Pssst - Wanna Be a Real Estate Millionaire? (Part14)

Chapter 14: Taxes

Do you know the difference between tax avoidance and tax evasion? You’d better know – it’s 15 years in jail. Tax avoidance is prudent. Tax evasion is illegal. One of the benefits of owning investment real estate is that it helps you legally reduce your taxes. Not to bore you with history, but when I first started investing, I had an unlimited deduction I could generate from investment property. With the 1986 tax law change, that deduction is now limited to $25,000. In English, this means that after you deduct all the standard operating expenses from your real estate income, you can still deduct depreciation, a paper deduction (see next paragraph). If the real estate generates enough depreciation, you not only offset the remainder of what otherwise would have been taxable income from the real estate, you can also generate additional tax deductions that offset other taxable income such as wages or bank interest. The current limitation is $25,000 over and above the offset of real estate taxable income. You don’t have to like the laws, but you certainly have to know what they are and how to use them to your best advantage.

The concept of depreciation evolved as a method to provide a sinking fund for buildings that lose value over time. Even if the buildings are well maintained, they become functionally obsolete over time. Ultimately, they “wear-out” and must be replaced with new buildings. Depreciation is the mechanism by which the funds are supposed to be accumulated to cover the cost of that replacement. Of course, almost no one actually sets-aside funds for this purpose. The only exceptions I can think of in our current economy are condominiums and townhouses. The only reason these associations actually accumulate sinking funds for replacement is that the law requires them to do so.

There have been many variations of depreciation allowed over the years. The two (2) major depreciation schedules used today are 1) Straight Line, and 2) Accelerated.

The straight-line depreciation schedule takes the exact same dollar amount of deduction each and every year. The accelerated depreciation generates the largest deduction the first year and then ever-decreasing amounts in successive years. Tax planning would dictate that if you plan to hold a specific property for many years, you’d use the straight line method. If your intention is to hold for only a few years, you’d benefit more from the accelerated method. There are always exceptions, of course, and the exception here is that depreciation is ultimately recovered and taxed at capital gains tax rates when the property is sold. However, if you plan your sales properly, you will trade many properties before you ultimately sell outright. Defer – defer – defer is the key to tax planning. We’ll also look at a method to totally avoid capital gains taxes – legally.

How do we calculate depreciation? Understand that your investment property actually consists of two (2) components: 1) Land and 2) Improvement(s). Only the improvements are subject to depreciation so you must first determine the fair market value of each. If you’ve ever really looked at a property tax bill in detail, you’ve noted that the bill separates the two components. While it is tempting to just use the Tax Assessor’s estimate, that’s not always in your best interest. Your objective is to maximize the value of the improvements and minimize the value of the land so that you can maximize the depreciation allowable. One way to verify the land value would be to find comparable land nearby and determine the sales prices of those parcels. One way to determine the value of the improvements would be to start with the replacement cost (dollars per square foot cost to build new) and then reduce that cost by the age of your actual structure(s). You will examine as many alternative methods as possible of determining the structure values and then select the method that gives you the largest structures cost. If questioned by the IRS, you will have a logical reason why you selected those figures. All the IRS can do at that point is quibble with your selection choice.

You’ve learned that my number one admonition regarding taxes is Thou Shall Pay No Tax Before It’s Time. Defer – defer – defer. Why is that important to you? It’s not how much you earn, it’s how much you get to keep that’s important. In the Forward to this book, I noted that it would require 7.69 dollars today to have the same purchasing power of just 1.00 dollar in 1960. That’s inflation. And that is just the “official” inflation rate. The real-life inflation rate is visible at the grocery store and gas pump. It’s not that “things” cost more; it’s that the dollar buys less and less as time goes by. The US Government continues to print dollars for which nothing of value was created or manufactured. In Econ 101, you learned that more and more dollars chasing fewer and fewer goods leads to increasing prices of those goods. The only option we have is to accept the fact that the dollar bill in our pocket today is as valuable as it will ever be. As time goes by, the purchasing power of that dollar will decrease. If you keep valuable dollars invested today and defer paying taxes on the profits you earn for as long as it is possible to defer those taxes, you’ll ultimately pay the tax with less-valuable dollars at some future time. You may pay more in numbers of dollars due to increases in the tax rate schedules, but the cumulative value of those dollars will still be less than today’s value. Albert Einstein said that the most powerful force in the world is compound interest. If you can keep all of your dollars compounding instead of siphoning-off some of the dollars to pay taxes, you’ll achieve your financial goals much more quickly.

