Legacy Wealth Holdings

How to Lower Your Income Tax Bracket (with Real Estate)

 

What’s up y’all? Today we’re talking about taxes.

How do you lower your active income tax bracket?

First of all, I’m not a CPA. Talk to your CPA about this.

One of the best strategies in the US tax code is the real estate professional designation. In this post, I’m going to give you a couple of strategies that I’ve seen work for a lot of people who passively invest in real estate. These people have been able to knock down their high active income pretty considerably on an annual basis.

UNDERSTANDING THE TAX CODE

It’s important to understand that the tax code was written by landowners.

Back in the day, the people who owned the land had all the money, and those people then had the power in the political system to influence the tax code. When you understand that perspective, you realize that there are a lot of incentives and a lot of benefits WRITTEN IN THE TAX CODE that specifically benefit landowners.

Typically the best incentives in the tax code are for landowners and especially rental real estate landowners. So that’s the first thing to understand. If you are commercial real estate landowner, that just takes everything and amplifies it pretty considerably because the dollar amounts are quite a bit bigger.

ACTIVE VS PASSIVE INCOME/LOSSES

The second thing to understand is that the tax code breaks up active income/losses and passive income/losses.

So let’s say that you have a traditional business and you make $500,000 a year in active income. That active income can be offset by active losses.

Typical business expenses like travel, legal, payroll, and all that can offset your active earned income because those are active losses.

Then you have your bucket of passive income. Passive income consists of things like interest income, royalty income, and dividend income. Passive income can be offset by passive losses. For instance, depreciation.

The issue is that if you are a traditional business owner (and not a real estate professional), you cannot consolidate passive and active income.

But if you are a real estate professional, you can!

Let’s say you’re a flipper and you buy, fix, and flip houses as your full time business. You can offset your active income there with the active losses of: what you bought the property for, your insurance or taxes, your utilities and all those operating expenses, your cost of capital.

Now that you’re a full time real estate professional, if you buy and hold some properties, then you can take the depreciation and the passive income and the passive losses, and the tax code allows you to lump it all into one bucket.

WHAT CONSTITUTES A REAL ESTATE PROFESSIONAL?

From the tax code, it says you have to spend 750 hours a year doing real estate activities. It doesn’t need to be where you make the majority of your money, but it needs to be where you spend the majority of your time.

If you have a W-2 income from somewhere that’s not your own real estate business, you cannot be a real estate professional.

If you’re a realtor, that’s seen as a sales professional, not a real estate professional.

But if you are actively buying and selling real estate, that constitutes a real estate professional.

And if you’re spending more than 750 hours a year (which is about 15 hours a week) of your time, and that’s the majority of where you spend your time, then you are considered a full time real estate professional.

Again, talk to your CPA, make sure you feel good about it, make sure your CPA feels good about it, but it’s just a designation that you put on your tax return.

COST SEGREGATION STUDIES

Let’s say you flip houses and you make $500,000 a year.

If you buy rental real estate and you depreciate that rental real estate, that depreciation — although a passive loss — gets put in the same bucket as your active income and active losses. You’re able to offset a lot of your active income with those passive losses.

You might have heard of something called a cost segregation study.

Let’s go through a quick example.

Say you go out and you buy a $2 million apartment building. That’s probably about 20 units.

When you’re depreciating the property, you can only depreciate the value of the building. Land is not depreciable, but the building value is depreciable.

For example, if you’re in the Midwest somewhere, the land value would be about 10% of that $2 million. So about $200,000. That allows you about $1.8 million of building value to depreciate.

The tax code allows you to depreciate the property over 27.5 years, but there are certain things that aren’t going to last that long. Now, if you do a cost segregation study, you essentially go around the property and identify things that won’t last 27.5 years, like the carpet, the HVAC, maybe the roof, the trim or the molding, the light fixtures, things like that.

A cost segregation company segregates out all the different costs that are associated with that building and the value of that building. Some things can be depreciated in the first five years or the first ten years or 15 years, and you can expedite some of the depreciation.

During the Trump administration, the government allowed accelerated depreciation, which means you could take all of that and put it all into the first year. I think it was anything under 15 years or less could be thrown into the first year. On average, what I’ve seen in my own properties equals to about 25% of the overall value of the building.

So on a building that has $1.8 million of depreciable value, you’d get about $450,000 of depreciation that first year. It could be more or less, depending on the type of the building, the age of the building and a lot of other factors. It’s why you just hire a cost segregation company in order to do that.

