I’m going to tell you my favorite thing about being a real estate professional.
Make sure to stick around for the entire post because what I share at the end will likely surprise you and might even get you to consider switching careers.
Today I want to share my favorite part about being a real estate professional.
And it’s most likely not what you think.
- It’s not the excitement of buying low and selling high.
- It’s not the sense of accomplishment you get from adding massive value to a distressed property.
- And it’s not even the thousands of dollars in passive income you can generate on a monthly basis.
It’s something else entirely.
But before we dive in, I feel compelled to do a quick disclaimer. Do not take anything I say in this episode, or on this channel for that matter, as financial advice. This is for informational purposes only. Please consult with your CPA and Tax Attorney to ensure you’re staying within the limits of the US Tax Code.
Alright, let’s dive in.
Tax Free Income
My favorite part of being a real estate professional is the tax-free income.
In just a second, I’m going to walk you down the path I’m taking right now to wipe away most, if not all, of our tax liability on an annual basis.
But before we do that, let me tell you why you should spend the next 10 minutes listening to what I have to say.
I invested in my first real estate deal back in December 2016. I didn’t figure out how to apply what I’m about to share with you until the 2020 tax year. It took me 4 years, almost 40 separate investments, and countless conversations with other full-time real estate investors to learn what I know now.
And I’m about to give you all of that knowledge for free.
In 2020, not only did my wife and I pay virtually nothing in taxes, but we also secured a little over $113,000 in Carryforward Losses.
That means the first $113K we make in 2021 won’t be taxed. If I play my cards right, we’ll have even more Carryforward losses for 2022 despite both of us growing our take-home incomes this year.
Here’s a little taste of what we’ll be discussing in the rest of this blog.
There are 4 main concepts you need to understand to move you closer to the goal of tax-free income.
Depreciation
The first thing you need to understand is the concept of depreciation.
Depreciation is a non-cash expense the IRS allows you to apply on your Profit & Loss Statement at the end of every year. So even though no money is leaving your pocket, you can write off depreciation against your passive income. We’ll go over what this looks like in a second.
First, let’s outline what it takes to qualify for depreciation expense.
- Since land alone cannot be depreciated, you must have improvements on the land with a useful life. Examples of land improvements include paved parking areas, driveways, fences, outdoor lighting, and the building itself.
- You must own the property, or own the entity that owns the property. You can’t depreciate something you don’t own.
- The property has to be income-generating. So you can’t take depreciation against your primary home or a vacation home you’re not renting out.
- You have to be able to determine the useful life of the property you are depreciating. Generally speaking, residential property is evenly depreciated over 27.5 years and nonresidential property is evenly depreciated over 39 years.
Ok so now that we understand how to qualify for depreciation, let’s walk through an example of how depreciation offsets the income of a rental property using one of my properties as an example.
In September 2020, we bought a 3-family property for $215,000. Of that $215K, we attributed $190K towards the property and improvements and $25K towards the land value.
Since we can’t depreciate land, we can only depreciate $190K over 27.5 years, or $6,900 per year.
To understand how this $6,900 in depreciation per year helps us, we have to now take a look at the Profit & Loss Statement for this property.
As of today, this 3-family home generates $3,750 per month in rental income.
Here’s a rough breakdown of our monthly expenses.
We spend $150 on property management, $225 on property insurance, $635 on property taxes, $100 on water and sewer, $100 on the landline, and then another $100 on common area utilities.
Over the life of our 30-year loan at a rate of 4%, our interest payment averages out to $510 per month.
Then we also budget 8% of gross collected rents for vacancy and 16% of gross collected rents for repairs, maintenance, and capital expenditures.
That leaves us with a net operating income of $1,030 per month.
You can’t write off mortgage principal so our taxable income on this property before depreciation will likely be $12,360 per year.
After applying the depreciation expense to the P&L statement, our taxable income on this property will be $5,460 per year.
So instead of paying taxes on the $12,360 that made its way into our pocket, we will only pay taxes on $5,460.
That’s less than half of what we earned here.
At this point, you might be thinking to yourself, “But Sunny, you said Tax-FREE Income”
And you’re right. We didn’t wipe away all of our income using the standard straight-line depreciation method.
To that I say, But wait! There’s more!
Accelerated Depreciation Through Cost-Segregation
This brings me to the next concept to understand: Accelerating depreciation through a cost segregation study.
A cost segregation study is a process that looks at each element of a property, splits them into different categories, and allows you to benefit from an accelerated depreciation timeline for some of those building components.
So instead of depreciating the cost of the property evenly over the span of 27.5 years for residential property or 39 years for nonresidential property, you can hire an engineer to identify individual components of the property that have a shorter useful life (typically 5, 7, or 15 years).
