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It's been awhile since I've last posted. Almost two months actually. I took a break both from writing for The Real Estate CPA and BiggerPockets mainly because business is heating up (a good thing!) and I'm trying to successfully implement my new monthly pricing model. It's working well but has come with numerous headaches.
The good news is that I'm starting to streamline processes which means I'll be able to get back to my roots and what I really love: writing awesome content. With that comes today's article. This topic has stemmed from me being asked, over and over, how rental real estate can benefit taxpayers if their income exceeds $150,000.
Once your income level hits a certain threshold, it is believed (or taught in seminars) that you no longer get tax breaks from your real estate rentals. This, of course, is hogwash. The topic just needs to be explained in a different light. To do this, we're going to start with the basics.
Forget Refunds, It's all about The Tax You Actually Pay
Few non-tax savvy individuals truly understand their tax positions. This is evident by the fact that CPAs can build businesses specializing in tax strategy. Further evidence can be seen when taxpayers ask the wrong questions or focus on incorrect results. Of course, it's not the taxpayers fault. It's the lovely members of congress trying to write laws that appease every special interest group out there. Votes dictate law.
More than likely, you have salivated at the thought of receiving a large refund come tax time. I did when I worked jobs in high school and college prior to specializing in tax. There's nothing necessarily wrong with this, unless you are using your refund amount it as an indicator to judge your tax strategy success.
Related: Why Investing in Real Estate Dominates Your Stock Portfolio
I had a client in 2014 that didn't work with me in 2015. The client's reasoning was that they "had always received a larger refund when preparing their taxes on their own and now, when they hire a professional, their refund decreased significantly." Aside from the fact that this client had some highly questionable compliance issues going on with their previously self-prepared tax returns, I consider losing this client a failure on my behalf for two reasons:
- The client was evaluating my performance based solely on comparing the difference between 2013 and 2014 refunds; and
- I failed to recognize this and educate the client how to properly evaluate their tax position.
You should never, ever evaluate your tax strategy, or your CPA's performance, based on the size of the refund you receive. This will ensure that you perpetually operate ineffectively and in non-compliance manner. Your refund can fluctuate drastically year-to-year and sometimes even go into an "owe the IRS money" territory. And that's okay!
Let me demonstrate with a couple examples. Let's say that your tax liability for the year is $20,000. If you paid in estimated taxes, or withheld from your W2, an amount of $21,000, you'd be receiving a $1,000 refund. Instead of self-preparing, you take your return into Big Box Tax Prep Services and Joe Shady prepares your return for you. Joe deducts all sorts of crazy things that will hardly hold up under audit. It makes you a bit nervous, but Joe Shady has worked your tax liability down to $15,000 giving you a $6,000 refund! The refund has increased sizably so you decide Joe Shady must know something you don't and you accept your return as-is.
Tax preparation is a compliance based service. You take ultimate responsibility for your returns when you sign.
This is a huge mistake. Yes, Joe Shady could have taken completely legitimate deductions, but my point is to not focus on the refund. A large refund blinds you to the facts and circumstances of your tax position. Instead of thanking Joe Shady for getting you a huge refund, you should follow up with questions to make sure your tax returns are in compliance. The tax preparation process is not the time to be implementing tax strategies. It is a compliance service based on previous facts. And remember, you take ultimate responsibility for your returns when you sign on the dotted line. Trust but verify, even with CPAs. We all make mistakes.
Let's suppose instead of going to Joe Shady, you go to a qualified CPA. The CPA determines that your tax liability is indeed $20,000 but works with you to put a plan in action to decrease your tax liability in the following year. Since your withholdings from your W2 were $21,000, you receive a $1,000 refund this year.
The following year, your tax liability is $19,000, but the CPA also had you withhold $1,000 less from your W2, meaning that your total withholdings were $20,000. This leaves you with a $1,000 refund. Since you received a refund of $1,000 this year and a refund of $1,000 last year, clearly the CPA's work was ineffective, right?
