\u201cAnyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one\u2019s taxes.\u201d \u2013 Gregory v. Helvering, 69 F.2d 809, 810 (2d Cir. 1934)<\/span><\/p>\n I bet it is no surprise that your tax bill is one of the largest expenses you pay, often more significant than your housing and healthcare expenses. If you have spent any measured amount of time on BiggerPockets, you probably have a high-level understanding that investing in real estate could help you offset some of your tax burdens.<\/span><\/p>\n For example, depreciation could help you shelter passive income (and possibly your active income) from your rentals. Using a 1031 exchange when you sell a property could help you defer your depreciation recapture and tax on capital gains. You could remove equity from your rentals tax-free through a refinance and invest in more property.<\/span><\/p>\n However, most investors who enter the real estate arena know little about strategically reducing their tax bills. If you\u2019re like me, we grew up being <\/span>trained to pay taxes. Yes, trained.<\/span><\/p>\n Do you think I\u2019m kidding?<\/span><\/p>\n I know for me, I was raised to go to school, get a great job, buy a house, get married, start a family, and contribute to my 401(k).<\/span><\/p>\n With this \u201cplan\u201d, the only chance of reducing my tax burden was to take a standard deduction, deduct my mortgage interest (if I could), get a tax credit for my kid, defer my income to retirement, and hope the tax rate would be low by the time my career came to a close and I had to pull from my retirement fund.<\/span><\/p>\n Somehow, with all of this, I still would wind up paying thousands of dollars in taxes.<\/span><\/p>\n It turns out that hope is not a strategy.<\/span><\/p>\n I\u2019m not a CPA, accountant, or tax guru. As with any advice, please consult a qualified tax strategist to understand how the information I\u2019m about to share with you can apply to your unique situation.<\/span><\/p>\n What I\u2019ve learned working with tax strategists and studying the wealthy is that there are better ways to approach reducing your tax bill. One of my favorite books on the subject is \u201c<\/span>Tax-Free Wealth<\/span>\u201c<\/span><\/i> by Tom Wheelright. <\/span><\/p>\n Overall, I have two critical takeaways from studying taxes.<\/span><\/p>\n First, there is a clear \u201corder of operations\u201d you must follow to maximize your tax savings. The traditional narrative I grew up with is not the correct strategy if you\u2019re trying to reduce your tax bill significantly.<\/span><\/p>\n Second, the U.S. tax code is actually a treasure map that tells us where to invest our dollars. Real estate and business are two spaces where the IRS wants the private sector to solve problems. As a result, investors get the best tax breaks.<\/span><\/p>\n Wealthy individuals know how to combine a clear step-by-step strategy with the tax code\u2019s \u201ctreasure map\u201d to reduce their tax burden significantly. Why couldn\u2019t you do the same?<\/span><\/p>\n Let\u2019s talk about how you can.<\/span><\/p>\n Investing in a business (even if you have just one rental) allows you to take more deductions. Ordinary tax-deductible expenses include:<\/span><\/p>\n The most significant deduction, which is borderline magical, is depreciation. The IRS understands that tangible assets (such as real estate) will break down over time. At some point, the carpet, cabinets, and HVAC will need to be replaced. In their eyes, it would be best if you, as an investor, keep the asset in good working order. Therefore, the gift of depreciation is awarded to help us offset costs and reinvest back into the property. You could also use passive depreciation to shelter passive income and keep it tax-free.\u00a0<\/span><\/p>\n Not sure how to maximize deductions for your real estate business? In The Book on Tax Strategies for the Savvy Real Estate Investor<\/a><\/em>, CPAs Amanda Han and Matthew MacFarland share the practical information you need to not only do your taxes this year\u2014but to also prepare an ongoing strategy that will make your next tax season that much easier.<\/p>\n<\/div>\n<\/div>\n There are two types of income: active and passive. If you want to enjoy lower taxes (and financial freedom), then you should focus on building passive income. <\/span><\/p>\n The IRS classifies employees or self-employed persons as active income earners, which get taxed at a higher rate. Business and investment income, on the other hand, is generally considered passive income and is usually taxed at a lower rate. It\u2019s important to note that the number of hours you spend on any given activity doesn\u2019t factor into the equation. Instead, it\u2019s purely based on what the IRS determines.