you're now listening to the taxmart REI podcast the number one tax podcast for Real Estate Investors hey thanks for tuning into this week's episode of the taxmart REI podcast today Ryan and I are going to break down how simply investing in rental real estate reduces your effective tax rate and puts you in a very favorable tax position even without offsetting non-passive income such as W2 income or income from an active Trader business and this is critically important because we work with a lot of investors who once they realize that they can't use the real estate professional status or perhaps don't want to invest in short-term rentals they start to believe that real estate won't actually help them reduce taxes and that cannot be further from the truth so we're going to break down a brief overview of the US tax system the critical role of depreciation in shielding income from tax what is your effective tax rate and how can it be calculated how passive investors build tax-free income through real estate and ways to minimize the impact of depreciation recapture if you're concerned that using the real estate professional status or investing in short-term rentals is the only way to minimize taxes then this episode is for you and we'll be diving into all of this in just one minute hey are you ready to discover how to use real state to build taxfree wealth well this year we're taking our annual Summit to the next level by incorporating wealth building strategies alongside our traditional tax and legal insights thus we proudly introduced the 2024 tax legal and wealth Summit for Real Estate Investors taking place May 17th 18th and 19th right from the comfort of your own home this extraordinary free 3-day virtual event is meticulously designed to arm you with the strategies the 1% use to cultivate taxfree wealth through real estate whether you want to build Safeguard or grow your wealth this Summit is your golden ticket visit ww. tax inlegal summit.com to reserve your free tickets today again that's ww. taxand legal summit.com to reserve your free tickets we'll see you there but for now we'll Dive Right into today's episode all right and we're back and before we jump right into today's episode we're going to do a brief recap or clarification on backd door reps which is on episode 268 of the taxmart REI podcast that we had some questions some confusion around that so we're going to go ahead and touch on that if you don't care about this part go ahead just skip right ahead it we'll be diving into the the meat of today's episode in about two or 3 minutes so back door our reps long story short we did an episode on episode 268 covering a concept that we dubbed backdoor reps and there was some confusion and questions from taxmart insiders or taxmart investors as a whole on how this concept works and really making it click so I'm going to go quickly through how it works then I'm going to cover what we're going to be doing with it going forward and then I'll touch on a little bit of about some other details all right so let's go ahead and just Dive Right into this so here's how it works when you have a rental property as we know by now if you're a long time listening to the show all rental activities are Passive by default that means losses from the rental activities can only offset other passive income such as income from other rental activities or perhaps other passive activities you might be involved in like passive businesses the only way to really turn these loss is non-passive and I'm speaking to specifically long-term rental properties if we're not talking about short-term rentals right now is to qualify for the real estate professional status when you qualify for the real estate professional status your rental losses are now non-passive and can offset your W2 your business income and other non-passive income sources all right now to qualify as a real estate professional you have to spend 750 hours more than half total working time very challenging for your typical investor to qualify however when you sell your property your passive losses are unlocked quote unquote and they will become non-passive and they can offset your non-passive income such as your W2 or ordinary business income which could be taxed at rates up to 37% and when you sell your property so you're going to unlock those passive loss is going to offset your non-passive income and then you're going to have capital gains and perhaps depreciation recapture from the sale of your property which are generally taxed at lower rates Capital Gains are taxed at a rate up to 20% and depreciation Rec capture can differ a little bit up to 25% on the straight line and ordinary on the other but the point is that when you sell your property your passive losses become unlocked they become non-passive which is what reps does all be it on the front end of the transaction when you usually you typically first buy a property but with back door reps it does it on the back end when you sell it it unlocks it and turns it non-p passive and this is a widely misunderstood concept and this is the reason why we bringing this to to light but really when we step back and think about this this entire concept we're talking about here backd door reps is part of an overarching tax strategy that we've also covered here on the show numerous times the The Lazy 1031 exchange or 1031 exchange light and with this strategy the lazy 1031 or the 1031 exchange light you're selling a property and you're going to expect a capital gain from it and you're going and buying another property to generate current passive losses that can offset the quotequote gain on sale or at least that's the way it's understood by many or you could use suspended passive losses to off so from previous years to offset the gain on sale so that's the lazy 1031 exchange and back door reps is really the mechanic within the lazy 