you'd pay $22,000 in income taxes on that amount. Then when we get with real estate, you can very well have a very sizable loss, especially thanks to bonus depreciation that could cause you to report a loss. So for example, let's say you had $100,000 in depreciation on this property, which is very possible with accelerated depreciation methods, including bonus depreciation. In that case, your taxable rental income would be negative 45,000 or you have a loss of 45,000, even though the fact that you generated $55,000 in positive cash flow. So let me just say that again, you had your rental income of 100,000, you had your operating expenses, and these are real expenses that you had to pay somebody else. You had to pay the property management fee to the property manager, you had to pay the property tax to the county, you had to pay the repairs to the Home Depot and to the repair people who came and repaired your property. This is money that actually left your bank account, right? But now you have this non cash expense called depreciation that only exists on paper. And, and that expense was so large in this example, thanks to bonus depreciation, that you actually told the IRS that you lost $45,000 even though you made 55,000. You put that in your pocket. I know I'm keeping things high level here, but I'm just trying to illustrate what this does, right? So in this case, you generate $55,000 in cash flow without paying taxes on it. And that is the first benefit of investing in real estate, which I think a lot of people overlook. A lot of people look at the short term rental loophole, they look at the real estate professional status and they think that that's the main way to, you know, help reduce taxes on their W2 income. But that's not quite the case. And here simply starting to shift your income, taking the money you're earning from your W2 or from your job, from your business and transport, pouring it into this tax advantaged asset class called real estate. And when you operate it properly, you are able to shield the cash flow that you're generating from tax. So let's take a look at an example real quick of what this does to your effective tax rate. And I'm specifically going to use New York City in a single person's tax bracket. Just to illustrate the concept here. Okay, so imagine you're a single taxpayer residing in New York City with an annual income of $500,000. When you consider federal, state, local, and FICA taxes, you typically pay around $214,000 in taxes. That results in an effective tax rate. And define your effective tax rate. Your effective tax rate is the total tax that you pay divided by your total income. All right? So in this case, your effective tax rate is 42.86%. Now, if you were to earn an additional $55,000 in W2 income, so you go get a bonus or you work a few extra hours, whatever the case may be, you would face an additional $26.5K. So $26,500 in taxes, that would push up your federal tax rate up to 43.38%. So you're increasing your effective tax rate. Right now, this is where things get interesting. If you were to earn that extra $55,000 from your rental properties and you were able to shelter it from depreciation, your effective tax rate would decrease to 38.61%. Because what's happening is you're generating more income or more cash flow in this case, but you're not increasing the amount of taxes you're paying. So you're still paying the $214,000 in taxes, but this other $55,000 of income, you're not paying taxes on it. That's decreasing your effective tax rate. All right? Now, let's just say over time, this amount grew to $100,000. All things being equal, your effective tax rate would drop even further to 35.71%. So I want to just pause here for a second and say this is the first chunk of. This is the first major benefit of investing in real estate that is often overlooked. Because here's the thing, when you're investing in real estate and doing this, you're not seeing this big massive refund or you're not seeing a, oh, I saved $50,000 in taxes this year. Let me go brag to my friends about it over at work on how I did this, right? This is a slow, gradual bill that if you commit to buying rental properties over the long haul, you buy them right? You buy cash flowing properties that tend to appreciate. And we'll get more into how to shield appreciation, the increase in value properties, in just a second. But if you're able to shield your cash flow from tax, you're decreasing your effective tax rate and you're earning income more Efficiently over time. Now, this isn't typically an overnight thing. This is something that takes 5, 10, 15 years to accumulate, depending on how quickly you go. But over time you are actually building tax advantaged income. And by the way, you could do this with rental properties. It could be single family, multifamily, commercial. It could be syndicates and funds that you're investing in as a limited partner. These rules really apply to anybody who's investing in rental properties across the board. So I just want to say this one more time, not to sound like a broken record here, but the first major tax benefit of investing in rental real estate is your ability to shield the rental income from tax, which if you do, if you invest correctly over time, is going to decrease your effective tax rate. You're not going to get this big major hit one day, you know, all at once. But over time, you are gradually putting yourself in a much better tax position. Okay, I think that's the thing that most people overlook and just get too hyper focused on the short term. Okay, we have to think bigger picture, which is what this episode's about here today. Thinking about the bigger picture on why real estate has been and will continue to be a tax advantage asset class, with or without bonus depreciation, with or without the short term rental loophole or the real estate professional status. So the next question is, what happens to this tax loss? Right. Tom, you told me that I made $55,000 in cash flow. Terrific. And I told the IRS I lost 45,000. What happens to the remaining tax loss? Well, obviously if you're able to qualify for the short term loophole or the real estate professional status, you'll be able to deduct this tax loss against your W2 or your active business income. But that's not the point of today's episode. For most people, if you're not using those strategies for