I still remember when I received my first year-end bonus.
$90,000. Wow. More than my full year salary!
A week later just $50,000 hit my bank account. $40,000 lost to the tax man.
If you’ve ever received a bonus check, or earned a multiple six-figure salary, you’ve probably shared in the pain that comes with seeing up to 50% of your hard earned cash deducted before you even had the chance to spend it.
How was I ever going to accumulate real wealth if I had to part with $0.40 cents of $1.00?
There had to be a better way.
It just felt like I was missing something.
Turns out I was… and now, thanks to this article, you don’t have to.
Legal Disclaimer: I am not an attorney nor CPA. These are my opinions as an experienced real estate investor. You should consult your CPA or attorney before making tax and legal decisions.
The Strategy in a Nutshell
(1) Purchase an investment property
(2) Run a cost segregation study
(3) Accelerate the depreciation (”Bonus Depreciation”)
(4) Convert passive losses into active losses that offset your other active income
Let’s unpack each of those steps:
1. Purchase an investment property
Perhaps the easiest step in the process, you’ll need to first find and purchase an investment property. Do not get stuck on this step of the process. In fact, if you already have an investment property that you rent out, even better.
We’re not focusing here on what makes for a good investment property.
That’s for another time.
2. Run a cost segregation study
The IRS allows you to deduct a certain portion of your property’s value every year until it reaches zero. This “Depreciation” is a non-cash expense that reduces the tax you pay on the cashflow your property generates.
For residential rental properties, the standard depreciation period is 27.5 years.
A cost segregation study is an engineering report that changes this 27.5 year timeline. It allocates certain components of the building to 5 and 15 year property.
A good example of this is carpet — it’s highly unlikely your carpets will last 27.5 years. In a cost segregation study, an engineer will appraise the specific value of your carpet and allocate it to 5 year property. Now you are able to depreciate the carpet’s value over 5 years, rather than 27.5 years.
Every single component of your building will be carefully inspected, appraised and allocated a useful life. It’s a super involved study and one that you want to outsource.
3. Accelerate the depreciation (“Bonus Depreciation”)
By completing a cost segregation study in step 3 you were able to allocate a substantial portion of your property to 5 and 15 year property. You have essentially “accelerated” the depreciation.
But that’s just the first step.
There’s this beautiful thing called Bonus Deprecation, which allows you to depreciate up to 100% of that 5 and 15 year property in the taxable year your property is placed into service.
Placed into service is just a fancy way of saying the calendar year in which you started renting the property. This will usually be the same year you acquired the property, but not always.
There is a way around this requirement, which I cover in the FAQs.
In 2022, the tax code allows you to depreciate 100% of 5 and 15 year property. That steps down to 80% in 2023 and by an additional 20% each year until its final year in 2026 (assuming politicians don’t step in before then to extend it).
4. Convert passive losses into active losses that offset your other active income
This is by far the most important step.
If you’re asking, “what is a passive loss?” start here: The Magic of Converting Passive Income into Active Income
All rental activities are, by default, considered passive.
If your household earns more than $150,000 per year, you cannot use passive losses to offset active income. Passive losses are “suspended” and carried forward to future tax years.
That passive loss limitation applies in all circumstances… except….
- If you, or your spouse, can qualify as a real estate professional
- You take advantage of the short-term rental loophole
Your specific situation will determine which of these two options is best for you.
If you are married and one partner is not working full-time, I would recommend path #1: qualifying as a real estate professional.
Otherwise almost anyone can qualify using path #2: the short term rental tax loophole.
How Much Tax Can You Save?
The short answer: a lot.
To appreciate the full power of this strategy, and unpack some of the complexity, let’s put numbers behind it.
We’ll work with a set of simple (rounded) assumptions and assume the property is used as a long-term rental:
- Your Active Household Income: $300,000
- Your Marginal Federal Tax Bracket: 40%
- Price of the Property: $1,000,000
- Down Payment: $250,000 (25% of purchase price)
- Net Rental Income Before Taxes: $50,000 ¹
¹ Rents received less debt servicing, property taxes, insurance, repair costs, etc. This may look a lot better for short term rentals, which are generally much more profitable than long term rentals.
Now let’s look at your two potential tax liabilities:
Scenario 1: You never read this article.
You will owe $20,000 of federal income tax on your taxable net rental income of $50,000 (40% marginal rate).
You will also owe $100,000 of federal tax on all $300,000 of your W2 Income. Again, round numbers here that include Social Security and Medicare tax.
Federal Tax Liability: $120,000
Scenario 2: You read this article, took action and consulted a great CPA.
You will commission a cost segregation study on your property.
This is not a hard rule, but in general, you can expect approximately 25% of the price of the property to be allocated to 5 and 15 year property.
25% of the price of the property is $250,000.
In 2023, you will take advantage of Bonus Depreciation to depreciate 80% of that 5 and 15 year property in the current tax year.
