In the last few weeks, our President’s $750 tax bill to the IRS brought to light how wealthy citizens are using business and real estate to pay significantly less in taxes, legally. Rather than getting into a polarized political discussion, we want to take a deep look into how that was achieved.   I want to share my experience where I went from paying tens of thousands in tax dollars to the IRS to paying no taxes in my most recent years using real estate investing.  Here are the fundamental components that you can implement to do the same.

Step 1: Hire a CPA

How did I know that not paying one cent of tax was even a possibility?  As in most situations, I started diligent research into this topic after hearing about this idea from a fellow real estate investor.  I learned from articles online, I read books and even dug into a few IRS documents.  However, reading and keeping up with different policy changes is just impossible and, honestly, not what I want to do with my time.  So I hired a Certified Public Accountant, or CPA, to do this work for me and become part of my team.  After a few years of trial and error with different CPAs and lots of networking, we found the right person for us.  

Finding and trusting professionals is how you can scale up your wealth-building efforts and reach the top faster.  Your CPA is one of your MVPs, your most valuable players, and you should be prepared to pay them accordingly.  Seeking out the most affordable CPA is not what we’re suggesting.  On the contrary, paying your CPA may be one of your largest business investments. A very good one at that!

So how do you know if you’ve found the right CPA?

• You should select a CPA that is well-versed in your line of business.  If you are a real estate professional, you should hire a CPA who has experience with real estate investments and who has other real estate investing clients. 

• Ask for three referrals from current clients who conduct real estate investment activity with that CPA.  Schedule a consultation to see if you are a good fit, keeping in mind personality and risk tolerance. 

• Ask if they have ever been audited and how they handled these situations.  Being audited is not a bad thing since audits are selected at random by the IRS.  As long as your CPA is 100% prepared and ready to back up any and all questions from the IRS when the time comes, you are in good hands.

• You may also want to hire someone who has a firm that backs them up instead of being a one-man operation.  Come tax season, you want your CPA to be available to file your tax returns on time.  Different CPAs specialize in different areas of accounting just like doctors and lawyers.  Your business may not be limited to just one dimension.  With a diversified firm, your CPA can ask for second opinions from co-workers that may be experts in other areas of tax code.

Step 2: Invest in Real Estate to Earn Passive Income 

Before hiring our CPA, I did my own taxes using TurboTax. Yes, I would still recommend this if you have a very simple tax. After owning our first rental, I learned about the term “depreciation.”  So I did a search on depreciation to find out more about how this affected my business during tax season.  This is when I discovered more about paying ZERO dollars in taxes on rental income.  I was floored, in a good way.  I wanted to learn all I could about the power of depreciation in regards to paying less in taxes. It is not until I hired my right CPA, was I able to harvest the power of depreciation fully. 

Depreciation is a reduction in the value of an asset with the passage of time, mostly due to wear and tear.  Any asset can have depreciation and real estate contains physical assets such as buildings, flooring, appliances, etc. You can claim paper losses due to the fact that the physical assets are getting older. They can all be depreciated. 

In the US, the IRS has prescribed the useful life of a residential property (including multifamily buildings) as 27.5 years and commercial property as 39 years.  Land is not depreciable.  For a residential rental, the depreciation is calculated by subtracting the land value from the property value (including building structures, flooring and appliances etc) and dividing the building value by 27.5 years. 

Example using a Single-Family Rental Home purchased in 2018 for $200,000

Conclusion: Not counting depreciations, you have $3,860 total taxable income. With depreciations, you have a LOSS of $2,321.82. You make NO money, thus, pay NO tax. 

If you are generating passive income from your rental, you can subtract your depreciation loss from your income. If you have a mortgage on your building, you can deduct that from your passive income as well. It is very likely that you may carry a loss on paper (in the eyes of the IRS) if you have the right amount of leverage with depreciation and a mortgage.  This example includes a paper loss even after receiving rental income for the property.  This strategy is how some landlords pay hardly any taxes at all for their rental income.  They are not cheaters, they are using the power of real estate and leveraging their assets.

Tax free cash flow is awesome and not something my Full Time Day Job can provide. After switching from TurboTax to a CPA, I was able to maximize these factors of my real estate investments to benefit me during tax season.  

With this foundational understanding, I added more and more rentals to our portfolio. Not only that, all the improvements we made to our properties increased our depreciation and base price, which set the stage for even more tax deductions.  Score!

Step 3: Implement Cost Segregation and Bonus Depreciation Strategies

Now we got the basics depreciation down. The depreciation method described above is called Straight Line Depreciation. Could you make depreciation happen faster than 27.5 years? If you can, that means more saving in the front. Turns out you can. 