1031 exchange that turns it non-passive and the reason why we had to bring this to light is because many people investors and tax professionals included believe that when you sell your property that the passive losses offset the capital gains and that's not quite the case the capital gains are not what's actually being offset by your passive losses it is the ordinary income okay that is backd door reps in a nutshell and I think during the episode because it's so Technical and we didn't have examples with tax returns and all that I think some people got a little lost and didn't quite click but the bottom line is backd door reps is when you sell your property your passive losses get unlocked to the extent of the gain but offset your ordinary income and not your capital gain so that's back door reps however going forward we will be simply referring to it within the lazy 1031 exchange strategy it'll just be clarified when speaking about that strategy because of some of the confusion that came around about why it was called backdoor reps because has nothing to do with reps apparently but what backd door reps does for you it turns your losses non-passive on the back end which is what reps does on the front end so that's why it was called back door reps having said that though we spent five minutes more than I want to SP on this we're going to dive right into the meat of today's episode which again is breaking down how investing in rental real estate reduces your effective tax rate even without reps or the short-term rental loophole and to set the stage for this we first need to quickly review how the US tax system works Ryan would you mind just giving us kind of a brief breakdown of how the US tax system works especially on earned income or W2 and business income Yeah couple ways that we can break this down number one is kind of non-passive and passive kind of just start with non-passive you might think about like you said Tom your W2 income you might think about business profit things like that and that kind of income is again non-passive and it's going to be subject to federal income tax state income tax if that's relevant to you and then FICA or self-employment tax kind of synonymous phrases there that's the 15.3% tax that we're talking about so we've got those kind of main categories again generally being non-passive from what we're talking about and then we've got say the passive okay and that's generally rental properties Andor passive investments in businesses the unique thing as far as the tax world or the tax rate in there is that rental properties are not subject to FICA or self-employment tax of 15.3% the only time that that could potentially be the case commonly would be like a hotel m hotel or a short-term rental where you're providing substantial services that then could become subject to self-employment tax but obviously a lot more rare for a lot of our listeners here so those are kind of the main two categories earned income again all three of those federal state income plus F tax and then rental properties again generally being passive essentially just not subject to FICA self-employment tax absolutely and and that's a great breakdown and just to kind of give a quick summary of that for everybody when you have a job you're going to be paying taxes at the federal level up to 37% at the state level up to 13.3% in the state of California and then again if you have a job you're paying FICA taxes up to a certain amount of your income of 7.65% and if you're self-employed you get the luxury of paying both sides of the FICA taxes so a total of 15.3% and when you add all of this up if you're a high income earner you can easily be paying 40 to 50% of each additional dollar you earn in taxes and that's quite painful right again you know if you were to if we give a quick example here right we'll go deeper into this example but if you were to be making 500k for example if you're high income earner and you're in the state of New York you can easily be paying an effective tax rate of up to 42.86% on that income and that's painful that could amount to taxes you know in the hundreds of thousands of dollars and it's painful to watch that happen but that's the reality of earned income hey are you tired of working with generalist CPAs that tell you you can't use the real estate professional stats the short-term r to loophole or cost segregation studies or Worse have no idea what these things are if so it's time to elevate your game and work with a CPA firm that gets it here at H CPA we worked with thousands of investors helping them save millions of dollars in taxes through proactive tax strategy and planning tax preparation and outsourced Accounting Solutions so if you're ready to elevate your game make tax filing painless and save, in taxes what are you waiting for just head on over to ww. theal cpa.com podcast to request an initial consultation today we are accepting clients for the 2023 and 24 tax years so if you're looking to make a change you have nothing to lose again you can request an initial consultation by visiting ww. theal estat cpa.com podcast we look forward to hearing from you and learning more about your situation and how we can help but for now we'll dive right back into today's episode all right so now we know how earned income works and how heavily taxed it can be it could be quite painful Ryan would you be able to kind of give us a quick breakdown of how depreciation works and how it helps Real Estate Investors reduce their taxes yeah so it's probably best to use an example and we'll try to keep it as simple as possible so we'll take an example of someone that's earning say W2 or business profit and we'll take the the real estate investor so first just the W2 business profit let's just pretend that's uh $55,000 okay and again to keep this simple we'll assume that they're making are going to be