﻿Alright, everybody, I’m Logan Allec, I’m a CPA, and in this video
I want to talk about a misconception that I think a lot of people have, I don’t know exactly why
this misconception exists, but it does. And this misconception is that if you make a lot of money
and you need a way to reduce your tax bill in a jiffy, you can buy a rental property and somehow,
through tax magic, a CPA or other tax professional can somehow take that rental property and save
you a bunch of taxes as a result. I see this misconception constantly online. For example,
there’s a real estate investing website called BiggerPockets that I used to be quite active in
five or six years ago, on BiggerPockets there are a lot of forums that people can ask real
estate questions to the BiggerPockets community at large and get answers so I provided a lot of
information and answers to people there on their tax questions and got a lot of clients
that way. And one thing I would see pop up all the time is, “Hey, I make a lot of money at my job,
and I’m getting killed in taxes, I heard that I can buy real estate and it’ll reduce my tax
bill dramatically.” Like for example, here’s a post, the guy said, “My fiance paid over
one hundred and fifty thousand dollars in taxes from her W-2 job. Would buying passive
income like a multifamily property offset her taxes?” And then later he said, “Her CPA claims
she has no writeoffs other than her property taxes and normal homeowner stuff. A buddy of
mine said if we get three million dollars worth of real estate that her taxes could literally be
zero through cost segregation.” And I see questions like this all over the internet,
in Facebook groups, on Reddit, in forums, people ask, “Hey, I need to save on taxes,
what should I do?” And most of the time, someone will chime in, “Buy real estate!” as if they know
what they’re talking about. So I’m here to set the record straight in this video, and I don’t
want to make it a boring tax lecture, so I’m going to explain the concepts I want to cover as I go
through examples. I’m first going to give you an example of a taxpayer who buys a rental property,
rents it out, takes all the appropriate deductions and reports them on their tax return, calculates
depreciation correctly, and nevertheless that rental property makes absolutely no difference
in their tax liability for the year. Then I’m going to give you an example of a taxpayer who
buys a rental property but it causes them to pay less in taxes this year. Then at the end
of the video I’m going to give you an example of a taxpayer who buys a rental property and accounts
for it correctly on their tax return, but in this taxpayer’s scenario, the rental property actually
generates a tax liability for them. And hopefully as I go through these examples, you can figure out
which bucket you’re in. By the way, if you are a real estate investor and you want to talk
taxes and real estate with me and if you’re looking for a CPA, feel free to email me
at realestate@loganallec.com, serious inquiries only, ideally you already have a real estate
investment or two under your belt or are dead-set on purchasing one in the very near future and have
the money set aside to do so. Alright, let’s get into it. Example number one is a taxpayer who buys
a rental property and it doesn’t do anything to his tax liability this year. So let’s say this
taxpayer buys a rental property for a hundred and fifty thousand dollars and let’s say,
just to use round numbers here, let’s say this property generates a thousand dollars of rent a
month, and I’m just making these numbers up, by the way, just to illustrate the example,
I’m not saying these are actual numbers anywhere right now, and let’s say the monthly mortgage
payment, which includes principal and interest and taxes and insurance, is,
I don’t know, six hundred dollars a month and this property’s other expenses, things like
property manager’s fees and repairs and supplies and maybe an average of capex and vacancies,
let’s say the other expenses are three hundred dollars a month on average, and again, I’m just
making these numbers up. So if we take the one thousand dollars in rent a month less the six
hundred dollar monthly payment to the bank less the three hundred dollars a month in
other expenses, that leaves us with a hundred dollars a month in cash flow, this sounds low but
it’s a round number so let’s roll with it, OK. So in real economic terms, this rental is generating
for the taxpayer a hundred dollars a month, which is twelve hundred dollars a year in cash flow.
