There are many different ways to save on real estate investment taxes. Rather than bog you down with the minutiae of tax savings tips such as keeping track of gas mileage for every trip to see a property, you're going get the most powerful, most effective 5 ways for real estate investors to reduce their tax liabilities. And sorry, you're not going to be given any creative deductions like writing off cruises to the Caribbean or setting up offshore accounts in tax sheltering countries. The following 5 tips are tried and true methods that allow investors to pay the least amount in real estate investment taxes year after year. Are you ready? Disclaimer: This is not accounting advice nor is the author a licensed tax professional. Consult a licensed tax adviser for any tax or accounting related advice.
1. Hire a CPA that Invests in Real Estate
First and foremost, you should hire a Certified Public Accountant (CPA), preferably in your local area, although not completely necessary, who also invests in real estate on the side. Ideally, this person both earns passive income with rental property and creates earned income from buying and selling, or flipping, real estate. Not hiring the right CPA will cost you more in taxes than anything else. When you are making good money, a solid CPA will pay for themselves many times over.
Finding the right CPA can be as simple as asking other real estate investors in your area who they use. However, sometimes your competitors aren't interested in telling you who they use. In which case, you can also try asking other people on your team, such as closing attorneys, real estate agents, mortgage brokers, and the like, if they know of any CPAs that also invest in real estate. Local real estate investor clubs could even have a CPA as an advertiser in their newsletter. It may take some time to find this person, but it is well worth the search effort. Try not to get discouraged if not a single CPA you talk to owns their own real estate. These types of CPAs do exist out there, you just may need to be persistent.
2. Separate Short Term & Long Term Investing Activities
The first piece of advice my CPA shared with me was to separate earned income activities, such as my flips, wholesales, assignments and rehabs, from my passive income rental properties. He didn't want my rental income to get taxed as earned income. This is critically important for those just starting out because if you own a rental property in your personal name, and then start doing some flips in your personal name too, that could cost you a lot in taxes. Therefore, if you own a rental property in your personal name, set up another entity to do your flips and wholesales.
What type of entity should you set up? There isn't a one-size-fits-all answer to such a question. For example, I've seen trainings on "the power of the LLC", which may have some valuable insight. But try telling that to Mr. Barrett in Nashville, TN, who owns over 300 single family homes free and clear in his personal name. Do you think a man that wealthy is missing the boat and should own his properties in an LLC? Nope. It turns out, in Tennessee, if you own real estate in an LLC, you are charged an extra 2.5% franchise and excise tax per year on the total value of the assets owned by the entity. That’s $2,500 per $100,000 property you own per year, even if you have a loan on it for $100,000! The State of Tennessee F&E tax alone can eat up all of a real estate investor's cashflow. However, sole proprietorships and general partnerships are exempt from that F&E tax. Mr. Barrett isn't quite so dumb now is he? (In case you were wondering how Mr. Barrett protects his real estate portfolio from potential lawsuits of those 300 tenants, he uses a general liability insurance policy.) Meanwhile, for short term investing activities, you may, indeed, opt for an LLC or perhaps an S-Corp. Who should you ask for clarity on which entity to set up for your short term as well as your long term investing activities? You guessed it...your CPA.
3. Get Organized
The IRS severely punishes disorganized business owners. The list of unorganized entrepreneurs who are either in prison or are no longer rich is both long and distinguished. There are several skills required to be successful in real estate; from finding good deals, to structuring deals so that everyone wins, to executing the most profitable exit strategies. In addition to those skills, you also need to have your books in order. Welcome to the wonderful world of being rich. You have to account for your riches 🙂
Every expense and income needs to be organized into a system. Quickbooks is the standard in small business bookkeeping management. There is now even an online version of Quickbooks that is very inexpensive. If you don’t want to learn how to use Quickbooks yourself, hire a bookkeeper. There are plenty of bookkeeping services out there and many charge a very reasonable fee.