taxed at 40% that would come to total tax of $22,000 okay can be painful right as as your income increases that rate could get higher and so forth but now let's take the real estate investor and let's just pretend you're kind of Imagine like a p&l right 100,000 in rental income rental Revenue minus let's say $45,000 of ordinary expenses that's now going to get us to a net operating income before any sort of depreciation of again that same 55 to try to keep the example as Apples to Apples as possible but now you might assume hey maybe we have $60,000 of depreciation which non-cash expense and now that's actually going to show a net loss for tax purposes of 5,000 and therefore we've completely eliminated any sort of tax liability from that property okay so now right $22,000 in tax for the business profit or W2 earner and zero tax 0% uh that's going on now for the rental property specifically so the power of the depreciation just even on its own is so invaluable compared to say a W2 earner who isn't going to be able to tap into that like a real estate investor is absolutely you hit the nail on the head there and so just to kind of summarize recap that so basically let's say for example that you had $55,000 in net income from your W2 job you paid $222,000 in taxes on that assuming you're at a 40% tax rate we're keeping that number nice and simple here however if you were to generate the same $55,000 in cash flow using the example Ryan just provided you're paying zero dollars on that income so you're telling the IRS hey I lost money on this but yet you put $55,000 into your pocket and I want I want to pause here for a second and just say this is one of the major benefits of investing in real estate you're able to generate income and shield it from tax something that's very challenging to do with earned income this is a big takeaway just understand that if you're in rental real estate you're already putting yourself in a fantastic tax position even without reps and without the short-term rental loophole but I'm going to go ahead and dive into this here I'm break down how this actually reduces your effective tax rate so just briefly I'm going to describe what your effective tax rate is then we'll dive into the example so your effective tax rate is the amount of taxes you pay so say for example $100,000 in taxes versus how much income that you make and before I dive into a more in-depth example here I'll give you a quick example of how this $100,000 example works here so let's just say that you paid $100,000 in taxes and you earned $500,000 in income all right your effective tax rate in this example would be 20% it would be much higher than that but just trying to keep the numbers clean now let's just say that you generated $100,000 in rental income so you built up this nice portfolio it's passive and you have all these passive losses you're offsetting all your rental income so now you added that another $100,000 now you're paying $100,000 in taxes right but now you have $600,000 in income and you're effective tax rate dropped from 20% to 16.67% all right the more income you're generating from the passive side so say it was $700,000 again I'm just using these to just to paint the picture all right now if you had $700,000 in income again this be $500,000 from your W2 wherever the case is and you're now have $700,000 $200,000 from your rental properties now your effective tax rate is now 14.28% so the more the bottom line here is the more income that you generate from your rentals relative to the amount of tax that you're paying your effective tax rate will continue to decrease effectively reducing the amount of taxes you're paying and this is again in and of itself I can't say it enough is super powerful for Real Estate Investors Ryan do you have any any comments you want to add in there yeah and just to highlight again that effective tax rate we're talking about is without real estate professional status or the short-term rental strategy obviously we've had tons of episodes about that and you can go back and listen to them but coming back to your main question your time so the way that I like to see it right going back to the very beginning part of our podcast we've got non-passive call it like a flywheel kind of a thing and then we've got passive as a different kind of flywheel two main buckets and this is obviously for tax purposes but as you're young and you're working right you're really got a lot of your effort and time and money coming into that non-passive flywheel if you want to call it that and you've got that accumulating maybe that's increasing over time and the effectiveness of using real estate over time at least to me is that part of this flywheel is essentially taking some of that income and moving it towards this this other hand called the the passive flywheel AKA real estate right so over time this is kind of accelerating over here but also this is starting to move as well and over time this is going to slow down like right if you think about real estate over many many decades you are eventually going to have this really big pool of money a lot of your retirement a lot of assets a lot of income and things coming over here and this is going to start to slow down as you move towards retirement right so over time as you think about your life and kind of your working career over time you're kind of siphoning off more and more to the passive side and as you think about the effectiveness for what we're talking about lowering that effective tax rate you could eventually be having this very efficient flywheel where effectively you've got very little to know taxable income being shown again for tax purposes lots of distributions lots of cash flow to yourself But continuing to use either that normal depreciation or continuing to go and buy another property every year with some of that excess cash flow from your