But that’s not what we would put on our tax return. For one thing, we would have to add
back the principal payment on the mortgage because you can’t deduct principal payments, and because
we’re early on in the mortgage, the principal paydown is probably really low because most of
the payments earlier on go mostly to interest, that’s just how mortgage amortization works, so
let’s say the monthly principal paydown on average for the first year here is two hundred dollars a
month. And then from that we have to subtract depreciation, so I’m not going to get into the
details of the calculation here, I plan on doing a dedicated video on depreciation in the future,
but you can see my little back-of-the-napkin depreciation calculation on-screen
here, but basically the monthly depreciation expense with the assumptions I’ve laid out
would come out to three hundred and forty-one dollars a month, and I also threw in a little
bit of amortization, loan costs on the mortgage would be amortized over the length of the loan,
I just put in nine dollars a month to get to a nice round number because the depreciation figure
was odd, so basically if we take our monthly cash flow of a hundred dollars a month, add back the
monthly principal paydown, subtract depreciation expense, and subtract amortization expense,
we come up with a fifty-dollar monthly loss for tax purposes, largely due to depreciation. So we
multiply that hundred-dollar monthly loss by twelve and we get a six-hundred-dollar
for tax purposes that this taxpayer would report on Schedule E on their tax return. So why is it
that this six-hundred-dollar tax loss generated by this rental property doesn’t help the taxpayer’s
tax situation this year in this first example? Well, first, let me tell you a
little bit more about this taxpayer in this first example. Just generally speaking, people in this
bucket are highly-compensated managerial-level employees or well-compensated sales professionals
or business owners who are doing fairly well for themselves, and by fairly well in this context
I mean they make at least one hundred and fifty thousand dollars, that’s a magic number here that
you have to keep in mind. So let’s say our first taxpayer here makes a hundred and fifty dollars a
year at their job as an engineer, and let’s assume that’s their only income, other than real estate
of course. So even though this taxpayer has a six hundred dollar rental loss showing on Schedule E,
a loss largely due to depreciation, this taxpayer can’t deduct that loss against their other income,
it does nothing to affect their tax liability this year,
their tax liability is the same this year whether they bought that rental property or not. Why?
Because of something called the passive activity loss rules. Due to these rules,
you cannot deduct passive losses, like a loss on a rental property, against your non-passive income
like the money you make at your job. That’s the general rule. There are exceptions, for example,
if you’re a real estate professional for tax purposes, I’m going to make a video specifically
about that, but in this situation, our taxpayer is not a real estate professional,
they have a full-time job as an engineer, given that fact pattern it is pretty much impossible
for this taxpayer to qualify as a real estate professional. Another exception to this general
passive activity loss rule is that if you actively participate in a passive rental real estate
activity like we have here, you might be able to deduct up to twenty-five thousand dollars’ worth
of passive losses against your non-passive income for the year with the rest being carried forward
to future years. But you can’t make too much money in order to qualify for this exception. The IRS
says, “The maximum special allowance of $25,000 is reduced by 50% of the amount of your modified
adjusted gross income that’s more than $100,000. [Therefore] if your modified adjusted gross income
is $150,000 or more, you generally can’t use the special allowance.” So this is saying if your
modified adjusted gross income is one hundred thousand dollars or less, and that’s the same
amount for single as for married filing jointly, so this is an example of a marriage penalty, so
if your modified adjusted gross income this year is one hundred thousand dollars or less, then you
can deduct up to twenty-five-thousand dollars in passive losses from rental real estate activities
you actively participated in, but for every dollar in modified adjusted gross income you have over
one hundred thousand dollars -- and this figure excludes the real estate loss, by the way -- so
for every dollar in modified adjusted gross income you have over one hundred thousand dollars for the
year, this twenty-five thousand dollars potential special allowance is reduced by fifty cents. So if
you make one hundred and twenty thousand dollars, you’re over the $100,000 limit by $20,000,
fifty cents times twenty thousand dollars is $10,000, and twenty-five thousand dollars
subtract $10,000 is $15,000, so you could only deduct a maximum of $15,000 of passive real
estate losses against your active income this year, and just doing the math, once your income
hits one hundred and fifty thousand dollars, that twenty-five thousand dollar allowance
would be zero, so you cannot deduct any passive real estate losses against your active income.
And this modified adjusted gross income figure, it’s based on adjusted gross income, not taxable
income, so it’s not lowered by your standard deduction or itemized deductions or QBI deduction.
So in our case, our taxpayer makes a hundred and fifty thousand dollars a year at their engineering
job, so they cannot deduct any of these depreciation-generated real estate losses against
their ordinary, active income. So what happens to these losses? Are they lost forever? No. They are
carried forward indefinitely to be applied against future passive income or potentially released,
say, if the asset is disposed of, I do want to make a video in the future about the ins and
outs of the passive activity loss rules, but for now let’s put example number one to rest here,
this poor taxpayer who can’t use their real estate losses this year and whose rental property made no
difference whatsoever to their tax liability this year. Now let’s talk about the second taxpayer,
the example of a taxpayer who does get a tax benefit this year for the rental tax loss. So
we can assume the same rental property, but let’s say this taxpayer, instead of making a hundred and
fifty thousand dollars a year, let’s say they make a one hundred and forty-eight thousand dollars a
year and they actively participate in this rental property. Well, this taxpayer can deduct the
entire six hundred dollar rental loss against their W-2 income this year. Why? Because just
to do the math again really quickly, the special allowance to deduct real estate losses against
your ordinary income is $25,000, which is reduced by fifty cents on the dollar for every dollar
your income exceeds $100,000, our second taxpayer here makes $148,000, so $148,000 less $100,000 is
$48,000, and $48,000 times fifty cents is $24,000, and $25,000 minus $24,000 is one thousand dollars,
so this taxpayer could deduct up to one thousand dollars of real estate losses against his ordinary
income for the year. And this particular property generated a six hundred dollar loss, which is
less than a thousand dollars, so this taxpayer can deduct all of that loss against their W-2 income.
