The IRS was recently infused with $80 billion in funding to spend over the next decade via the Inflation Reduction Act so we thought now was a good time to share some of the completely legal ways to reduce your tax burden through real estate investments. When you consider that taxes are the largest expense we bear as Americans, it becomes clear the fastest way to put more money back into your pocket is through reducing your tax bill. The beauty of investing in real estate is that your investments lower your tax obligation rather than increase it, unlike some other investment vehicles, such as stocks and mutual funds. Any time you’re investing your hard-earned money, you should do your due diligence to gain a working knowledge about how you may be taxed as a result of your investment and explore the best strategies to decrease your tax bill. Unfortunately, not all CPAs are created equal, and you should ensure you are working with one that is familiar with real estate investments and understands the importance of tax planning. In this article, we’ve highlighted few of our favorite strategies to reduce your tax burden using real estate investments.
Depreciation Benefits through Real Estate Syndication Investments
When investing in real estate syndications, depreciation benefits you, as the investor, because as you earn cash-on-cash returns, the tax on the amount you receive is deferred. This means you are not required to pay taxes on the earnings from the asset until it’s sold, unlike other investment vehicles like stocks and mutual fund earnings. You also have the option to elect bonus depreciation, if you choose, which can even further maximize your tax benefit.
Cost segregation amps up the tax advantages even further. The 2017 Tax Cuts & Jobs Act allowed for the depreciation of some components of an investment to be accelerated and realized in year 1 by utilizing a cost segregation study (bonus depreciation). This means real estate investors can deduct 100% of 5, 7, and 15 year property all in the first year. This is what makes cost segregations studies so powerful and can lead to significant tax savings. Cost segregation speeds up depreciation benefits, so investors can have further tax advantages within the investment hold period. Maintaining a portion of your investment portfolio with these type of tax benefits is key to building wealth.
Although the depreciation benefits are realized during the the property’s hold period, there is a depreciation recapture at the time of sale. However, real estate investors can continue to defer paying tax through a powerful tax strategy called a 1031 exchange. 1031 exchanges allow you to defer capital gains on investments by trading one property for another. The process involves selling one investment and taking the proceeds to buy another qualified asset. After the exchange, the investment continues to grow tax deferred, enabling you to build wealth faster. Some investors use the strategy to delay taxation until retirement, while others put off paying taxes permanently, giving heirs a tax-free inheritance. The IRS does not limit the frequency or number of times you can use a 1031 exchange.
These exchanges are subject to several rules, but at a high-level, the following conditions must be met to qualify for a 1031 exchange.
- Acquiring a new asset of comparable or greater value than the property being sold
- Both properties must be like-kind
- Within 45 days a replacement property must be identified
- Within 180 days a replacement property must be purchased
Here at One Street Capital we allow investors to 1031 their proceeds from deals they invest in with us into subsequent deals offered. We also look for opportunities to allow investors to 1031 their proceeds into our deals using outside funds from deals that we were not involved with.
offset capital Gains with Losses
Timing your investments so that capital gains from real estate are offset by losses is what makes tax planning so critical to building wealth. The key is to manage your investments so you have both passive income coming in and passive losses from depreciation. This is where working with a good accountant is key. As I mentioned, not all CPAs are created equal. Unfortunately, we’ve had some investors tell us their CPA said passive losses cannot offset gains on the sale of property. This is simply incorrect. You want to ensure you are working with someone who understands real estate investing and will work with you on tax strategy and planning.
As real estate investors, we regularly use strategies that utilize bonus depreciation from new syndication investments to offset capital gains from the sale of investments in properties. This is yet another way to minimize the tax impact of your gains if you elect not to do a 1031 exchange.
REAL ESTATE PROFESSIONAL STATUS (REPS)
Real Estate Professional Status (REPS) allows couples to divide and conquer – one high-income earning spouse gets to lean into their profession while the other claims the REPS designation and assumes responsibility for managing all real estate investments’ day-to-day activities, qualifying the couple for significant tax benefits.
Amazing, right? Another cool tidbit about REPS is that there’s no test to pass, formal certification to achieve, or degree you need to earn.
Anyone can claim real estate professional status (REPS) as long as
- More than half the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
- To read more about how you can achieve REPS, you can check out our article here.
By investing in real estate, either actively or passively, you can qualify for significant tax advantages. Unlike the capital gains treatment from your stock portfolio, you can use the deductions earned from real estate investments to offset your other income and ultimately greatly decrease your tax bill each year. In order to build wealth, it’s not enough to earn income, you also have to know what strategies can best help you maximize the tax benefits available to you. Investing in real estate syndications gives regular people the chance to build wealth quickly and sustainably, while also mitigating risk. The more money you retain today, the more you can reinvest into other investments or your own business.