real estate and then doing another say cost segregation study now we've got additional losses to continue to offset that Year's profit and so it becomes very efficient and you had just again a couple minutes ago Tom kind of talked about like this reduction in effectivess effective tax rate I should say so the more you can just move towards where you were kind of leading us Tom you can see that the lower your tax rate can be and it could literally get to zero okay we have seen that where investors have dozens of properties and they're continuing to do cost segregation studies for depreciation offsetting any sort of taxable income from their property so continue continuing to move in that direction again even without real estate professional status or the short-term rental strategy real estate overall can be very very effective and efficient when it comes to saving on taxes absolutely it's such a powerful strategy I mean this is what I use in my investing strategy so again the way this works is you have your earned income which is tax at high tax rates we just talked up to 37% and you have all the state and stuff like that can easily be between 40 and 50 and we see this all the time especially with people in New York people in California where there's High state tax rates perhaps local taxes where you might be paying a substantial amount of your earned income in taxes however as you start investing into passive income sources like real estate whether it be direct property you own or it be a syndicat or fund whatever the case is you're now generating income but you're not paying taxes on this so it's a much more effective vehicle and as your income in that passive bucket starts to increase because you're not paying taxes on it your effective tax rate decreases because your income is increasing relative relative to the amount of taxes you're paying so this is one of the core benefits of real estate I know I said that like three times now but I just I have to keep hammering at home because it's that big of a deal and like Ryan was saying is if you do this enough over time you'll eventually be in a bucket you'll be at a point where you reach quotequote Financial Freedom where your passive income which is sheltered from tax right is eclipsing or or it's exceeding perhaps the amount of income that you're earning through your job or business and there's a lot of people out there who use this strategy right who simply just invest in passive income sources using their earned income and they end up in a very solid tax position and we just walk through a nice example of the effective tax rate and how that works all right so that's kind of the point that's what we're trying to drive here today that you don't need reps you don't need the short-term rent the loophole to save money on taxes even if you're high- income earner and look if you can use the real estate professional status to turn losses non passive great that's fantastic and use it against your ordinary income or your earned income to save additional taxes there that's fantastic that's icing on the cake same thing with the short-term rental loophole or short-term rental strategy that's another effective way if you can use it you can stack these strategies on top of each other they're not mutually exclusive you can combine them but work with so many clients over the years seen so many investors where you'll talk to them you weling through how this all works they realize they can't use reps they can't use a short-term under to loophole and boom real estate just becomes all a sudden not the shiny object or the golden ticket perhaps that everybody thought it was and we just want to say that it's still very powerful even without those strategies it's those are not the end all and be all Ryan you have any comments on that I would just add in as you were talking about that I it made me think of syndicators out there who might be pumping out you know hey real estate can can bring you all all these tax benefits and it could but it depends right we could talk about we've talked about real estate professional status in the past and if you can get additional losses from the syndication and use them non-p passive we've talked about that but what we're kind of just talking about here is even if you don't meet real estate professional status and you're investing in something like a syndication and it's going to be passive to you right they're likely going to have either one the first year do a cost segregation study and so any distributions they send out to you in that first year could have zero tax right and that's what we're talking about so whether it's a indication or whether it's something that you own 100% control there's still tax benefits because we're going to get depreciation because we're buying an asset that is depreciable over time so that was just the other comment I wanted to throw in there as as people think about and I hear from syndicators really real estate passive nonp passive has its benefits from a tax perspective absolutely now you know normally when we get to this part of the conversation people start asking well hey Tom Ryan you know this is all great I'm able to Shield my rental income from tax today but I know when I eventually sell the property I might have to be subject to depreciation recapture taxes so the way you like to describe that for the most part is that there's a handful of reasons why taking depreciation makes sense the first one is that depreciation is mandatory you cannot not claim it on your tax return if you don't claim it on your tax return the IRS will assume you took it and then charge you to appreciation Rec capture taxes anyway so there's no getting around depreciation you have to take it okay the second reason is the time value of money the time value of money states that a dollar today is worth more than a dollar tomorrow so for