I'm a 2% W2 income earner and on pace to be at the bottom of the 1% level on W2 income by the end of this year.
Thus, Let's assume you earn $100,000 in your day job and pay $20,000 in taxes. Your effective tax rate is 20%. Now let's also assume you pick up a rental. It sports a net operating income (NOI) of $200 a month, but is being depreciated at a rate of $300 per month. Because depreciation is higher than your NOI, you'll report a passive loss for tax purposes, meaning the $200 monthly NOI is tax free.
If we add this $200 per month NOI to your $100,000 W2 income, your total income is now $102,400 for the year. Yet your taxes stay the same at $20,000 because only $100,000 is subject to tax as the $2,400 in net operating rental income is tax-free (technically they would decrease due to the passive loss which I'll touch on in a second). We've now decreased your effective tax rate to 19.5%.
Even better is the fact that the passive loss of $100 ($200 - $300) per month, or $1,200 annually, would decrease your income subject to taxes. Instead of having $100,000 subject to tax, you now only have $98,800 subject to tax. Assuming you are in the 28% tax bracket, your taxes owed will decrease by $336 to $19,664 ($20,000 - $336).
So now you are paying taxes of $19,664 on $102,400 of earnings for an effective tax rate of 19.2%. This decrease in your effective tax rate can be construed as additional return on your investment. You should strive to decrease your effective tax rate as much as possible.
The power of investing in real estate lies in the ability to offset your income with the passive losses generated by your real estate investments. That is why I will never understand people that leave the W2 world and lose that benefit.
When your Modified Adjusted Gross Income (MAGI) is below $100,000, you can take up to $25,000 of passive losses annually.
As your MAGI increases above $100,000, the $25,000 passive loss begins to phase out. The rate of the phase out is $1 per every $2 of MAGI increases. So, once your MAGI eclipses $150,000, you can no longer take any passive loss from real estate. Note that these MAGI thresholds and passive loss phase outs are always the same regardless of whether you are single or married. If you have ever heard of the “marriage penalty,” this is another great example of such penalty because when married, the thresholds stay the exact same as they were when you were single.
This poses a problem for high income taxpayers like me, especially when MAGI is above $150,000 (My gross is over $400k/year). High income taxpayers cannot tap into the passive losses their real estate generates unless they (or their spouse) qualifies as a real estate professional.
When your MAGI creeps (or explodes) past $150,000, you can no longer use your real estate losses to offset your ordinary income. Instead, the real estate losses simply aggregate and are carried forward into future years. Future passive income and sales of real estate will be offset by your accumulated passive losses.
The best way to tap into your suspended passive losses is to become a passive investor in a business. And no, I don’t mean become a passive investor in a real estate rental business. I mean become a passive investor in a legitimate, non-publicly traded business that produces solid net income for its investors.
The key here is net income. You need to invest in a business that is producing net income or has the ability to produce net income shortly after you invest. The reason is that you are trying to tap into your passive losses. You don’t need any more passive losses; you need passive income!
You will need to be a passive investor in the business, meaning you are not materially participating in the business, meaning you hand the business operator the money and sit back and wait for your quarterly reports. You don’t call the shots; you’re out of that game. This makes you passive and makes the income passive, which allows it to be used to offset your suspended passive losses.
You can invest in an LLC, a partnership, S-Corp, or sole proprietorship. You can't invest in a C-Corp, as the dividends and capital gains are classified as portfolio, not passive, income.
First, the passive business income you earn will be completely tax-free until your suspended passive losses are exhausted. In my example above, where we imagined you had $100,000 of suspended passive losses, this means that you can receive passive business income for a number of years completely tax-free.
Second, as you receive business income, you invest this tax-free money back into rental real estate to produce more passive losses. This way, as your private and passive business investments grow, your passive losses from your growing real estate portfolio are also growing, sheltering your passive business income.
Third, all the while, as long as your real estate continues to produce passive losses, not only are you (hopefully) cash flowing from your rentals, but the cash flow is all tax-free. Couple that with your tax-free passive business income, and you’ve transformed yourself into a savvy wealth manager.
