Tax Strategies for Passive Investors

“…in this world, nothing is certain except death and taxes…” – Benjamin Franklin

For most Americans, taxes are their largest annual expense. Therefore, it is no wonder that many are seeking ways to make additional income and lessen the impact of their tax bill.

In December, we brought in Ted Lanzaro, certified public accountant, real estate investor and broker, to speak to the Passive Investing Made Simple Masterclass about tax strategies available to passive real estate investors.

Here are my notes from this amazing masterclass…

Tax Benefits of Passive Investing

Investing in real estate potentially allows your money to work hard in five places at once (unlike publicly traded securities). One of the wealth generators of real estate—even passive real estate—is the various tax benefits. Below are five tax benefits that every investor should know about.

Depreciation: This is the amount that can be deducted from income each year as depreciable items age. The losses generated from all types of depreciation are paper losses (not income losses). These losses help keep the income from the investment tax-free, and depending on your personal tax situation, may be used against other income as well.

Cost Segregation: This is a study performed by an engineer to identify all the improvement items of a property and assign them to a particular depreciation timeline; between one and 27.5 years for multifamily, and one and 39 years for self-storage/commercial. When this study is completed, investors may be able to accelerate depreciation to the early years of a project, accelerating losses, and reducing their taxable income.

Bonus Depreciation: With the Tax Cuts and Jobs Act of 2017, items that depreciate in less than 20 years can be accelerated to the first year of ownership. This allows investors to capture losses quickly.

Return of Capital via Lending: Just like your personal investment property, when you perform a cash-out refinance or secure a second line of credit, capital can be returned to the investor tax-free to invest in future projects. In theory, your capital could help you access multiple investments at the same time, amplifying returns.

1031 Exchanges: This is the swap of one investment property for another that allows capital gains tax and depreciation recapture to be deferred (we will talk more about this below). It gets its name from Section 1031 of the US Internal Revenue Code and can be a very powerful generational wealth-building strategy.

If executed correctly, all these strategies potentially allow the investor to keep all (or part) of the income and gains of a passive investment tax-free.

Tax Implications of Passive Investing

What the IRS giveth, they could (potentially) taketh away. Here are two tax implications that investors need to be aware of upon the sale of an asset:

Depreciation recapture: This is the gain realized by the sale of depreciable capital property that must be reported as ordinary income for tax purposes. Depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis (the original value, or purchase price, of an asset).

Capital gains: This is determined by subtracting the cost basis from the net proceeds. If it’s a negative number, you have a loss. If it’s a positive number, you have a gain. As of 2021, that tax rate is 15% if you’re married and filing jointly with taxable income between $80,000 and $496,600. If your taxable income is $496,600 or more, the capital gains rate increases to 20%.

How a Real Estate Tax Strategy Builds Wealth

As discussed earlier, you can defer depreciation recapture and capital gains taxes through a 1031 exchange. You could possibly eliminate your depreciation recapture and capital gains tax if you continued to “swap” real estate through a 1031 exchange and pass away holding the asset. When you pass away holding your assets, you would avoid any personal taxation and your heirs could potentially inherit the assets tax-free. This is known as the “swap until you drop” method or “buy, borrow, die.” The error most investors commit is gifting assets to their heirs early, thereby triggering taxation.

While 1031 exchanges are the gold standard for deferring taxes, they can be difficult to time and execute. Another way to offset taxation on depreciation recapture and capital gains (in all or part) is to liquidate your asset and then immediately invest all your capital within the same calendar year into another asset that has comparable tax benefits (depreciation and bonus depreciation) to the asset sold. This strategy has been lovingly named “the lazy man’s 1031.”

Nicknames aside, both strategies are highly effective at eliminating a large tax bill, allowing you to reinvest those savings, and build generational wealth.

Tax Implications on Funding Your Initial Investment

Another question that I often get from investors is how they should fund their investment for the best tax impact. There isn’t a clear-cut answer to this question.

What is clear-cut is that you need to understand what your investing goals are.

Do you need the cash flow now or later?

Do you need the equity now or later?

Do you need the tax benefits now or later?

The main takeaway is, if you invest through an entity or tax-free or tax-deferred account, just know that all cash flow, equity, and tax benefits flow back to that account (e.g., if you need to realize the tax benefits now for your investment, investing in a retirement account most likely won’t align with your goal). Therefore, the answer lies with you on which funding strategy matches your investment goals.

Wrapping It Up

So, what are the next steps to developing your passive real estate tax strategy? 1) Define your goals; 2) Don’t go at this alone — Sit down with a tax strategist to put together a plan before you invest. A tax strategist differs from a tax preparer. So, find someone that will look at your entire tax situation and give you proactive advice on how to plan to lower your tax bill. If you have already invested in a deal (or a few), now is the next best time to meet with them; 3) Meet with your tax strategist regularly (one to two times a year) to keep your plan on track; 4) Talk to your tax strategist before each major investing or sales decision — While some tax strategies can be implemented after the transaction, there are a few tax strategies like the 1031 exchange that must be done in real-time.