362. The Quiet Strategies High-Income Investors Use Instead of REPS or STRs

You're now listening to the TaxMart REI Podcast, the number one tax podcast for real estate investors. Your source for 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 used to grow their business and how they steer clear of all things. Thanks for tuning into this week's episode of the TaxMart REI Podcast. So today we're going to be zooming out and talking about why real estate is such a tax advantage 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 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 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 to refresher on why real estate is one of the most tax advantage 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 the real estate newsletter worth reading, and that's because we hadn't created hours yet. The REI Daily's newsletter you actually want to read, whether you own one property or a hundred, 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 in the head of the game. Get the real estate and tax news that actually matters straight to your inbox. Subscribe to the REI Daily newsletter today at the realstatescpa.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're going to go back to the basics on the US tax system. Then we'll cover shifting earned income into passive income, and then why that is so powerful. And then we're going to talk about tax-efficient investment in exit strategies and how you can really turn up the jets here. All right, so let's start 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 of your 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 owner, 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 be quite painful. This is why many people seek strategies like the real estate professional staffs 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-opener 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 that cost to have you operate your property. You're able to deduct those against your rental income and not pay taxes on just your raw rental income. 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, as I said, you're in the 40% affected tax rate when you add up all of the taxes that you're paying between federal, state, local, and all that. And let's just say you wanted to earn additional $100,000. I'm keeping the number 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, whatever 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." So that's the first unlock here, is that you're generating income from your rental properties, but you're not paying taxes on it. And by the way, rental income, if you did have net rental income, is tax up to 30%, 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 or the fight taxes, but it's still tax and 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 an example of what this might look like. 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, selling and so forth. Well, that's leaving you with $55,000 of net income. Now, in most businesses, if you have $55,000 in net income, and for all my accounts 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 30% the federal level, state, local, and then self-employment taxes on that. So if you were at the 40% effective tax rate, in most businesses, you 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 -45,000 or you have a loss of 45,000. Even though the fact that you generate $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 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 and 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 real estate, which I think a lot of people overlook. A lot of people look at the short-term rental, gluple, they look at the real estate professional status, and they think that that's the main way to help reduce taxes on their W2 income. But that's not quite the case. And here, simply starting to shift their income, taking the money you're earning from your W2 or from your job, from your business, and transferring it into this tax advantage 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 specifically, we use New York City in a single person's tax bracket just to illustrate the concept here. Okay? So imagine your single tax payer residing in New York City with an annual income of $500,000, where you consider federal, state, local, and phycate taxes, you'd 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 $26.5,000. 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, more cash flow in this case, but you're not increasing the amount of taxes you're paying. So you're still paying to $214,000 in taxes, but there's other $55,000. thousand dollars 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 point to your first second and say, this is the first chunk. 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, it will 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 are 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 advantage income. And by the way, you could do this with rental properties. It could be single family, multi family, 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 the sound of 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 once, but over time, you're gradually putting yourself in a much better tax position. 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 is 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 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 call five for the short term of the 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 today's episode. For most people, if you're not using those strategies for one reason or another, what's going to have 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 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 don't poof and vanish. These losses will be suspended and carried forward onto future year's tax returns where they can help offset future year's 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. 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 short term rental loophole, but you're seeing how these losses can be utilized in other ways. That is the first benefit. Now we're going to go down into another reason why real estate is tax advantage. This one's going to be called, you probably heard this one before, ready? It's called buy, renovate, rent, refinance, repeat, or burr for short. Now it'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. So ideally you renovated or you otherwise, you'll find ways to increase its value. Maybe the rent has been laying in the market for a really long time. But the bottom line here is you increase the properties value through renovations or other efficiencies that you built it. Secondly, as your property appreciates, you will pay down the principle 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 he locks. So you have this property, you bought it, you're increasing its value, you have a lot of money, tap trapped it 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 you to 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 taxed up to all as well. So as you're seeing, this is just another piece of why real estate is 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 he locks 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, how Elon Musk actually bought Twitter. He used 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 the tap into it and use it for cash flow. In this case, he used the cash-out refinance 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. Banks will 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. That's 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 or capture 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, or 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 all set in the capital gains taxes on those stocks is going to be through selling other capital assets at a loss in generating capital loss and get off set. That's typically how it's done. Unless you're able to, of course, use the real estate professional status to short from the loophole 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 10301 exchange. The 10301 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 into appreciation, recapture tax until down the line. And the interesting thing about a 10301 exchange is since the Tax Cousin Jobs Act passed in 2017, this is exclusive to real estate and rental properties. You cannot use a 10301 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 save $100,000 to 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 in current 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 aggregation 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, qualifying opportunities, own 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 I'm going to be I don't want to use a 1030 exchange to have to buy another property that I'm not to match. 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 7201 exchange, which we also discussed here on the show, which also is another tax advantage exit strategy for when you're ready to go past it. So there's a lot of ways you can exit real estate tax efficiently. Now let's get to 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 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 up to sell property along the way, you are using a 1030 exchange to defer the taxes down line. Now here's the thing. If you eventually sold a property that was highly appreciated, you're going to 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 paying a massive capital gains tax. However, if you hold it to 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 data or death. So what does this mean? In other words, your errors 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 were bought a property in 2026 for $500,000. Now in 2056, it's now worth $3 million. Right? Notwithstanding, it was great to ignore depreciation or capture for a second. 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 and top of state and local taxes if you're in that jurisdiction. So you're looking at $2.5 million our capital gain. But if you tell that to the day you die, your errors receive at $3 million at the fair market value at the data or death, 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 borough die. What people will do is they'll buy these assets. Like I said, they'll use all these tax manages throughout their life. They'll borrow against their assets to continue to buy more and then they'll hold it to the day they die and their errors 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 wrong, 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 this short term benefits of investing in real estate. So let me sum this up. This is why real estate such a tax avenge asset class even without the real estate professional status or short term of the loophole. So first of all, earned income is tax at high rates. Again, up to 37% the federal level, the name of state, local and fight the 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 the short term of the 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. Appreciation 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 incomes. That 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 equity without selling your properties tax-free using cash out refinances or he locks. 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 errors that 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 five, 10, 15, 20, 30 years, you start to realize that it is a very powerful tax strategy in 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 networks in the tens and hundreds of millions of dollars without ever using the real estate Professional status and another like shocks in 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 in short to month old loophole generate now having said that there's nothing wrong with those strategy I don't want people to say oh it's Tom doing a hit piece on the real estate professional status or short-term other strategy by no means I'm just saying that there's more to investing in real estate than just a short-term up to 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 and we're even making 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 one two three four rental properties a year whatever the goal is for you in the next five ten 15 years I'm gonna put myself in a much better tax advantage position than I would have if I pursue these other investment strategies Then I think that the picture starts to unveil itself and you start to see it But it's very difficult to think that long term and 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 were 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 for mental real estate They came in they worked with our team and we were able to help them use cost aggregation 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 can find the case study under a case studies on the real estate CPA dot 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 advantage 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 and see how we can help because chances are if your CPA is just Profiling 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 at time So we'd love to help you out safe this way. We can help you drive down your taxes 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 fill out that link in the description to this video and we'll catch you on the next week's episode of the Tax Park Ariane podcast The tax month 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 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 used of an access to this podcast or any of the links or Resources and contain or mention 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 can duck your own two diligence before engaging any vendor for more information reference the show notes or Description of this episode. 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