<\/span><\/p>\n For example, I have real estate notes that I spend no time managing, but it\u2019s considered active income and taxed at ordinary income rates. Yet, my rental properties and partnerships take more time to manage and earn a good share of income but still get taxed at a lower rate because of the way the IRS classifies the income.<\/span><\/p>\n The big idea is that those who earn income through their own business or earn from a company they invested in will pay the lowest taxes. For more information on this, I suggest reading \u201cThe Cashflow Quadrant<\/a><\/span>\u201c<\/span><\/i> by Robert Kiyosaki.<\/span><\/p>\n Now that you have steps one and two, it\u2019s time to partner with your tax strategist to look for ways to shift your income to lower tax brackets. You can do this by employing your dependents if you have any.\u00a0<\/span><\/p>\n Yes, I really mean to hire your kids if you have extra work that they can cover for you. It\u2019s legal.<\/p>\n If your child is under 18, they can work for you in your real estate business and earn up to their standard deduction (currently $12,950) before they have to pay taxes on income.<\/span><\/p>\n Just think, you could have your 16-year-old file paperwork, clean the office, keep the books, and maybe manage your social media. With what you pay them, they can use those funds for their expenses, save for college, start a Roth IRA, or invest alongside you.<\/span><\/p>\n The same strategy could apply to other dependents you support.<\/span><\/p>\n However, you have to be careful. The IRS is fully aware of this tax loophole and is purposely looking for anyone mischievously taking advantage of it. Ensure that whatever your dependent is hired for, they are actually doing their job. You can\u2019t just place them on the payroll and not have them do anything. Otherwise, the IRS will call it out and disqualify the tax break.<\/span><\/p>\n Partner with your tax strategist to craft an accurate job description, pay scale, and maintain proper documentation before hiring any dependents.<\/span><\/p>\n There are a number of different tax credits you may qualify for. Speak with your tax strategist for a personalized look into your situation. <\/span><\/p>\n Credits are a dollar-for-dollar reduction of income. Some credits may apply to your personal tax situation, examples being the saver\u2019s credit or child tax credits. <\/span><\/p>\n There are also credits that may apply to your business (energy credits, water credits, tax abatements, and more). Credits are another way the IRS incentivizes behavior, so be sure to know what you qualify for.<\/span><\/p>\n If you still want to reduce your taxable income after moving through the first four steps, then you should consider deferring income. This means you can push aside part of your income to be reported towards next year\u2019s taxes or later. This is helpful when you need to reduce your reported income just enough to be placed into a lower tax bracket.<\/span><\/p>\n It\u2019s worthwhile to note that if you are still working a W-2 job, it may be beneficial for you to fund your retirement accounts to maximize employer matches and pensions.<\/span><\/p>\n If you choose to fund your retirement accounts, be sure to explore contributing to self-directed IRA accounts (SDIRAs) or other qualified retirement plans that are in your control. With these types of accounts, you have more options to invest in alternative assets like real estate while maximizing the tax code. For example, through an SDIRA, you can invest in:<\/span><\/p>\n Ask your tax strategist to create a model to see if funding these accounts will genuinely help your overall situation.<\/span><\/p>\n \u201cIn this world, nothing is certain but death and taxes.\u201d \u2013 Benjamin Franklin<\/span><\/p>\n Taxes are among the most significant expenses eroding your wealth, along with <\/span>investment fees<\/span><\/a> and <\/span>debt<\/span><\/a>. Just imagine how much you could boost your investing journey by generating an additional $10,000, $20,000, or $50,000 in tax savings to reinvest.<\/span><\/p>\nHow the best in real estate approach taxes<\/span><\/h2>\n
Step 1: Take deductions (including depreciation)<\/span><\/h3>\n
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![\"tax](\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2021\/03\/tax-book.png\" "\\"5")
<\/source><\/source><\/picture><\/a><\/figure>\nDreading tax season?<\/h3>\n
Step 2: Focus on building passive income<\/span><\/h3>\n
Step 3: Lower your tax bracket through creative employment<\/span><\/h3>\n
Step 4: Reduce income through tax credits<\/span><\/h3>\n
Step 5: Defer income to lower your tax bracket this year<\/span><\/h3>\n
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Closing thoughts<\/span><\/h2>\n