How To Pay $0 In taxes

Yes, it's possible and completely legal.

What do you think of when you hear the word depreciation? I used to think of deprecation as a bad thing. I thought it meant that something loses value and therefore negatively impacts you. When it comes to real estate investing depreciation does not negatively impact you at all. In fact, it's an incredible benefit and the more you can get your hands on the better. Think of the richest people you can… they’re using depreciation and there’s a good chance that dollar for dollar they’re paying less taxes than you are.

What Is Depreciation?

When you buy real estate and rent it out things tend to wear out over time. (Only the structure wears out. Land can not wear out because well… it's land.) The IRS states that residential properties have a useful life of 27.5 years and commercial properties have a useful life of 39 years. Because real estate wears out and therefore "loses value" the IRS gives you a tax benefit called depreciation that you can deduct from your income taxes therefore lowering your tax bill. Let's take a one-million-dollar residential home and depreciate it over 27.5 years. Remember you could have purchased the home for 1.5 million but the structure was worth 1 million and the land was worth 500k and can’t be depreciated. $1,000,000/27.5 = $36,363.63. This means that you can reduce your taxable income by thirty-six thousand dollars per year! Now let's say that your property provides cash flow of $25k a year. All of your rental income is now completely tax-free because of your depreciation and you have another $11k+ you can use to reduce your income taxes.

A Paper Loss… What’s that?

Depreciation is an incredibly powerful tool because you’re essentially telling the IRS “Hey my property is going down in value. It's falling apart and things are wearing out. I need a tax break!” but generally real estate goes up in value over time. That’s right, the IRS is giving you a tax break for something that is making you money and going up in value every year. Let’s take a deeper look into this using the example from above. If your property brings in $25k in rental income but your depreciation for the year is $36k you are telling the government that you lost $11k that year… but you didn't. You made $25k in cash flow AND received an $11k tax deduction. It's called a paper loss because on paper it looks like you lost $11k but in reality, you’re laughing to the bank with your $25k and your tax deduction. It only looks like a loss on paper.

Cost Segregation

Now what if there was a way to get even more depreciation and an even bigger tax break… well there is a way and it's called cost segregation. When a property wears out the components that make up the property wear out at different rates. Some components wear out after 5 years, some after 7 years, and some take 15 years. The actual structure of the building is still 27.5 years. A cost segregation study separates those items into their respective buckets and allows you to depreciate them over the length of their useful lives instead of depreciating everything over 27.5 years which is called straight-line depreciation(the strategy we discussed above). Why is depreciating an item over 5 years better than depreciating it over 27.5 years? Because of something called the time value of money which means that a dollar today is worth more than a dollar tomorrow. The more I save on taxes the more money I have to go and invest in more real estate which in turn will make me more money and provide me more tax benefits. Money today is better than money tomorrow because it starts the compound effect faster.

Bonus Depreciation

Yes, it gets better... Bonus depreciation allows you to take every item that has a useful life of 15 years or less and depreciate it 100% in the first year. While you are not technically getting more depreciation you are getting a large chuck of it upfront and a HUGE tax deduction. Let's say you purchased that property we talked about above for $1.5 million and put down 20% or $300k. A cost segregation study could provide you with a year-one tax deduction of around 10-30% of the purchase price which would be $150k-$450k! Now it is easy to understand how some people are able to reduce their tax bills to $0 while still making a lot of money. Remember it just looks like you are losing money but in reality, you are not. In order to not pay taxes year after year you need to continuously buy real estate so that you can receive more tax benefits. One thing I should mention is that bonus depreciation is tapering off at 20% per year until 2027. If you were to employ this strategy in 2023 you would only be able to bonus depreciate 80% of the value of the items that have a useful life of 15 years or less.

Incentives Not Loopholes

Something that I often hear is that the ultra-wealthy use tax loopholes that are not accessible to the average person. That could not be farther from the truth. Sure, they have tons of money to pay the smartest people on the planet to solve their complicated tax situations, but the strategies they are using are available to normal people like me and you as well. With a little education, there is nothing stopping us from doing the same and taking control of our biggest expense, our taxes. So if it's not a loophole what is it? It’s an incentive from the government for using your money to invest in real estate. When you do what the government wants you get rewarded for it. Investing in real estate is not the only action that the government will reward you for but it is the best one. Other things that the government will reward you for include opening a business, investing in research and development, energy, agriculture, etc.

Are You Eligible?

Now that you know how depreciation works the question is are you eligible to take full advantage of it? Taking full advantage of it takes some dedication and planning. Many investors have designed their lives and careers around the ability to take full advantage of depreciation by becoming what’s called a real estate professional. Most people are not real estate professionals which means there is a cap on how much depreciation they are eligible to take per year. The details of what a real estate professional is and how to become one are outside the scope of this newsletter. The next newsletter will go over that topic. Subscribe and look out for that post!