one reason or another, what's going to happening is that loss doesn't simply disappear. That loss can first offset any other passive income you have, including other rental properties you may own. So you might be able to take that loss from property A and you use it to shield any positive cash flow from properties B, C, D, etc. Secondly, if you do not have any passive income or the passive losses still exceed all of your passive income in that particular year, you don't just lose these losses, these losses just don't poof and vanish and these losses will be suspended and carried forward onto future years tax returns where they can help offset future years cash flow. Meaning you can have a loss that can help shield other futures in the future or B when you sell a rental property right that's hopefully appreciated for you, those losses can help offset the capital gain and depreciation recapture from the sale of that rental property down the road. So as you can see here, we're not even using the real estate professional status or or short term rental loophole, but you're seeing how these losses can be utilized in other ways. Hey, real quick, if you've been a longtime listener to the show, then you know we give everything away for free from how to use the real estate professional status and the short term rental loophole to save tens of thousands of dollars on taxes to upcoming tax changes. We don't hold anything back. And the only way we're able to help more real estate investors is if you rate, review and share the show. It just takes 15 seconds to leave a quick rating review or share with a friend who may find this information useful or on their real estate journey. That's all for now. We'll dive right back into today's episode. That is the first benefit. Now we're going to go down into another reason why real estate is tax advantaged. This one's going to be called, you probably heard this one before already. It's called buy, renovate, rent, refinance, repeat or BRRRR for short. Now there's a variation of this called buy, borrow, die and I'll drill down into that in a second. But it's all part of the same concept. So first with real estate you can buy a property that ideally can be renovated to increase its value. Okay, so ideally you renovated or you otherwise you'll find ways to increase its value. Maybe the rent has been lagging the market for a really long time. But the bottom line here is you increase the property's value through renovations or other efficiencies that you build it. Secondly, as your property appreciates, you will pay down the principal of your mortgage and your equity within the property will increase. So you're basically increasing the equity you have in this property. Now here's where this gets starts to get powerful. You can tap into the equity tax free via cash out refinances or HELOCs. So you have this property, you bought it, you're increasing its value, have a lot of money tap trapped in this property. How do you unlock that? Well, of course you can sell. You can sell and you might have capital gain. And again we're going to get to in just a second how to mitigate that as well. But what happens is you have this asset and you can tap into the equity without selling, use a cash out refinance. And the best thing about the cash out refinance, those proceeds are not taxed, they're not taxable. So you go, you buy a property, you renovate it, you increase its value, pull cash out tax free, and you can take those proceeds and use them as down payments on new properties or towards rehabs of other rental properties. And long story short, the interest, if you use it for business purposes, like I just mentioned, will be tax deductible as well. So as you're seeing, this is just another piece of why real estate so powerful. Now, one more comment on this strategy. The specific ability to use your rental property as collateral, right. And tap into the equity using tax free cash out refinances or HELOCs is not exclusive to the real estate asset class. You could do it on something called a pledged asset line. You can do it on your stock portfolio. In fact, this is how Elon Musk, I think we talked about this here on the show. This strategy is how Elon Musk actually bought Twitter. He didn't use real estate. He had his Tesla stock and part of the financing came from. He pledged his Tesla stock as collateral, which allowed him to retain his Tesla stock. He didn't have to sell it. He retained his Tesla stock and took a loan out against his Tesla stock and then used it to buy Twitter, which is now X. All right, that was a few years ago now. But this is a strategy that's used by the wealthy to build and retain a pool of assets without selling, but still being able to tap into it and use it for cash flow. In this case, he used the cash out refinance. Okay. And took a pledge asset line. That's another key of why real estate is so powerful. Because real estate is one of the easiest asset classes that banks will lend against. Right. Banks always lend against real estate, whether it's investment property or primary residence. It's one of those easy asset classes to get financing against. Okay, so the second big key here. But Tom, eventually we're going to have to sell our property maybe and we're going to face capital gains taxes and potentially depreciation recapture taxes when we sell. Well, here's where things get interesting. If you think about stocks, think about other asset classes. When you sell a stock, unless it's within your retirement account, like your 401k, your IRA or what have you, you're going to pay capital gains taxes on that and really the only way, for the most part, that you're going to be offsetting the capital gains taxes on those stocks is going to be through selling other capital assets at a loss and generating capital loss and get offset. That's typically how it's done. Unless you're able to of course use the real estate professional status for short term of the loophole, or generate non passive losses to offset your stocks, that's typically going to be the way you're going to do it. But with real estate, with real estate, you can use something called the 1031 exchange. The 1031 exchange allows you to sell your property and use the sales proceeds to acquire another asset, another rental property specifically, and defer your capital gains and depreciation recapture tax until down the