Must-Know Tax Strategies for Real Estate Investors

As a financial professional who has 30 years of practice in both tax & real estate businesses, I always tell my clients “Real Estate is the best investment under the current tax code”. Why? Because the government encourages long term holding of rental real estate by incorporating very favorable tax treatments for rental income and capital gain derived from real estate investment.

If it is done right, there might even a possibility that you don’t need to pay tax on your real estate investment income. There are some basic but critical strategies you should consider to maximize your tax savings when you file your tax as a real estate investor.

First and Foremost Concept Is Depreciation

1. What is depreciation?

It is a tax code written to offset your positive cash flow from a rental property. How does it work? IRS stipulates that if you acquire a Residential Property, the property starts to depreciate from the moment you put it into use and at the base of your acquisition cost for 27.5 years. Any major improvement you make on the property will be added to your base for depreciation. So, you see, the Depreciation here is a phantom expense, not a real one. Your property does not really depreciate over time, it actually appreciates over the long run due to the economics of supply and demand, at least in most instances.

2. How to calculate depreciation?

Let’s do an example.

  • Positive cash flow: If you purchase a one bedroom condo in the River North neighborhood in Chicago for $275,000, you will get $2,000 monthly rent, deducting HOA, Property Tax, Landlord Insurance and Property Management Fee and other expenses, you will probably net $1,000 a month to your pocket. That is $12,000 a year in net cash flow!
  • Depreciation cost: Do you need to pay tax for that $12,000? Let’s see. Your depreciation cost will be $10,000 ($275,000/27.5). That will be used to offset your net cash flow directly.
  • Profit for tax: So, now your Paper Profit will only be $2,000. This is a great example of how the Tax Code of Depreciation creates “Tax Free Rental Income” for you!

Of course, above is just a simple example, and the real-life case could be way more complicated than this one because there are different depreciation calculation methods and also different types of property or even different components of your rental could have different depreciation rules as well. We would cover more of that in depth in our next blog.

2nd Strategy Is Mortgage Interest Deduction

1. Why we should leverage?

Everyone knows interest rate is at the lowest historically right now. Second thing I tell my clients: “Leverage when you invest in real estate”. Why? Besides the common wisdom of “making money using other people’s money”, there is a favorable tax code here too. All the mortgage interest you pay is 100% deductible on your rental real estate tax return. No restriction. Everyone knows after Trump’s Tax Reform of 2018, a lot of people are not benefiting from the Home Mortgage Interest Deduction because they no longer itemize their deductions. A lot of my clients do not like to borrow money, I always joke with them that if they really do not want to carry a debt, go and pay off their home mortgage. But buying rental real estate with cash or paying off rental real estate mortgage is a very unwise move, both financially and tax wise.

2. How to deduct your interest expense on your tax return?

Let’s go back the example we have earlier. If I put $75,000 down and borrowed $200,000 at 4% interest rate when I buy the afore mentioned condo in River North, I will have generated $8,000 in interest expense. Now, on my tax return, I will show a $6,000 “Loss”, instead of the $2,000 “Gain” in the previous example. I definitely do not have to pay tax any more, I will even use that loss to offset my regular income and get a tax refund. Let’s assume I am single and I make $80,000, after standard deduction, my taxable income is $67,400 and my federal marginal tax rate will be at 22%, plus the State Income tax rate of 4.95%, that $8,000 mortgage interest will be saving me $2,156 ($8,000 x 26.95) in tax refund. Isn’t that amazing! You will still have cash flow (after you pay the mortgage), but you not only do not have to pay tax on the positive cash flow, you even get a bigger tax refund due to the “phantom expense” of depreciation of the utilization or leveraging.

3rd Strategy: Use 1031 Exchange to Defer/Avoid Paying Capital Gain Tax

Third concept I would like to discuss here is how to avoid paying tax when you sell your rental property. How to make the investment totally TAX FREE, which a lot of Rich People are doing generation after generation. Because they know the Tax Code and they are utilizing it to their benefit. The Tax code here is Section 1031 Exchange.

1. What is 1031 Exchange?

Basically, when you sell your property, you buy another property (equal or higher in value) to replace the property you sell within 180 days. It is a quite complicated maneuver procedural wise, but with a team of accountants and attorneys you will be rest assured it will be executed correctly and save you a bunch of tax dollars.

2. How does it work?

How does it work? Let’s get back to the same example. If I sell the River North condo in 10 years for $500,000, and purchase a multi-family unit in Buck Town for $1 Million. Let’s do some math here. If I put down $75,000 buy this condo, and borrowed a 30 year mortgage of $200,000, After 10 years, my principal balance will be around $160,000. The net proceeds of selling the condo will be $340,000 ($500,000 - $160,000), you will use that as the down payment for the multi-family unit and borrow $660,000. You made good money from this transaction, right? $225,000 in capital gain ($500,000 - $275,000). Plus you enjoyed $100,000 in Phantom expense of Depreciation ($10,000 X10). And, now you roll into a bigger property with a bigger depreciation expense. And, you will definitely enjoy a higher net cash flow and higher tax saving, how does that sound? Let us step back and ponder: If I made money in selling my stock holdings, do I get to enjoy this preferable tax treatment? Not in a million year!

4th Strategy: Use “Step Up Basis” To Eliminate Tax!

The last concept is “Step Up Basis”, another tax code to complete your quest for TAX FREE income from Rental Real Estate. Let’s go back to the example. With my $75,000 initial investment in my early 20s, I very likely will grow my portfolio to $5 Million when I hit my 82s, through hard work and smart tax strategies. When I pass away, my kids will inherit my portfolio at Market Price. I will be successfully using tax strategy to avoid paying any income tax for my long term real estate holding, while enjoying positive cash flow during my life time.

Sounds too good to be true? The answer is it is true and many rich families have utilized this tax strategy to the utmost to build up their wealth. But ordinary people like us can do it too! Knowledge is the Power. Most of my clients are of Chinese or Asian descent, the love of real estate runs in our blood. I am fortunate enough to be witnessing a lot of success stories in my own book or businesses and I am very proud that I also helped a lot of my clients in their path to financial freedom through smart tax strategies. As a matter of fact, our accounting firm has a real estate investment arm just to help our clients to acquire and manage their real estate portfolio. We are even nicknamed “Real Estate CPA Firm” by some of my long-term clients. We also serve landlords all over the world as long as they have US real estate holdings.

You could click here to learn more about our tax filing & advisory services for Real Estate Investors.

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About The Author

Justine Zhou

Justine Zhou is the CEO of Zhou Agency. She is also a senior CPA and extremely knowledgeable advisor with well-rounded expertise in tax, real estate investment and insurance services.

Justine believes in understanding clients’ needs first and providing tailored consultation to clients’ unique situation. She uses language that the audience can easily understand and is good at incorporating her expertise in both tax & real estate to help real estate investors achieve maximum tax savings.

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This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Zhou Agency assumes no liability for actions taken in reliance upon the information contained herein.