Happy April! To many of us across the United States, this means it’s officially the beginning of Spring and we can begin to pack away our winter gear. For all of us across the country, it also means Uncle Sam is counting down the days until April 15th, when he unleashes his tax wrath on all of his beloved taxpayers.
This time of year always causes to remember the age old adage, that it’s not how much you make, but what you keep. If you’re a fan of Robert Kiyosaki, you know all about the cash flow quadrant. The acronym ESIB has a lot of depth to you and you fully understand the differences of each category. You know exactly what the transgression means to move from employee to self employed to investor to business owner. These are certainly topics that are rarely if ever covered in school.
When I read Tom Wheelwright’s book, Tax Free Wealth, I learned a lot about the tax code and the principles in which it was written. If you study the tax code, you notice that it is written as incentives for what the government wants you to do. We are incentivized to invest in commercial real estate because it creates jobs and places to do business. Taxpayers are incentivized to invest in multifamily real estate because it provides housing for the masses. Business owners are incentivized because they are providing employment and economic growth. It’s all in the code, just do your research (or read Tom’s book)!
In real estate, there are three specific ways that you and I are incentivized to invest. Let’s discuss those from a high level to earn you three stars in your basic real estate tax benefits education.
Depreciation - Every real estate investor learns to love depreciation, which is essentially a reduction in taxable income due to “wear and tear” on the subject property. For a commercial property, the government allows you to depreciate your property over 39 years. For a residential asset (which includes multifamily), the property is depreciated by 27.5 years. (BONUS:) In addition to this, savvy investors hire professional consultants and engineers to conduct what’s called cost segregation to accelerate their depreciation to capture paper losses now rather than wait for that entire depreciation schedule. The reason for seeking an accelerated depreciation essentially is to capture the full benefit now, rather than wait (ie. time value of money). (BONUS #2:) The other beautiful part of this is that while many other asset classes (such as automobiles) truly do depreciate in value, usually real estate simultaneously appreciates in value historically.
Interest - For investors who utilize leverage (ie. debt) on their properties to enhance their cash on cash returns, they enjoy other tax reducing benefits as well. Interest on debt is generally a tax reduction item, although the new tax law has had some changes. Not only is the lender helping you spread your risk, but he is also giving you another olive branch towards a tax reduction.
Passive Income vs. Earned Income - Most of us have experienced times where we were surprised at how much tax is due on our primary occupation income. If you’re in a W2 job, you may not even realize how much of your check is withheld each pay period to pay taxes. If you’re self employed, you may even be more exposed depending on your structure. Depending on the state, many earned income positions pay the highest tax rates, at times exceeding 40-50% of their income depending on the tax bracket. In real estate investing, cash flow is taxed at a lower rate, another incentive the government is providing to encourage this activity. Additionally, real estate professionals receive additional attractive treatment.
Certainly consult with your CPA on all tax related matters, and this is no exception. I don’t play a CPA in real life, and certainly don’t on the internet. However, it’s safe to say that investing in real estate is one of the very best ways to receive the available incentives from the government.
At the end of the day, we have to play the cards we were dealt. When it comes to taxes, behave the way the IRS wants you to behave and he will let you keep more of what you earn!