Optimizing investment strategy to increase paper losses?

[Jesse Dahms]

Current Situation: My wife and I have been slowly getting into REI over the last 4 years. We currently have 5 SFH long-term rentals and a short term rental.

Up until 2022 we both had W2 jobs, but we just had our first baby and my wife is now full time mom and full time managing our properties. I'm learning about how she can now qualify as a Real Estate Professional and she will meet the qualifications in 2022 (750+ hours). 

In my W2, I make about 200k a year and Id like to figure out how to pay less in taxes through passive losses in Real Estate but currently all of our properties cash flow well and even with write offs and depreciation we don't show losses. My CPA has advised that any cost- segregation studies would likely not be worth the cost on these SFH as they are around 150k homes. 

Goals:  Legally minimize taxes, build long-term wealth

Question: Is there an asset class or investment strategy we should be targeting for future deals that can optimize paper losses (maybe through cost-segregated depreciation?) while still being cash flow positive. 

Any other recommendations for our situation? Thanks in advance!

[Justin Beasley]

I get wanting to pay less taxes, but it sounds to me like you are on the right track. Tax strategy is certainly part of the process to become better RE investors but I am more concerned with finding great value, increasing cash flow, and mitigating risk. Also, on the tax side....with the increase in cost to purchase a STR in a vacation market I have met a number of people who are doing cost seg studies to accelerate their depreciation and plan to 1031 exchange their properties in 5 years or so.

[Michael Porche]

Thats a great question. I would advise you to get a free consultation to Anderson Business Advisors. They are a firm that specializes in structuring people's assets and tax savings. I literally saved thousands in taxes because of them. I actually have a link I can send you if interested, it allows for the free consultation (usually is $750 an hour... yikes). Definitely worth it.

[Dave Foster]

@Jesse Dahms

One of the best ways to meet your goal of minimizing taxes is as @Justin Beasley said, 1031 exchanges. A 1031 exchange allows you to move your portfolio into any area or sector that you feel you could get better returns, without paying taxes or depreciation recapture on the sale. This is one of the best tools you can use to meet your goal of minimizing taxes and building long-term wealth.

[JD Martin]

Quote from @Jesse Dahms:

Current Situation: My wife and I have been slowly getting into REI over the last 4 years. We currently have 5 SFH long-term rentals and a short term rental.

Up until 2022 we both had W2 jobs, but we just had our first baby and my wife is now full time mom and full time managing our properties. I'm learning about how she can now qualify as a Real Estate Professional and she will meet the qualifications in 2022 (750+ hours). 

In my W2, I make about 200k a year and Id like to figure out how to pay less in taxes through passive losses in Real Estate but currently all of our properties cash flow well and even with write offs and depreciation we don't show losses. My CPA has advised that any cost- segregation studies would likely not be worth the cost on these SFH as they are around 150k homes. 

Goals:  Legally minimize taxes, build long-term wealth

Question: Is there an asset class or investment strategy we should be targeting for future deals that can optimize paper losses (maybe through cost-segregated depreciation?) while still being cash flow positive. 

Any other recommendations for our situation? Thanks in advance!

You should have no problem meeting the threshold since your wife doesn't have any other job other than managing your properties. As long as she's logging 15+ hours per week on the business (750 hours per year or more) you've met one of the 7 requirements to be "materially participating" in the business. When you both had full-time W2s, you couldn't pull that off because your full-time job would have exceeded your real estate participation. You will want to consult a good real estate CPA (plug for my buddy @Natalie Kolodij here) but her profession should be "real estate property manager" or similar for your business, because that's what you have. And 15+ hours per week should be simple to meet with 5 LTRs and an STR.

[Tony Kim]

Quote from @Jesse Dahms:

Current Situation: My wife and I have been slowly getting into REI over the last 4 years. We currently have 5 SFH long-term rentals and a short term rental.

