In the United States, high-income earners often face a harsh reality: paying up to 40-50% of their income in taxes.

This picture changes when we explore the world of real estate investing and its crown jewel, depreciation—a deduction that reduces tax burden. Depreciation is the most powerful tool in the IRS code.

If you aren’t familiar with the term, think of depreciation as the decrease in the value of an asset over time. One example of depreciation is the value of your car decreasing as soon as you drive it off the lot. Real estate is one type of investment that benefits from the power of depreciation. The value of real estate increases (appreciates) over time but the tax basis is decreasing as the property depreciates. Additionally, as you earn cash returns in the form of distributions, the tax on the amount you receive is deferred, meaning your tax on those earnings are offset by the paper losses from depreciation until it’s sold. The beauty of investing in assets like 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.

 

The High Cost of Earned Income

When you earn money from your job or a business you’re actively involved in, the tax code takes a big bite. Federal taxes can be as high as 37%, then there are state taxes that can go up to 13.3%, along with FICA (that’s the Social Security and Medicare tax), or if you’re self-employed, even more taxes. After all that, you might end up losing nearly half of what you earn to taxes.

 

Real Estate: The Game Changer

Real estate investing introduces depreciation, the powerful tool that can make your taxable rental income vanish on paper. For example, $100,000 in real estate income, after expenses, could leave you with $55,000 in net income. In normal businesses, a significant portion of this would go to taxes. However, with depreciation, you might show a tax loss despite having $55,000 in cash flow—effectively reducing your tax obligation to zero on that income.

 

Impact on Your Effective Tax Rate

Let’s imagine someone in New York City who makes roughly $500,000 a year. Normally, they’d pay about 42.86% of that salary in taxes. If they add $55,000 to those earnings, their tax rate could go up to 43.38%. However, if they get that $55,000 from rental income and use depreciation to lower their taxable income, their effective tax rate would drop to 38.61%. And if they have $100,000 in passive income from real estate, their tax rate could fall even more, to 35.71%.

 

Conclusion

Passive income can help reduce your effective tax rate due to the powerful tool of depreciation. Being aware of this strategy can help drive strategic investment decisions and a more efficient path to financial growth.