line. And the interesting thing about a 1031 exchange is since the Tax Cuts and Jobs act passed in 2017, this is exclusive to real estate and rental properties. You cannot use a 1031 exchange right now on any other asset. So that's why this is powerful, because you can sell your property, your rental property and buy another one. Use the sales proceeds to buy at least another property and defer the taxes. All right, so to give you an example what this might look like, let's say you saved $100,000 in capital gains taxes. Well, that unlocks $400,000 in additional purchasing power at a 75% loan to value ratio. So you're able to buy more property, bigger and better properties, typically without incurring capital gains tax. Now there's another strategy that you can use to exit tax efficiently called a lazy 1031 exchange. The lazy 1031 exchange involves buying another property in the same year you sell this property, your original property you're selling, and using a cost segregation study and the depreciation to create such a large loss that can offset the gain on sale of the original property you sold. They call it a lazy 1031 exchange because it has roughly the same outcome as a 1031 exchange. But you don't have to go through the timelines and jump through all those hoops. So the point is, and there's other tax advantage exit strategies, qualified opportunity zone funds, so on and so forth. But the point is, real estate is not only as you're building your portfolio, you're shielding your cash flow. You're able to tap into the property's equity cash free with cash out refinances, while retaining those assets, assuming they're good, high quality assets. But then when it does come time to sell property, you do have ways to exit tax efficiently as well. And by the way, if you did want to go passive and you did eventually say, you know what, Tom, I don't want to deal with real estate anymore, I'm in retirement or going to be entering retirement, I don't want to use a 1030 in exchange to have to buy another property that I'm have to manage. Well, you can invest into a Delaware statutory trust or DST, which is, long story short, a passive vehicle that is 1031 exchange approved by the IRS. So you can sell your property, invest in a DST, which will typically invest, it's like a syndicate, so to speak. Typically a class A retail or commercial property that you can 1031 exchange into. So you can go past it. There's also the 721 exchange, which we also discussed here on the show, which also is another tax advantage exit strategy for when you're ready to go pass it. So there's a lot of ways you can exit real estate tax efficiently. Now let's get to the the end game here, right? This is something called the step up in basis, okay? And this is where things get really interesting. Let me paint this picture. So, you know, you spend your entire life, you build up this big rental portfolio. Along the way, you're shielding your rental income from tax thanks to depreciation. You're using cash out refinances to tap into the equity, allowing you to retain properties while expanding your portfolio. And when you do have to sell property along the way, you are using a 1031 exchange to defer the taxes down the line. Now here's the thing. If you eventually sold a property that was highly appreciated, you're gonna pay a massive capital gains tax if you don't use a 1031 or another tax advantage exit strategy. So if you do eventually sell without using one of those, you're gonna pay a massive capital gains tax. However, if you hold it till the day you die, that capital gains tax may not exist. And that's thanks to the step up in basis. So the step up in basis, what it does is it steps up the cost basis of your property to the fair market value at the date of your death. So what does this mean? In other words, your heirs will receive the property that you pass down to them at the fair market value, erasing all the capital gains and depreciation or capture taxes you would have paid. So say for example, you bought a property in 2026 for $500,000. Now in 2056, it's now worth $3 million. Right. Notwithstanding, we're going to ignore depreciation recapture for a second and we're just going to take a look at just the capital gain, 3 million minus 500,000. You're looking at a capital gain of $2.5 million which is currently taxed up to a max rate of 20% plus potentially the net investment income tax of 3.8%. So you're looking at somewhere at the upper range of 23.8% at the federal rate alone on top of state and local taxes if you're in that jurisdiction. So you're looking at a $2.5 million capital gain. But if you held that to the day you died and your heirs received it at $3 million at the fair market value, the date of your death, that and they sold it theoretically at the next day, then they would pay no capital gains taxes. So that's the end game. So this is the part of the buy, borrow, die. What people will do is they'll buy these assets like I said, they'll use all these tax advantages throughout their life. They'll borrow against their assets to continue to buy more and then they will hold it to the day they die and their heirs will receive a tax free wiping out all of the capital gains. Now having said all that, this is certainly easier said than done. Please do not get me wrong. But. But it certainly happens. We see it, we see it from time to time. It happens for those people who are willing to be patient and play the long game and not just look at the short term benefits of investing in real estate. So let me sum this up. This is why real estate such a tax advantage asset class even without the real estate professional status or short term on the loophole. So first of all, earned income is taxed at high rates again up to 37% the federal level. Then you have state, local and FICA taxes, sometimes self employment taxes if you are self employed. So rates can easily between 40 to 50% for high income earners. We see it all the time here at whole CPA and it is painful to watch. And I don't blame everybody for wanting to use a short term rental loophole or the real estate professional status. Those are certainly powerful strategies. However, that's not the only way to do it. So the second thing here is rental income can be sheltered from tax thanks to a non cash expense called depreciation. Depreciation shelters your rental income from tax which