These past couple of years have been good to me when it comes to real estate. Just this week I closed on my fifth property! But what I haven’t done yet is actually live in any of them. Each one is used as a rental property.
There are 2 reasons for this. First of all, I love having someone else pay my mortgages. It's one of the best feelings in the world making money for doing absolutely nothing. The second reason - the current and future tax savings are too good to pass up.
Using rental property to reduce taxable income has been one of the easiest things I’ve ever done and is the biggest reason I’ve been able to build wealth these last few years. Here’s how it's done.
Deduct Cash Expenses
One of the benefits of using rental property to reduce taxable income is that you can deduct all cash expenses related to its upkeep. This is very different from a personal residence, as we’ve seen in Tax Avoidance: Using Your Home to Reduce Taxable Income.
Below are some common cash expenses that may be used to reduce taxable income made from your rental property:
Mortgage Interest
Property Taxes
Homeowners Insurance
Private Mortgage Insurance
Homeowners Association Fees
Property Management Fees
Maintenance and Repairs
Travel costs related to the Upkeep of Your property
Other Professional Services Fees
You’ll notice that repayment of principal (money borrowed to purchase a home) is not included above. Even though you’ll spend money to pay it off, it is not considered a deductible expense.
Before you purchase a property, you’ll want to make sure that the rental income you make each month covers a large portion (if not all) of the costs. The last thing you want is to have to put up a bunch of money for a place you don’t even live in. Sites like Zillow can help you determine the estimated rental income of a property and a majority of the expected monthly costs before making a purchase.
Depreciate Your Property
My favorite thing about using rental property to reduce taxable income is that while I make money each month (my rental income is more than my cash expenses), I pay no taxes on it. And that’s because of this lovely thing called depreciation.
Depreciation is a non-cash expense that the IRS allows you to deduct, over time, to recover the cost of buying and improving your property. You are allowed to take a deduction for depreciation expense on your rental property and its improvements (excluding the land) over 27.5 years.
Other items such as appliances, furniture and carpeting can also be depreciated over time. But after the passage of the Tax Cuts and Jobs Act, you can now expense their full cost upfront up to $1,050,000 for the 2021 tax year (a section 179 deduction).
In order to use the depreciation deduction, you must meet the following requirements:
You must own the property
The property must be used in your business
The property has a determinable useful life (basically, the property goes through wear and tear)
The property will last more than a year
It’s very possible that depreciation will be your largest deduction each year so you’ll want to make sure you take advantage of it. There might even be times when the sum of all your deductions for the year are more than the income you made, which is where I am happily situated. I’ll tell you why this is the perfect scenario for this side hustle in the next section.
Use Tax Losses to Offset Taxable Income
In the previous section, I mentioned how I am able to make money each year on my rental properties while avoiding the feds knocking on my door for their cut. There’s another bonus - I also report a tax loss to the IRS every year. The phrase "tax loss” just means my deductions are greater than my income.
We’ll get into why a tax loss can work in your favor shortly, but first, I’ll show you how I make it happen by using my first condo as an example. I purchased the property for $138,000 back in 2018 (my depreciable base) and received $1,149 a month for rent (condo was first rented in the middle of January 2019). This is what my first year of renting the place looked like from both a tax loss and cash flow perspective:
Here are some ways I can use this tax loss to my advantage:
Reduce Future Taxable Income from the Rental Property
Although I had a tax loss on my condo in the scenario above, this will not be the case forever as my monthly rental income will increase over time. And when the time comes that I do have a taxable profit, I’ll be able to offset it with losses I’ve racked up in the previous years (these are called carryforward losses). However, this reduction is limited to 80% of your taxable profit.
For example, let’s assume in 2020 I made a profit of $1,800. Because of the tax loss of $1,523 I had in previous year, I am able to reduce my taxable income by $1,440 (80% of $1,800) to $360. The remaining $83 can be used to reduce taxable income in the future.
Carryforward losses are reported on form 8582 of your tax return and do not expire.
Reduce the Taxable Gain Made from a Sale of Rental Property
Not only are carryforward losses good for offsetting future rental income, but they can be used to offset a gain on the sale of your rental property.
If I sold the condo in January of 2020 for a profit of $5,000, I could use the $1,523 in carryforward losses to reduce that taxable gain to $3,477.
Reduce Taxable Income from Other Rental Properties
If you have multiple rental properties, you may find yourself in a situation where at least one of them has a taxable profit for the year, even after deducting depreciation expense. However, that profit may be offset with losses from your other property or properties.
That means if I had another rental property that had a taxable profit of $2,000, I would only end up paying tax on the net profit of $477.
Reduce Taxable Income Made from Your Day Job
For most people, making money through rental income is considered a passive activity. A passive activity is a business activity or trade that you minimally participate in (if at all).
In general, you can only offset passive income with passive losses. However, the IRS allows you to deduct up to $25,000 of passive losses from your earned income (like the money you earn from your day job) if your modified adjusted gross income is $100,000 or less.
Take Advantage of a Like-kind Exchange
And here is where we start to play with the big dogs in real estate.
A like-kind exchange, in its truest form, allows you to swap one investment or business property for another without recognizing any gains on the exchange. The goal here for rental property is to swap your old place for one that will get you more rental income without handing over a dime to Uncle Sam.
While historically a like-kind exchange involved an actually swap of properties, nowadays they most commonly occur through what is called a delayed exchange. During this process, a middleman (called a qualified intermediary) will hold onto the cash made from the sale of your investment or business property and use it to buy the next one for you. A qualified intermediary is important because once the cash is in your possession, the sale becomes taxable.
There are 2 timing rules you’ll have to be aware of when going through a like-kind exchange: the 45-day rule and the 180-day rule. Within 45 days of your old property being sold, you must choose at least 1 property that will replace it. Within 180 days of the old property being sold, you must close on the new property or properties.
There is no limit to the number of times you can do a like-kind exchange. A smart investor can turn a $200,000 home to a $1,000,000 home (or multiple homes) in just a few years.
Avoid Self-employment Taxes
If you are a business owner, you may already be familiar with the burden of the self-employment tax. If not, then this is one way to make sure you never have to deal with it.
Self-employment tax is the tax that a business owner, who works for themselves, must pay to the IRS for Social Security and Medicare. Because self-employed individuals are viewed as both the employer and the employee of a business, the percentage they pay towards these social programs doubles from 7.65%, which what an employee pays, to 15.3% (though taxable income for Social Security ends at $142,800 in 2021).
When using rental property to reduce taxable income, the net income you make is not subject to self-employment tax since it is considered passive income as opposed to earned income. There are exceptions for those who are real estate dealers or owners of real estate complexes, however.
How to Join in on the Fun
After reading this, you may be wondering how you can get your slice of the pie. And that certainly puts a smile on my face.
But make no mistake - it takes work. And most of it comes before you even buy the property. Crunching numbers to make sure you'll make money, building up a downpayment (expect to put down at least 20% for a rental property), searching for the right area and property, choosing a reliable property manager. These are just a few things that will be important to the success of your rental property.
That's where we come in. From creating a plan to save up a downpayment to determining your estimated cash flow before making a purchase, we got you. If you would like to learn more about how we can help, hit that contact button!
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