You all know by now that Selenid and I are big fans of real estate investing. The reasons are multifold – we enjoy it, it serves a greater purpose, and the returns are fantastic. One of the unique things about real estate investing – and what makes returns so great – is the ability to turn real estate losses into gains. And that is what we are going to talk about here.
I would argue that real estate is the only investment vehicle where you can truly do this. You can count real estate losses while still actually accruing real gains. And then those losses can further be flipped into gains using tax advantages and other mechanisms. This is evidenced in our 1-year review of our first investment property…
But there is a key
You have to create the real estate losses strategically and with a purpose. Just spending willy nilly without a plan won’t do you any good.
That’s why it is so important to educate yourself and prepare a strategy before sprinting into action. Like so much in real estate investing, it comes down to the numbers. And the better you know the numbers, the less uncertainty there is and the more you can move forward confidently.
With this said, let’s dive into the 3 major ways that you can turn losses into gains with real estate investing…
3 ways to turn real estate losses into gains
And away we go!
This is a big one. Depreciation represents a paper loss that can be used to offset actual income from real estate investing.
Confused? Let me break it down.
The IRS has decided that every real estate property depreciates or loses value equal to 1/29th of its purchase price every year. That means that in 29 years, the property, in the eyes of the IRS, is worth $0.
As an example, if you buy a property for $100,000, its value depreciates by ~$3,448 ($100,000/29) each year.
But the beautiful thing is that this depreciation occurs regardless of if that property is cash flowing or not! So, this property may be making you 10% cash-on-cash ($10,000) every year. But to the IRS, it actually lost money based on depreciation! That’s why depreciation is called a “paper loss.” It only happens on paper, not in reality.
Now, even better, this paper loss offsets the active income that you make from the property. In the example above, your income from the property is $10,000. But your taxable income taking only depreciation into account is actually $6,552 ($10,000-$3,448).
In essence, your “paper” real estate loss just became a gain.
The next step is to avoid recapturing this depreciation…
The flip side of depreciation is that your basis in the property decreases right along with the depreciation.
Again, using the example above, your basis in the property would decrease by $3,448 each year. After 29 years, your basis would be $0. If you then sold the property for $150,000, you would owe capital gains taxes on all $150,000.
But, there are ways to avoid recapturing this depreciation so you can keep it as a gain.
- One is obvious, just never sell the property. If the property is cash flowing, why sell it. Just keep letting it put money in your pocket every month and then leave it to your heirs when you die. Your heirs get a step-up in basis and the depreciation isn’t recaptured.
- The second way is using a 1031 exchange. With a 1031 exchange, you sell your property and within a certain time period buy another property of equal or lesser value. You have to do this using a 1031 exchange company and there are many rules to follow. However, by doing this, your depreciation is not captured as you do not pay capital gains taxes on your sale. This is because you roll the sale right into another property investment.
Now that we’ve covered depreciation, let’s talk about turning your rehab costs into gains…
2. Rehab costs
When you buy a rental property, chances are really good that you are going to need to do at least some rehab work. This is why…
The only way to avoid this is by buying a turn key property in which someone else did all the rehab and renovation and you just buy it rent ready. The problem with this is that the turn key company has already increased and harvested all the value from the property.
Instead, what you really want is to buy a place that you can rehab to increase the property’s value through forced appreciation. This rehab can be significant or minor. But you want something you can do to increase value. Then you get to benefit from this added value.
Where people get hung up is that rehab can cost a lot of money. It is seen as one of the real estate losses. But I hope to change your perspective so you can see how we really want to turn rehab costs into gains.
How can you do this?
The first way is really simple. Your rehab costs are tax deductible. They count against your taxable income from the rental property. If they are greater than this income, you can carry them forward to future tax years as passive losses to offset future passive gains.
The other way is through a cash out refinance.
Imagine a property that you buy for $100,000. You then put $50,000 of rehab work in. Now it’s after repair value is $200,000. You can then do a cash-out refinance of the property, get it appraised at its $200,000 value, and take a mortgage out for 75% of the value, $150,000. Now, about $100,000 of this will go towards the original loan if you used a mortgage to buy the property, but the other approximately $50,000 will go right back to you.
In this way, you just recycle your rehab costs back to you to use again. That is a huge gain in the efficiency or velocity of your money since you can now use that money again to invest in another property.
The key in this scenario is to ensure that property continues to cash flow after the refinance. Because you are sacrificing cash flow for increased efficiency of your money.
With these two down, let’s talk about your most valuable currency…time. And let’s see how time losses in real estate can really become your gains!
Time is the number one loss that potential investors quote to me as reasons they do not pursue real estate investing.
And in a sense, yes the time you spend on real estate investing is a loss in the sense that it is time you don’t spend doing something else.
But I’d like to pretty strongly hit back on this for 3 reasons – two philosophical and one tangible…
First, let’s adjust our mindset here. Real estate investing is time spent creating wealth and accelerating your path to financial freedom. So yes you spend time. But your spend time with a purpose. Which in my mind is the best way to do it.
Second, time spent on real estate investing is time spend buying back your future time. Whoa! Did I lose you? Well, by investing in real estate creates leveraged income. That means that my income from real estate is not tied in a 1:1 fashion with my time.
Take this post as an example. And going further, every time we buy a property, it takes a good amount of time to get it running…to fix it up, rent it out, etc. But after that, it becomes really passive. To me, that initial time that will buy my future financial freedom is well worth it.
Lastly, you can use your time losses in real estate investing to become monetary gains!
How? Through Real Estate Professional Status!
One achieves real estate professional status or REPS by logging 750 hours or 1 hour more than their other job, whichever is greater, materially participating in their real estate investment business.
When you or your partner achieve REPS, all of the passive losses – like depreciation, rehab costs, etc – can now be counted against your active W2 income, not just your passive real estate income.
Because now you can use techniques like accelerated depreciation through a cost segregation study to create larger depreciation “paper” losses that now can offset your W2 income. Because now your expenses like rehab costs can offset even more of your taxable income.
Selenid and I do this.
So now, every hour that we spend on our properties doesn’t feel like a loss. It feels like a huge gain helping us to, again, accelerate our path to financial freedom!
Determine what works for you
My goal here is not to convince you to become a real estate investor. Only you can decide that.
My goal is to shine light on how real estate investing comes with a lot of advantages that we can use to gain financial freedom, practice medicine on our own terms, and become better doctors.
Because it is true that real estate investing involves losses. But with the right strategy and mindset, you can easily turn those losses into big gains that push you forward.
If you feel ready to learn more about real estate investing, check out this guide to real estate investing for physicians, learn how to screen and analyze properties the right way, and practice these 5 questions to ask and find the right investor real estate agent.
And don’t forget to check out my free masterclass webinar on The 12 Steps to Financial Freedom for Physicians!
What do you think? Do the losses in real estate dissuade you from investing? Have you turned losses into gains? Let me know in the comments below!