Last year, a study carried out by White House economists found that The Forbes 400 (aka America’s 400 wealthiest families) paid a lower income tax rate than many middle-class families. While some were quick to accuse these families of tax evasion, unrealized capital gains were found to be the key differentiator between these ultra-wealthy families and the average American household. So, what exactly does that mean? Well, Americans are required to pay capital gains tax on profits earned from selling an asset like stocks and real estate. But, if those assets are never sold, the gains are considered “unrealized” and therefore no taxes are owed —regardless of how much those assets appreciate.
This tax discrepancy comes down to the fact that the IRS does not treat all sources of income equally. So, although Americans are taxed on 100% of their salaried income, income derived from profits, dividends, rents, and capital gains are treated much differently. As a result, tax literacy has become an invaluable skill that wealthy Americans utilize to legally reduce the amount of taxes they pay. While I could discuss various tax strategies at length, depreciation is one of the ultimate perks of investing in real estate — so let’s start there.
What is Depreciation?
Depreciation refers to the reduction in the value of a fixed asset within a fiscal year. Aside from the land itself, virtually every element of a property depreciates over time (due to age and use). To compensate for this inevitable loss, the IRS allows investors to deduct depreciation from the value of the asset to reduce their tax basis. So, although the term sounds negative, it’s actually a good thing when it comes to real estate investments. Here’s a recent example from our portfolio to illustrate how significantly you can alter your taxes by leveraging depreciation laws.
Last year we acquired a gas station that paid 8% cash-on-cash return, which is great. Unfortunately, our profits on this asset were shielded by the property’s substantial tax loss. But, by leveraging our knowledge of depreciation, we were able to depreciate 100% of this property in one year, creating a massive tax write off that streamlined our income-generating timeline. While this outcome is certainly not typical, it illustrates how real estate investors can simultaneously earn passive income from an appreciating asset, while utilizing the depreciation allowance to reduce their taxable income.
What About Real Estate Fund Taxes?
When you invest with a real estate fund, the overall tax strategy will be dictated by the fund manager, but individual taxes will vary from person to person. Having the right team of professionals (with relevant experience) is a crucial component to optimizing your investment is optimized while minimizing taxes. So, don’t shy away from asking questions and involving your CPA from the beginning. As a starting point, you want to know about the overall plan for the fund, their tax strategy, and how that will affect you as an individual investor. If the fund manager doesn’t have clear-cut answers for you, that’s not a good sign.
At the end of each year, our investors are sent K1s, which outline their gains or losses for that year. From there, it’s up to your CPA to determine the best way to incorporate those gains or losses into your tax return. Now when you invest in a fund (rather than in real estate directly), you typically won’t be able to individually benefit from tax strategies like depreciation or the 1031 exchange. But your individual taxes will be affected by the profits you earn from the fund. Depending on the fund, these may be paid out quarterly, annually, or upon exiting the fund — all of which may have varying effects on your annual earnings. Ultimately, the payment structure is determined by the fund manager, which is why it’s essential to ask these questions and consult your CPA before signing on the dotted line.
Partnering with a CPA or team of CPAs with a thorough understanding of real estate can save you hundreds of thousands of dollars in taxes, so don’t be afraid to meet with a few before making your decision. With that said, I never condone putting yourself in a vulnerable position in an attempt to eliminate taxes altogether. Remember, owing more taxes means you’re making more money, which is the ultimate goal here — taxes are merely part of the overall equation.
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