So you not only want to make money in real estate but you want to keep it all too? Jeez, it’s always more, more, more with you. Well, we like your moxie. So here are 5 ways to keep what you make with real estate investing (and perhaps a wee bit more).
- Pocket the cash flow tax-free
- Sell the House Tax-Free
- Get Your Equity Tax-Free
- Pocket Profits from Selling Real Estate Tax-Free
- Never Ever Never Pay Taxes from Selling Real Estate, Ever
Let’s say you buy a great house for $100,000, rent it out, and you earn profits from your investment in year 1 of $2000. How much will you pay in taxes at the end of the year? Zero. U.S. tax laws provide for a depreciation deduction for real estate that will be offset against income from the property.
In our example, our purchase price will be allocated to the house (say, about 80%) and a portion to the land. The portion allocated to the house, $80,000 in our example, will be depreciated for tax purposes over 27.5 years, resulting in a deduction of $2,909.09 per year. So, our taxable income from our example is $2000 minus $2909.09 which equals zero. Zero income, zero taxes.
Wait, we just ran these numbers on our financial calculators and found out that $2000 minus $2909.09 does not equal zero. It equals $-909.09. Well, if you haven’t quit your day job (and you make less than $100,000 per year), then you can deduct the $-909.09 from your ordinary income (up to $25,000). Bonus! (That’s the “wee bit more”).
Let’s say in year 2 you sell that great house for $120,000 (we’ll make that number net of selling costs, so I don’t have to open any spreadsheets). Congratulations, you just made $20,000. How much will you pay in taxes? Zero. Tax laws allow you to buy another property (or two, for that matter) and defer paying taxes on profits from the one you sold, known as a Like-Kind or 1031 Exchange.
True, you can’t go out and spend the cash from Property No. 1, but is that the plan anyway? And if you plow those profits back into good real estate investments, it certainly should increase your cash flow on the next property.
So, now you have Property No. 2. You bought this one with the cash from the sale of Property No. 1, which included any down payment, plus profits, plus the reduction in the mortgage amount from your regular mortgage payment. All told, let’s say that amounts to $30,000 in cash reinvested in Property No. 2.
Let’s assume that you bought Property No. 2 for $120,000. You made a good buy and it’s worth $150,000. Since you had $30,000 cash, your mortgage is $90,000. So, you have $60,000 in equity in Property No. 2. You pause here to look contentedly at this line item on your financial statement.
Snapping out of it, you decide you want to get some of that equity. Well, you can take a trip to the bank and borrow against the equity of Property No. 2. We’ll assume your bank will loan up to 75% loan-to-value. Seventy-five percent of $150,000 (the value of Property No. 2) is $112,500. Since you owe $90,000 on your first mortgage to purchase Property No. 2, your bank hands you $22,500 in cash. How much will you pay in taxes on this tidy sum? Zero. Tax laws don’t treat borrowed funds as income, even though borrowing in this example allows you to get access to profits from your wise real estate investments.
Let’s jump back to Property No. 1. Instead of selling it and buying Property No. 2, you decide to, well, just keep your money. You’ll recall you made $20,000 on Property No. 1. If you’ve kept Property No. 1 for more than a year, you’ll pay taxes on your capital gain of only 15% or $3000. I know, you’ll point out that $3000 is not tax-free, and technically (as well as non-technically) you’re right. But consider this—on the income from your day job, you may be paying income taxes at somewhere around 28%, which means that you would pay the same $3000 in taxes, but on only $10,714 in income. From your wise real estate investment, you’ve incurred that same $3000 in tax liability on $20,000. Comparing mangoes to mangoes, that’s like getting $9286 ($20,000 minus $10,714) from your real estate investment tax free.
So, you’re wondering what the catch is. And indeed, the catch with many tax savings now is that you have to pay for them later. For example, that depreciation up in item number one that you’ve enjoyed all these years may result in “depreciation recapture”—a tax rate of 25% when you sell your property. Or that tax-free exchange you did in item number two may result in paying taxes on the profits from Property No. 1 when you sell Property No. 2.
So you’re saying you not only want to make money in real estate but you want to keep it all too—forever? Well, your moxie’s starting to get a little annoying. But OK, fine. Die. You don’t have to get around to it anytime soon. 50 or 60 years will be fine—whenever you find the time. Tax laws provide that your lucky heirs will receive a “stepped-up” basis in your assets when you croak. This means that your lucky heirs will receive your real estate empire and for tax purposes be treated as if they bought it from you at market value at the time of your demise. In other words, they can immediately sell the property and pocket the cash tax free.
So, all told, your strategy looks something like this. Let’s say, from our example, you have Property No. 1 for a few years, you take the income tax-free after your depreciation deduction, then you sell it and buy Property No. 2 in a tax-free exchange, keeping the profits tax-free. You enjoy the higher cash flow from Property No. 2 for awhile, then sell it, and buy more real estate, then do it again, and so on and quit your day job, then buy a yacht, write your memoir, reflect on life, then die. Lucky Heirs sell all of your properties and pocket the cash tax free.
Keep in mind a couple of final notes on tax aspects of real estate investing. Never make an investment decision based on tax consequences. In short, it leads to bad investment decisions. Instead, make your investing decisions based on the merits of an investment. Just execute those decisions with tax consequences in mind. This is where a tax advisor certainly can come in handy. You probably should have one anyway at the outset of a real estate investment strategy. Also (and we know this one’s a shocker), tax laws change. This means that any tax strategy should allow for the possibility that Congress will muck around with the laws next year.
One final thing, because item number 5 is so replete with material, we would like to solicit your thoughts for names for this tax strategy. We’ve come up with three so far:
- “Swap ’till you drop” (We borrowed this one)
- “Buy the house, then buy the farm” (Rob’s)
- “The Charlton Heston Gambit”–a/k/a “You can have my money when you pry it from my cold, dead hands” (Mike’s)
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