Breaking down of TAX concepts

Below explanation is just for sake of education and to understand concepts, it should NOT be considered as tax or financial advise. Please consult your personal CPA and tax advisor as each persons income and tax situation is unique. Tax laws are rules can change totally or be amended therefore its a must to work with qualified professional to implement any of these tax strategies. Article written and published on Jan 17, 2020

Plenty of professionals (Engineers, Architects, Doctors, Lawyers, Business Owners) living in Silicon Valley, CA and other locations make very high income, and they feel they have made it in America. However, some high net worth individuals never take time to reflect on the fact where is money is going out.

If one adds up all the taxes, income, property, sales, capital gains, short term gain etc very quickly the realization hits home that close to 35% to 50% of annual gross income may be going out of the door. 

During the pursuit of learning wealth building strategies, the discovery of being tax wise and focusing on not just what is coming in as income but what is going out as taxes and other expenses is they key to building generational wealth.

ITS NOT WHAT YOU MAKE BUT WHAT YOU KEEP END OF THE DAY COUNTS !

Real estate investors are "special" in sense of IRS code has provisions to encourage commercial real estate investments and provide tax breaks, deductions and incentives:

Key Concepts:

• Depreciation
• Cost - Segregation
• Bonus Acceleration  
• Depreciation Recapture 
• Real Estate Professional
• Short Term Rentals

Depreciation: 

Real estate depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property placed into service by the investor. Depreciation is essentially a non-cash deduction that reduces the investor’s taxable income. Many investors refer to it as a “phantom” expense because they are not actually writing a check. It is merely the IRS allowing them to take a tax deduction based on the perceived decrease in the value of the real estate. 

Real estate depreciation assumes that the rental property is actually declining over time as a result of wear and tear. But we know this is not typically the case. Not many other forms of investment offer comparable depreciation deductions. As a result of real estate depreciation, the investor may actually have cash flow from the property but may show a tax loss.

Cost Segregation: 

Cost segregation is a tax planning strategy used by real estate investors that accelerates the depreciation of certain components of their properties. This amounts to a reduction in your current tax liability, resulting in upfront cash flow.

This is done by breaking down and reclassifying certain interior and exterior components of a building, which are typically depreciated over 39 or 27.5 years for commercial and residential properties, respectfully, to personal property or land improvements that are depreciated over 5, 7, or 15 years.

Bonus Acceleration:

Commercial real estate developers are in a prime time to save money on their tax bills. The tax reform law known commonly known as the Tax Cuts and Jobs Act (TCJA) enhanced the bonus depreciation percentage to 100 percent for qualifying materials placed in service from Sept. 28, 2017 through Dec. 31, 2022.

To take full advantage of the bonus depreciation provision – while it is at its 100 percent mark – many developers may want to take a closer look at the new and new-to-them property that they have accumulated since Sept. 28, 2017 and potentially plan for future acquisitions. Bonus depreciation, combined with other tax deductions, gives real estate developers a unique opportunity to maximize their tax savings before Dec. 31, 2022.

Depreciation Re-capture:

At some point, its time to sell your rental property. Depreciation will play a role in the amount of taxes you’ll owe when you sell. Because depreciation expenses lower your cost basis in the property, they ultimately determine your gain or loss when you sell.

However, not all gains benefit from the long-term capital gain tax rates. Depreciation recapture is the portion of the gain attributable to the depreciation deductions previously allowed during the period the taxpayer owned the property. The depreciation recapture rate on this portion of the gain is 25%. The reasoning behind the depreciation recapture rules is since the taxpayer received the benefit of a depreciation deduction that offset ordinary income tax rates (a potential Federal tax savings of up to 39.6%), the government is not going to grant the most favorable capital gains rates on the portion of the gain relating to these prior depreciation deductions.

Real Estate Professional: 

The “Real Estate Professional” classification allows taxpayers to deduct 100% of all real estate losses against ordinary income.  Many clients making this special election on their tax return, and who also have several rental properties can create thousands of dollars in tax deductions resulting in a zero tax liability at the end of the year.

To qualify as a ‘Professional’ for tax purposes, a taxpayer, or their spouse, must meet a two-part test: (1) the taxpayer must spend the majority of his or her time in real property businesses, and (2) the taxpayer must spend 750 hours or more in the real property business and rentals in which he or she materially participates.

Sample - Redacted Images of K1 forms from actual investments in multifamily deals.

Short Term Rentals:

Short-term rentals, on the other hand, are the exception to the rule. IRC section 469 states that an activity isn’t considered “rental activity” if the average length of the stay is seven days or less. So what does this mean, exactly? 

Well, it means that, with an STR, you can deduct rental losses as non-passive, allowing you to offset income from your day job without attaining real estate professional status.

Needless to say, for high-income earners like physicians and silicon valley high technology professionals, this is a huge advantage. We normally don’t have many ways to reduce our taxable income. Come tax time, the ability to deduct depreciation from your real estate properties means that you’ll likely pay significantly less to Uncle Sam. 

As a quick side note: the flip side of this advantage is that you can’t count short-term rental hours toward your real estate professional status. So if that’s a goal for you, STRs won’t be a great way to help you get there. 

As with any investment, short-term rental properties are not without risk. The biggest one has to do with the economy. After all, most people seek out STRs for vacations, and if people are losing jobs or are otherwise strapped for cash, vacations are usually the first thing to be cut from the budget. 

And of course, if you aren’t able to fill your property with tenants, you could be losing money. 

However, between the significant tax breaks and fantastic profits, short-term rentals can be a truly lucrative addition to your portfolio. 

Also, I typically don’t recommend that doctors and busy professionals manage these types of places themselves. Their time is worth way more than the hassle in my opinion. So you have to factor the cost of management into the numbers.

So, in order to make the best decision, ask yourself how comfortable you are with that level of risk, and how hands-on you want to be. Because when it comes right down to it, though STRs do require more attention, they can be equally rewarding. 

References:

https://www.irs.gov/businesses/small-businesses-self-employed/real-estate-tax-center

https://passiveincomemd.com/your-guide-to-short-term-rentals/

https://www.therealestatecpa.com/guide-to-qualifying-as-a-real-estate-professional