Ep 114: Real estate tax 101 – How to defer taxes and save as a real estate investor

Mitchell Baldridge, my close friend, mentor, and CPA, joined the podcast for a live interview and Q&A. We talked about bonus depreciation, recapture, real estate professional status, short-term rentals, 1031 exchanges, and a ton more.

No matter where you put your money, you want to be a tax-efficient investor. In a case like mine, my main business is real estate, and I make money from real estate every year, but I also have income on the side from other businesses and ventures. As a real estate investor, I can use depreciation to minimize my tax liability. If I buy $50M of real estate a year, the standard approach is to deduct the value of that real estate (excluding land) over 39 years in equal increments. 

Straight-line depreciation is great, but we want to be as tax-efficient as possible, and that’s where cost segregation comes into play. A cost segregation study will take the building I just bought and blow it up into a diagram of every material component that makes up the building–windows, roofing, light fixtures, and so on. Each of these materials has its own useful life; some might be 5 years, others 10 years, and others 15+ years. Most of the components within the building will have a useful life below the 39-year lifespan the IRS assigns. With this cost segregation study, we’ll have a breakdown of the costs and useful life of every piece of the property, and then we’ll be able to create our own tax-efficient depreciation schedule.

Oftentimes you’ll find that 25-30% of the total property value is made up of components with a lifespan of under 15 years, and that’s where bonus depreciation comes into play because you’re able to depreciate the full value of those components in your first year of ownership. This gives you a huge year-one tax deduction, which shows up as a loss on paper and allows you to minimize your taxable income. You can even apply this for properties you bought in prior years but haven’t bonus depreciated yet.

In 2021 I made $2M of income and bought $50M of storage with $20M down. After a series of cost segregation studies, I was able to deduct $12.5M in depreciation that year, even though my income was only $2M! This even allowed me to carry forward $10.5M of depreciation to future years to offset my income for taxes. 

So why wouldn’t everybody do this? It helps that I’m a real estate professional, which allows me to offset my active income with passive losses. Unless you’re a real estate professional, which requires spending 750 hours a year and more than half of your working time focused on real estate, you can’t mix active income with passive losses like that for tax purposes; your real estate losses can offset other real estate income, but not your W-2 job.

Anybody who has bonus depreciated has probably been warned about recapture. When we buy property and take a loss on bonus depreciation, that means our basis drops as well. If you buy a building for $1M and take $300K in bonus depreciation, in the eyes of the IRS you’ve now only paid $700K for that building. If you were to sell it for $1M now, you would show a $300K profit and owe taxes on that amount. But recapture shouldn’t scare us because we’re still acting in a tax-efficient manner. By pushing tax down the road for years until sale, we’re effectively getting an interest-free loan from the government. If I buy a couple of properties a year and never sell, I create a cycle of avoiding taxes and am able to invest that money to grow rather than pay taxes immediately. It’s also going to be easier for me to pay taxes back to the government when I have a cash windfall after selling a property, rather than when I’m heavily investing and cash-constrained.

There are even ways around paying recapture taxes upon sale if you hold the property your entire life. Plenty of people make real estate investments throughout their lives while making tons of cash and paying little in tax. When they pass away, they pass their real estate down to their children, and their inheritors get a step-up in basis to fair market value immediately. Even if they were to sell the property as soon as possible, they wouldn’t have to pay tax because in the eyes of the IRS, there are no gains.

Beyond depreciation schedules, real estate investors are always finding ways to invest tax efficiently. The truth is that the government incentivizes this behavior in the tax code because they see real estate development and investment as positives for the economy. The government has designated certain areas that were having economic struggles as qualified opportunity zones, which incentivizes investors to develop or buy in these areas and substantially rehab the property. Once you substantially improve the property and hold it for 10 years, you don’t have to pay capital gains tax because it steps up in basis. You can even take capital gains that already exist in your portfolio and invest it in opportunity zones to avoid taxation.

Lastly, a popular tool used by real estate investors is the 1031 exchange. If you sold a $1M property for $3M, you’re typically in line for a huge tax bill. Through a 1031 exchange, you can earmark this money to buy another investment property with the gains, pushing your tax bill down the road further. There are rules around identifying and closing on the property and they allow for the same strategy of tax deferral. If you keep your money from Uncle Sam, you can invest it and grow it until you need to pay later on.

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I started the Sweaty Startup in December of 2018 because I believe the Shark Tank and Tech Crunch culture is ruining the real spirit of low-risk entrepreneurship.