When your books are organized into Quickbooks, you also activate the true power of a CPA. Investors that bring a shoebox full of receipts to their accountant once a year miss out on all the creative ideas a tax professional can unleash when you have everything in an easily accessible digital format. In essence, you are allowing your CPA to do his/her job the best way that they can when you organize your books digitally. You wouldn't provide a painter with a toothbrush to paint your house, would you? That's effectively what you are doing when you don't use a system like Quickbooks.
When you begin to get your books in order, you may discover that you are co-mingling personal and business transactions in the same accounts. That's a big no-no. Every business deposit and every business bill should be transacted through bank accounts and credit cards specifically set up for the business. There is a huge shortcut whereby certain banks like Bank of America and certain credit card companies like American Express integrate with Quickbooks so you can click one button and automatically import all of the transactions. So if you don't already have a separate bank account or credit card set up for your real estate business, when you go to get these, make sure the bank or credit card integrates with Quickbooks. It saves hours and hours of time each month on bookkeeping duties, which even if you hire a bookkeeper, will still save you money on the costs of their services.
When your books are organized, you can also see clearly what is going on in your business. I learned a whole lot about where the real profits are made in real estate after studying my Quickbooks P&L reports. Your biggest and easiest profits don't always originate from where you think. For example, I discovered the secret to flipping houses was, in most cases, to wholesale the deal to a contractor investor buyer rather than rehab it myself. I also realized just how potent retail wholesaling was. These were breakthroughs that have earned me a fortune since then...all because I took the time to get organized.
4. Own Some Rentals
Rental income is extremely tax advantaged money. It stems from this wonderful deduction the IRS allows you to take called Depreciation. For a single family rental property, the IRS allows you depreciate the tax basis amount of the property (the amount you purchased the property for minus the value of the land) over 27 1/2 years. For example, let's say you buy a $100,000 rental home that has a land value of $10,000. Your tax basis would be $90,000 ($100,000 sales price - $10,000 land value). When you divide by 27 1/2 years, you get a tax deduction of $3,272.73 each year. That's a significant "expense" to have on your tax return! Then, let's estimate that after all normal rental property bills, including maintenance, you’re left with a positive cash flow of $270 per month. The $3,273.73 in depreciation each year would completely offset all of your positive cash flow. So essentially, you wouldn't be paying any income taxes on your rental income! It’s incredible. Plus, as your property increases in value, you’re not paying any tax on the appreciation (so long as you don't sell it). Rental property is one of the most tax advantaged ways to earn money in the United States.
5. Earn Money Like the Ultra Rich
Have you heard folks like Warren Buffett (one of the world's wealthiest people) share that percentage-wise, he pays less in taxes than his secretary? Or perhaps you remember during the presidential election the big stink that was made over how little Mitt Romney paid in taxes? Technically, the majority of richest people in this country pay a very large total sum in taxes. In fact, the wealthiest 20% in America pay for nearly 70% of the total tax revenue. However, on a percentage basis, the rich pay far, far less than the middle class. Why? Because the wealthy earn some (or all) of their income through investments as opposed to W2s and 1099s created by working for other people. Rental property is one such investment that allows the wealthy to earn great money but not incur a heavy tax liability. Another example is when you sell your investment property after more than one year of ownership. You may incur a long term capital gains tax (15%...soon to be 20%) as opposed to ordinary income tax (15% - 35%+). One example of how this is applied in the real world is when you buy a property, fix it up, and then sell it on a 13 month Rent to Own so that the tenant buys the property in little over one year. The net profit can then potentially be considered a long term capital gain. Not only is your tax liability potentially much less, but you also can usually sell a property on a Rent to Own for top dollar and you typically don't have to pay real estate commissions. That’s a winning combination!
Another creative way to earn money like the ultra rich is with a 1031 exchange. When you sell a rental property, you can defer your profits from being taxed by doing a 1031 exchange. In simple terms, this is the real world example of what you do in the game of Monopoly when you exchange 4 green houses for 1 red hotel.
How can the richest people in this country pay the least percentage-wise in taxes? They earn their income from investments as opposed to jobs. Shouldn’t you be earning more of your income from investments?
Those are the top 5 ways to save on real estate investment taxes. Do you recommend any other ways to save on real estate investing taxes?