Christian Osgood breaks down how seller financing and the IRS's capital-account rule can trap hundreds of thousands in depreciation deductions. A zero-down deal might generate cost-segregation benefits you can't claim, but borrowing part of the purchase price counts as equity and unlocks the full deduction.
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We did not know this. We thought, oh, we bought zero down, but we get these crazy tax benefits. This is amazing. Well, I wasn't able to use 'em in 2022 or 2023. When it comes to investing in real estate, taxes are a multi-hundred thousand dollar burden that you really have to manage well. We learned this the hard way in year 1 and 2 buying with creative finance, and we learned there were some things we didn't know we didn't know that did cost multiple six figures. How can you avoid them? What does it mean as a tax implication for a buyer and a seller using seller financing? I'm gonna share that in this video. Right now. Welcome back to the channel. I'm Christian Osgood. This is Multifamily Strategy, and this is going to be one of the most valuable videos I've ever shared on tax strategy. Now, before you go and skip and go, oh my gosh, taxes, I don't want to hear about taxes, this is something that's going to save you a ton of money if you are looking at starting with no to low money or otherwise using creative finance in your portfolio. I'm going to talk about the strategy for the buyer and the seller, starting with the basics of the seller end. So I'm gonna use a hypothetical situation. Let's say you're buying a million-dollar property, 10% down. If you are a seller of real estate, you are not taxed on money you haven't received yet, which is really good because imagine someone writes a note, you get taxed on the sale of the property, but you only receive the 10% down. So I give you $100,000 and I default. You never received the money, but you had a tax burden. That wouldn't make any sense. So as a seller of a piece of real estate in this hypothetical model, I put $100,000 down. There's a note made for $900,000. We'll call it a 10-year note. It's interest only, so I'm making interest-only payments, but I'm not paying down the principal. You are not receiving a brand new capital gain for all of that principal in the property. Now, work with your CPA on this if you're the seller. And if you're buying, let your seller know you're not a tax expert. Like, if they ask you specific tax questions, It's gonna be unique to their situation, but on a 101 level, they're not gonna be taxed on capital gains they have not yet received. This is a way to, one, spread that gain over multiple years. Two, you're not getting taxed all upfront. Three, they can earn interest over time, which is gonna be taxed at the standard rate that interest would be taxed at. On a tax management standpoint, it could make a ton of sense, especially if a seller doesn't need cash right now, to spread out their burden over multiple years, work with their CPA, plan their own tax strategy. It is a fantastic way for them to manage that. Now, as a buyer, there's some very unique pitfalls that you need to be aware of. One, you can do whatever you want on your taxes as far as a cost seg, straight-line depreciation, but there's a lot of write-offs that you get that are unique to real estate where you can take a lot of depreciation, which is a direct write-off, and essentially pay no to low taxes on your income from your properties. Where can this go sideways? Well, in seller financing, you could do deals, especially if you're raising private capital, where you have none of your own money in the deal. So while you do get these amazing write-offs, and as a real estate professional, can even go against your active income, you may not be able to claim any of those. We learned this the hard way. You can only claim the money that you have in the deal, which is called your capital account. If I bought a deal $0, now that account will grow as if I inject capital or as I receive rents. I do have a growing capital account that I can write off against.. But if I did a cost segregation study and let's say I have a $100,000 tax benefit, I want to go claim— this happened to me. Well, I wasn't able to take that tax benefit because I didn't have $100,000 of equity built in that deal as far as internal equity. Now externally, I had hundreds of thousands of dollars of equity, but I didn't have enough cash invested into the account to actually depreciate all that money. So while I was relying on one or two properties' cost segregation studies to offset a sale of another property and other active income, you come to learn that I get to claim it and I can use it in a future tax year, but I'm still gonna have to pay taxes in that tax year for that property. How would we avoid this? Put in money when you buy a property. Well, if you don't have any money, that might not be super helpful, right? Well, there's a way to do this. If I have a real estate investor who's going to come into a deal and say they're going to fund 100% of the deal, we're going to be 50/50 partners. We'll just keep this as a super easy example. If they lend me half the cash and the other half of their cash goes towards their equity, I've borrowed the money and now I've put it into the deal. So now 50% of my money in the deal, which exactly matches my equity in the deal, which the IRS loves, by the way, capital accounts are balanced. I have an investment in there, that 50% of money that I borrowed from someone else does work as my write-off. I can now claim my portion of the depreciation in proportion to my equity maximized at the amount of cash that I've put in. That is an easy workaround. Had I known this, I would have structured more deals with either a blended amount of debt or it's just entirely as debt so I can take all of the associated tax benefits. Borrow with debt, you can claim it. If you're doing equity only and someone buys in and you have misbalanced capital accounts, which means they have all the money in, But your equity does not match the amount of money that is in under your name. You can't just go magically claim benefits on their cash. We did not know this. We thought, oh, we bought zero down, but we get these crazy tax benefits. This is amazing. Well, I wasn't able to use them in 2022 or 2023. Now that I've done a whole bunch of renovations where I have injected my money into those properties, 2024, I now get those benefits. If you have not heard this before, you're starting in real estate, you're like, oh, I'm going to go zero down. Just know that if you actually do make a lot of money or you have a large exit from a property or a large injection of capital that comes out of a property, your tax burden may be much higher than you think because you might not be able to utilize the write-offs that you get from your very strategy. If you've heard of cost segregation studies or any other way to modify your depreciation, just know it may or may not apply to you. That's why it's really important to, one, buy a property first, like get into the game. But very quickly, once you've bought your first property, you really should be talking to a CPA about how you're going to manage it and the actual structure of each of your deals. Because at the end of the day, build phase is when you need the most cash. And if you're building your portfolio, you do not want to be giving away a bunch of taxes to the government up front. That's why we do 1031s. That's why we delay taxes as much as we can. Because you're going to build up, and out of all the cash flow, you can pay for more taxes later, which is why we depreciate our properties, a lot of them, on an accelerated schedule. If you want to learn more about cost segregation studies or other strategies around creative finance, follow this channel. We launch videos like this all the time. But this is what you need to know, especially if you're getting started filing your first or second tax return for real estate. You cannot depreciate beyond what you have in the deal. Learn what your internal and external equities really look like, what it looks like to have cash in a property versus have just general equity, and what you can actually write off against. Now, I'm not a CPA. I can't tell you exactly what to do, but I can tell you what happened to us. And had I managed this better, $200,000 when I was starting my career would have gone a long way, and instead it went to Uncle Sam earlier than it should. Hope this was helpful. Please like and subscribe to this channel for more, and we'll see you on the next episode.
