I’ve said many times that real estate investing has been a huge accelerant in my wealth building process over the last 3+ years. In fact, from my past net worth update, you can see that real estate accounts for a decent chunk of that net worth. And one of the big advantages in real estate investing is the tax savings.
And yes, when tax strategies for real estate investing are well planned out and executed, the tax savings can be massive.
But, there are also ways that these tax savings can backfire. And unfortunately, I have seen this happen too many times.
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The exact root cause of this is difficult to pinpoint. It could be a lack of education. Or overzealous investors and/or advisors. Or just a plain old mistake. But whatever it is the cause, the ramifications can be really big and halt your wealth accumulation in your tracks.
That’s why I want to spend some time and review tax benefits in real estate investing as well as 3 massive, scary ways that they can backfire.
Cash flow, tax savings, and real estate investing
There are 5 basic ways that real estate investing makes you money:
- Cash flow
- Appreciation (Market or Forced)
- Equity pay down
- Inflation hedge, and
- Tax benefits
Assuming these factors all carry equal weight, you can see that it actually would be quite silly to invest focusing only on one of these 5 ways to make money.
Related Post:
A Real Estate Investing Guide for Physicians
However, they are not equally weighted.
From this post which goes through a 1 year review of our third investment property, you can see that cash flow, forced appreciation, and tax benefits carry the largest monetary benefits.
Example of money-making weights from our third investment property:
- Cash flow: $15,632.35
- Appreciation: $300,000
- Tax benefits: $31,000
- Equity pay down: $2,000
- Inflation hedge: $844 ($15,632.35 * 5.4%)
Examining how real estate investing can impact your taxes
So, we see from above that tax savings can result in a significant amount of money made for any real estate investor.
However, doctors like me are high income earners and are therefore subject to the highest tax brackets. That makes us particularly keen to figure out (legal) strategies to lower our tax burden.
While there are many ways for physicians to lower their tax burden like these, real estate holds unique advantages. And the biggest of those advantages is the potential to use passive real estate losses to offset our high active income.
Let me explain more
Passive “paper” losses in real estate investing come largely in two forms:
- Expenses from running the property and
- Depreciation
The government and IRS says that each real estate property loses value each year. In fact, after 27.5 years, the value of any property is $0 in the IRS’ eyes. And this 27.5 years resets every time a property is sold or changes hands.
So, each year, every property you own loses 1/27.5 of its value. This is called “straight line depreciation. And this loss in value is the depreciation of the property and is considered a passive loss. You can then use this passive loss to offset passive income – like rental income. You can do this even without REPS.
This is a huge advantage. Especially when you realize that your property didn’t actual lose value but provided immense value as a source of rental income and possible appreciation!
But wait, theres more! You can accelerate this depreciation…
By hiring a cost segregation company to “cost segregate” your property, you can divide items and parts pf your property that actual depreciate to $0 in much less time than 27.5 years.
After the cost segregation is done, you can take advantage of forced appreciation to claim much more depreciation of value for your property. You can use these massive passive losses to offset more passive gains or carry them forward to future tax years.
The problem is that most people don’t have huge amounts of passive income. But they have huge amounts of active income, like from W2 jobs in our case.
This is where Real Estate Professional Status comes into play
By qualifying as REPS by meeting the below two requirements,
- 750 hours and
- At least 1 hour more than you spend in any other job,
you can now take these massive “paper” depreciation losses and not just offset passive income, but also offset active income like from your W2 job.
In this way, you reduce your taxable income for that tax year immensely and owe way less in taxes. This is a huge benefit obviously.
(For a more in depth discussion of REPS, check out this post.)
Again, however, the actual real estate investing strategy used to implement and achieve these tax benefits really does matter. If you don’t implement them with care and intention, things can backfire.
3 ways real estate tax savings can backfire
Let’s take a closer look…
1. Accelerating depreciation and selling short
This is the biggest one. And I think it hoopoes most often because investors don’t really understand what happens when you depreciate a property.
So let’s use an example with straight line (regular) depreciation
To do so, let’s go back to our third investment property. We bought it in 2021 for $202,000. And so, our “basis” in that property, the value of the property that we hold, is $202,000. If we sold the property the following year for its market value of $250,000, our basis would still only be $202,000. Therefore, we would have to pay taxes on $48,000 of that sale ($250,000-$202,000).
However, after 1 year, our basis wouldn’t actually still be $202,000. Because that property would have depreciated on paper by 1/27.5 of its value in the eyes of the IRS. Thus, my basis would decrease by $7,345 ($202,000/27.5) making my new basis at the time of sale equal to $194,655. And then, when I sold the property I would actually owe taxes on $55,345 of the sale.
Ultimately, that doesn’t make a huge difference.
But, what about if you used accelerated depreciation instead of straight line depreciation?
In 2021, Selenid met criteria for REPS and we performed a cost segregation study on this investment property and accelerate depreciation. As a result, we cost segregated ~$77,000. At a marginal tax rate of 39.6%, this results in roughly $31,000 of tax savings!
