#85: 7 Great Tax Benefits of Investing in Real Estate

Foreign welcome to the Passive Income MD podcast where we talk about creating your ideal life through multiple streams of income. I'm your host, Peter Kim. If you enjoy hearing about this stuff, make sure to hit subscribe so I can bring it to you every week. Now let's get on with the show. Well, hello everyone. Hope you're having a great week. As I always say, this week we're going to be talking about some interesting things. But before we get to this week's episode, wanted to remind you that we have a survey that we're putting out at the end of the year. We're asking people and whoever is listening to this might be reading our blogs or part of our communities. We'd love to get to know you better. And the only way to do that is to actually hear from you directly, you know. So we're asking you to if you can. It mean a lot to us if you could take a few minutes, answer this survey that we have@ passiveincomemd.com survey2021. 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Now, if you've been part of our world at all, you know that we're all about creating passive income and you know that we primarily do this through real estate investing and entrepreneurship. And you know, there's so many benefits, right? I mean, that's why real estate is such a popular side hustle for physicians and high income professionals. I mean, you get that ability to create generational wealth in the cash flow and the cash flow is what really is able to replace your income, allows you to have that freedom from your day job and allows you to spend your time how you want, right? We talk about it on our Facebook group all the time. We talk about it in our communities and we talked also about different ways to make money right through investing in real estate. Just a quick summary. There are four main ways to do that. We talked about this on a whole podcast. But number one, appreciation. The property value goes up over time. Number two, cash flow. We just talked about that. It can be a source of monthly recurring cash flow into your pocket allows you to make different decisions in life, how you spend your time. Number three, mortgage pay down. Your mortgage gets paid down over time by your tenant if you own rental property. And what that does is it increases the amount of equity you have in the property. Right? And then last but not least, number four and the reason we're talking about things today, taxes. Now I've touched on a few of the tax benefits in the past, but I'd like to in this podcast episode to elaborate on them a bit further. It's at the end of the year. I think about taxes primarily around the first deadline, somewhere in April this year was May, and then the second deadlines were around September, October, and then before the end of the year. I really think about taxes and how to strategize and position myself well to end the year and start the year off right. So I just want to start with this quick disclaimer. I'm not a tax professional, you know. If you're going to take some advice from this, please consult your CPA or tax professional before making any decisions with your own money and portfolio. But we're going to be talking about seven tax benefits of investing in real estate. You might have heard the term capital gains, right? And for those who don't know, that's just simply the profit that you receive from the sale or from having an asset. Just like any other gains, whether you have it through real estate or through like a stock market or whatever it might be, it's subject to being taxed right? The government's going to get their piece right. And depending on a few factors, it's taxed differently. And knowing what those different ways are, it's going to help you to really work things out in your favor. So there are things called short term and long term capital gains. So depending on the length of time that you hold an investment before selling it, those capital gains can be classified again as either short term if it's held for less than a year, or long term A year longer. Now, why that makes a huge deal is that they're taxed completely differently. Short term capital gains, again, you know, assets held for less than a year before you sell them off, they're taxed at your ordinary income tax rates. So it really depends on whatever tax bracket you're in. Now, for the typical person listening to this, you're probably in one of the higher tax brackets where, which at the time of this might be 35%, might be 37%. As everyone knows, this can and will be changing probably in the near future, but that's what it is for now. And if you're in the long term capital gains brackets, well, it's different. The brackets are different and it kind of depends on your income and your marital status, just like it does with the short term capital gains. But for the way they're taxed, it's typically taxed at either 0, 15 or 20%, depending on the amount of profit. Now those numbers are significantly different, right? 20%, 15, 20% versus 35 or 37%. So let's think about scenario here. If you sold a rental property for a profit of, let's say $450,000, let's say you're a married couple, you actually would be paying a capital gains tax of 15% on that profit. That equates to a tax amount of 67,500 on that 450,000. Now compare this to if you had to pay 35% like your normal income tax rate in this scenario, like if you're in that tax bracket, you'd owe $157,500 in taxes. You know, that's quite different from $67,500. That's a $90,000 difference. So one of the benefits of investing in real estate is you can actually take advantage of that. The short term and long term capital gains, you don't have to get taxed at your normal ordinary tax bracket. So most people, when they're investing in real estate, they're really strategic about this. They try to be in that long term bucket, and that's one of those benefits. Now, number two, there's something called the capital gains home exclusion tax benefit. Now this has to do with your own primary residence. Now, if you've owned and used a property as your primary residence for at least two out of the last five years before selling it, you're eligible for this exclusion. Now, according to the irs, this exclusion states that you know, if you have a capital gain from the sale of your main home, right, your primary Home, you may qualify to exclude up to $250,000 of that gain from your income or up to $500,000 of that gain if you file a joint return with your spouse. Let's give you another example of that. Again, let's say you're married and you bought a home for $500,000. You know, you lived in it for the last two years and then you rented it out for the last three years and then decided to sell it. It sold for let's say $1 million. Right. Things