Investors dive into real estate for a variety of reasons. Some want to build wealth and others want to hold a tangible asset. Most investors agree that, while supplemental, they invest in real estate to reduce their tax burden.
After interviewing and strategizing with hundreds of investors, I’ve come to realize that most don’t actually know how real estate helps reduce their taxes. Many investors track their total tax liability year-over-year and can’t understand why it doesn’t drastically decrease when they buy rental property.
Of course, the confusion is warranted. The U.S. tax code is a rambling mess of text. You would only need to invest a few thousand hours to read through it all. Not a daunting task at all.
Yet it’s still a good idea to have a general understanding of how real estate actually reduces your taxes. That’s what we’ll explore today.
Your Effective Tax Rate Matters Most
Everyone has an effective tax rate, but few people track it. Your effective tax rate is your tax liability divided by total net income.
Your federal tax liability is found on Line 63 of Form 1040. However, if you hold a W-2 job, you also need to factor in your share of FICA taxes (7.65% of your gross wages). Lastly, you should also factor in your state tax liability. The combination of these three taxes will yield your total tax.
You will then divide your total tax by gross wages plus net income from trades, businesses, and investments. Note that net income does not equal net taxable income. The result will be your effective tax rate.
How Real Estate Reduces Your Effective Tax Rate
The cool thing about real estate is that you can have net income from a rental property of $10,000, but due to depreciation and amortization, you don’t pay tax on the full $10,000. The beautiful thing about this though is that the full $10,000 still hits your pocket as cash flow.
Let’s look at an example.
Assume that you are single and earning $100,000 a year in W-2 gross wages. If this is your only income stream, you’ll pay roughly $18,000 in federal income tax. You’ll also pay $7,650 in FICA taxes. Excluding state taxes, your tax liability is $25,650 which means your effective tax rate is 25.65% ($25,650 / $100,000).
Let’s assume the same facts above but now you have two rental properties that each generate $10,000 in net income before depreciation and amortization. Your depreciation and amortization deductions are $7,000 per property. This leaves you with $3,000 in net taxable income per property, or $6,000 total. As a result, your tax bill increases to $27,330. But because we’ve added $20,000 in net income between the two properties, our effective tax rate has actually dropped to 22.78% ($27,330 / $120,000)!
Most people will look at the increase in total tax and think that real estate has failed them. But that’s clearly not the case. Thanks to the real estate generating income that was not taxed, our effective tax rate drops meaning you are paying less in tax per dollar earned.
What About Passive Losses
The above assumes that we have passive taxable income. In the event that we have passive losses, a few more factors come into play.
First, if your Modified Adjusted Gross Income (MAGI) is less than $100,000, you will be able to take up to $25,000 in passive losses. For most investors with a MAGI of less than $100,000, rental losses are generally manageable and not a problem.
As your MAGI increase, the $25,000 passive loss allowance is reduced by $1 for every $2 increase in MAGI.
When your MAGI exceeds $150,000, you can no longer take passive losses. Unless of course you or your spouse qualifies as a real estate professional.
Even if you have passive losses that you cannot claim, rental real estate still helps reduce your effective tax rate. Assuming you have $10,000 in net income and a $12,000 depreciation and amortization deduction, you’ll have a passive loss of $2,000. If you cannot claim that loss, it becomes suspended and carried forward until it can be utilized. But you still sheltered $10,000 of net income from taxes. Thus, your effective tax rate has been reduced.
Wrapping It Up
It’s all about your effective tax rate. Focus on it, and track it year-after-year. You’ll come to find that by focusing on reducing your effective tax rate, you’ll naturally invest in income streams that are tax sheltered. You may even find yourself starting a business to have more control over the income you report each year.
Eventually, you’ll be paying taxes of $1MM per year, but your effective tax rate will only be 10%, meaning you earned $10MM. That’s the dream, right?