Let’s now talk some tax strategy as it applies to investment property expenses. In English, if you make what qualifies as a repair, the entire expense is tax-deductible in the year of that expense. If you make what would be considered a capital improvement to the property, that expense must be depreciated over the useful life of that improvement. Chances are, you paid cash up-front for the improvement, but now you only get to recover that expense over a period of time. Your objective, therefore, is to make as many repairs as possible and as few capital improvements as possible to your investment properties. There isn’t much wiggle room here because the IRS has stipulated what types of activities represent repairs and what activities represent capital improvements.

A case in point would be a new roof. The IRS says a new roof has a specific useful life – perhaps 15 years. So if you had to replace a roof that cost $15,000 and you used the straight line depreciation method, you’d only recapture $1000 per year of your $15,000 expenditure ($15,000 divided by 15), but you’d get that $1000 recapture every year for 15 years. When the IRS came up with this restriction years ago, some enterprising investors decided to “repair” one-half of the roof during one taxable year and then “repair” the other half of the roof in the following taxable year. Yes, the IRS got wise to that trick too, and squelched it. So some components simply require you to “capitalize” the expense and then depreciate it over the useful lifetime. It’s important that you know what differences are involved before you begin your repair programs.

Keep receipts. I’ve been audited many times and it’s not fun, but I’ve sailed through the audits because I kept good records. I could show how I accounted for each and every deduction. The IRS had no choice but to allow those deductions. One of the easiest ways to keep track in today’s world is to take advantage of the credit card bookkeeping services that come automatically with the card. I use a “business” credit card for all my real estate repair purchases. At the end of the year, the credit card company provides me with a detailed list of all the expenses. In effect, they keep my books for me at no extra charge. As you acquire larger properties, you’ll probably want to establish separate checking accounts and separate credit cards for each property. I’ll have much more to say on this subject when we discuss Asset Protection techniques in the next chapter.

Earlier, I mentioned we’d discuss a legal method of never paying capital gains tax when you sell a property. Never. While this generally applies to older investors reducing their real estate portfolios and essentially retiring, there is no limitation or restriction as to who can use this technique. Capital Gains are taxed at a lower percentage rate than ordinary income as long as the asset has been owned for at least one year before it is sold. If you’ve used depreciation as part of your income tax reporting, that depreciation is recaptured as capital gains when you ultimately sell the property. So you have an incentive to minimize- or even eliminate capital gains, if possible. Enter the Charitable Remainder Trust. This is a legal document that allows you to gift a portion of an asset to a charity and get a tax deduction for that gift. Since capital gains tax is at a lower rate than ordinary income tax rates, you usually only have to gift a portion (percentage) of a property’s value in order to completely offset the total capital gains tax that would otherwise be due on sale. If properly structured, you get outright tax-free cash for the portion not gifted to charity and you also get a lifetime annuity from the portion gifted to the charity. Yet the charity also wins by inheriting whatever the remainder of the proceeds from their portion when you ultimately pass away.

I opened this chapter by asking if you knew the difference between tax avoidance and tax evasion. You have an obligation to yourself to legally avoid paying taxes to the best of your ability. Some folks think they are being smart by simply failing to report some of their income, especially if they tend to receive large portions of that income in cash. Dumb! That’s asking to be sent to jail and have the key thrown away. That’s tax evasion. You will report every penny of taxable income. Then you will aggressively work to reduce the taxes on that income. If the IRS challenges your deductions, it’s only a difference of opinion, not tax evasion.

NOTE: Stay tuned for Part 15 - Asset Protection