Obviously you can see what I'm getting at. Your refund doesn't matter because it depends on what you are withholding or paying in estimated taxes as much as how your actual "out of pocket" tax cost changes.
What truly matters is the tax you actually pay. And when you divide the tax you actually pay by the total income you earn, you get your effective tax rate. This is the gold standard for tax strategy performance measurement.
How Real Estate Rentals Affect your Effective Tax Rate
Now that we know what really matters is the tax you actually pay, let's talk about your effective tax rate. Your effective tax rate is the rate at which you pay tax compared to your total income for the year. Ideally, we want to get this as low as possible. Wealthy individuals focus on lowering their effective tax rate above all else (Warren Buffet anyone?).
The formula for calculating your effective tax rate is: [Total Tax / Total Income]. Simple.
Seeing that, we can easily see that their are two ways to decrease our effective tax rate: (1) lower our tax; or (2) increase our income. Typically, when you increase your income, your tax increases relatively proportionately. And this is where real estate rentals come in handy. I teed this up perfectly didn't I?
Time for another example. Let's assume you earn $100,000 in your day job and pay $20,000 in taxes. Your effective tax rate is 20%. Now let's also assume you pick up a rental. It sports a net operating income (NOI) of $200 a month, but is being depreciated at a rate of $300 per month. Because depreciation is higher than your NOI, you'll report a passive loss for tax purposes, meaning the $200 monthly NOI is tax free.
If we add this $200 per month NOI to your $100,000 W2 income, your total income is now $102,400 for the year. Yet your taxes stay the same at $20,000 because only $100,000 is subject to tax as the $2,400 in net operating rental income is tax-free (technically they would decrease due to the passive loss which I'll touch on in a second). We've now decreased your effective tax rate to 19.5%.
You should strive to decrease your effective tax rate as much as possible.
Even better is the fact that the passive loss of $100 ($200 - $300) per month, or $1,200 annually, would decrease your income subject to taxes. Instead of having $100,000 subject to tax, you now only have $98,800 subject to tax. Assuming you are in the 28% tax bracket, your taxes owed will decrease by $336 to $19,664 ($20,000 - $336).
So now you are paying taxes of $19,664 on $102,400 of earnings for an effective tax rate of 19.2%. This decrease in your effective tax rate can be construed as additional return on your investment. You should strive to decrease your effective tax rate as much as possible.
Rental Real Estate Decreases Effective Tax Rates Even When You Are Phased Out of Passive Losses
In the above example you were earning $100,000 and were able to take that passive loss. You are able to take passive losses until your income exceeds $150,000. I have met many people who earn far above $150,000 and the question I always get is: will I be able to benefit from the tax shelters real estate offers?
The answer is a resounding yes! In the above example, I demonstrated that your effective tax rate will decrease because you are earning tax free rental income. This decrease occurs before passive losses were factored into the equation. By earning tax free income, your total earnings increase but your taxes owed stay the same.
This is a tough fact to drill into some people's head. When they buy rental property, they expect to see big changes on their tax returns. But this isn't always going to be the case. The devil is in the details and a good CPA will help you see that.
If you are phased out of passive losses, they will become suspended and used in the future when you show passive income. Check out a BiggerPockets article I wrote about how you can tap into suspended passive losses. The key for our discussion though is that if you are phased out of taking passive losses and they are instead suspended and carried forward, figuring out how to tap into those passive losses will reduce your effective tax rate. Why? Because you'll be earning more money that will be offset by the suspended passive losses. More tax free money causes your effective tax rate to decrease!
Conclusion
I hope that this article makes sense for you. We talked about ignoring your refund and focusing on how much tax you actually pay. We then discussed how that translates into your effective tax rate and how rental real estate reduces your effective tax rate. Even if you are phased out of taking losses, you will still largely benefit, tax wise, from investing in rental real estate. The more tax free income you earn, the lower your effective tax rate becomes.
As always, be careful with your investment strategy. The market has been hot for a while now and great deals are harder to come by. Stick to your investment criteria and never invest solely for tax purposes.