went really, really well and you got a profit of $500,000. Well, under this exclusion, this tax benefit, you know, even though you lived in it for two years and you've been renting it out for the last three, the fact that you had that two out of five years, you qualify to receive that profit and completely tax free, $500,000 tax free, that's a huge big deal. Especially if you're a high income professional like we are in a high tax bracket. That could be significant savings. All right, number three, there's no self employment or FICA F I C A taxes paid on rental income. Now rental income, just so you know, it's not subject to Social Security Medicare taxes. So depending on whether you're employed or self employed, you know, you could be paying right now I don't know if you know this but like 7.6 or you know, somewhere between 715 to 15% towards this whole FICA tax on other income. Now the tax is in the amount of somewhere around 15% and normally it's split about 50, 50 between the employer and the employee. Now if you're self employed however, and you have no employer, you're responsible for that full, you know, 15.3%. And this is known as like self employment tax. Just so you know, this could kind of depend on whether you're an S corp or C Corp. But still 15% is a huge and pretty significant amount of. To me it just shows that like you know, again re emphasizes the point that people need to understand that not all income is treated equal. Right. It might be amount a similar amount when it comes to you, but what's left in your pocket can be completely different depending on the type of income. Again, it's a reason for me to just push for more passive income sources. Right? Particularly those like designated by the IRS as completely passive. Right. Because again different taxes are paid on it and certain things are owed on it versus your primary income. Number four. Now this is a biggie. It's called depreciation Now, I like to talk about this all the time because it can be a huge benefit for real estate investors. The irs, just so you know, allows you to deduct the cost of business items, right, that have a shelf life, like a building. Right. When you own a rental property, some people consider this the most powerful tax benefit, investing in real estate. Now, over time, the real estate in which you've invested in, whether you own your own rental properties or whether you invest in a syndication, they know that this property, at least the building technically, it starts to break down. So you're allowed to write off part of that property based on wear and tear. Now, I'm just going to give you a quick overview of how it works. First, you have to determine the value of the actual building apart from the land, because this really only applies to the building itself. And then you divide that value by the useful life of the property. So just in numbers, According to the IRS, that lifespan, it's just a number. They said it's 27 and a half years for rental property and 39 for a warehouse commercial property. I don't know where they got these numbers, but it must be data somewhere. Then you deduct that precise amount each year. I'll just give you a quick example. If your rental property is valued at like $500,000, you would divide that by 27 and a half years, then that equals about $18,000. You can deduct $18,000 as a depreciation expense every year for 27 and a half years. So using this deduction, you can report a smaller profit to the IRS every year. Right, because you're going to reduce it by $18,000. And so ultimately you reduce the amount of taxes that you owe. You can help offset some of the gains you have each year in terms of the passive income. You can also use that loss, just so you know, against other passive gains, not just from that one property itself, but other investments that these real estate investments that are passive or other. Like if you own a business passively and that sort of thing. Now, I know what most people ask. They always ask us, can you deduct that loss on paper against your primary W2 income? Normally you can't. It stays in what's called the passive bucket, right? Passive losses offset passive gains and active losses offset active gains. Now, there are quick, two quick exceptions to this, and again, I don't want to get into this too deeply, but number one, you're able to deduct all of your cumulative passive rental losses against non passive income. The year, you sell the property. That's number one. Number two, if you or your spouse qualify as a real estate professional, I'll probably talk about this in a future episode. You're able to offset active income. That wall and barrier between passive and income is actually gone. And it's a powerful tool, right? Something that, you know, we use personally to help offset some of our other income. I used depreciation in a massive way. The other thing I have to quickly mention is that there's something called bonus depreciation as well as accelerated depreciation. So what people have been able to do is they're able to take these huge losses on first years when they're, you know, the first year when they buy a property, when they invest in a syndication or fund, you might notice a big loss on paper. Now, just so you know, this isn't like a forever thing. This will kind of what they call sunset or decrease in terms of this benefit over time, over the next, you know, five years or so. But it's something that people are taking advantage of now. We'll talk a little bit more that about that in a Future episode. Number five. 1031 Exchange. Now, 1031 Exchange is. It's simply called, you know, it's in section 1031 of the IRS tax code. Now, it states that a taxpayer, you can defer recognition of capital gains and related federal income tax liability on the exchange of certain types of properties, including real estate. And so why that's powerful and just in simple terms is that capital gains, it's only taxed when you have the sale of a property when it's sold, right? But when you do an exchange, right, you move that property into another property and kind of exchange it. These taxes are deferred until you ultimately sell and don't do a future exchange. Now, why this is so valuable is because you can roll over your capital gains from one investment to the next and you can avoid being taxed until you sell your property or you don't sell it. You know, this can really lead to compounding gains. You know, these are some of the benefits of, you know, investing in certain retirement accounts, right? You're able to kind of have a gain and gain and gain without being taxed on those gains. And it just allows it to compound faster, larger over time. Now, there are some specific rules to this. First, the replacement property, just so you know, when