“Don’t just learn the tricks of the trade. Learn the trade.” ~ James Bennis
One of the biggest drags on our financial lives is the dreaded certainty of TAXES. It’s true – it’s kind of a bummer when you work hard to make $100 only to be left with $55 worth of spendable income.
The negative effect of taxes is partly what drives a lot of us toward investing, since upon a little studying we come to realize that income generated through investments is generally-speaking taxed at a much lower level that W2 or 1099 income. There is a lot of argument in America today as to whether this is fair or not, and I am certainly not going to pass judgment on the subject here. I will say, however, that this reality is not hard to understand – the government wants and needs to incentivize investment in a capitalist consumer-driven economy, and lower tax burden is how they do it. Understand – the Internal Revenue Code is the vehicle through which our government incentivizes our behavior. If you do this, we’ll lower your taxes and let you keep more money – works every time…
Well, what can I say – lower taxes is a good thing, but no taxes at all is even better – wouldn’t you agree? From an investment stand-point, any strategy allowing us to avoid paying Capital Gains Tax which drives down our ROI is a good thing indeed, and in real estate we can do just that – well almost…
Before we can talk about this in more specificity, I must underscore some generalities relative to taxation of income generated through investments in real estate.
PROFITS IN REAL ESTATE
Relative to long-term real estate investments there are basically two main profit modes – we make money with rents throughout the life of an income-producing asset (Cash Flow), and we make money at the time of sale (Capital Gains). At least this is how it’s supposed to work when done properly lol. Let’s discuss how these two types of income are taxed:
CASH FLOW
Cash flow is what’s left of the income after we pay all of the expenses. The formula is:
Cash Flow = Gross Income – Expenses
where Gross Income is sum of all of the revenue streams produced by the asset, and Expenses is sum of all of the operating costs associated with the asset plus the debt service (mortgages).
So, if for example you pay $130,000 for a 4-Plex whereby all units are rented for $500/month for a total of $2,000/month of Gross Income, and your expenses including all mortgage payments total $1,500, then the monthly Cash Flow from this building is $500. All things being equal, this Cash Flow, which will add up to $6,000/year, is what you’ll be taxed upon. These earnings are taxed as ordinary income, though there are a couple of interesting points regarding this:
This $6,000 number in actuality will be off-set by something we call paper losses. Paper losses are deductions that the IRS allows us to take on paper which have the effect of shielding the income – they are not real expenses that we have to spend money on, but on tax return they act as expenses. One such loss is depreciation of property and equipment; another is the interest on financing attached to the asset; and there are others. Now is not the time to get into this minutia, suffice it to say that on a building such as this you may be able to write off about $4,500 in the first year, leaving you with taxable gain of only $1,500.
This income, as I mentioned, is taxed as ordinary income, and the rate at which you’ll be taxed is a function of the income tax bracket that you happen to be in. If you are in the 10% tax bracket, for example, you would need to pay $150 worth of tax – not bad… Having put in the bank $6,000, you only pay $150 worth of tax, leaving you with $5,850 of spendable income!
There are two points to be made here. First of all, having started out with $6,000 of “in your pocket” income, the paper losses have enabled you to hide (shelter) 75% of that as far as the IRS is concerned – LEGALLY! This may not seem like a huge deal, but what if in lieu of a little 4-plex we were talking about a 40-Unit, and in lieu of sheltering $4,500 out of $6,000 we were talking about sheltering $45,000 out of $60,000 – would this make it a bigger deal?
Yes – yes it would! Why – because $60,000 of taxable income might put you into the 25% tax bracket, while $15,000 of taxable income might put you into the 10% bracket, and considering that the amount of tax you pay is a function of the bracket you find yourself in, this is a very big deal indeed! What’s better, paying $15,000 of tax (25% of $60,000) or $1,500 (10% of $15,000)? What’s better, earning $60,000 of Cash Flow and being left with $45,000 of spendable income, or earning $60,000 of Cash Flow but being left with $58,500 – this ain’t rocket science…
Also needs to be mentioned the fact that while investment income such as this is taxed as regular income, it is not subject to either Social Security or Medicare tax, which doesn’t hurt since it shaves over 15% of tax liability. All and all, the above is why a lot of us prefer to make a living with rentals in lieu of W2 or 1099 income!