$50,000 of net rental income less $250,000 of Bonus Depreciation.
Your tax return now shows a rental LOSS of $200,000.
Not only do you owe no tax on the income from your property, but since you meet one of the two qualifications above, you can use the extra $200,000 rental LOSS to reduce the tax liability on your active household income of $300,000.
Now you owe federal tax on just $100,000 of active income. Congratulations — you just unlocked massive tax savings.
Federal Tax Liability: $20,000
So How Much Tax Did You Save?
And to be clear, this tax savings is not an imaginary figure. It is literally cold hard cash that is either sent back to you in the form of a year-end refund (if you overpaid the IRS throughout the year) or higher take home pay in your semi-monthly paychecks.
And remember, thanks to the power of leverage, you only invested $250,000 of cash to buy the property in the first place.
Combine the $100,000 of tax savings and $50,000 of cashflow from the property itself and you’re looking at a 60% cash-on-cash return in the first year of your investment.
That’s the kind of return, when compounded, that creates generation wealth.
And guess what, if you live in a one of the 18 conforming states — Alabama, Alaska, Colorado, Delaware, Illinois, Kansas, Louisiana, Michigan, Missouri, Montana, Nebraska, New Mexico, North Dakota, Oklahoma, Rhode Island, Utah, West Virginia — then you can take advantage of Bonus Depreciation on your state income taxes.
Those lucky folks can tack on another $25,000+ in state income tax savings.
1. It Takes Work
This isn’t a get rich quick scheme.
Depending on which path you take to convert passive losses into active losses you will still have to spend time managing your rental property.
For those attempting to qualify as a real estate professional, 750 hours equates to roughly 15 hours per week, equivalent to a part-time job.
For those taking advantage of the short term rental tax loophole, 100 hours isn’t quite as high of a bar to jump over, but if you’re already working 80 hours per week, finding the extra time can be quite challenging.
There’s no such thing as a completely free lunch. This strategy is no exception.
2. High Fees
It can be expensive to run a cost segregation study. If you use a good firm – one that sends an actual engineer to visit your property – you should expect to pay $3,000-$5,000 per study.
Certainly not cheap, but in context of your overall tax savings it’s not much.
You will also need a seasoned CPA with experience advising real estate investors. Sorry, TurboTax just won’t cut it.
I can tell you from first hand experience finding a great CPA is not easy. When you do find someone you like, with the right credentials, do not be cheap. It’s way too easy to be penny-wise, pound-foolish here.
Find the best and pay them fairly.
3. Depreciation Recapture Tax
When you go to sell your property, if you do not elect for a 1031 exchange, you will need to pay recapture tax of up to 25% on the depreciation you took.
I’m a big believe in the Buy, Borrow, Die Strategy, but if you’re looking to sell your property without finding a like-kind real estate asset to exchange into you should expect to pay some recapture tax.
Even still, a dollar in my pocket today (rather than with the IRS) is worth more than a dollar tomorrow. So in our hypothetical example above, I can take my $100,000 of cash tax savings and reinvest those dollars to earn more income now.
Hopefully by now your mind is spinning with ideas.
Don’t be surprised if your average TurboTax CPA hasn’t heard of it (or doesn’t fully understand it). This strategy is not simple.
But it can be incredibly powerful, particularly when diligently applied over and over and over again…. for decades.
Real estate is already considered one of the best investments you can make for many reasons:
- Low Risk
- Current Income
- Value Appreciation
- Access to Leverage
The list goes on….
But this tax strategy takes things to a whole new level. Thousands of investors before you have followed this playbook to build crazy generational wealth.
It’s time you joined the party.
Can I run a cost segregation study and use Bonus Depreciation on a rental property I already own?
Yes. You will need to take two additional steps after you complete a cost segregation study:
- Your CPA will need to fill out Form 3115, which allows you to change the accounting method of your property from straight-line depreciation to accelerated depreciation.
- Your CPA will need to make the Sec 481(a) election when completing Form 3115. This election will allow you to take full advantage of Bonus Depreciation, even though you technically placed your property into service years earlier.
This process is complicated. Consult an experienced CPA.
What is Section 179 and how does it differ from Bonus Depreciation?
Section 179 and Bonus Depreciation are both incentives created by the IRS to encourage businesses to invest in themselves by purchasing new equipment and receiving an immediate tax benefit.
Here are the key differences between Section 179 and Bonus Depreciation:
- There is a cap on how much depreciation you can take using Section 179 ($1,080,000 as of 2022) whereas there is no cap on Bonus Depreciation.
- Your Section 179 deduction (i.e. the depreciation you take using Section 179) cannot be larger than your property’s annual taxable income. Bonus depreciation does not have this restriction.
- You can take Section 179 deductions after the year the property is placed into service.
What’s important is that you can (and should) take advantage of Bonus Depreciation and Section 179. You may even use both in the same tax year. Like I’ve said countless times now, consult an experienced CPA.