Wealth Formula Podcast
574: How Real Estate Investors Pay Less Tax
Whether or not you currently invest in real estate, you've probably heard people talk about the enormous tax advantages that come with it. You hear about people like Donald Trump paying no taxes. You hear people complain that wealthy real estate investors somehow play by a different set of rules. Well, actually they do. But what exactly are they doing? A huge part of the answer comes down to one seemingly magical word: depreciation. Here's what's strange about depreciation. We all know that real estate tends to appreciate over time. But for tax purposes, the IRS generally treats the building as though it is wearing out and losing value. For residential real estate, that building is normally depreciated over 27½ years. So, very simply, if you buy a rental property, you can deduct a little bit of it as lost value every year for 27½ years. But this is where something called a cost segregation study comes in. A cost segregation study is essentially an engineering analysis that looks inside the building and says: Not everything we bought here is really a 27½-year building. Some components may qualify as personal property with much shorter depreciation schedules—things like certain flooring, cabinetry, appliances, electrical components serving specific equipment, and other items. Other components, such as certain landscaping, parking areas, fencing and site improvements, may qualify for 15-year treatment. Instead of depreciating everything over 27½ years, you're identifying portions that can potentially be depreciated much faster. That's great but it even gets better: bonus depreciation. Bonus depreciation can allow qualifying shorter-lived depreciation schedules identified through a cost segregation study to be deducted much more rapidly—including, under current law, 100% in the year it is placed in service for qualifying property. Now think about what that can mean. In my own experience with multifamily properties, I've often seen somewhere around 30% of the depreciable basis reclassified into shorter-lived categories. The actual number obviously varies tremendously from property to property. But consider the math. If you're putting 20% or 30% down on a property and a cost segregation study generates a first-year depreciation deduction of a similar magnitude relative to the purchase price, you may effectively generate a tax deduction comparable to much of the cash you initially invested. That's an extraordinary concept. And importantly, depreciation doesn't necessarily stop there. You still have depreciation deductions associated with the remaining basis in the property in subsequent years to offset rental income. But here's the catch. Having a big depreciation deduction doesn't necessarily mean you can offset it against your salary or other active income. For most investors, rental real estate losses are considered passive losses. Generally, those losses can offset passive income, but they can't simply be used to wipe out W-2 income. So if you are an owner in a surgicenter or dialysis center, you can potentially offset some of that income if it is passive—but not your W2 paycheck. That's where something called the "real estate professional status" becomes incredibly important. Under the tax code, qualifying as a real estate professional generally requires spending more than 750 hours during the year in real-property trades or businesses in which you materially participate, and spending more than half of your total working time in those real-property trades or businesses. There are additional material-participation rules, so this isn't simply a box you check because you own some rental properties. But when the requirements are met, rental real estate depreciation losses can potentially become nonpassive and therefore usable against other types of income. And here's where this gets really interesting for high-income professionals. If a married couple files jointly, only one spouse needs to satisfy the real estate professional tests. Imagine a physician earning significant W-2 income whose spouse legitimately qualifies as a real estate professional, and the couple meets the applicable material-participation requirements. Depreciation losses from their real estate portfolio may potentially be used against that physician's W-2 income. That can be a massive tax-planning opportunity. In some households, the tax savings can be significant enough that it may even be worth considering whether the lower-earning spouse should devote substantially more time to managing the family's real estate investments instead of working another job. Now, if that's not going to work for you, there's another strategy I've brought up before that you should understand and that may allow someone who isn't a real estate professional to use real-estate losses against active income: the so-called short-term rental loophole. The simplified version is this: under certain circumstances—most notably when the average guest stay is seven days or less—a short-term rental isn't treated as a "rental activity" under the normal passive-activity rules. If you then materially participate in operating that property, losses generated through depreciation and cost segregation may potentially be treated as nonpassive. That means someone with a full-time job may potentially generate depreciation from a qualifying short-term rental and use those losses against active income without qualifying as a real estate professional. Now remember, none of what I am telling you should be considered tax advice. There are very specific rules around all of this, and this is absolutely an area where you want a good CPA who understands real estate taxation. But the larger point is simple: investing in real estate can have some enormous tax advantages that are just not available anywhere else. And depending on your income and circumstances, we're not talking about saving a few thousand dollars. These strategies can potentially have a life-changing impact on your after-tax wealth. So in this week's episode, we're going to get into the nuts and bolts of the engine that makes this all happen: the cost segregation analysis.
