In this post, I’m going to outline a powerful strategy I’ve seen many of our clients at The Real Estate CPA use to build substantial wealth while paying as little taxes as possible.
Before we get started, it is important to note that this strategy may not be the right strategy for everyone. It also might not be the best strategy for every phase in a cycle. Finally, it is not the only investing strategy available to individual real estate investors to build wealth.
Start with a Strong Primary Source of Income
As the saying goes, it takes money to make money. It’s no secret that real estate is a capital intensive business and in order to build a real estate portfolio, you need to have enough capital to make down payments.
Yes, I know there are creative and no money down financing strategies out there. But in my experience, that’s not how a majority of people make it. So how do they?
They start with a strong primary source of income. By strong I mean they’re earning $300,000, $500,000, $1,000,000 per year or in some cases even more. They are often frugal enough to save a substantial portion of their income and use it to acquire investment real estate (i.e. rental property or buy & hold real estate).
The question you may be asking now is what is their primary income generator? Great question, generally there are two categories I see wealthy people generate substantial primary incomes.
One of the ways I’ve seen my clients build wealth is through having a high-paying “W-2” job or career. These jobs and careers include:
- Software developers
- Musicians and writers
The above is a shortlist of careers that I’ve seen clients generating a substantial amount of money. Like I said earlier, $300,000, $500,000, $1,000,000, and even more in some cases per year in salary, bonuses, commissions, or a mix.
If you’re on one of these career paths, keep moving up the chain, it will likely pay off. If not, the only career I’ve seen somebody be able to jump into and be financially successful relatively quickly was sales. There’s a lot of money in sales if your good at it.
I’m also lumping the self-employed, or solopreneur, into this category as the income tends to be similar. Although you could certainly argue they deserve their own category.
“I would rather earn 1% off a 100 people’s efforts than 100% of my own efforts.” – John D. Rockefeller
Another way to build wealth is by starting and scaling a business. If you’re not in one of the jobs or careers listed above, starting a business might be your vehicle generating substantial amounts of income. In fact, being a business owner offers you the potential to generate limitless amounts of income. Plus business owners are provided with many tax benefits employed individuals aren’t.
That said, if you intend to build a business that generates a substantial amount of net income, you must be ready to scale that business. That means you can’t be the sole deliverer of the product or service your business provides. In fact, you want to build a business that can operate without you.
Selling a Business
Some business owners sell their business and generate a substantial amount of cash at sale. They then turn around and use that cash to acquire a rental property.
Use the BRRRR Strategy to Build Your Portfolio
Simply acquiring real estate at good prices and holding it long-term for cash flow and appreciation is one way to build wealth. But there’s a more powerful strategy called Buy, Rehab, Rent, Refinance, Repeat (BRRRR).
The BRRRR strategy involves acquiring property, ideally below market value, and increasing its value through renovations. Almost like flipping a property. However, instead of immediately selling the property after increasing its value, you refinance it and use the additional cash to acquire another property and repeat the process.
The BRRRR strategy allows you to grow your portfolio faster because you are able to not only acquire properties with the capital saved from your primary source of income, but also the additional capital generated by the BRRRR process.
Have a Plan to Minimize Taxes
Often, tax is a person’s single largest expense. You heard that right, largest expense. Wealthy people understand this and have a plan to minimize their taxes.
While the tax code provides business owners with many opportunities to reduce their tax liability, a W-2 earner’s are limited. The good news is, investment real estate comes with many tax benefits. Which is why many wealthy people own real estate.
The Hardest Hitting Tax Strategy for Real Estate Investors
There is a lucrative and highly sought after tax strategy known as the real estate professional status. Those who can qualify as a real estate professional can use the losses generated by their investment property against their other income, including W-2 and business income.
Now you may ask, why would you want a loss on your real estate? Well, there’s this non-cash expense called depreciation, that when combined with other operating expenses, creates a “paper loss” or tax loss. in other words, you may have generated positive cash flow (actual income received – actual expenses) but this non-cash depreciation expense causes you to show a loss.
For example, let’s say you have a rental property that generates $10,000 in rental income and have $6,000 in actual expenses (e.g. interest, property management fees, repairs & maintenance, etc. that leave your pocket. You also have a non-cash depreciation expense of $6,000. Thus you have a tax loss of $2,000 despite generating a positive cash flow of $4,000.
Not only did you not pay any tax of the $4,000 of cash generated, but as a real estate professional, you can use that $2,000 loss to reduce your other income. what’s more, there is another tax strategy called cost segregation, that when combined with bonus depreciation, can allow you to increase the depreciation significantly. I’m talking about 20%-25% or more of a property’s cost basis (i.e. purchase price).
Powerful right? But what’s the catch?
Qualifying as a Real Estate Professional isn’t Easy
We’re not going to go into the nitty-gritty details here, you can get those in this article from The Real Estate CPA, or in the podcast above. However, whats important to know, in order to qualify as a real estate professional, you must spend more than half of your total working time in a real property trade or business.
If you work a W-2 job, this is pretty much impossible. Only one tax court case I’m aware of (and we’ve done a TON of research on this) agreed that a taxpayer with a full-time W-2 job qualified as a real estate professional, and it required substantial testimonials from the taxpayer’s associates to substantiate.
So how to qualify?… Well, there’s good news if one spouse qualifies then both spouses qualify. Thus, it’s possible to have one spouse generate a substantial income, while the other runs the real estate portfolio and qualifies as a real estate professional.
Another way to qualify is to do it is to work full-time in a real property business such as real estate brokerage, flipping, wholesaling, property management or development in order to qualify. Or build a business to the point where you can step back and spend more than half your total working time in a real estate business.
The Bottom Line
I’ve seen multiple investors qualify as real estate professionals, build large enough real estate portfolios, and increase the depreciation expense to the point where they paid no tax at the federal level (and in some cases at the state level too). It’s THAT POWERFUL!
Now all of this is easier said than done, and the real estate professional status has technical nuances not discussed here and does carry additional audit risk. Thus it’s important that you work with an experienced tax adviser before making this election. Above are two podcasts with clients we’ve helped achieve this goal. If you’re trying to build a plan to qualify, you can schedule an initial consultation by following this link.
Finally, even if you can’t qualify as a real state professional, real estate investments are still tax-advantaged. Remember, you can still put yourself in a loss position and eliminate taxes on your rental income, and with proper planning, capital gains on sale. You just can’t, generally, use the losses against your W-2 or business income.