On one of my recent “new client consultations,” I had a real estate investor ask a great question. Rephrased a bit, his question was: “If my income phases me out of being able to capitalize on all of the great tax benefits
real estate has to offer, should I scale a portfolio quickly using creative financing or just focus on slow and steady growth by purchasing all cash?”
This guy has thought through his situation, and even better, he has familiarity with how his income affects his ability to take passive losses from his rentals!
I’m going to cover the tax side of the issue today and talk about what I’d do and what my many clients in this situation do. However, I think this question comes up short, as it seems to focus purely on taxes rather than risk tolerance.
You see, taxes are only one (small) part of the equation. In this case, leverage would be needed to quickly scale a portfolio. Yes, the larger the portfolio, the larger the tax benefits, but the point is that leverage must generally be used.
So the root question should really be, “Am I OK with the additional risk brought on by the use of leverage?” If you don’t have a high degree of risk tolerance—rather, you’re risk averse—then forget about the tax issues and just ask yourself whether you are using the right amount of leverage!
Anyway, back to taxes. It’s true that if your income is above $150,000, you may be phased out of taking passive losses from your real estate activities. Should that fact alone stunt your growth plans? Let’s find out.
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When you invest in rentals—and especially in today’s market—the rentals may produce a passive loss for tax purposes. The key to the previous phrase is “for tax purposes.”
You see, your rentals produce hard expenses, such as property management, legal, accounting, repairs, maintenance, and interest expenses (remember, the principal balance of your loan payment is NOT deductible). When you subtract these expenses from your rental income, you get something called EBDA (Earnings Before Depreciation and Amortization).
Your EBDA, also Net Operating Income, is what actually hits your pocket. Consider it similar to your cash flow. The difference between EBDA and cash flow is that EBDA doesn’t account for principal and escrow payments to your lender. This factor makes it a true indicator of your property’s performance.
Notice that EBDA is “before depreciation and amortization,” so naturally, our next step is to subtract soft expenses such as depreciation and amortization. I call these “soft” expenses because these expenses do not require the continual outlay of capital to claim the expense. Instead, soft expenses are essentially a credit to help offset the large outlay incurred when you purchased the property.
After subtracting depreciation and amortization, we are often thrown into negative earnings territory. This is where it can get confusing from both an operating and tax perspective.
From an operating perspective, you may think you lost money. But this isn’t the case because your EBDA can easily be positive, and your EBDA is what is actually hitting your pocket. Yet on your tax return, you’ll see a negative number. How is this so? Because again, depreciation and amortization are soft expenses. They are a direct result of the price you paid for the property when you bought it. So even though you have a taxable loss from your rental, you will want to add back depreciation and amortization to see a true reflection of your property performance.
You must be able to articulate this fact to potential buyers, investors, and sometimes lenders. EBDA is the true operating results of the property, not what you see on your tax return.
When your rentals generate passive losses, there are a whole slew of tax rules that you must now pay attention to. That’s what we’ll dive into next.
Explaining Passive Losses
When your rentals produce a passive loss, as indicated by your tax return, you may or may not be able to utilize your passive losses when calculating your annual tax bill. The key is to understand how your income levels phase you out of the ability to utilize passive losses.
Now, when I say “income,” I really mean your modified adjusted gross income. But I’m trying to keep it simple, and I want to avoid frying your brain.
If your income is below $100,000, you can use up to $25,000 of passive losses annually. As an example, if you have $25,000 of passive losses and your income is $100,000, you will only be required to pay taxes on $75,000 of income. Yet the real estate producing the passive losses could actually have a positive EBDA! So you can have an asset producing income that isn’t taxed due to depreciation and amortization offsets, and the passive losses can further be applied to your ordinary income. That’s the power of real estate investing.
As your income increases above and beyond $100,000, the passive losses you are allowed to claim will begin to decrease. You will be completely phased out of taking passive losses once your income hits $150,000.
This can be a painful realization for many people.
In my experience, many of the people investing in rental property have incomes above $150,000. This makes sense, as rental real estate is quite expensive to acquire. You must generally have solid income to qualify for a purchase. I say “generally” because there are people who buck the trend and creatively acquire real estate. More power to you!
So anyway, you have all of these investors with incomes above $150,000 who have been told that real estate will make their tax positions much better. They drink the Kool Aid and then get upset when they realize they can’t utilize the tax benefits their new investment was supposed to grant them. Then they call me because they don’t understand what’s going on, and I have to give them the “real” scoop. Here’s what I tell them.
Your Passive Losses Will Be Suspended
When you can’t use your passive losses, they become “suspended.” This means that you don’t lose them, you just can’t use them today. Instead, the passive losses will be carried forward until they can be used to offset passive income or gains from a sale of a property.
