Whenever I talk to doctors about real estate investing, they seem to get most excited talking about the potential tax benefits. More than any other aspect. This always intrigues me. So, I think it is important to discuss the question of if it is worthwhile to invest in real estate just for the taxes?
But before we go too much further, let’s review the financial benefits of real estate investing…
How investing in real estate makes you money
There are tons of different strategies for investing in real estate. To review, my strategy consists of:
- 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.
- 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.
- 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 are starting with 2-4 unit properties but will go bigger in the future.
However, regardless of your strategy, 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.
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 benefits can result in a significant amount of money made for any 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
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 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!
(For a more in depth discussion of REPS, check out this post.)
So, which factor is most important in real estate investing?
Well, I’ve actually laid out the 4 Reasons That I Think Cash Flow Is King in Real Estate Investing before.
So, it’s not a surprise that my answers to the question of this post, “Should doctors invest in real estate just for the taxes?” is “no.”
Why doctors should not invest in real estate just for the taxes
In my mind, there are a lot of reasons. But let’s go through the most salient ones in my mind.
1. You should invest holistically
This is most important to me. When investing in real estate, you really should invest in a way to maximize all 5 ways of making money with your investment.
I’ve seen doctors invest in a horrible property via the cash flow metrics that I use to analyze potential deals just because it is an expensive property and they think they can reap the massive tax advantages.
This just makes no sense! Why would you buy a property that you are losing money on just to harvest some tax benefit?
Bottom line, optimize all streams of wealth building in all of your investments, but especially real estate.
2. You may not get REPS
Achieving REPS is possible. Don’t believe me? Ask Selenid. She has done it the past few years and it has afforded us the ability to harvest massive tax benefits.
But it is really hard work.
And it is pretty much impossible for a full time doctor. So, you either need to have a spouse that buys in and is passionate as you are. Or you need to cut back clinical hours.
And you still may not get REPS.
So it behooves you to make sure the property makes sense as an investment even if REPS doesn’t come through.
3. Accelerated depreciation is phasing out
2022 was the last tax year for 100% bonus or accelerated depreciation. In 2023, it goes down to 80%. And it will be down to 60% in 2024.
And it will phase out completely in 2027.
There will still be a benefit to using bonus depreciation even when it is only 20% in 2026 (assuming your gains are greater than the costs of the necessary cost segregation study). Something is always better than nothing. However, the impact of this real estate investing benefit for your taxes is significantly diminished.
So, you had better be sure that your investment works even after this depreciation schedule!
4. The actual best tax advantages are “underwhelming”
In my mind, one of the coolest advantages from real estate for your taxes is that the majority or all of your cash flow from rent is tax-free.
This occurs because your usual or accelerated depreciation (AKA passive losses) cover that income.
Additionally, you can see your property in the future using a 1031 exchange to buy a property of equal or greater size without recapturing the depreciation that you have already claimed. Essentially, selling the property with a 1031 exchange makes it a non-taxable event.
This is a massive advantage and one of the 3 reasons that Selenid and I don’t sell our rental properties.
However, despite these being great advantages, I never see any investor get too overly excited about them. Because when you compare them to writing off active income via accelerate depreciation and REPS, they seem basic.
But basic is not bad. Investing at times, or maybe most of the time, should be boring. But these basic benefits for your taxes are not a reason alone to invest in real estate.
And there you have it!
The bottom line is: Don’t let the tax tail wave the investing dog.
We all have a complicated relationship with taxes. And whether we agree with them or not, they are a reality of our lives that is not going away. So, while it makes sense to work to minimize our tax burden, I encourage you to instead focus on optimizing and maximizing any of your investments in a holistic manner.
And yes! Good deals are still out there, even in a higher interest rate environment. More on that here…
Here are some other great posts on the topic of taxes and real estate investing!
- The Real Estate Flywheel Effect for Successful Physician Investors
- An Inside Look at My Personal Tax Plan
- 5 Steps for Doctors to Start Investing in Real Estate
- 7 Steps to Visualize the Big Picture in Real Estate Investing
What do you think? Should doctors invest in real estate just for the taxes? Or is this a mistake waiting to happen? Let me know your thoughts in the comments below!