Once the engineer identifies all the components that have a useful life of fewer than 20 years, you can then take 100% bonus depreciation in year one for all of those items.
Let me demonstrate this point with a bid I recently received to do a cost segregation study on my 4-unit mixed-use property.
Here’s what the report said.
If I take the standard depreciation on this property, I could expect to write off $267,750 over 27.5 years, which comes out to $9,700 per year.
If I perform a cost segregation study with 100% bonus depreciation, I can write off up to $47,332 in year one alone!
This is where things get really interesting.
Not only am I then going to be able to wipe out all of the income from this property, but I’m also going to be able to wipe out the passive income from my other properties.
This sounds pretty good, right?
Unfortunately, It’s not that simple.
This is where we encounter our first hurdle.
Passive Loss Limitations
There’s a catch to excessive passive losses.
The Tax Reform Act of 1986 added Section 469 to the US Tax Code, which says Passive Losses are capped at $25,000 for rental real estate activities.
Not only that, but rental real estate losses up to $25,000 may be deducted by an individual whose modified adjusted gross income is less than $100,000.
The $25,000 exception is phased out at the rate of $0.50 for every $1 of modified adjusted gross income over $100,000. So if your income exceeds $150,000, the $25,000 offset is not even allowed.
Why did Congress put this in place? The answer is kind of obvious. When wealthy people receive tax breaks, it’s typically a hot topic in the United States and they stepped in to plug the loophole.
Prior to 1986, high-income earners like doctors and lawyers sheltered their wages and business income with passive losses from real estate. A physician, for example, could earn $500k per year, buy a few rentals, and accelerate their depreciation. Their rentals would create a large enough loss that would offset or even eliminate the tax burden on their $500k of income.
But then in 1994, Congress made a slight adjustment to Section 469 of the tax code.
Real Estate Professional Status
Section 469 now allows a taxpayer qualifying as a real estate professional to deduct all rental real estate losses regardless of how high their Modified Adjusted Gross Income might be.
Here’s the issue: qualifying as a real estate professional is super tough, and it’s not an area of the Tax Code you should try to game.
To qualify as a real estate professional, a taxpayer must meet the following two criteria:
- More than half of your working hours throughout the year must be spent materially participating in real property trades or businesses.
- You must perform more than 750 hours of services during the taxable year in real property trades or businesses.
What does that mean? At least 51% of your time has to go towards materially participating in real property trades or business and the minimum commitment is 15 hours per week.
In other words, it will be difficult to qualify for real estate professional status if you work a part-time job and nearly impossible to qualify if you work a full-time job.
If you’re wondering what qualifies as real property trades or businesses, Sec. 469 of the tax code outlines 11 of them.
There’s Development, Redevelopment, Construction, Reconstruction, Acquisition, Conversion, Rentals, Operation, Management, Leasing, or Brokering.
If you are an entrepreneur involved in multiple real property trades or businesses, you may group them for purposes of meeting the hours requirement described in Section 469. For example, you can be a real estate agent with a property management business that does a few flips a year and count all of that time towards your 750 hours and as long as you spend more time doing that, than any non-real estate related trade or business, you should be able to qualify as a real estate professional for tax purposes.
In the case of a married couple filing jointly, one spouse must achieve both #1 and #2 on their own, meaning spouses cannot combine service hours for the purposes of achieving real estate professional status.
This is why you might see spouses of high-income earners often take a position as a real estate professional as either a realtor, broker, property manager, or otherwise. If the couple can acquire rental properties and take advantage of accelerated depreciation, they can effectively wipe out the high income of one partner through the real estate professional status of the other partner.
Oftentimes, the income tax savings for the higher-earning partner can be more than the gross income earned by the real estate professional partner.
Before moving on from this point, I want to be clear about material participation. You must be involved in the operations of the activity on a regular, continuous, and substantial basis.
Which brings me to our next hurdle.
Burden of Proof
The burden of proof is on you. Keeping a daily log of how you spend your time is probably your best bet if you want to be taxed as a real estate professional.
Even then, your time must be spent doing things that affect the day-to-day operations of your business. You can’t count research and education towards your 750 hours. Nor can you count travel time, analyzing deals, or reading investor reports.
Here are some examples of time that counts towards your 750 hours:
- Non-research hours spent acquiring property
- Showing the property to prospective tenants
- Writing and placing rental ads
- Taking tenant applications
- Running background checks and screening tenants
- Preparing and negotiating leases
- Cleaning the units after tenant move-out
- Doing repairs yourself
- Purchasing supplies and materials for use on the rentals
- Communicating with tenants, responding to their complaints
- Collecting rents
- Evicting tenants
Basically you have to self-manage your rentals.
