If you’re a real estate agent, you’re self-employed. You’re essentially a business owner. Sure, gas and marketing expenses add up, but the biggest expense for most agents is their time.
You can setup an S Corp and pay yourself a salary but it’s still a bit tricky to quantify the value of your time to the IRS.
If you’re a high producing agent, you end up with a highly profitable business – and a big tax burden. But you’re in a desirable tax category – a qualified real estate professional, which means you can offset your income in numerous ways.
Here are some of the various techniques that wealthy individuals, particularly business owners and real estate agents, employ to leverage real estate investments to significantly lower their tax burden.
Understanding Depreciation in Real Estate
One of the key tax advantages of real estate investment is depreciation. Depreciation is a tax deduction that allows investors to recover the cost of an income-producing property over its useful life, as determined by the IRS.
For residential properties, this period is typically 27.5 years, while for commercial properties, it’s 39 years. This means that each year, investors can deduct a portion of the property’s cost from their taxable income.
Depreciation serves as a significant tax shield, especially for high-earning individuals. By reducing taxable income, investors lower their overall tax liability.
This strategy is particularly advantageous for business owners and real estate professionals, as it offsets the income generated from their primary business ventures, thereby reducing their overall tax burden.
Cost Segregation: Accelerated Depreciation
Cost segregation is another sophisticated tax strategy used in real estate. This involves breaking down the property into its constituent parts and depreciating some components (like new floors, light fixtures and kitchen improvements) over a shorter period, typically 5, 7, or 15 years.
Cost segregation studies are often conducted by tax professionals or engineers who specialize in this area. They analyze the property and allocate costs to different categories.
This accelerated depreciation results in substantial tax savings in the early years of property ownership. You’re essentially front-loading the tax savings and taking more of them in the early years instead of spreading them out evenly over a much longer period of time.
Real estate is the land + the structure. Keep in mind that you can’t depreciate the land so if you buy a rental in an amazing location where the land itself comprises a substantial portion of the value of the real estate, you won’t see a great return on a cost segregation study.
Rental Properties: A Tool for Tax Savings
Contrary to popular belief, many wealthy investors use rental properties not primarily as a source of income, but as a tool for tax savings. You’re not getting rich off the $150/month in profit from your rentals.
Besides depreciation, other deductible expenses include mortgage interest, property taxes, maintenance costs, property management fees, and insurance.
These deductions can offset the income generated by the property, often resulting in a net loss for tax purposes. However, for high-income business owners, these losses can be used to offset other taxable income, effectively reducing their overall tax liability.
This strategy is particularly effective for those in high tax brackets with significant business income.The cash flow from rental properties may cover the expenses and mortgage payments, but the real benefit lies in the tax deductions it offers. Saving 50K in taxes is just as good as making it.
Real Estate Professional Status
The IRS grants special consideration to individuals who qualify as real estate professionals. You’re a full time agent, right? To qualify, individuals must spend more than half of their working hours and at least 750 hours per year in real estate businesses.
This status allows realtors to deduct all of their rental real estate losses against other types of income, a benefit not available to passive investors.
This is a game-changer for high-income earners who actively participate in their real estate investments. It enables them to use real estate losses to offset their high taxable income from other sources, leading to substantial tax savings.
Bottom line, think about investing in real estate as a way to save money as well as make it. Real estate investment is less about generating income and more about strategic wealth growth (through equity appreciation) and tax minimization.
Through depreciation, cost segregation, and the use of rental properties, high-income individuals, especially business owners and real estate professionals, can significantly lower their tax bills.
Understanding and utilizing these strategies can lead to substantial long-term financial benefits. Remember, it’s not what you make. It’s what you keep.
Disclaimer: None of this is legal or tax advice. This is purely for entertainment purposes. You should consult a tax professional to review your options on what works best for you.