How to realize Massive TAX Benefits with Real Estate
by Christopher Levarek
“Under the tax law, there are producers and consumers, and one group receives more incentives than others — producers. The government favors producers like business owners, real estate investors and agriculture and energy producers and provides huge tax incentives because they create economic activity. “
- Tom Wheelwright
After speaking with many new and experienced investors into real estate over the phone, online, in meetups and in-person, there is one very common attraction to real estate, the “tax benefits”. In fact, I’d rank the tax benefits of real estate investing as the number one if not number two reason people choose real estate instead of stocks, ETF’s, metals, crypto-currency, etc.
Now before we dive into the what, why and how behind these tax benefits, let me start by saying I am not a CPA. I highly recommend consulting one focused on real estate who can help you with a tax strategy based on your goals/lifestyle. However, I do consult and have conversations with CPA’s and investors well-versed in the area of real estate investment and realizing some of these beneficial tax advantages. I also use much of these same strategies in our company tax strategy and my own personal tax strategy as well.
This article will focus mainly on the benefits to taxes by investing in real estate in general, the various forms of income and finally how someone can attain the coveted “real estate professional” status for tax advantages.
How to realize Massive TAX Benefits with Real Estate
What are These Massive Tax Benefits to Real Estate?
If we compare investments side by side looking for pros and cons of each, typically one of the first advantages with real estate are the tax benefits. So what do we mean by tax benefits?
At a high level, the government uses credits and incentives to motivate businesses and investors into areas that need growth or investment. These tax credits and incentives or “tax benefits” are found most predominantly in real estate.
When we speak to investing in real estate and realizing such benefits, it simply means being able to put money into real estate and defer taxes on the gains of those investments or even offset other income with the losses. Deferment of taxes on gains from real estate can be ultimately deferred for long periods of time and even until death, making this investment “tax-free”.
So how does one defer taxes with real estate? Much of this has to do with depreciation of property on paper which equals a paper loss for taxes. By depreciating assets or pieces of the property, the owner can show a loss on paper to offset taxable income. A person can even speed up this depreciation to realize all the loss in one year, effectively allowing for an owner/investor to properly time big gains with big losses so they offset. This is often the case with real estate syndication and is completed by using a cost-segregation study to combine the depreciation into a single year.
Now of course how an investor or individual translates the paper loss to their own tax situation or strategy is where a qualified CPA comes into play. However the opportunity to use such losses against other passive income or even other types of income is an opportunity not found in many, if not any, other investment classes.
Passive Income and other Types of Income?
So if you do get a loss from an investment on paper, how does this get used for your personal tax return? Like anything else it depends on your tax strategy and personal financial situation. However, most people know that they are taxed on income levels or “buckets”.
Typically, a person works a normal W-2 job and collects an income to which they then pay tax upon. If you make “insert amount here” in income, you are taxed in a certain bracket or bucket. If you are able to lower your taxable income, you pay less right?
This is why investment advisers recommend putting as much into a 401k as possible, right? Well, yes, but there are many ways to get there.
As the first section described, with real estate investment, you can use the losses generated on paper from an investment into real estate and potentially lower your overall income generated for the year, on paper.
Ok, What’s the catch? There is a catch right? It depends…
Income in general is broken into various categories :
Passive Income : From passive investments into real estate or another business in which a person is not actively involved
Non-Passive Income :
Active Income (W-2)
Personal Business Income
Portfolio Income (Also considered Non-Passive Income for Tax purposes)
Dividends, Interest, etc. - (Stocks, ETFs, Private Loans,etc)
So the catch is that the losses match whatever income category. If you sustained personal business losses, those apply to your non-passive income bucket. If you sustain passive income losses on a passive investment, those apply to passive income gains.
That’s right, you can use passive losses from real estate to offset passive investment gains in another business. (Yes, Ex-President Trump, I’m looking at you with your Trump University, Trump Plaza Hotel and Casino….)
You should be seeing just how powerful investing in real estate is with the ability to take passive losses against forms of passive income, something other investments aren’t as easily able to achieve. This keeps more capital in the pocket of the investor. And remember, these are simply using available credits and incentives put in place by the Tax code to stimulate investment in areas of need.
BUT How does one use passive losses against Non-Passive Income?
Real Estate Professional - Using Passive Losses Against Non-Passive Income
Now we finally reach the topic of the “Real Estate Professional”. If you haven’t heard this term before, it simply is a status or qualification according to the IRS that allows for certain tax benefits due to real estate activity. Mainly, it allows a tax payer to use losses generated in the passive income bucket against income in the non-passive income bucket.
Let’s imagine you had $25k in losses on a $100k investment, a 25% paper loss from depreciation of the real estate property. If you or your spouse, joint-filing, qualified as a real estate professional, you would be able to apply $25k loss to your W-2 income and possibly get a massive check back from the IRS for taxes paid on your W-2 salary.
So what does one need to qualify?
Two main criteria serve as guidance for qualifying as a real estate professional :
More than 50% of the personal services you perform in all businesses during the year MUST be performed in a real estate business you materially participate.
You must work at least 750 hours in a real estate trade or business
If you or your spouse are able to meet these qualifications, you are able to tap into the benefits of the real estate professional status. For a more in depth look at understanding this qualification, I highly recommend watching this very well-explained 4 part video series on the subject by the The Real Estate CPA, an experienced firm focused on real estate business tax and accounting services.
In Final
Tax incentives from the government exist to encourage investors to invest in areas of need. Although, not always a fun topic for many, understanding what is available in the tax code and working with a qualified CPA are paramount to successful investing or attaining financial goals. I hope with this article you are able to see some of the massive tax benefits available through real estate by leveraging some of these available options.
Perhaps, you are even getting excited for an upcoming tax season? No? Ok, that might be a bit much… ;)
In any case, Happy Investing!