Up until 2022 we both had W2 jobs, but we just had our first baby and my wife is now full time mom and full time managing our properties. I'm learning about how she can now qualify as a Real Estate Professional and she will meet the qualifications in 2022 (750+ hours). 

In my W2, I make about 200k a year and Id like to figure out how to pay less in taxes through passive losses in Real Estate but currently all of our properties cash flow well and even with write offs and depreciation we don't show losses. My CPA has advised that any cost- segregation studies would likely not be worth the cost on these SFH as they are around 150k homes. 

Goals:  Legally minimize taxes, build long-term wealth

Question: Is there an asset class or investment strategy we should be targeting for future deals that can optimize paper losses (maybe through cost-segregated depreciation?) while still being cash flow positive. 

Any other recommendations for our situation? Thanks in advance!

Yes, if you are an accredited investor or qualified client, I would look into investing in an equity syndication. A properly run investment will have very large paper losses the first year, despite having positive cash flow. If you decide to go this route, be sure to spend a lot of time researching before pulling the trigger. The financial models involved in assessing these types of deals are a little more involved than direct ownership. And don't get swayed or pulled by folks who aggressively market their deals. I have found that the best sponsors generally fill up their deals quickly without having to do much marketing. 

Outside of that, I agree with @Dave Foster on the 1031 exchange. It's definitely THE MOST effective tax management tool available to us if you want to build up your portfolio.

[Bill F.]

Maybe I'm not as quick on the pick up as everyone here, but with your W2 income and rental income you should fall squarely in the 24% tax bracket [$178,150 to $340,100 for MFJ] 

At best with your wife fulfilling Real Estate Professional status and you getting into asset classes with large paper losses you'll move down to the 22% bracket [$83,550 to $178,150 MFJ] but even if you had a MAGI of $180k, you'd need over $100k of paper losses to push you down to the 12% bracket. 

Making a toy model apartment deal based on syndications OMs I've read [ 250 units, $1,200 avg rent, valued at a 5 Cap, 65% LTV] you'd need to own between $500k-1M of the equity to get the needed $100k of passive loss.

That seems like a whole lot of of work and risk to save at most $2-10k in taxes, but that's my opinion. 

[Tony Kim]

Quote from @Bill F.:

Maybe I'm not as quick on the pick up as everyone here, but with your W2 income and rental income you should fall squarely in the 24% tax bracket [$178,150 to $340,100 for MFJ] 

At best with your wife fulfilling Real Estate Professional status and you getting into asset classes with large paper losses you'll move down to the 22% bracket [$83,550 to $178,150 MFJ] but even if you had a MAGI of $180k, you'd need over $100k of paper losses to push you down to the 12% bracket. 

Making a toy model apartment deal based on syndications OMs I've read [ 250 units, $1,200 avg rent, valued at a 5 Cap, 65% LTV] you'd need to own between $500k-1M of the equity to get the needed $100k of passive loss.

That seems like a whole lot of of work and risk to save at most $2-10k in taxes, but that's my opinion. 

 You'd need to invest around 200k to get paper losses of around 100k your first year. At least that's what's been happening with the deals I've been investing in. The accelerated depreciation is applied to the entire property. Equity investors would represent what? Around 25 to 35% of the financing? Some even less.

[Jonathan R McLaughlin]

please be careful, as @JD Martin alluded to, the 750 hours is only one part--in order to deduct losses against other income (i.e. "active) there has to be over 500 hours in direct rental activities/actively managing rental properties, you also have to make an election to link your properties, etc.  Memories of other comments and personal experience here only, no tax advice.

But keeping the losses witheld may actually benefit you on sale more than taking the savings now, so its not the worst thing to accumulate.

[Paul Moore]

Hi @Jesse Dahms. I don’t know if you are interested in investing passively, however, with your family and job it might be a wise move. We have found that investing passively in mobile home parks can provide awesome paper losses. You’re going to want to be sure the syndicator does a cost segregation study. We were shocked to get a paper loss of well over 200% of our investment in a mobile home park last year. Of course, using leverage and a great cost segregation study are necessary to achieve this. Feel free to reach out to me if you want to see the math on this. Good luck!

