I love it, Brian! So, we’re talking about how we can potentially save taxes in 2024, and we’ve talked about retirement plans on the employee side. We’ve talked about investing in some of the favorable tax rates. Well, this next one I think is one that gets the most press, the most publicity in terms of people thinking about tax savings, and it’s a big one. It is real estate, but it may not be exactly what you’ve been pitched that it will be from a tax-saving standpoint. However, it can be incredibly attractive when it comes to saving taxes.
Yeah, this is one I love talking about because it’s true. Real estate is one of those things where it has tremendous tax benefits. And it’s to the point that I think sometimes people put this at the front of the line where they’re letting the tax tail wag the dog. But I don’t want to minimize this. It is an incredible benefit. But I still want you focusing on the ‘get wealthy’ behaviors of having steps one through eight of the financial order of operations before you get to this. This is a step eight abundance goal. But once you get into this level of investing in wealth, squeezing the fruits is pretty sweet, B. And when we’re talking about real estate here, we’re talking about specifically directly investing in real estate—whether you’re doing residential investment, commercial investment, raw land, or development, or even real estate syndication. So, we’re not talking about investing in real estate through publicly traded securities. We’re talking about direct investment.
Well, one of the big tax benefits, similar to what we said on the investing side, is that when you buy a capital asset, when you buy a piece of real estate and you hold it long-term, and if you make money on that asset when you sell it, you actually pay favorable long-term capital gains rates. So when you sell that piece of real estate, it’s not going to be taxed at ordinary income rates. It’ll be taxed at the lower capital gain rates. That’s a pretty substantial benefit for real estate investors. But here’s the thing: a lot of times, you think that you have to choose to be a real estate investor. But here’s the secret: a lot of us are real estate people in the best way possible with our primary residence. Because think about this, guys. We talk about favorable capital gains rates. There are very few things out there as good as the Section 121 exclusion of gain with your primary residence. If you’ve lived in your primary residence for two out of the last five years, and by the way, even if you haven’t lived in it two of the last five years but you got relocated for work or other things, there are some carve-outs. But primarily, it’s two out of the last five years for individuals. You get to exclude $250,000 of capital gains. For married couples, it’s $500,000 of excluded capital gains, meaning zero percent tax rate or zero taxes on those gains. And that’s the gain. So I’m talking about—you could have bought a $500,000 piece of property that you sold for a million dollars because of this big run-up through the pandemic, and that’s the full gain, tax-free if you’re a married couple. So because it’s only on the gain, pretty powerful stuff.
But what’s really, really exciting is when it comes to real estate that’s on your primary residence. We think, ‘Okay, if I sell this and I have a large capital gain, it’d be great to not pay taxes on that.’ There actually are mechanisms where even for investors, not folks that are just buying their primary residences, where you can defer those capital gains. These transactions are known as 1031 exchanges. Essentially, what I can do is I can sell one investment property, one asset, then I can go buy a different one. And so long as certain qualifications are met, I can actually defer having to pay income tax on that first transaction, and I can keep kicking it down the road. A lot of people get excited about these 1031 like-kind exchanges, but I gotta go ahead and warn you: there is some prep that is needed, and most people wait until the last minute. And then they’re caught, and they get a check issued, and then it’s like, ‘Oh God, they’ve blown the whole thing up.’ So, let me go ahead and give you the things to think about just in case you think you want to jump on the 1031 exchange train.
First of all, you can never hold the money. The money’s got to be held by a qualified intermediary that can actually do it. So, it’s typically a trust company or somebody who helps with the closing. They’ve got to be qualified. They’ll very much—if you call ahead, they’ll know exactly to say, ‘Yes, we are structured where we can hold your money, and we can make sure it’s held appropriately.’ Don’t wait until the last minute. If you think you’re like two weeks from closing and you’re going to tell them, ‘Hey, by the way, I want to do a 1031,’ you’re probably going to have a lot of heartache on that. Because there’s also some setup you have to do before closing. You have 45 days to declare the properties you’re interested in, then 180 days to actually close. So, it’s not uncommon if you go do 1031 exchanges that you don’t just declare one property that you think you’re going to buy. You might want to choose two, three, four pieces of property because more than likely, there’s a lot of curveballs with real estate. You want to make sure at least one of the declared properties actually does get to the 180-day closing mark. And you want to make sure that when you are exchanging properties, they are like kind. There are specific rules around what types of property can be exchanged for others. So, you want to make sure that you don’t run afoul of that.
And what I think is great about 1031 exchanges is it’s not a one-and-done. You can actually rinse and repeat this strategy. So, you might buy one property and hold it for a number of years. And then 1031 into another property and hold it for a number of years. And you can keep kicking that can down the road until ultimately one day you sell your final asset. And that’s where you would end up paying the capital gain. Or if you die with the asset and you leave it to your heirs, they’ll actually get a step-up in basis on that. So, there is some tax planning assuming that certain qualifications are met as you work through. I mean, one limitation that I think of that people run into is that you have to always buy same price or higher. So sometimes it can be. So if you think you’re going to be downsizing and doing some unique things, there are some catches or limitations to it. Also, I want to give a word of caution because you’ve heard us speak very favorably on house hacking. We love house hacking because it’s a way that you can actually get into a primary residence that you all like a duplex, a triplex, or a quadplex where you not only have your primary residence, but it’s also investment property. We have other tenants in there paying. But it does complicate that whole Section 121 with the tax-free gain, plus the 1031. So just make sure you do your research, maybe even hire a tax professional to navigate those complexities.