CAPITAL GAINS
Let’s say that 5 years down the road you decide to sell this 4-Plex, and that you manage to get $170,000 for it. You will be taxed in two ways. First, you’ll have to pay tax on all of that income that you were able to depreciate (shelter) over the five years that you owned the building – I discussed this in detail here. For the purposes of this example, let’s say that you’ve depreciated a total of 18,000 – think of it as income that you were allowed not to pay taxes on as you went. Ordinarily, at the time of the sale you would have to recapture this depreciation at whatever your income tax bracket rate is at that point. If you happen to be in the 10% bracket at the time you sell, you’d pay $1,800 worth of tax as it relates to depreciation recapture.
Further, ordinarily you’d need to pay taxes on your Capital Gains. Considering your original purchase price of $130,000 and the liquidation price of $170,000, your capital gains in this deal will be $40,000. While the rate for the long-term Capital Gains Tax fluctuates every few years depending on the political environment and who is in the White House, it is currently at 20%, which means that all things being equal you would typically owe $$8,000 of tax due to your Capital Gains. And once again, this type of income is not subject to Social Security tax. Thus:
EFFECTIVE TAX RATE
If we combine the $1,800 tax from the recapture of depreciation with $8,000 Capital Gains Tax, we arrive at total tax burden upon the sale of the building of a bit under $10,000. With no Social Security tax attached and juxtaposed against $40,000 of gain on the sale, this seemingly represents a 25% effective tax rate. However, what about the Cash Flow throughout the 5 years?
Well – if we combine $5,850/year of after-tax income for 5 years ($29,250) with $40,000 of Capital Gains at the time of sale, we realize that the total gain over the life of the investment is $69,250. The income taxes paid throughout the life of this investment add up to ($150/year x 5) + $10,000 (Cap Gains) = $10,750. Juxtaposed against total income over the life of the investment of $69,250, this constitutes an effective tax rate of 15.5%. In the world where how much you keep is much more important than how much you earn, 15.5% effective tax rate represents a phenomenal opportunity. Even more so when you consider that this asset could have been fully financed with OPM (Other People’s Money)!
But, why stop there? Wouldn’t it be great not to pay that big tax bill when you sell? Well ladies and gents – If we are talking real estate there is a way to do just that, and it’s legal.
HOW TO AVOID CAPITAL GAINS TAX ON REAL ESTATE
Section 1031 of the Internal Revenue Code outlines what is essentially a handy loophole for real estate investors. The exchange allows us to sell a property and roll the money into a bigger, newer, and otherwise better property, and if we do it in accordance with all of the rules and regulations put forth by the IRS, then we are allowed to defer taxes on the gains associated with the sale.
I will talk about the 1031 Exchange in more specificity in another article and I advise you to speak to your CPA before using it. For now, simply understand that Capital Gains are taxed when they are reported, and since the exchange provides a mechanism to roll those gains without actually reporting them, provided the exchange is administered correctly, no gains are taxed and no depreciation is recaptured; both are deferred.
Now, deferment is not the same thing as exclusion – you still owe the money and you will eventually need to pay up. But, it is thought that in later years, as your productivity goes down and with it your income, so will your tax bracket. And besides, if you play your cards wright and get away from the highly taxed earned income, you may very well make much more money and yet be in a lower tax bracket than in your younger years when you earned a lot more via W2 and 1099. With this in mind, it seems to make sense to take the hit on recapturing the depreciation and taking those Capital Gains at some time later. And as to the Capital Gains Tax, it changes as often as occupants of the White House, so we have to do the best that we can…
CONCLUSION
No one likes taxes, but in their quest to avoid capital gains tax or other taxes many people fall into the trap of playing the game of cat and mouse with the IRS. This is not only illegal, but totally unnecessary. The IRS tells us exactly what to do in order to achieve a lower effective tax rate legally and ethically – all you’ve got to do is read…
Did this help? Feel free to leave comments and questions below.
Disclaimer: I am not a CPA – I simply know enough to be able to speak intelligently to my advisors. The purpose of this article is to help you speak intelligently to your advisors. The information contained herein is presented for educational purposes only and is not mean as legal advice. Before acting upon anything you read here or anywhere, you are advised to seek council of qualified professionals.
Photo Credit: The Cat Burglar via Compfight cc
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