OK so let’s say you qualify as a Real Estate Professional and you’re able to take accelerated bonus depreciation after performing a cost-segregation study. Congratulations! Your passive losses probably exceed your free cash flow so you’ve achieved tax-free income.
If it sounds too good to be true, it’s because it is. There’s one more hurdle to overcome.
? Depreciation Recapture
If you ever want to sell an investment property, you will have to pay a tax called Depreciation Recapture.
Depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis.
What does that mean?
Let’s go back to using my 4-unit mixed-use property as an example. I bought that property in March 2021 for $315,000. Let’s say I take bonus depreciation in year one for $47,000, my new adjusted cost basis will be $268,000. Let’s say at the beginning of year two, I find out the property could sell for $400,000 and I want to cash out.
My taxable gain wouldn’t be $400K minus my purchase price of $315K. My taxable gain would be $400K minus my new cost-basis of $268K.
So now I have to pay ordinary income taxes on a $133,000 gain, even though the property only went up in value by $85,000.
The reason for this is simple. Since depreciation of an asset can be used to deduct ordinary income, any gain from the disposal of the asset must be reported and taxed as ordinary income as well, rather than the more favorable long-term capital gains tax rate.
But don’t worry. There’s a work-around for this as well and we’re ending on a high note.
Refi Til You Die
If you want to avoid paying depreciation recapture tax, you have two options.
The first option is to Refi Til You Die.
Instead of selling the property, you can periodically perform a cash-out refinance to tap into any locked-up equity.
Every few years, as you pay down your mortgage and the property presumably increases in value, you can refinance your mortgage and pull some cash out to stuff your pockets.
So let’s say you’ve completely depreciated the property down to zero.
Instead of selling it and paying a bunch of ordinary income taxes on the gain, you can just hold the property until you die and let your kids sell it at a stepped-up basis. They will inherit the property at the current market value and sell it for the same, which means they won’t have to pay taxes on gains because there likely won’t be any.
1031 Exchange
The second option to avoid depreciation recapture tax is to perform a 1031 exchange.
A 1031 exchange is a swap of one investment property for another that allows capital gains and ordinary income taxes to be deferred.
For capital gains taxes to be deferred the properties being exchanged must be considered like-kind in the eyes of the IRS. If used correctly, there is no limit on how many times or how frequently you can do a 1031 exchange.
But beware, a 1031 exchange is not easy to execute. First of all, you can’t touch the money from the sale of one property before buying the next property. That means you need to send the money to a 1031 exchange intermediary.
Second of all, there are two timing rules you have to abide by.
The first is the 45-day rule. The 45-day rule says you have 45 days to identify a property you want to buy. If you don’t identify a new property to buy within 45 days, you will be taxed on your gain.
The second timing rule is the 180-day rule. The 180-day rule says you must close on the new property within 180 days of the sale of the old. If you don’t, you will be taxed on your gain.
Finally, to completely avoid paying any taxes on the sale of your old investment property, you can’t walk away with any cash or originate a smaller loan amount when buying the new property.
So let’s say you sell your old property for $1M and there was a loan for $750,000. In this scenario, you will send $250,000 to the intermediary.
You have to use all of that $250,000 towards your new property and be sure to get a new loan for more than $750,000. So you basically need to buy something that costs more than what you sold your last property for.
If you fail to do that, you will pay taxes on any cash you don’t use or any negative difference in the loan amount originated.
Closing Comments
At the end of the day, it’s not easy to put yourself in the position to generate tax-free income. It took me years to learn how to do it and sometimes I still feel like I don’t know what I’m doing. Despite how difficult it is to achieve, I think the benefits are worth it. Taxes are most people’s largest expense, especially high-income earners. It’s worth figuring out how to avoid them as long as you’re doing it in a way that the tax code supports.
Before I sign off, I want to do a quick recap of what we learned today.
First, familiarize yourself with the concept of depreciation.
Then, get a little more advanced and start reading up on accelerated depreciation through a cost-segregation study.
More likely than not, you’ll hit the speed bump of passive loss limitations.
If you like what you read in this blog, it might be worth switching careers in order to qualify as a real estate professional.
If you’re married and your spouse wants to work in real estate, that’s another way to achieve the benefits of unlimited passive losses.
Depreciation recapture tax is a toll you aren’t required to pay. You can either take local roads by adopting the strategy of periodically performing a cash-out refi til you die, or you can simply skip over the toll altogether by completing a 1031 exchange.
