Tax Efficient Real Estate Investing

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No Tax On Appreciation

Qualified Opportunity Zones & Other Tax Efficient Real Estate Investment Strategies by MCA

One of the most tax-efficient methods to build wealth is simply not selling. Warren Buffett often says my favorite holding period is forever.

When you sell, you pay transaction fees, commissions, and taxes. All of these costs drag down your long-term performance because you forever lose the ability for those dollars to compound and grow.

And real estate appreciation doesnt get taxed by the IRS. So, if you buy and hold for many years its possible to let your net worth grow with minimal tax exposure.

And when you do choose to sell, real estate has other benefits.

Real Estate Tax Myths Debunked $59

There are tons of free information on the internet. Some are really great resources while others provide completely false information. In this course, we take a deep dive into what some of the most commonly heard myths are and reveal the truth behind each of them. We discuss:

  • What legal tax deductions are available to investors
  • Scare tactics frequently used by CPAs and attorneys
  • What you need to know about depreciation myths
  • What is a real estate professional for tax purposes

And much more.

This Video & Audio course is a digital product that you can download immediately following your purchase.

Tax Advantages For Real Estate Investors

Reviewed by Mynd Editorial Staff

Investing in single family residential real estate offers multiple ways to increase wealth, from cash flow from rental income, to appreciation from an increase in a homes value, to leveraging borrowed money to boost returns, to building a portfolio of properties to act as a hedge against inflation.

Saving on taxes is a bonus as well.

A savvy investor can use a number of different strategies to ease their tax burden. Some sections of the tax code are geared toward encouraging improvements and will reward a property investor who makes improvements.

Some of these strategies are outlined below, and because of the complex nature of the tax code, investors are encouraged to consult with a tax professional or other adviser to make sure they follow the law correctly.

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Passively Investing In Real Estate

When investing in Canadian REITs, investors can buy shares and sit back to watch their investments grow, relying on the professional management teams behind the REITs to do all the work. However, you do need to pick quality investments that you expect will grow over time and aim to buy at cheap valuations.

You can begin your research with the following Canadian REITs that are relatively cheap and have growth potential.

Currently, InterRent REIT trades at a decent discount of nearly 21% from the 12-month consensus price target of $19.63. Other than a yield of 2.2% paid in the form of a monthly cash distribution, you can also expect price appreciation. Lets be more conservative and assume that InterRent stock can arrive at $19.63 per unit in two years instead of one, itll still return total returns of approximately 14.6% per year. InterRent has raised its cash distribution every year since 2012 with a five-year dividend-growth rate of about 7%.

In late January, portfolio manager Andrew Moffs said this:

Weve been bullish since the recent selloff of the stock. InterRent has a dynamic management team. It is in the Ottawa, Toronto and Montreal areas where there is population growth. This includes immigrants who are looking for reasonably priced housing.

Andrew Moffs, senior vice president and portfolio manager at Vision Capital

How Important Are The Tax Benefits Of Real Estate Investing

Tax

The greatest expense that many Americans face is taxes, which makes the subject of tax-advantaged investments so critically important.

In fact, the Tax Foundation estimates that in 2017, Americans will pay $3.5 trillion in federal taxes and $1.6 trillion in state and local taxes for a total tax burden of $5.1 trillion. That is 31% of the nations income. Therefore, Americans will spend more on taxes than they will on their basic needs .

Given the progressive nature of our tax system, high-income and high-net-worth individuals like our investors typically shoulder a much heavier tax load than the average American.

Therefore, it should come as no surprise that they are looking for highly tax-efficient investments. Many have heard about the tax benefits of real estate and they want to learn more.

In fact, one of the most common questions I get from investors is about taxes. Now I always preface these conversations with the disclosure that I am not a CPA or a tax attorney and that they should always seek advice from their trusted tax professional as to whether or not a particular tax strategy will work for their individual situation.

Having said that, Im not a novice either. In my years working and investing in the multifamily apartment world, Ive had the opportunity to see what really works.

Multifamily real estate carries some of the strongest tax benefits out there, and the cornerstone of those advantages is depreciation.

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Getting Positive Cash Flow

However, most real estate investors don’t want to feed money into their properties. At a minimum, they want it to at least pay for itself. What is the minimum amount of money you need to put down to get that? Well, it depends on the cap rate of the property and the terms of the loan. Let’s assume that same $100K, cap rate 6 property. Let’s assume a 5%, 30 year loan. If you put down 10%, you have a loan on $90K. Your total mortgage payments would be $5,575, so you’d be slightly cash flow positive. Your gross rents would be $10,909, your non-mortgage expenses would be $4909, and your mortgage expenses would be $5,575. You’d be left with $425, or $35 a month in positive cash flow, for a cash on cash return of 4.25%. If you only put down 3%, you would have zero cash flow and your cash on cash return would be 0%.