is also taxed at ordinary income tax rates. But because you're creating a loss on Your properties, you're not paying taxes on the cash flow. So again, earned income tax at high rates, rental income also tax at high rates, but you can shelter it from tax using depreciation. And this lowers your effective tax rate over time. Because what's happening is you're generating more cash flow or more income from your rental properties, but you're still paying the same tax rate against your W2 income set. Pushes your effective tax rate down over time. It's gradual, it's not usually overnight, but it can be quite powerful. Next, as you're growing your portfolio of cash flowing properties as they appreciate, as you pay down the principal on the loans, you're able to tap into the equity without selling your properties tax free using cash out refinances or HELOCs. Okay, so that is the next benefit, right? And rich people use this stuff all the time in order to build their wealth. Now the next thing is eventually you might have to sell a property. Not all properties are going to hold the day you die. Sometimes market shift properties start to become out of alignment. Sometimes you just need to sell it in order to unlock the full capital that's in within that property, the full equity to buy a much larger property or a much better property. And you do have to sell. Well, that's where strategies like the 1031 exchange and the lazy 1031 exchange and other exit strategies come in. They allow you to defer the taxes when you buy more real estate, okay. And continue to build your portfolio. And now when you get to the end, you could pass your properties to your heirs at a stepped up basis or the fair market value at the date of your death, eliminating all the capital gains taxes you would have otherwise paid. Okay? So this, if you zoom out and you look at the bigger picture of investing in real estate over the course of 5, 10, 15, 20, 30 years, you start to realize that it is a very powerful tax strategy in and of itself. Just investing in real estate, thanks to all these tax benefits, you get along the way and you could build extreme wealth by doing this. And there's been people, there's been clients that we've had who've built net worths in the tens and hundreds of millions of dollars without ever using the real estate professional status. And I know that might shock some people, but if you zoom out, you play the long game, you start to see that there's a lot more to real estate than just the short term tax hits that the real estate professional status and short term rental loophole generate. Now having said that, there's nothing wrong with those strategies. I don't want people to say, oh, is Tom doing a hit piece on the real estate professionals that is a short term rental strategy? By no means. I'm just saying that there's more to investing in real estate than just the short term rental loophole and real estate professional status. And it often does not get a lot of attention. And I believe that's largely because human beings, like most animals, we are short term thinkers. For the most part. We have to survive today in order to even make it to tomorrow. Which is why so many people focus on the short term. It takes a lot of patience to zoom out and say, okay, great, let me look at these numbers here. And if I just invest in 1, 2, 3, 4 rental properties a year, whatever the goal is for you in the next five, 10, 15 years, I'm going to put myself in a much better tax advantaged position than I would have if I pursued these other investment strategies. Then I think that the picture starts to unveil itself. You start to see it, but it's very difficult to think that long term, it just is. So that's the bottom line. And by the way, you know, we had this one client who had had a passive portfolio, much like we're discussing here, and they didn't receive the tax guidance that they should have received from their their current CPA and they were paying taxes on their cash flow from rental real estate. They came in, they worked with our team and we were able to help them use cost segregation and bonus depreciation on some of their properties that they had acquired to start shielding their rental income from tax. And they saved quite a significant amount of money. You could find the case study under case studies on the realestatecpa.com but if you're wondering if you've never received quality tax advice, whether you're looking to use the real estate professional status short term of the loophole, or you're looking to just simply grow a tax advantaged portfolio real estate over the long term, then I invite you to fill out the form in the description to this video or to the podcast and book a discovery call with our team. We'd love to learn more about your situation to see how we can help. Because chances are if your CPA is just providing your tax return for you every year and they're not giving you tax advice, you're probably leaving money on the table. We see it all the time, so we'd love to help you out, see if there's a way we can help you drive down your taxes. We Whether it be this year or over the long term, there's a lot of strategies that you have at your disposal. So go ahead and fill out that link in the description to this video and we'll catch you on the next week's episode of the taxmart REI Podcast. The Taxmart Real Estate Investors Podcast is for general information purposes only and is not intended to provide and should not be relied upon for tax, legal or accounting advice. Information on the Podcast may not constitute the most up to date legal or other information. No reader, user or listener of this podcast should act or refrain from acting on the basis of the information on this podcast without first seeking legal and tax advice from counsel in the relevant jurisdiction. Use of an access to this podcast or any of the links or resources contained or mentioned within the podcast show or show Notes do not create a relationship between the reader, user or listener of the podcast and the host, contributors or guests. Any mention of third party vendors, products or services does not constitute an endorsement or recommendation. You should conduct your own due diligence before engaging any vendor. For more information, reference the show notes or description of this episode.
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