The way that code was written is that bonus depreciation would start to wane by about 20% every single year. So you get 100% of the depreciation in 2022. You get 80% in 2023, 60% in 2024. Next year, 2025, is going to be 40% and then 20%, and then it eventually goes away.

It’s actually on the table right now to reinstate bonus depreciation. I think the House has already passed it, and Biden has said that he will pass it if it passes the Senate as well. In that case, it would go back to 100% of accelerated depreciation in this year.

So if it goes back to 100%, you’ve got $450,000 of depreciation in that example above. That is a passive loss. But it goes into the same bucket as your active income and active losses.

HOW DEPRECIATION WORKS FOR YOU

If you make $500,000 a year in active income flipping houses, and it gets offset by $450,000 of depreciation, that takes your taxable net income from $500,000 down to $50,000 for the year.

So what that does for you financially is, you know, if you’re at $500,000 a year, you’re in one of the higher tax brackets.

Actually, I think that’s the highest tax bracket, depending on your state income and all that kind of stuff.

It probably blends out to be somewhere around a 30%, maybe more, 35%, tax bracket. So on $500,000, if you’re saving a third of that, you would have been paying $170,000 to income taxes.

Whereas in this case, if you go and buy a real estate asset, the government is incentivizing you.

Why? As you invest, you pay more property taxes. As you invest, you create more jobs. That’s why they wouldn’t allow you to depreciate and offset your active income taxes this way.

By buying a property, you’re able to take that $170,000 and instead of paying it out to the government, you’re able to save that money and put it into an investment in a new deal. So it incentivizes you to go out and make these additional investments.

Over time, those rents are going to grow. You’re going to pay down the principal balance. And over time, you’re going to find yourself sitting on a bunch of equity in this $2 million building. 25 years from now, it’ll be paid off free and clear and cash flowing like crazy. It’ll probably double in value or do around $4-5 million in value. And it’ll increase your net worth pretty considerably. That’s the beauty of doing this. The entire time you’re able to depreciate that property value and offset a portion of your active and earned income.

WHAT IF YOU AREN’T A REAL ESTATE PROFESSIONAL?

Now what happens if you have a traditional business? Let’s say you’re a white collar professional, you’re a dentist or a doctor, or you have a traditional business, an e-commerce business or a brick and mortar store.

How can you benefit from this?

Let’s say somebody makes $2 million a year in their business and they don’t have the tax breaks. Even though they’re a business owner, they can only offset their income with active and earned losses, but not with passive stuff.

Unless your spouse is a full time real estate professional.

If your spouse is a full time real estate professional and you’re actively investing through them and their entity, they are a full time real estate professional taking their depreciation that they get on an annual basis combined with your active and earned income.

If you’re married and filing your taxes jointly, their depreciation can now offset your active and earned income.

I have a celebrity friend who came to me the other day saying “Dude, I’m making way too much money and I’m paying so much in taxes. How can I utilize real estate in order to help me out?”

His spouse doesn’t work, but does have a real estate background.

I was like, “Well, obviously talk to your CPA, but from my understanding, you can put a real estate investment company together that your spouse is the majority owner of, and put all the real estate investments through them as they go out and buy property and accumulate property and accumulate depreciation from those properties. You’re married filing joint taxes together, so that depreciation can offset your active and earned income.”

It allows them to then go and invest in more real estate, create more jobs, pay more taxes, property tax, all those things, and reduces the tax liability on their active and earned income tax bracket.

That is a huge, huge gain if you understand how that can work.

TALK TO YOUR CPA

This is not meant to be tax advice. It’s meant to stir up some conversations. If your CPA is not having these conversations with you, you need to bring these conversations to them and ask them these things. If they shoot it down, find another CPA because there’s a lot of different ways that you should be asking progressive questions to your CPA.

There’s a lot of different ways that you can reduce your taxable income by investing in real estate and commercial assets. So if it’s not something that you’ve looked at, make sure you look into it. Make sure you talk to your tax professional about it.

If you need some references on awesome tax professionals, I’m happy to introduce you to a couple of folks. There’s a few in the Legacy Family, which is my mastermind, who represent a lot of real estate investors and a lot of traditional business owners who both actively and passively invest in real estate. If I can be a resource for you and make some introductions, don’t hesitate to reach out.