Let’s go back to our Single Family Rental example.  Not everything in this property is depreciated at the same time.  For example, appliances only last about 5-10 years.  The structure, however, may last more than 30 years.  

To clarify these points, the IRS has assigned a standard lifespan for a given category of assets. You have the option to assign different depreciation speeds to different categories of assets. Who has seen a fridge last longer than 27.5 years? The IRS does not think a fridge can last this long, either. Therefore, they determined that appliances have a lifespan of 5 years. Let’s say you bought a house with a brand new fridge.  The depreciation of that fridge will be it’s value divided by 5 years instead of 27.5 years. If you take all this up in the first 5 years, your deductible is higher. This is called Accelerated Depreciation. Let’s demonstrate how this works with some math.

Conclusion: This is $818.20 more deduction you can take in the first five years using Accelerated Depreciation vs. Straight Line Depreciation. A dollar today is more than a dollar in future.

How do you know what the depreciation of your assets should be? These estimates can’t be pulled out of thin air.  The last thing we want is to be on the naughty list of the IRS.  You should have professionals to backup your depreciation claims.  A cost segregation study is needed at this point.  Professional engineers perform this study on investment buildings. The engineers will access the structure, take pictures and assess each item to determine how much usable life remains.  Some CPAs can perform a rough estimate of cost segregation, but an official study is highly recommended to back up these claims. This is a best practice for those who want to invest in real estate and leverage the tax benefits wisely and legally. When the IRS comes knocking, you are prepared as an investor.  

At the time of this writing, bonus depreciation is still in effect. This is a relatively new policy, started in September, 2017.  For buildings acquired or improved after September, 2017, investors can decide to take the majority of the depreciation assigned, to 5 and 15 year depreciation schedules, to the first year of ownership. There is a 25% penalty of the remaining depreciation if taken upfront when the asset is sold. If you believe that a dollar today is better than a dollar tomorrow, you have realized the power of bonus depreciation. Some of the top earners are in the tax bracket higher than 25%.  Thus, with the penalty rate, you still end up a winner. 

So let’s use that fridge to demonstrate this concept again.

Conclusion: That is $800 more depreciation you can take in year one using Bonus Depreciation vs. Accelerated Depreciation.

This is awesome! You can watch my interview with Yonah Weiss as he takes a deep dive into cost segregation and bonus depreciation.  Why doesn’t everyone do this?  A study like this costs thousands of dollars. A rule of thumb to decide when a cost segregation study makes financial sense is if the purchase price of the property is over $500K.

For residential properties worth less than $500K, KBKG offers this service for a fraction of the cost. You can take the report to your CPA as a backup to your claim. 

Cost segregation and bonus depreciation was a game changer for us when we started to acquire large apartment complexes.  For each project, we had our cost segregation company come out in the first year and implement the bonus depreciation when filing tax.  Our investors received anywhere from 40% to 100% of their invested amount in terms of paper loss on their partner returns.  We continue to use this strategy.

Step 4: Qualify as a Real Estate Professional and Scale Up Your Real Estate Profile

As we expanded our capacity to add more real estate to our portfolio using the above strategies, we got more involved in projects on both the passive and active side of real estate.  At this point, we had the paper loss and accomplished paying ZERO income taxes from our real estate passive income.  We also realized that we couldn’t take advantage of the six figure loss in full scope because of our W2 day jobs.

For our international readers, a W2 job is a full time job for an employer, not working for yourself.  The name “W2 job” comes from the W2 Form an employee receives from their full time job indicating income from an employer.  

There are tax breaks for business owners and investors, but rarely any for a job holder.  Not only that, remember all the paper losses like depreciation and cost segregation?  Unless you are a Real Estate Professional by the IRS standard, you are subject to the passive loss limitation which phases out completely if you are making $150K+ annually at the time of this writing. This means, you can stare at these lovely losses but you won’t be able to use the losses to your benefit immediately. You will have to carry the excess loss forward until the property is sold. 

It actually pays to be an IRS classified Real Estate Professional. If you are a Real Estate Professional who is materially participating in your own projects at least 500 hours a year, you can use your passive losses to offset your active income. WOW! 

What is an IRS defined Real Estate Professional? To be a Real Estate Professional, a taxpayer must prove material participation in your real estate investments. This can be proven in a number of different ways, but ultimately it nets out to proving at least 500 hours worth of work each year. Check out our other article which dives into the details of what exactly it takes to gain REP status here.

