***Please note that I am not a tax professional and you should always consult with your accountant and/or CPA before making decisions or implementing anything you read in this article.
Most of my real estate investment career has been aimed towards a simple strategy – buy 1-4 unit buildings in up and coming areas, rehab them, rent, refinance and repeat. I’ve learned a lot from rehabbing 50+ properties, dealing with dozens of our own tenants, and having conversations with investors further down the line who own much larger portfolios than I do in the Philly market. The past two years I’ve made a significant change – we’ve sold off nearly all of our residential properties, purchased two self storage facilities, and I’ve focused on selling commercial real estate.
One of the most interesting things I’ve learned from investors that build up enormous amounts of wealth is they devote a lot of attention to the topic that no one wants to talk about…taxes. Most people spend most of their time and energy thinking of ways to increase their income but don’t take enough time to plan on how to leave (legally) leave the IRS with as little as possible every year. There are a two basic strategies that can save hundreds of thousands or millions of dollars over a lifetime:
1031 Exchange
A 1031 exchange is a provision in the tax code that allows a real estate investor to defer paying capital gains tax when selling one investment property and buying another. The properties don’t have to be in the same asset class (ex: you could trade a house for a warehouse, an office building for a multifamily building, etc) but there are strict time limits on how the exchange is done.
Many long-time property owners who have significant equity in their properties can benefit from using this strategy. It’s easy to understand, very quick to set up, and very effective as the numbers get bigger. Imagine if you had a property that you owned for 30 years, signed an agreement to sell it, then realized you’ll owe the IRS $250,000 in capital gains taxes once it sells? I’ve seen many people in that scenario that are able to defer the taxes and continue putting the money to work.
Cost Segregation Study
Imagine this – you use the 1031 exchange to take $350,000 of tax-free sales proceeds from a small multifamily building and you buy a $1,000,000 warehouse (with a $650,000 mortgage) that is rented out to a single tenant. Did you know that you can accelerate much of the depreciation of your new building and take all of it in year 1? In other words, you came out of pocket $350,000 but you might be able to take up to $300,000 in depreciation that first year.
What benefit does that have? If you are a high-income earner and/or a real estate professional, you can write those losses against other income. How much you save depends on what tax bracket you fall in but this is another strategy that can have massive benefits. If you’re a high-earning real estate professional, you might have just saved yourself $100,000 in taxes that year.
These are just two of the many things you can do to get ahead financially using real estate. There are many ways to implement these strategies and others (especially when organizing partnerships and syndications) but the point that I want to get across is that it’s worth spending the effort to plan your taxes ahead of time if you plan to be in real estate for the long term. A dollar saved today that you can compound for ten years can turn into a fortune – especially when the market dips and the opportunities open up again. Don’t be afraid to try something new…your future you will thank you for it!
Rodney