So even though this taxpayer cash flowed twelve hundred dollars for the year on this property,
they still get a tax deduction for six hundred dollars on this property. How much is that worth,
well assuming this taxpayer is single they’re in the twenty-four percent tax bracket for federal
income tax purposes, so twenty-four percent times six hundred dollars is one hundred and
forty-four dollars, so this rental property reduced this taxpayer’s federal tax liability
by one hundred and forty-four dollars and possibly reduced their state tax liability as well if they
have one. Now let’s talk about a situation where a rental property would actually cause you to pay
more in taxes, and this scenario is quite simple. It’s simply that even with depreciation,
your rental property still has taxable income. So what if in five years, rental market’s going up,
instead of charging a thousand a month, let’s say taxpayer number two, for example, starts charging
eleven hundred dollars a month. He hasn’t refinanced or anything, fixed-rate mortgage,
so principal and interest are the same, but maybe taxes and insurance have gone up a bit, so instead
of six hundred dollars for those expenses let’s say it’s six-twenty-five. And let’s say the other
expenses are the same, realistically maybe the property manager is collecting a little more now
if their fee is based on rents, so we can increase the other expenses by say ten bucks a month or
something, so other expenses are three hundred and ten dollars a month now. Monthly principal paydown
is probably more now, maybe two hundred and ten dollars a month let’s say, but what stays
the same? Depreciation and amortization, assuming the taxpayer didn’t make any capital expenditures
they would have to depreciate during this timespan, because their basis is their basis,
their basis is what they paid for the property five years ago, and depreciation is based on that,
they haven’t refined, so their loan costs are the loan costs they paid five years ago,
so the depreciation and amortization, they don’t change, so moral of the story here is as time
goes by and you increase your rents and hopefully the increase in your rents outpaces the increase
in your cash expenses, but that depreciation stays constant, and a big driver of that tax
loss earlier on is depreciation, but that stays constant, so over time on a typical
rental property, you might start seeing taxable income generated by the property because while
your rents are going up, your depreciation is staying constant. And on top of that, depreciation
doesn’t last forever, it lasts a long time, to be sure, but on a rental property, the life is
twenty-seven and a half years for depreciation, so say year thirty, your depreciationed out
other than depreciation on perhaps other capital improvements you made over the years,
but the bulk of the depreciation is done. So back to our fact pattern here, in this third scenario,
now this rental property is generating taxable income of three hundred dollars a year,
let’s say taxpayer is in the twenty-four percent tax bracket, so twenty-four percent
times three hundred dollars is seventy-two bucks, not a lot in the grand scheme of things, but if
we’re talking about more properties and scaling and all that, it can make more of a difference.
But I do want to point something out here, and that is that even though the property generated
in this scenario one thousand, nine hundred and eighty dollars in cash flow and on top of that
two thousand, five hundred and twenty dollars in principal paydown, which is a net worth increase,
that’s your tenants paying down your mortgage for you, so let’s say just back-of-the-napkin here
forty-five hundred dollars in economic increase during the year, and that’s not even including
appreciation of the value of the property itself, but only the cash flow and the principal paydown,
but on all that your taxable income attributable to the property is only three hundred bucks and
your tax bill is only seventy-two bucks. That’s pretty incredible. So my point is, if you make
good money, and you don’t qualify as a real estate professional, buying property isn’t going to be
the magic bullet to lower your tax liability, but if you just isolate the real estate and look
at the economic benefit you’re getting from the real estate itself, forget about writeoffs against
your W-2 income, just isolating the real estate itself, in those depreciable years, and assuming
the property’s a good investment, you’re getting outsized economic increase, net worth increase,
every year far beyond the income taxes you may or may not pay on your real estate activities.
So I hope this was helpful for all of you out there who are thinking about getting into real
estate or you are in real estate but you don’t completely understand all the tax ramifications,
like I said earlier if you’re a real estate investor and thinking about getting a CPA or a new
CPA, reach out to me, realestate@loganallec.com and we will chat. Alright, folks, that is all I
have for you today, feel free to check out these other tax videos I have for you right over here,
I think you’ll learn a lot from them, and I will see you over in those videos, buh-bye.