When you work 40 hours per week for an employer, you will need to accrue an additional 20 hours per week of real estate business work.  We recommend that you keep a highly detailed log of your activities and hours. Based on court case hearings, the vast majority of people who have a W2 job loses the battle with the IRS on when trying to claim Real Estate Professional status.  Working 60 hours or more a week is difficult and not justifiable in the eyes of the IRS. Again, we DO NOT want to get on the naughty list with the IRS. 

If you scale back on your full time job and instead work as a consultant or work part time, it will now become easier for you to work more on your real estate business. If you work 30 hours a week, you need 10 hours a week or more dedicated to your real estate business. That starts to look achievable.

This is a great plan for people who are real estate investors to ease into. Increase your real estate portfolio and set a goal to shift from a full time employee to part time work or consulting.

It is important to note that there are plenty of Real Estate Professionals who are not taking advantage of this.  If you are a real estate agent, flipper or a builder who does not own your own rentals, then you are not taking advantage of this fully.  You need an additional 500 hours a year to part take your own rentals (passive income) in order to apply that nice looking passive partnership return you get from passive apartment investing to offset your active income. This means instead of flipping, maybe consider holding a few properties to utilize as rentals.  Instead of just being a transactional agent, you may want to see if you can roll your commission into investment properties. 

To put this into perspective, let’s dissect a fix-and-flip scenario and see how the effect of holding that property will play. 

If you are just doing a conventional Fix and Flip, you will be taxed at ordinary income rate. We assumed that is 24% in the following calculation. Here is your profit if you were just doing a conventional Fix and Flip.

If you are to hold the property as a long term rental instead, you will not only gain long term cash flow, but there are tax benefits using the depreciations discussed before. Here is what will happen if instead of flipping the property, you fixed it up and hold it as a long term rental property.

Conclusion: This is a $14,400 difference without even counting the accelerated and bonus depreciation strategy. 

Let’s now look at what would happen if you were to do this couple more times and racked out 500 hours on your own rentals. This allows you to take advantage of negative K1 passive partnership returns. Then you reinvest that $52,400 into a syndication deal passively to gain a negative K1 using bonus depreciation strategy.

Let’s now look at what will happen if you were to do this couple more times and racked out 500 hours on your own rentals. This allows you to take advantage of negative K1 passive partnership returns. Then you reinvest that $52,400 into a syndication deal passively to gain a negative K1 using bonus depreciation strategy.

Conclusion: This is additional $5,030 in your pocket, not even counting the profit made from syndication returns. Compared with traditional fix and flip, fix, hold and reinvest in project that has bonus depreciation will net you extra $19,430 (which is 51% more) dollars to keep after tax.

WOW!!! 51% More To Keep!

I hope you have grasped the power of leveraging the right strategies and working to set yourself up properly. Knowledge is the best!

At one point, our apartment business had grown to such a state that by quitting my W2 job it would allow me to qualify as a Real Estate Professional. My passive and active partnership returns have grown so much that it covers all my gains in one year and six figures more on losses. I was able to use these losses to offset my W2 job income for the year I quit. I achieved paying ZERO income taxes that year, legally. 

Step 5 Bonus: Using the CARES Act to Get My Tax Refund

Think that paying ZERO income tax is awesome?  How about getting money back from the IRS for taxes you have paid in previous years?  Under the CARES Act of 2020, taxpayers can carry back Net Operating Losses (NOLs) generated in taxable years after December 31, 2017 but before January 1, 2021, for up to five years. 

After we applied our losses to our active income for the year, we qualified as Real Estate Professionals and we are still staring at a very large paper loss from our apartment investments. The CARES Act changes that are mentioned above basically said we can now retroactively apply these losses to 2014-2018. This means that we can go back and claim 6 digits of tax refunds from the previous five years of income tax that we paid the IRS from to our W2 jobs. (Yes, we did pay a large amount in taxes during our W2 years.) Now this is really something to write home about! 

To learn more about this CARES Act Change, please click here to view an interview we did with our CPA, Thomas Jones, on this topic. 

I am hoping by now, you can agree with me that investing in real estate is pretty AMAZING!  Whether you believe in paying taxes or not, I think we can all agree that life is about obtaining knowledge and making improved choices based on the information we know.  What better reason is there to become an investor and scale back on your day time job?

Disclaimer, we are writing this purely from our personal experience with applying certain tax strategies to our investments.  We are not financial advisors or tax professionals.  Everyone’s tax situation is different.  The topics we covered here are very advanced tax strategies.  You should consult a tax professional to help implement strategies like the ones mentioned above. 

However, if you are interested in discussing your financial independence or real estate investing goals, please schedule a call with us to see how we can help!