Real Estate purchases as a tax strategy.
“I want to buy real estate because I need a tax shelter.” This is a common idea I hear from new real estate investors. The problem with buying real estate to gain a tax shelter is most of the time this strategy does not work the way they think it would.
Let’s say you are a W2 earner and decide to buy a rental house on the side because you are in a high tax bracket and want to create a tax shelter. Although you may be creating a tax shelter, you are likely not structured to have your real estate shelter your earned income from your W2 earnings. There are many tax strategies one could get into here, but for the sake of this conversation we will use a common scenario:
The typical person doesn’t understand that to shelter earned income you would need earned income expenses.
Your real estate expenses don’t necessarily offset your earned income. The shelter that the real estate provides is primarily sheltering the investment income that your capital gain or real estate puts off. The same theory goes for passive income investments like notes – although I will show you a tip to permanently reduce your taxes owed on this type of investment. We can think of income and expenses as water in buckets. There are typically 3 different kinds of tax buckets. To shelter income from one bucket, you need to use expense from that same bucket. There are many different methods and strategies, including reducing your tax bracket, that can come into play. Make sure you have a CPA look over the things you are doing, and that they are dialed in.
The strategy of buying real estate that does not cash flow to help your tax situation is a joke. Why would you lose money and increase liability just to offset taxes? Isn’t the point of investing to make money? The key is to buy or invest in assets that create cash flow and position yourself with an entity that has expenses to go against that new income. In fact, you may show a loss on taxes but put money in your pocket! This can be accomplished with the help of depreciation and proper expenditure. The most important thing is that you properly track and organize your expenses. That is one way to truly shelter your income.
Tip: reducing what you would owe in taxes and protecting yourself from a higher tax bracket can be done with passive note investments as well. This is done by creating a Limited Liability Company, with guidance from your CPA on how you should set it up for tax purposes. The LLC does the investing and receives the income. That LLC also has expenses from doing business. Those may be passive expenses or loss against your income.
Your CPA can help clarify and bring this strategy to life for you. For now, you can dive into as much tax code as you want at www.irs.gov or get educated with books like “Tax Free Wealth” by Tom Wheelwright. Click here to learn more.
Remember, it’s important to have a tax strategy, but it is only as good as your personal education and CPA. Being aware that tax strategies exist and that you want to use them is the first step. Understanding how they work and how to use them is the second, and implementing them correctly will save you thousands of dollars in taxes.