However, it also reduced our basis in the property by that amount. So, our new basis is $125,000. That means, if we sold the property the following year as in our current example, we would now owe taxes on $125,000 of the purchase. At a marginal tax rate of 39.6%, that comes out to $49,500!
Thus, any tax gains we made are property erased and then some. We actually came out losing in this scenario.
And this is the biggest way that tax savings can backfire in real estate investing
If you cost segregate and accelerate depreciation, you need to be investing for the long term with a buy & hold approach to your real estate investing.
Ideally, you will never sell your property. And if you do, you should be planning to sell with a 1031 exchange so you can use the gains to buy another, bigger property without owing those taxes.
If you sell the property early, any tax savings will be wiped out and you will come out owing money to the IRS depending on how much the property has appreciated.
So, how do you make sure you don’t need to sell short? Well, this goes into mistake #2…
2. Not investing for cash flow
In real estate investing, cash flow is king and queen.
As you can see from above, it is not always the biggest line item in terms of money made from the property in absolute terms. But it is the most consistent and the one that just keeps coming and coming over time.
The tax savings you get from real estate really happen once per property. Cash flow is forever. If you do it right…And to do this, you need to know How to Screen & Analyze Investment Properties the Right Way.
I see too many investors overlook poor cash flow number sin potential properties only to buy them for some other reason. Maybe they buy for the tax savings. And in. the first year the accelerate depreciation and get a nice tax return.
However, if the property doesn’t cash flow enough after that to cover the mortgage, insurance, and other expenses, those investors have to come out of their own pocket to cover every month. This may not be financially viable so they are forced to sell the property.
But they already performed the cost segregation and accelerated depreciation so they get hit with a (even more) massive tax bill. This is exactly why I am adamant that doctors should not invest in real estate just for the tax savings!
This can happen with any property but I see it most often happen in the types of properties we will talk about in mistake #3…
3. Investing in short term rentals
I know many doctors who successfully invest in short term rentals. And there are compelling reasons to do so. Including generally higher rents and the fact that the threshold to be able to reduce your active income is much lower with short term rentals.
Unfortunately, this also means that these tax savings strategies are more tempting and most likely to be used erroneously and backfiring.
However, there are significant downsides to investing in short term rentals. The biggest ones I review here include an unfavorable regulatory environment and increased turnover.
And these issues can manifest as increased vacancy. Moreover, that vacancy is more highly correlated with external factors like to overall economy. Less people go on vacation and stay at short term rentals when money is tight, but they still need a place to live (like a long term rental).
Thus, with short term rentals, cash flow is more labile. And tax savings are more easy to realize. Plus, short term rentals tend to carry a higher purchase price given their usual locations and demand.
This is a recipe for an expensive asset that can be easily depreciated but then lose cash flow requiring a sale on the part of the investor.
Boom. That sound was the tax savings backfiring.
What can you do to avoid these real estate tax savings pitfalls?
Thankfully it’s pretty simple. And these examples aren’t to deter you from real estate investing. I think it is an amazing wealth building vehicle! But you need to do it the right way.
And the way that you avoid these pitfalls is to design your real estate investing strategy to minimize these risks. And then you have to stick to that plan. Even if some new stray seems so exciting and enticing and is the new fad strategy.
Our investing strategy breaks down to these main components:
- Buy – Well, you can’t own real estate without buying it so there’s step #1
- Rent – By renting the properties, we can have the tenants pay our mortgage with their rents. In addition, since the total rents exceed the mortgage/tax/insurance/etc. payments, we keep the extra money as cash flow. Through careful analysis, we are conservative and ensure that cash flow will be very unlikely to ever dry up.
- Hold – The overall real estate market is not unlike the stock market. They both go up and down in the short term. However, in the long term, they generally go up. So, in buying properties that cash flow and holding them for a long time, we can increase the chance that the property gains value by the time we eventually plan to sell it. Plus we minimize the risk of losing our tax savings.
- Multifamily – By increasing the number of units under one roof, you decrease the cost per unit, increase profit in general, and make your business more efficient. Right now, we invest in 2-4 unit properties but may go bigger in the future.
Each of these strategic decisions minimizes the risk that we will need to sell short or lack cash flow. Thus, our ability to optimize and take advantage of the tax savings available with real estate investing is maximized.
I encourage you to design a strategy with the same goals in mind!
Throughout this post, I’ve references a bunch of resources related to successful real estate investing as a doctor, so I’ve gathered them all here in one place:
- A Real Estate Investing Guide for Physicians
- How to Screen & Analyze Investment Properties the Right Way
- Lessons for Picking the Best Real Estate Market
- How I Bought My First Investment Property
You can also check out my flagship course, Graduating to Success, that guarantees to teach you to thrive personally, professionally, and financially including how to use real estate investing the right way as a doctor here!
What do you think? Can tax savings in real estate investing backfire? Have you seen or experienced this? What happened? How could it be avoided? Let me know in the comments below!