Take Advantage Of The 20% Pass

The Tax Cuts and Jobs Act of 2017 included an intriguing tax perk for small-business owners, including real estate investors.

On the simplest level, it allows small-business owners to deduct an extra 20% of their net business income. Of course, nothing is simple with the IRS. The allowed deduction is the lesser of:

  • Your combined qualified business income OR
  • 20% of the excess of taxable income over the sum of any net capital gain
  • What exactly is combined qualified business income? For some types of businesses, there are income limitations in place: $329,800 for married couples and $164,900 for single filers, in tax year 2021.

    You can read the full IRS definition of qualified business income or save yourself the headache and talk to your accountant about it.

    While it remains untested and not entirely clear from the IRS, with a sharp accountant, you should be able to deduct an extra 20% of your real estate investing business income from your taxable income.

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    Personal Income Tax Rates Decrease

    Most real estate investors own property personally or in an LLC . Because in both instances taxes are paid on a personal level, the new tax law was a win with its reduced personal tax rates. Here are the new tax brackets for single and joint tax filers as of 2018:

    Single Filers

    $161,379 plus 37% of the amount over $600,000

    Avoid Paying Double Fica Taxes

    Leveraged Buyout Small Business in Probate: PLUS Most Tax-Efficient Real Estate Investing Strategies

    As mentioned above, if the IRS classifies you as a dealer rather than an investor, youre considered self-employed and owe double FICA taxes.

    FICA taxes are employment taxes designed to fund Social Security and Medicare. Theyre split between employers and employees, with each party paying 7.65%. If youre self-employed, you owe both, for a total of 15.3% in addition to your federal, state, and local income taxes.

    Anyone who flips houses should form a strategy to avoid dealer classification by the IRS and thereby avoid this extra 15.3% tax. One way to avoid dealer status is to demonstrate investment intent for the profits of each sale.

    In other words, build a case that you dont sell properties as part of your regular business practice, but to generate capital for other investment projects. These other investment projects could include paying for improvements to another property or making a down payment on a long-term rental investment property.

    Another strategy is to avoid doing business through a single-member LLC, which is typically disregarded for tax purposes. Instead, you can create a legal entity such as a partnership LLC or S-corp that changes how investors are taxed.

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    Make Your Tax Breaks Count

    There are many advantages to real estate investing, and tax benefits are just one. We encourage you to consider real estate as an investment when youre trying to decide if you should buy a house. But, before you make any commitments, be sure to speak with your accountant and thoroughly inspect and research any property youre seriously thinking about purchasing.

    Get approved to buy a home.

    Rocket MortgageĀ® lets you get to house hunting sooner.

    Depreciation The Cornerstone Tax Benefit Of Real Estate Investing

    Rental property depreciation is an accounting convention that allows investors to write off the value of a property over time. For resident-occupied real estate, that time period is 27.5 years.

    As an example, lets look at a multifamily property valued at $34,500,000. Keep in mind that apartments have both a land value and a building value. Since land is not depreciable, its value would have to be subtracted out of the total. For the purpose of this example, lets say that the land is worth $7,000,000. That would leave the value of the building at $27,500,000. Again, that building value is what gets depreciated over 27.5 years. The formula looks like this:

    $27,500,000 / 27.5 years = $1,000,000 a year in annual depreciation for the next 27.5 years.

    That million dollars of annual depreciation represents a paper loss that can be taken against the actual gain from cash-flow of the property. Additionally, that passive activity loss gets reported on a K-1. Those investors who have K-1 passive activity gains from other business activity are pleasantly surprised to find our paper losses can offset their actual gains and save them taxes in other areas of their portfolio.

    We can also front-load our depreciation by using a cost-segregation study. This is called accelerated depreciation, which allows all of the non-permanently affixed items to be depreciated over an even shorter time period . Ive written more on rental property depreciation here.

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    Real Estate Provides Significant Natural Tax Shelter

    While this article focuses primarily on real estate disposition strategies, the starting point for analyzing real estate dispositions is that real estate ownership generally provides significant tax benefits during the ownership period. In general, the owner of investment real estate is entitled to take depreciation expense deductions, which reduce the owners taxable income attributable to ownership. Frequently, even though a real estate investment is producing positive cash flow, the investment is generating little to no taxable income as a result of the depreciation expense deductions. When real estate is disposed, however, the disposition generally results in taxable gains, including recapture of prior depreciation expense. As a result, even if a property is sold for no gain or loss , the owner may be subject to tax on sale. Further, depending on whether the owner has borrowed a portion of its purchase price, the amount of tax due on sale can potentially exceed the owners cash proceeds. Accordingly, when considering sale of a real estate investment, the strategies outlined below may be extremely beneficial.

    Depreciation Shelters Income From Tax

    Tax

    The IRS uses depreciation to acknowledge that an asset wears down over time. Somehow they discovered that residential real estate wears down in exactly 27.5 years . Other assets have different timelines.

