How vital is tax management for investing in property? Which tax strategies do successful real estate investors use to make substantially higher profits?
Imagine ordering a pastrami sandwich in a deli and getting served just a pile of meat. Although going breadless may save you some calories, it kind of defeats the whole concept of a sandwich. Similarly, while buying and managing the buildings is the meat of the business, skipping tax planning for real estate is almost missing the point.
There are infinite loopholes in the tax code, but real property offers probably the best tax shelter combination of any industry, which partially explains why so many have made their fortunes in real estate. Most real estate professionals pay little if any tax, which enables them to grow their incomes and portfolios much more quickly. It is important to either self-educate on the following tax strategies or find an involved accountant to guide you.
“Fake” losses equals real savings
Incomes are heavily taxed, and professionals can find themselves handing over as much as 50% of their salaries to the government. Real estate professionals, however, receive a significant depreciation deduction which lowers their annual taxable income. A depreciation deduction accounts for how much a business asset, such as property, machinery, or a vehicle, gets used up or becomes obsolete over time.
Depreciation is considered a loss to the business and lowers taxable income dollar for dollar. While this makes perfect sense for things that really go down in value over time, well-located real estate often increases in value much more than it depreciates. Despite this, those who make most of their money from real estate can claim this supposed loss and avoid paying tax on their incomes. Depreciation can shelter much or even all of the properties’ continuous distributions and is calculated and deducted automatically.
Save a lot with a little patience
When it comes to taking out real estate’s capital gains (profits gained as assets increase in value), there are multiple ways to do so while paying little or even no tax. First, any investment held more than a year gets taxed at a much lower rate (the long-term capital gains rate) versus ordinary income. Where doctors or lawyers can easily be hitting 50% tax rates on their salaries to Uncle Sam, you can pay less than half of that on profits from selling a property by merely holding onto it for more than 12 months.
It therefore bothered me when a friend mentioned that he’d paid full tax rates on a property flip he’d done. He purchased a house for $100,000, and after investing about $50,000 to improve it, had sold it nine months later for $250,000. By simply structuring the contract to close three months later (and renting it to the buyer in the meantime), the flipper could have easily saved $15,000 in taxes. What he didn’t know definitely hurt him!
However, lowering your tax bill by 50% is just the beginning for a real estate professional. It’s pretty easy to never pay any capital gains tax on your buildings’ increases in value by refinancing, then exchanging, and finally stepping up. Let’s explain that. As property goes up in value, owners can borrow an equivalent amount tax-free and use that money to buy more buildings or however they please. While cash gained through taking on debt is always tax-free, real estate debt is by far the easiest to come by, and on very advantageous terms. As long as you like the building and the income can support it, you can keep refinancing, taking out more and more profits tax-free.
If you find a different property with more potential, you can even sell your current building and pay no tax on your gains as long as you do it within a structure called a 1031 exchange. The concept behind the exchange rules is that although you’re supposed to pay tax on gains upon the sale of a property, if you never actually touch the profits, it’s just a swap instead of a sale. The way a 1031 exchange works is that you sell one property, but the earnings from the closing go directly in a third party’s escrow account to be held until you identify the different property to swap into. The third party then sends the cash directly to the seller of the exchange property. As long as all the escrowed money goes into the new property, the swap is complete, and no taxes are owed unless a sale occurs further down the line.
Till you drop
1031 exchanges can go on indefinitely, with taxes being deferred for life. Most real estate professionals will only sell a property when they know they can exchange for a larger and better one, always rolling over their gains and taking out cash only via a tax-free refinance. While you may imagine this cycle has to end at some point, this is not the case. The final step in the tax avoidance process is a step-up. This ultimate gift provides inheritors possession of the deceased’s property with all the deferred gains taxes owed along the way wiped out at no cost! The old saying that taxes and death are inevitable is only partially true for the savvy real estate professional.
Don’t lose the ikar for the tofel
You wouldn’t buy an empty sandwich just because it’s discounted, but many real estate investors do just that because of the pressures associated with 1031 exchange’s strict rules. There are minimal windows of time allowed for identifying and closing on the swap properties, and some investors lose sight of the bigger picture when under the gun. Although tax savings can enhance real estate investment significantly, grabbing the bread (a tax deferral) while ignoring the pastrami (getting the right property at a reasonable price) will leave you frustrated and hungry.