example if you were able to save $10,000 in taxes thanks to depreciation then what that $10,000 could do for you is you could take that $10,000 and reinvest it and if you were to reinvest this $10,000 at an 8% compounded return which is fairly conservative for Real Estate normally you see it in the double digits compounded over a 10year period you're going to end up with roughly 21 ,500 give or take that's $11,500 that you did not have before that money would not exist for you had you just paid the government and not use depreciation all right you had a zero onto that as these numbers grow for you that $100,000 that you just saved in taxes compounded at an 8% rate over 10 years ends up coming out to be roughly $215,000 give or take when all is said and done and that's hundred roughly $115,000 that you did not have before okay so that's the power of the time value money and that's why taking depreciation makes sense it's why it makes sense whether you're on the passive side like what we just talked about here on today's episode or even if you are using reps if you are using the shortal loophole these are all reasons why taking depreciation makes sense and using this tool the third reason and we'll break some of this down is that you can defer minimize and perhaps in some cases even eliminate depreciation recapture through strategic tax planning via strategic exits so there's a handful of strategies we'll break down briefly on how you can do this but those are the three reasons to take depreciation just to recap you have to take it a b uh the time value money allows you to take that the savings and reinvest it and continue to build your wealth and three depreciation recapture can be minimized upon the sale of a rental property and look before we break down the specific strategies I just want to say that real estate is not a one and done thing it's not a short-term thing the way to look at it is not like okay I'm going to buy a property take take the tax savings and and I'm done no the people who built the most wealth in real estate have been it for decades and have been using strategies like depreciation or been using deductions like depreciation and combining it with strategies like the 10301 exchange which we'll dive into it briefly here to shelter the gains and depreciation recapture from tax or defer it when they sell the property so Ryan do you have any comments on that before we start breaking down talking a little about these exit strategies well I know some people listening might say well what if I didn't take depreciation in the past you know what can I do and just to comment on that really briefly and then I think let's move into exit strategies but essentially two main options you have either one if it's kind of been just a couple years that you missed taking depreciation you could go back and amend that's option one just go back and amend your tax returns properly get that depreciation and number two is that you could file form 3115 and do a 481a adjustment to to catch up the depreciation that you missed so just be aware there are two options there if you're like oh shoot I should have you know been doing this all along and I didn't well you have some options there so with all this in mind right we have to take depreciation there's no way around it and we're not going to dive into all the exit strategies that are available we just did seven strategies that you can use seven tax efficient exit strategies a few episodes back go ahead scroll down the feedy and you can listen to that entire episode if you do want a full breakdown on these strategies but Ryan could you just maybe take us through how the most popular strategy or arguably the most popular exit strategy the 1031 exchange could help investors defer depreciation recapture on the sale allow them continue to grow their wealth yeah so like you're saying you sell a property and over the time that you've owned that you've taken depreciation so we sell the property there's generally going to be two main elements uh we're going to focus on one for our discussion but it's the appreciation right call it capital gains so you're paying capital gains tax and then we've got depreciation recapture to pay depreciation recapture tax so that's that's kind of mostly what we're focusing on here and so when we sell a property say without a 1031 we have to pay tax on all of that okay but if we do a successful 1031 exchange kind of cave out there right make sure you're working with a qualified intermediary to help you with taking the proceeds and doing all that we won't get into the details here but if you can do that you can then not only defer say the appreciation the capital gain but what's commonly missed is that you can defer that depreciation recapture as well so it's it's all of it the entire gain the two elements of your gain you can defer that now if you think about a common strategy that has commonly been referenced in different names defer defer defer die right maybe that's morbid to some of you but that's that's really a strategy that that people are thinking about and as Tom has mentioned just a couple minutes ago this is like a lifelong view in mind of using real estate to build wealth and to create income or Financial Freedom for yourself just using real estate specifically as the vehicle right so we have this unique thing kind of do a 1031 exchange defer that tax and now we're effectively moving that additional cash flow right because we didn't pay to the government in tax we're now moving that effectively into the next investment and now we could potentially actually buy at a higher purchase price because now we've got more of our proceeds moving there and now we just continue to do that over the lifespan of our our life and then the the DI part which maybe is more bid again but you continue to do this until your death now all this potential kind