This is what upsets many of the higher net earners who thought real estate was going to save their tax situation. If you have been expecting awesome tax benefits but realize at tax time that you can’t utilize passive losses, and instead they just kind of sit there and accumulate, you may be bummed out. Working with a good CPA is key here, as you’ll put a plan together to tap into your suspended passive losses and earn tax-free income!
If you want to see whether or not you are carrying forward passive losses, check out Form 8582 which should be included in your tax return package. If it’s not included, you don’t have passive losses.
You Can Still Tap into Passive Losses
I wrote an article a couple of weeks ago
about strategies you can use to tap into your suspended passive losses. Basically, when you incur real estate losses that you cannot take, you don’t want to let them simply accumulate. That accumulation of passive losses is costing you today’s dollars, mainly in the form of tax savings. We want to figure out how we can tap into suspended losses in order to earn tax-free income.
For instance, if your income is above $150,000, your passive losses generated from your rentals will be suspended and carried forward. Let’s assume you are carrying forward $10,000 in suspended passive losses. If you can figure out how to activate those passive losses, you can earn up to $10,000 tax-free because the suspended losses will offset the income. A strategy to tap into $10,000 of suspended passive losses is worth $2,800 of tax savings if you’re in the 28% tax bracket.
In my article, I detailed strategies we can use to do this. Such strategies consisted of buying better cash-flowing rentals, selling property, and taking a passive ownership stake in a business (not a C-Corp!).
Another strategy that I did not cover is qualifying your non-working spouse, if applicable, as a real estate professional. Doing so will not enable you to tap into previously suspended passive losses, but you’ll be able to claim all future passive losses regardless of your earnings level. In this case, we “stop the bleeding” as some of my clients like to put it.
The main point that I am trying to demonstrate is that while your income may phase you out of being able to currently deduct passive losses, you shouldn’t simply give up. You should connect with a solid CPA and develop a game plan for activating prior suspended passive losses and utilizing all future passive losses.
Related: 7 Myths About the Real Estate Professional Tax Status, Debunked
Your Effective Tax Rate Will Decrease as You Scale
Even if you can’t take passive losses due to your high income levels, you will still reap the tax benefits of investment real estate. This is a fact that is relatively difficult to drill into a new client’s head, but it’s very important to understand.
Think about it like this: If you earn $150,000 and pay $30,000 in taxes, your effective tax rate is 20%. Now let’s say your buy rental property that cash flows $300 per month and produces a depreciation write-off of $400 per month. In this scenario, you have a $100 passive loss ($300-$400) per month or a $1,200 passive loss annually. You will be unable to claim this passive loss due to your income level. But the question is, have you lost all of the tax benefits associated with your rental?
The answer, of course, is a resounding NO! In this case, we have an additional $300 per month or $3,600 per year in tax-free income. It’s tax-free because the depreciation write-off is producing a passive loss. Yet it’s not actually a loss from an EBDA perspective because our rental income exceeds our operating expenses.
Now, our total earnings are $153,600, but we are still paying the same $30,000 in taxes. Our effective tax rate has decreased from 20% to 19.5%. That’s an excellent demonstration of how real estate helps your tax position, even if you are a high earner.
And it only gets better once your quit your day job. Maybe that’s not your goal and you are going to stick it out until retirement. Fine. But regardless, once your quit, your portfolio of rental properties will be producing tax-free income—or close to it. Have you ever seen someone pocket $100k per year tax-free? I have. It’s a very real scenario that you should consider striving toward as you scale your portfolio.
Answer: Continue to Scale Your Portfolio, But Be Smart About It
To sum up my very long-winded answer, you should continue to scale your portfolio even if you are a high income earner. Regardless of earnings, real estate will most usually help your tax position. While your passive losses may become suspended, there are always ways to tap into them and activate them. Additionally, income from rental real estate decreases your effective tax rate, which is what we should all be striving for.
My clients, and other investors I’m close with, utilize leverage to acquire real estate to build their passive income. They understand that, while leverage is risky, the tax benefits compound as a portfolio expands. While I don’t want to advocate one way or the other, and you should think long and hard about your own asset allocation and potential purchases, utilizing leverage does grant us the ability to scale our passive income, wealth, and corresponding tax benefits much more quickly than purchasing assets all cash.
The key is to be smart. The market is hot, and deals are hard to come by. There is no point in investing in an asset simply to lose money. And by that, I mean actually lose money, not just providing a passive loss. Unless, of course, you are investing for appreciation purposes which I’m not a fan of.
Cash is king, and cash flow is queen. The great thing about rental real estate is that your cash flow can be tax-free regardless of your income level and corresponding tax bracket.
Disclaimer: This article does not constitute legal advice. As always, consult your CPA or accountant before implementing any tax strategies to ensure that these methods fit with your particular situation.
[Editor’s Note: We are republishing this article to help out our newer readers.]
Investors: How do you scale while continuing to take advantage of real estate’s tax benefits?
Let me know your thoughts with a comment.