All Cash, No Tax

Most great businesses end up as real estate businesses, and there's no mistaking why. If you start a great business that kicks off cash, and buy a bunch of real estate as a pro, you can end up with ALL CASH and NO TAX.

There are stories of wealthy real estate folks in every town who pay ‘practically no tax’. It’s true for them — and it can be true for you.

How the Heck Does This Work??

This tax strategy can work for business owners as well as high-income W-2 employees, and it’s centered around generating passive real estate losses using leverage and depreciation. Let's dive in!

Real estate professionals use an 'paper loss' out there called depreciation.

Buying real estate is different than other business expenses. It's not like buying a stapler for your desk, or even a new Macbook for business use that you can write off the year of purchase.

When buying a property, the expenditure must capitalized, and the depreciation is cast out over 27.5 or 39 years depending on the property type.

An Opportunity for Those in the Know

Real estate has always been a great business to lower your taxes, but recently it has been supercharged. In 2017 the Tax Cuts and Jobs Act was passed, and 2 major allowances were made:

1. Bonus depreciation was extended to 100% for 2017 - 2022. This means that you can take a 100% deduction for all 5, 7 and 15 year property (more on that later). Bonus is stepped down to 80% for 2023, and 60%, 40%, 20% and ultimately 0 for years 2024-2027 respectively.
2. Bonus depreciation is allowed on used property. This is YUGE. Meaning you can take a 30 year storage facility that is new to you and bonus all eligible property.

One crazy thing about bonus depreciation - it can take your income to less than zero and create losses going forward. This is massive.

Why Isn't Everyone Doing This?

Everyone should do this, right? But not everyone can.

Real estate losses are passive in nature, and there's a rule in the tax code that says a taxpayer cannot offset active income with passive losses unless they are a Real Estate Pro. You cannot use the losses from your real estate to offset your ordinary income from your business or job.

In order to qualify for that sweet tax deduction, you’ll need to become a real estate pro — which unfortunately isn’t as simple as passing the real estate exam.

The IRS defines a real estate pro as a person who both:

• Spends more than 750 hours in real property business. (11 types of activities)
• Spends more than 1/2 their time in businesses where the taxpayer materially participates
  • In order to be materially participating, you must be involved in the operations of the activity on a regular, continuous, and substantial basis.

Once you meet the requirements of the pro test, the material participation tends to come along for the ride, as you are able to aggregate your participation.

What If I Can't (or Won't!) Become a Pro?

There are a few other options for you:

1. It's been said there is no better marriage than a high W-2 earner and a Real Estate Pro spouse. If you have a spouse that is already interested in real estate or willing to spend the 750 hours to learn and work, that can be a tax marriage made in heaven!
2. Buy real estate for your business - Tons of service pros (Doctor's, Lawyers, CPAs and the like), own their own buildings. If you are using a building as an office, warehouse, or meeting space for your business, you can take business losses against ordinary income without being a pro.
3. The STR Loophole - Piggybacking off of #2, folks who run short term rental businesses are allowed to deduct their losses as well. In short, an AirBnB is closer to a Hotel (that happens to own their own real estate) than a long term passive rental. You still must meet material participation requirements!

So How Does the Rubber Meet the Road?

As a real estate investor, you can use a engineering study called a Cost Segregation Report to break down the property into smaller components, thus allowing the depreciation to be expedited. By doing this, you will be able to accelerate years off property losses to TODAY.

There are Five Factors to consider when considering how much depreciation your property might deliver relative to your investment.

By completing a cost seg and utilizing bonus depreciation, you are able to create a large tax deferral in the year you lay out equity to buy a property. This creates a Deferred Tax Liability vehicle similar to a retirement account, but with all the optionality of real estate.

Caveat Emptor -

1. You are in the deep end of tax planning here — and presumably making a large investment. I am a CPA, but (perhaps) not your CPA. Get qualified assistance before making an investment decision.
2. When taking large losses against W-2 income, you should be mindful of the Excess Business Loss rules.
3. Taking bonus depreciation early is a tax deferral, not a tax savings. You have a lot of options on how to manage recapture depreciation upon sale, but depreciation exists, and so does recapture! There’s no free lunch in the IRS code.
4. There are a bunch of other ways you can use cost seg + bonus to tax plan - but depreciation still exists, and debt must be repaid. Never let leverage come crashing back against you.

Given everything that was said today, real estate can be a wonderful source to defer income to retirement (or even death)

Until next time,

​
Mitchell

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