    Unlike other business expenses, depreciation is a paper loss. This means you dont spend any money, yet you still get the expense. This expense can offset taxable income and save money on your tax bill.

    Here is a basic example:

    Scenario #1 :

    $5,000 taxable rental income x 25% federal income tax rate = $1,250 taxes owed

    Scenario #2 :

    $5,000 rental income $3,000 depreciation expense = $2,000 taxable rental income

    $2,000 x 25% federal income tax rate = $500 taxes owed

    Tax Savings = $1,250 $500 = $750

    The higher your tax rate, the more taxes you would save in this example.

    Depreciation is not unique to real estate, but real estate investing uniquely benefits from depreciation. Why? Because the cost of real estate is so large and often purchased with debt.

    A $200,000 building depreciated over 27.5 years provides tax shelter of $7,272 per year. If you had 3 rental properties, youd shelter $21,816 of income from taxes and possibly* save $5,454 on your tax bill !

    *There are catches to how much you can depreciate. Ill cover those in the next section.

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    Three Strategies For Tax

    Learning how to make tax-efficient investments can help you keep more money in your pocket when filing your taxes. Heres a breakdown of our top three recommendations on how to maximize your tax savings when investing:

    • Aim for eligible dividends: Investing in specific eligible dividends from Canadian organizations can automatically reduce the tax youll pay due to the lower rates. While both eligible dividends and non-eligible dividends can be a good investment, its a good idea to try to buy eligible dividends where you can to get a bigger tax break when filing.
    • Use CCA and capital losses to offset your capital gains: Claiming capital cost allowances and capital losses from investments that lost money are key to offsetting how much you pay on your profits. Remember, both of these can be carried forward to offset gains in later years as well. So even if you havent used them now, you can use them later.

    Use tax-advantaged accounts to save money before you invest: Serious investors should understand the importance of placing their investments in the right accounts. Using TFSAs and RRSPs are a great way to let your savings grow tax-free and maximize your earnings in the long run.

    I am pretty meticulous and up-to-date on my tax strategies and deductions yet TurboTax found me another $124 dollars Ka-ching!

    Do I Need To Report My Cryptocurrency Gains And Losses

    Cryptocurrency like Bitcoin and Ethereum might not be as straightforward as Canadian dollars, but the CRA treats crypto the same when it comes to reporting capital gains and losses. So, even though crypto transactions can be anonymous, youre still required by law to track and report your transactions each year when filing your return.

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    The Guide On Tax Efficient Investing In Canada

    If I had the opportunity to redo my whole investing portfolio and start over again, my portfolio would look different than what it looks like now. Over time I learned better ways to have a more tax-efficient portfolio and the scars of my previous investing methodology are scattered throughout my portfolio. I would have focused on more tax efficient investing in Canada.

    I havent had the guts to make a complete overhaul of my portfolio because, at heart, I have trouble accepting change! Here are ways to incorporate tax-efficient investing into your portfolio, the right way the first time! This is what I would do if I was in my early 20s and started my journey of investing.

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    As you know, there are lots of places to keep your money. In an RRSP, in a TFSA, or in non-registered accounts. There are certain accounts that are better for certain investment allocations that will help you pay less tax in Canada.

    After all, the money you earned from your income is taxed, and then the money you save to invest is also taxed to an extent so might as well learn some tips to avoid paying so much tax!

    Tax Saving Strategies For Short

    Tax Efficient Investment Strategy: Buy REIT ETF Inside Roth IRA

    In addition to great cash-flow, short-term rental investors may be eligible for a lot of added tax benefits that may not be available to traditional long-term rental investors. Join us as we discuss:

    • What exactly qualifies as short-term rental for tax purposes?
    • How to take advantage of bonus depreciation for your short-term rentals
    • Strategies to maximize and utilize any tax benefits from your properties
    • Pitfalls to watch out for when using your rentals for personal benefits
    • and much more

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    What Is A 1031 Exchange

    A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows an investor to avoid paying capital gains taxes on the sale of an investment property, as long the proceeds are reinvested within certain time limits in a property or properties of equal or greater value.

    Depreciate Costs Over Time

    Depreciation is the incremental loss of an assets value, generally due to assumed wear and tear. As a real estate investor that holds income-producing rental property, you can deduct depreciation as an expense on your taxes. That means youll lower your taxable income and possibly reduce your tax liability.

    Youre allowed to take the depreciation deduction for the entire expected life of a parcel . Lets say you purchase a home you intend to rent out. The value of the building itself is $300,000. If you divide that value by the 27.5 year expected life of the dwelling, you can deduct $10,909 in depreciation each year.

    Once you sell, though, be prepared to pay the standard income tax rate on the depreciation youve claimed. This is known as depreciation recapture, which you can avoid if you pursue other tax strategies, like a 1031 exchange .

    Pro tip: Ask your accountant about depreciating major improvements youve made to your investment properties, such as installing a new roof.

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