Another thing that we know is true of real estate is that there are other costs associated with them. If we’re having to borrow money to pay for them, we have maintenance, we have other things that go into it. Well, one of the great things, whether it’s your primary residence or whether it’s an investment property, is you are able to deduct some of those expenses. If it’s your primary residence and you’re an itemized deductor, you can deduct the mortgage interest, and you can deduct the property taxes. If you’re an investor, you can deduct the expenses associated with managing and operating the property. It won’t flow through on Schedule A. It’ll flow through on your Schedule E. But you can keep track of the costs that you’re incurring in real estate, and you can use those costs as a means and a mechanism to decrease your overall tax bill.
Yeah, and it’s not uncommon. I see people who own multiple real estate properties also to deduct some of those direct business expenses: the travel, the legal accounting fees, the office space, advertising, maybe even a salary for a family member that’s managing the properties. All those things can be qualified expenses if they’re structured properly. And it’s something that a lot of people take opportunities out of.
Another big benefit of real estate—now, this is specifically on the investment side. This does not count towards your primary residence. But if you are buying commercial property or buying residential property for investment purposes, you are actually able to depreciate that asset. Brian, you’re the accounting guy. You’re the CPA. Walk through what does it mean to depreciate an asset.
Well, there’s several things to know. First of all, you don’t depreciate land. It’s only the building structures that you’re depreciating. But guys, this is a big one. Now, residential is typically—the life of residential property is 27 and a half years. Commercial property is 39 years. And look, this is something I always tell people is that you’ve got to pay attention to if you’re going to sell this property in the future and gains because depreciation recapture is a true thing. So a lot of times, if you have a primary residence and you forgo the 121 tax-free exclusion, decide to turn it into rental property, be careful with some of those things because the depreciation recapture is actually a real thing that you need to pay attention to. But a lot of people get caught up in that. But the thing I like to talk about, and this is where we get excited with commercial real estate, cost segregation. I mean, anything that is not long-term assets—I’m talking about anything that really has a life expectancy less than, like, 15 years, like the sidewalks, the sheetrock, the fixtures in the buildings and so forth—you can accelerate the depreciation on that if you have the income to offset. You know, that’s the—there are limits to how much, whether it’s passive property or you’re actively managed, it’s there. There’s all kinds of limitations. But you can truly accelerate a lot of deductions with cost segregation studies. As you can imagine, if you’re able to take a lot of these deductions and take a lot of this depreciation, it can potentially have a huge impact on your tax bill. But you want to make sure you know what you’re doing because Brian always says this: the one group of people that you do not want to run afoul of is the IRS because they’re the folks with the guns. They can come and take your stuff. So make sure that before you enter into some of these more complicated transactions and some of these more complex tax strategies, you’ve actually measured two, three, four times, and you know that you know what you’re doing so that you don’t get yourself into a bad situation.
So, another benefit of real estate, Brian, and this is something that changed with tax laws a couple of years ago. Now, real estate, you can actually have passive income and pass-through deductions based on qualified business income. It was something that changed a number of years ago where essentially you can look at the net profit across your real estate properties and have a deduction up to 20% of that net income. Now, this will be going away in 2025. But for real estate investors right now, it’s a huge tax benefit that exists on the tax. I thought it was so interesting when we were going through the lawmaking process, the legislation is that they carved out so many professionals from qualifying for this QBI deduction. But real estate professionals, architects, those types of things all seem to be somewhat protected. I thought that’s man—you can tell that the real estate lobby is strong. The force is with them. So it is a benefit. Their ability to lobby to keep that QBI and those deductions in there is something you can actually benefit from if you are a real estate investor.
And then the last thing that’s just worth noting in terms of decreasing your taxes is one of the big benefits of real estate. If you go out and buy an investment property and you’re generating income through that, that income is not considered self-employment income. It’s considered passive income, not subject to self-employment taxes. So if you’ve ever done any sort of side gig or side hustle or you’re self-employed, you know how cumbersome those self-employment taxes can be. You’re having to pay both sides of Social Security and Medicare. Well, in a number of circumstances, rental income as it’s flowing in is not considered self-employment. So it’s not subject to those taxes. So that can be a lower tax bill than income otherwise. Now, that is a positive that it’s not subject to that 15.3%, but there is a negative to it is that it also doesn’t qualify for retirement plan contributions. A lot of people—you know, like, ‘Well, hey, I had that type of income.’ No, but that wasn’t subject to the 15.3%. It’s not wages. So you don’t get to count it towards retirement contributions. Just something to be aware of. But still, real estate, as you can tell, has tremendous benefits. For more information, check out our free resources.