of growth of again depreciation recapture and the capital gain over your lifespan you give that over to your heirs They will receive a step up in basis at the fair market value of the date of your death okay so we could walk through a brief example but that's kind of the big picture of it continuing to use 1031 exchanges to not pay that tax move it into effectively your wealth and then that could effectively be gone or eliminated by using now the step up and bases to your airs Ryan would you mind giving a quick example of how that works with the 1031 exchange and then we'll go ahead and summarize everything we discussed here today put a nice little bow on everything yeah so I'll try to keep this simple because this could get complex with numbers and you you can't maybe see this but imagine that you are going to take a property that you're considering selling and you are going to have a tax due from selling this property of say $50,000 okay if you do a successful 1031 exchange you are effectively instead of paying that to the IRS okay now that that money is gone essentially forever you are actually now moving those that $50,000 of gain tax into the new property okay so now you you've pushed up your wealth into into property that you continue to own okay so now if we continue to do that think okay 10 years later or five years later we've got another say $50,000 of tax uh plus the one before right because this continues to add up the more that we kind of have this delineation between your cost and your ultimate kind of sale price this growth this gain and therefore the tax is going to continue to be multiplying right so if we continue to do that by the end we are essentially going to have potentially hundreds of thousands of dollarss of potential tax that's now pushed into the properties whereby again that now is not being paid to the government it's now in the real estate itself and therefore your heirs are then receiving that and not having to pay the tax let me pause I feel like I wouldn't need to like pull up a spreadsheet to like actually walk through a a good example hey you know what we're going to actually go ahead and skip the example if you do want a fuller breakdown on the 1031 exchange and and other strategies you can use to make a tax efficient exit go check out our previous episode a few weeks ago seven tax efficient exit strategies and you'll get a full breakdown there but we're going to go ahead and summarize this episode and then we'll be on our way for this week all right so first things first right when you have earned income income from a job or a business it's highly taxed it's considered ordinary income tax up to federal tax rates up to 37% then you have state taxes local taxes and FICA taxes and can easily put you between 40 to 50% in your tax rate where you're paying 40 to 50% on each additional dollar you earn so again if you were to earn say your effective tax rate was 40% and you were to earn $55,000 you're going to pay $22,000 in taxes on that right however if you were earn that same $55,000 from Real Estate it's often going to be sheltered from tax thanks to the non-cash expense code depreciation so you tell the IRS hey I lost money but you actually pocketed $55,000 that you did not pay tax on so in other words you paid zero dollars in taxes and again right here this is the core of what makes real estate so tax advantaged even when you're not a real estate professional or using the short-term rental strategy okay that is the big takeaway but then the question often becomes well hey great I'm making all this money now I'm not paying any taxes on it but eventually I have to pay the piper right eventually I'm G have to pay Uncle Sam the depreciation Rec capture tax when I sell the property and we're saying here not so fast there's seven tax efficient exit strategies you can use many of them will help mitigate or defer the depreciation recapture on sale including the ever popular 1031 exchange and if you do this throughout your lifetime you take the long-term View and not just a short-term view you take a long-term view of real estate you can do this over and over and over again and build this massive portfolio we have clients who've done this is not a pipe dream it's easier said than done not going to lie about that but we have clients who've done this you have this massive bucket of assets this massive net worth that you built for you and presumably your family using this strategy and then when you pass away if you structure your state correctly your heirs can actually get these assets at the stepped up value or stepped up basis at the fair market value dat of your death if they go and sell the property they're wiping out all of the depreciation all of the capital gains taxes you would have paid had you sold this property or properties during your lifetime and this is the true engine the true value of investing in real estate and that's what we're trying to drive home today it's not all about reps it's not all about the short-term of the loophole and there's so many more benefits to to investing in real estate than just those two strategies with all that being said we are accepting clients for the 2023 and 2024 tax years so if you're looking for a new CPA there's no better time than now you get a conversation started by going to ww. theal estat cpa.com podcast request initial consultation we' love to learn more about your situation and how we can help and also with now April 15th behind us tax season is over for us us accountants at least for now if you're looking to make a switch this is the time to do it you want to change in Pace you want to start over fresh we are hiring so you go on over to ww. theal estate cpa.com careers go ahead and apply today we'd love to learn more about you as well but with that being said we'll catch you on next week's episode of the taxmart REI podcast
