Passive Income: Cash Flow Without Breaking a Sweat … And So Much More
Earned income is subject to marginal tax rates depending on one’s effective tax bracket. Therefore, the only way to reduce your earned income taxes is to actively spend more in order to offset income. On top of that, you can’t just spend on anything. It must qualify as tax-deductible by the IRS.
Passive income, on the other hand, is still subject to marginal tax rates but there are many “shelters” that reduce your taxable amount of income that don’t require additional spending. We will breakdown these shelters below.
Depreciation – The Phantom Expense
We get very excited about this one; however, we will try to keep it short and sweet. Real estate naturally deteriorates over time which theoretically lessens the property value. The IRS determined the lifespan of a property to be 27.5 years. Therefore you can calculate depreciation by taking the property value (excluding land value) and dividing by 27.5.
However, real estate investors don’t usually hold properties for much longer than 5 or maybe 10 years so how do we fully benefit? Thanks to the 2017 Tax Cuts and JOBS Act we’re able to accelerate the use of depreciation via 100% bonus depreciation which allows us to front-load the deductions, offsetting the passive income generated in the early years of the investment. We recently wrote a more in depth article on this topic, click here to read more about bonus depreciation.
Unfortunately, the 100% rule was phased out as of 12/31/2022 and beginning 1/1/2023, we dropped down to 80%. Still a large benefit!
Mortgage Interest – Just Like Your Personal Mortgage
Similar to your mortgage on your personal residence, the mortgage interest payments tied to the loan on an investment property can also act as a tax deduction. Although not a phantom expense like depreciation, they both offset your passive income.
Carryover Losses – The Gift that Keeps on Giving
In many cases, the deductible amounts from depreciation and interest often outpace income because depreciation is usually front-loaded (as explained above) and interest payments always start higher and decrease over time. This will result in a surplus of losses in year 1. Good for investors, these losses can “carryover” to the next year and be used to offset future income.
Self-Employment Tax – Don’t Worry, Not Applicable
If you’re self-employed, working for yourself and generating income while doing so, your subject to Self-Employment and Social Security/Medicare taxes. This totals 15.3%!
Theoretically, generating enough income through real estate syndications can make you “self-employed”. However, real estate investors can cash-in on their income in peace because this is considered passive income which is not subject to this 15.3% tax.
Capital Gains – Taxed, But Less than Normal
The large influx of cash in a real estate syndication comes when you exit the deal via sale or refinance. This is considered capital gains. Unfortunately, capital gains are taxed but it caps out at 20% while other types of earnings are subject to 37%.
1031 Exchange – Keep the Ball Rolling
As stated above, when your sponsors decide it’s time to sell or refinance, you will usually receive a large influx of cash. If you’d like to take this cash to the bank or spend it on a new car you can expect to pay capital gains tax. BUT, if you’d like to recycle your earnings into another “like-kind” real estate investment within the allotted amount of time (45 days to identify and 180 days to deploy), you can avoid this tax and continue making your money work for you! This is how generational wealth is created!
Investing in real estate via a syndication offers many benefits, including healthy returns. These tax benefits simply add another layer which attracts so many investors to participate in this asset class. So next time when you’re assessing a new deal, consider these benefits as the “cherry on top” of the marketed returns.
As always, we hope this is insightful. If you’re interested in learning how to invest or discussing some of our current investment opportunities, don’t hesitate to reach out!
Mitch and Kevin