Today, we would like to talk about one the main advantages of real estate investing: tax benefits. Full disclosure: I am not a CPA so please consult with your own CPA when making investment decisions.
Everyone says real estate provides incredible tax benefits. Is it really true? If so, what are they?
Real estate investments often generate a paper loss for tax purposes, as a result of depreciation. The “useful life” of residential rental property is 27.5 years, and annual depreciation expense of investment property often produces net loss for the investor. And let me tell you, property depreciation is an investor’s best friend!
So what does it mean for you?
- You can shelter income from your real estate investments with depreciation
- If your adjusted gross income is less than $150K a year, you can deductup to $25K of your “passive losses” on your tax returns, assuming you actively participate in the management of the property
- If your adjusted gross income is more than $150K a year, you generally are not permitted to report a loss on your tax return. It does NOT mean you “lose” those losses, they just get “suspended” and can be carried over and be used in future years to offset passive income from other investments
- If you qualify as a “Real Estate Professional” AND materially participate in rental activity, then you CAN deduct your real estate losses against ordinary income, such as W2 income. This, my friends, is what I call“GOD’S GIFT” for at least some of you. Why? By way of example, if you are married and you generate W2 income and your spouse qualifies as a Real Estate Professional and materially participates in rental activity, then you CAN deduct ALL of those losses against your W2 income. How awesome is that?! You are welcome!
- You can generate very substantial losses for tax purposes by using a so-called “bonus depreciation” which allows you to drastically boost the depreciation deductions in Year 1 of ownership. The idea is simple. When you buy multifamily real estate, the purchase price is allocated to land (not depreciable asset) and real property (depreciated over 27.5 years). If you do something called “cost segregation study” (hire a professional to allocate specific components of the purchase price for you) – the study will allow you to allocate a portion of the purchase price to “personal property” (can be electrical wire, window coverings, roofs, etc) with the useful life of 5, 7, 15 years. ALL of the value that allocated to such personal property can be expensed in Year 1!! Practically, it can mean that you invest $100K in a project and you immediately, the same year, generate $80K paper loss!
For those of you who were wondering:
- No, you cannot use your passive real estate losses to offset Portfolio income (such as income from stocks and bonds)
- How do you qualify as a Real Estate Professional? There are two main criteria that you must meet:
- More than one-half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
- What does it mean to “materially participate” in an activity? You need to satisfy one of the material participation tests as prescribed by IRS. You can find those on page 5 of this doc: https://www.irs.gov/pub/irs-pdf/p925.pdf
What many multifamily investors do, they start to invest in many multifamily (or other commercial real estate) projects and use losses generated by one investment to offset gains – such as capital gains at sale, for instance – of another project. For example, you can sell your LP interest in one deal and then invest in another deal, the same year, that would generate paper losses from depreciation for you (by doing cost segregation study). This way, you can “shelter” your capital gains.
Now you have some background on how real estate can help you build wealth and reduce your tax liability. Whatever you do next, please consult with your favorite CPA!