Buying Real Estate to Reduce Tax Burden

Sean Nelson · 2021-05-17T11:20:59-07:00

Newbie here. Im fascinated with the depreciation aspect of real estate and I have a question.Lets say I own a few different non-real estate related businesses. And my earned income from those businesses equals about $275,000.Now lets say I buy real estate for the sole purpose of achieving a depreciation write off which equals about $275,000/yr. This means I would have to have a real estate portfolio or a single property with a value of $7,562,500. Assuming im understanding tax law correct, i could write off $275,000 each year because $7,562,500/27.5 = $275,000Lets just assume the real estate property doesnt even cash flow. I just break even.So in simplification purposes, I would be paying no taxes right?$275,000 in earned income - $275,000 in depreciation = $0 in taxable income?Is this all above correct, or is there some limit Im missing out on? Is there ever a maximum amount of Depreciation that I can use to offset my earned income? For example, lets say I make $1,000,000 in earned income each year, but I have $1,000,000 in depreciation

Julio GonzalezPro Member

Specialist · West Palm Beach, FL · Member since 2008 · 4k+ posts · 1k+ votes

5y

Hi @Sean Nelson. Welcome to BP! An additional aspect of depreciation is the use of a cost segregation study. In your example, you utilized straight-line depreciation over 27.5 years. If you were to perform a cost segregation study, you could depreciate the assets included in the purchase that have shorter useful lives much more quickly which helps increase your cash flow of the property.

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Steve Vaughan

Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes

5y

I'm no tax guy but passive 'losses' can only offset earned income if you're a RE professional as far as I know.

if this doesn't get answered here, try again in the tax and legal forum in a week or 2. It's tax deadline day.

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Bonnie Griffin KaakePro Member

Real Estate Consultant · Denver, CO · Member since 2021 · 661 posts · 389 votes

5y

@Sean Nelson @Steve Vaughan Most of the time, passive losses can only be used against passive income. RE professionals can group their properties and make all those "active" if they meet the material participation rules and keep excellent records. Owner/occupants also have the option to make their buildings "active" and use the large losses created by cost segregation and compliance with the Tangible Property Regulations against the business income. This last issue is a whole different discussion. Let me know if you have additional questions. I am here to help.

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Don KonipolBusiness Member

Investor · The Woodlands TX / Avon, CT · Member since 2009 · 6k+ posts · 10k+ votes

5y

@Sean Nelson

You’re about 30 years too late. Since 1987 depreciation on real property can only be used to offset passive income. In fact, the 1987 tax reform act classified income as either earned/active income, investment income, or passive income. Real estate investing, by default, is considered a passive activity, unless you’re in the real estate business as a full time occupation. This has both positive and negative tax implications. For example, passive income isn’t subject to FICA/Medicare taxes, while earned income is. However, if you do qualify as a full time real estate investor, as your primary occupation, then your profits in some real estate activities may qualify to be offset by “excess depreciation”.

Another thing to keep in mind is that any depreciation deductions are recaptured as ordinary income when the subject property is sold. This can result in a large tax Bill when selling a property, the inability to receive top dollar using owner financing because the amount owed may be more than you receive for the down payment, or not being able to accept a great purchase offer because unwilling or unable to pay the taxes. Depreciation, like most deferred retirement plans, postpones taxes, it doesn’t eliminate them, unless you never sell the property, or keep “exchanging it” , usually on less favorable terms and with large third party fees. When inflation and interest rates are high, there is a lot of value in paying taxes five years from now rather than now; much less value when inflation is low and interest rates lower still.

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Sean Nelson

OP

Tulsa, OK · Member since 2014 · 2 posts · 1 vote

5y

Thanks for the excellent info! I knew my thinking was too good to be true!

One more question to fully clarify and hammer my question home. I did read where passive "losses" can only be used for passive income. But Im not necessarily referring to "losses".
Im simply asking if the deduction for depreciation "expense" from my real estate investments can be used to offset my earned income from my non-real estate businesses on my individual tax return?
To clarify further. Lets say I make $100k from Sean's Moustache Grooming Salon. But I have 25k in depreciation expense from all of my real estate investments (and to simplify things, lets say all of my RE investments are exactly break even)
In this scenario, is my taxable income $100k or $75k?
I think you already answered this but I wanted to sharpen up my question just to be sure.

Ok another hypothetical scenario. Lets say I sell all my businesses and enter the wonderful world of passive real estate investing full time. This time, i buy a property or portfolio of properties that is worth $7,562,500. But this time, it actually cash flows $275k a year. Under this scenario, I make a good $275k in income but dont pay any taxes on it?

@Bonnie Griffin Kaake Im curious as to why a RE pro would want to convert their properties from passive to active? Are you saying that you can only use cost segregation if you are an active participant? Or are you saying that RE professionals are the only group of individuals who have the ability to offset their "active" income with passive losses?

@Don Konipol I was under the impression that when you sell the property, depreciation recapture can only be maxed out at the gain (profit) that you make on the property. Further, I thought depreciation recapture is taxed at 25% (not ordinary income). In addition to the depreciation recap, you would also have to pay cap gains tax of course.
Therfore, I think as long as you are making a gain on the property, you should be able to accept any offer. Of course the taxes will definetely reduce your gross profit, but the taxes should never make a scenario in which you are incurring a net loss.
Am I thinking this right?

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Buying Real Estate to Reduce Tax Burden

Buying Real Estate to Reduce Tax Burden

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