Real estate investing to reduce W2 income

[Karl S.]

I'd like to get feedback on a strategy I want to pursue. I work in Silicon Valley and make well into the maximum tax bracket. I wanted to pursue REI both as a way to invest extra money (already maxed all other tax advantages accounts) and a way to further reduce my tax burden.

My understanding is that if my spouse (not employed) becomes an RE professional, and if we perform a cost segregation study on a purchase, we can deduct approximately ~25% of the purchase price from my W2. This would only work on Federal tax, not FICA or California tax as the state does not participate, but it is still 37%, and may be more in the years to come.

The strategy would be something like this:

year 1: buy multifamily for ~$1M, cost segregate, deduct

year 2: buy multifamily for ~$1M, cost segregate, deduct

year 3: buy multifamily for ~$1M, cost segregate, deduct

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.

.

stop at some point and enjoy having cash flow + $100k of cash savings a year due to reduced taxes.

Spouse is onboard and would do most of the work buying these properties, and managing them if they are reasonably local.

Exit strategy would be don’t exit. Keep the assets for my kids and take advantage of stepped up basis, or at least sell a long time from now at a highly reduced tax burden due to inflation.

Is anyone doing this? Any pitfalls to this strategy to watch out for?

The other question is location. My father lives in Sacramento and is a general contractor. So the reasonable choices I see are:

1. Bay area: Close and easy to manage, cash flow negative and speculative, non-diversified from our assets and my job.
2. Sacramento area: Cash flow neutral-ish, have a trusted person to help in rehab if needed as part of BRRRR, too far to property manage for spouse to get RE professional hours? (that's is question)
3. Out of state somewhere: good cash flow, but need to setup a whole team, but could spouse still qualify as RE professional?

What would you do in my situation? Thanks.

[Michael Plaks]

@Karl S.

While your overall plan makes sense and is being used by many investors, I'm not sure if you fully understand an important point brought up by @Yonah Weiss. It does not change the concept, but it does change the numbers in your projections.

Specifically, cost segregation does not have its own separate tax deduction. It is thrown into that one big pot where all your RE income and expenses are. If your taxable income was exactly equal to your deductible expenses (including the "normal" slow depreciation) - then cost segregation creates a loss. If your taxable income exceeded your deductible expenses, then the additional depreciation from cost segregation offsets this income first, and the loss is whatever is left.

What is important to remember here is that accelerated depreciation from cost segregation eats into the full amount (tax basis) available for depreciation, so in the future years you will actually have LESS depreciation than you would've had without cost segregation. This can create net positive taxable income in the future years, where otherwise it would have been a loss.

Further, all properties are combined for the final tax liability. If you cost seg Property A in 2020 for a massive write-off, this property may end up with net income in 2021. If in 2021 you buy Property B and repeat the drill, the tax deductions from Property B will have to offset income from Property A before they can create an overall loss.

This does not make your plan bad, but it may factor into calculating how much in actual savings you can squeeze out of it.

Also, you used the term "cash flow" when comparing your target areas. Do not forget that cash flow is not the same as taxable income/loss. Many types of cash expenditures do not become a matching tax deduction. For example, property search and acquisition costs, costs of obtaining funding, principal payments towards mortgage, property improvements that have to be capitalized, etc.