you replace the exchange to another property, the it must be equal to or greater, you know, in terms of price than the existing property. Second, the exchange should be for like a, like asset. And then third, the property needs to be held for productive use in a trade or business or investment can be exchanged for a like kind property. Right? So there's just some quick specific rules. There are companies that are set up just to help you do this because there are ways to, you know, you can screw this up by having the money kind of going different places in the wrong place before it gets exchanged. So you definitely want to employ a company to help you out with this exchange. However, just so you know, the cool thing is you can exchange this thing out and then if you end up holding this property until your death, the time the podcast is recorded, whoever inherits your property, they also don't inherit that tax burden. They get what's called a step up in basis, meaning that it's as if they, you know, when they get the property after you know, when they inherit it, it's as if they bought the property at the current market value. So they only pay taxes going forward based on that current value. So for example, the Property appreciates from $500,000 to a million bucks. Normally you'd have to pay taxes on that amount. However that moved on stepped up to, you know, to your kid, it's like they bought the property for a million dollars. So if it sold the next day for $1,000,001, for example, they'd only owe taxes on that $1. I mean again, there's some other rules on this, but there's estate taxes where it could come into play if your state is greater than 5 million. Again, these numbers tend to change over time with different administration and different presidents and different congress. But at the current time, this is kind of where we're sitting right now. All right, number six, the ability to tax free borrow. I also like to call this refinancing. Now if you refinance, then you're able to borrow against what's called the appreciation, right? And the increased equity of a property. Tax free right. You can actually refinance your property, take some cash out. You can use those funds for other investments that and acquire more properties. And that's a not a taxable event. For example, let's say you bought an apartment building for again the $500,000. The property is now worth a million dollars, right? You can do what's called a cash out refinance and potentially you could pull out that $500,000 of gain and you could put it towards the purchase of the next building, right? Kind of pull that forward. This is a tax free situation. And one you can continue to utilize again and again to help grow your portfolio, your streams of passive income without paying more in taxes. And this can be extremely powerful. And lastly, number seven, there's something called opportunity zones. Now this one's kind of new, came out in 2017 with the tax Cut and Jobs Act. There are special zones around the US They've been designated as what's called opportunity zones, right? These are areas where the government's trying to stimulate growth investments in those areas and the way that like they do many things, they decide, you know, they, they motivate people by tax incentives there. So I, I've talked about this in another post called Investing in Opportunity Zones, like on my blog. But in essence it's an opportunity to again further delay paying taxes on gains for, for many years as well as put those gains to work. And then also you actually don't have to pay taxes on a lot of the profit that happen within that opportunity zones. Again, it's a little bit too complicated to talk about all the stipulations right now, but to get the max benefit of it, the earlier you invest in this, the better you can do. It can actually reduce your taxable burden on that investment. And also some of the appreciation and the gains you get can be completely tax free. So if that's something where you're sitting on some potential capital gains, right, like maybe your stock market portfolio has done really well, certain properties have done really well and you're trying to figure out a way to move this into another investment in a way where you don't have to pay taxes right now, maybe you can actually reduce your taxable burden in the future and also get some future gains that are tax free. You might want to look at some opportunity zone investments and again, it's to your advantage the way they've set this up to invest in these earlier than it is later. So anyways, if you've been around real estate, you know, people love tax benefits, right? Just so you know though, even though these tax benefits are so powerful and this can be a temptation of many high income professionals, they're just looking for those tax loopholes and tax benefits. Sometimes we have to be worried about what's called don't you know what some accountants say and people say is though they'll say the saying don't let the tax tail wag the dog, you might have heard of that before, basically just means that you shouldn't make investment decisions based on the tax benefit. It comes later. It's one of the great benefits. But first you want to make sure that you are getting into a great investment first, because it's not worth it to have a poor investment and you get some tax benefit. But it should work the other way, where you should find investment, where the investment's great and they also have great tax benefit to really juice your returns on that. So in any case, just so you know, having a good CPA to be able to discuss these issues with, to talk about your own portfolio, your own investment strategy, whether you're investing in your own rental properties, whether you're, whether you're investing in passive investment, real estate investments like syndications or funds, there are ways to take advantage of the tax code in a way that is really, truly created to incentivize people to invest in these things. Right? It just takes being savvy to figure these things out. And hopefully this has given you a little bit of a preview into some of the major tax benefits and you can take advantage of that in the future. In any case, hope you have a great week. Take care and let's talk again soon. Enjoy the show. Let me know by dropping a review in the podcast app you're listening to us in. And if you haven't already, make sure to hit subscribe. Are you a part of our community yet? Join thousands of physicians who are also on this journey to creating their ideal lives through multiple streams of income. You can join us on our Facebook group PassiveIncome Docs, and you can always learn more at our website, passiveincomemd.com thanks again for allowing me to be a part of your journey. See you next time.