We All Need a Tax Shield
Why do President Trump, Warren Buffet, and Jeff Bezos all pay so little in taxes? Are they criminals? Are they laundering money? I don’t know for sure, but the likely scenario is they are playing by the rules of the game. Whether or not you agree with the rules…not a topic of debate for today. The cold hard truth is the tax code incentivizes business owners and individuals who take risk. I want to help you understand the beauty of owning real estate and how you as the investorcan keep as much of yourhard-earnedcash as possible. This is one of the more misunderstood topics in investing, so grab a cup of coffee and stay with me.
First things first: Real estate investors enjoy five major categories of tax write-offs though the direct ownership of real estate.
1. A 20% business income write-off known as the199A deduction. (The deadline for this write-off is sunset on December 31, 2025, but for now we can make use of it.)
2. The CARES Act allows commercial property owners to take 100% bonus depreciation for all nonstructural improvements made. That means when you replace the roof or install a new HVAC unit, you can write off 100% of the cost in that year.
3. There are two types of income: active and passive. Active income is earned income from a job,often as a W-2 employee. Passive income is income earned from investments. Real estate income is passive income; the major benefit here ispassive income does not pay self-employment tax which is an approximately 15% savings.
4. Each month the property owner paysinterest to the bank, which is tax deductible.
5. The IRS states the life of commercial property is 39 years, which allows you to depreciate the asset equal to the purchase price divided by 39 years. Also allowed under the IRS tax code is something called cost segregation. In a nutshell, here’s an example of what that looks like:Athird-partyengineer looks at all the components in the property—like the electrical wires, roof, and the carpet—and then assigns a useful life value to each to them. Maybe the carpet’s life is 5 years and the roof’s life is 15 years. This allows the property owner to depreciate the asset over a much shorter time period,which equates to a huge tax benefit over the first 5-7 years.
I am using a lot of words to talk about numbers, so let’s take a look at a real example of a property we purchased for $1,425,000.
After all expenses are paid, the property generates $128,000 in Year 1. But because of the Big 5 tax write-offs, the partners will show a loss of $12,440 in Year 1.How did you make a profit but showed a loss? Surely you must be joking.No, I am not; it is incredible. But wait!There’s more!
Afterfive years, we decide to sell the property. We can take the profits and pay taxes OR we can do what is called a 1031 exchange. The IRS allows property owners to 1031 exchange into a “like kind” property of equal or greater value within 180 days of the sale. This allows the seller to avoid taxes and roll everything into the next property. But the real magic is compounding. By letting the original investment compound tax-free over time, real wealth can be created.
A third option exists, which is my personal favorite.
Instead of selling in five years, lets imagine the property has appreciated in value due to an increase in rents or substantial lease up in the property. You can now refinance the property and take out all or most of your original equity and hold the property forever. What’s more, the money is returned to you TAX-FREE. What? Yep.Tax-free. You can go buy a new truck or a pair of shoes, but I recommend that you keep playing the game.
