Why Real Estate Investment is the best investment under the “Current” Tax Code
As an accountant of 30 years, I am by nature conservative. I always joke with my younger clients who like to play with the stock market that only 1% of the people in my book of business who actively trades in stock market actually makes money, but more than half of my real estate investors make money. Why? Go watch the newly released movie “Dumb Money”, you will get the picture.
Jokes aside, there is a fundamental reason why real estate is a better investment than stock trading:
Tax Codes Favor Real Estate Investment
Tax Codes are designed by the government to motivate/demotivate taxpayers’ certain behaviors. The US Government understands how important the Real Estate Industry is to the economy since the beginning of times. Let me break it down for you:
“Depreciation” creates phantom expenses to deduct your rental income
We all know real estate Appreciate over time and statistics show that real estate actually appreciates much more than inflation over the long run. That is why in a high inflation environment like we are in now, real estate is a great asset to invest in.
So, why the tax code Depreciates real properties? In the accounting world, most assets have a finite life and when we record any asset on the financial statement, we record an “depreciation expense”, The IRS arbitrary stipulates that any Residential Building is depreciated over 27.5 years. Let me give you an example, if you purchase a one-bedroom condo in downtown Chicago for $300,000. The land is probably worth $25,000 and the structure $275,000. The IRS allows $10,000 Depreciation Expense on the building ($275,000 divided by 27.5 years). You will very likely receive $15,000 in net cash flow; you only need to pay tax on $5,000.
This is HUGE. Where else the government allows you to make money without paying tax?
2017 Tax Reform introduces Bonus Depreciation to create bigger paper loss for RE investors
Bonus Depreciation allows tax payers accelerate depreciation. In the same example, if we conduct a cost segregation for that condo, we very likely will be able to capture $55,000 worth of depreciation in the first year and that will actually generate a $40,000 paper loss for you (even though you have $15,000 actual net cash flow from the investment). Now, you do not have to pay any tax on your income and you even might be able to use that $40,000 paper loss to offset some of your W2 income and a nice chunk of refund from your withholding tax.
Wow! Is it legal? Yes, it is. The government is encouraging everyone to invest in real estate!! Have you heard that a lot of the high earning physicians in this country became Die Hard Real Estate Investors since the tax reform? Now you know why.
“Like Kind Exchange” enables you defer your capital gain when you sell your rental real estate
We all know there is no Free Lunch. All the depreciations we used to offset our rental income will need to be recaptured at the time we sell our property. Let’s still use the example above. After 10 years, we are selling the same condo for $500,000, you will need to pay tax on both the capital gain ($200,000) and depreciation recapture ($100,000). Good news is the tax rate. Your pay here is definitely lower than your W2 income.
But the government designed another tax code here to motivate you to continue your real estate investment journey: 1031 exchange. Basically, as long as you use all the proceeds from your sale to purchase another or multiple other real estate properties in the US, you do not need to pay tax at the time of the sale.
The good news is there are no restrictions on location, type of properties, number of properties, etc. Most of the Savvy Real Estate investors utilize this code to expand their real estate portfolio. Why paying tax while you can use the tax money to make more money for you?
I am sure by now you are going to say, what is next? I can not continuously 1031 exchange, I will have to stop somewhere, right?
“Step up Basis” ensures you not paying any capital gain taxes ever
Let’s say I start with $10,000 investment in Real Estate in my youth, leverage with mortgage, collect net cash flow along the way, doing multiple 1031 exchanges to bigger and better investments, by the time I die, I have a portfolio of $10 Million in real estate, what happens then?
My children will inherit my real estate portfolio at its Market Value and I just forgo my entire life’s capital gain tax! That is called Step Up Basis, it is also a tax code. It is once in a life time “Step Up”. Now my children can either sell the properties without worry about any tax consequences!
That is a pretty nice story to tell, right? I will definitely be smiling from my grave.
Summary
Understanding the tax codes, utilizing the tax codes to our advantage and planning ahead are key factors to successful investment. Real Estate Investment is the best investment under the current tax code because of the following 3 tax codes:
Depreciation
Like Kind Exchange
Step Up Basis
Consult A Tax Professional
If you own real estate investment and would like to seek assistance in tax deductions for your rental real estate, you could contact us to request a consultation session by clicking the button below. We serve clients across different states of the U.S. and would love to provide you with the help you need!
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 purpose only and does not constitute legal, business, or tax advice. Each person should consult his or her own accountant, attorney, or business advisor with respect to matters referenced in this post. Zhou Agency assumes no liability for actions taken in reliance upon the information contained herein.