[Jesse Dahms]

@Paul Moore This is exactly what I'm looking for, however I am not an accredited investor. I haven't been able to find any syndications that will allow me to invest. Any recommendations?

[Yonah Weiss]

@Jesse Dahms if you're not accredited, you'll have to at least be a 'sophisticated investor' and have a pre-existing relationship with the syndicators who are doing a 506(b) exempt offering, before investing. I know quite a few that are in the MHP space, and happy to make some intros if you want, feel free to send me a DM

[Bill F.]

@Tony Kim

I'll cede to your real world MF syndication experience in terms how much depreciation can be accelerated via cost seg in a run of the mill syndication. 

Maybe I'm missing something, but even if he was to be able to get $100k of yr 1 dep, that's only a loan from our friendly Uncle Sam. With depreciation recapture at 25% I can't see the logic of reducing a tax burden at 24% to get taxed on that same amount at 25% 3-5 yrs later...

[Jim Pfeifer]

Quote from @Jesse Dahms:

@Paul Moore This is exactly what I'm looking for, however I am not an accredited investor. I haven't been able to find any syndications that will allow me to invest. Any recommendations?

 There are plenty of syndicators who accept non-accredited investors.  As Paul mentioned, the paper tax losses can be great.  I would recommend joining a Community that specialized in syndication investing - there you will likely meet other investors who can share some of their favorite operators with you.  BP is a great place to start on every thing real estate, but sometimes you can get the specific information you are looking for from a more specific group.

[Greg O'Brien]

@Bill F. Recapture doesn’t work exactly that way. You recapture at a MAX of 25%. However, there are great strategies to minimize the impact. The lower your tax bracket the lower the marginal benefit from the TVM created by accelerating depreciation

[Tony Kim]

Quote from @Bill F.:

@Tony Kim

I'll cede to your real world MF syndication experience in terms how much depreciation can be accelerated via cost seg in a run of the mill syndication. 

Maybe I'm missing something, but even if he was to be able to get $100k of yr 1 dep, that's only a loan from our friendly Uncle Sam. With depreciation recapture at 25% I can't see the logic of reducing a tax burden at 24% to get taxed on that same amount at 25% 3-5 yrs later...

I reread your post and it appears that you are basing your numbers on the actual tax benefit that one would receive after accounting for the the recapture that would inevitably come after you've kicked the can down the road as far as you could go. In that case, I agree with your numbers. I agree that when accounting for recapture when a syndicated deal matures, the tax benefit is limited only to deferment and the actual amount of hard dollars you would save is quite minimal. 

Of course, a syndicator would say, "that why you cycle your investments". I.E., keep investing in new deals every year so that your accelerated losses can offset any recapture. I believe this might work, but at the same time, I can see things crashing pretty hard into a perfect storm if one relies too much on this strategy. I'm happy to take my accelerated losses, but I also feel more comfortable rolling them forward as large PALS on an annual basis instead of cashing them in against my ordinary income. 

And this is of course, assuming one would qualify as a RE professional, which IMO is one of the reddest of the red when it comes to IRS flags. And even if you do qualify, rest assured the IRS will do  thorough job of reviewing the rest of your return. 😊

[Bill F.]

@Greg O'Brien

Thanks for keeping me honest. I was under the impression that no matter what the deprecation recapture is 25%. I take it that is incorrect? 

How does it work? Keeping it simple, I'm in the 22% tax bracket forever; if I have a SFR that I take deprecation on every year for five years and end up with $100k in accumulated deprecation. When I sell it what rate do I pay on that $100k? My marginal rate?

@Tony Kim

Sorry for not making that clear in my original post.  I'm of the camp that deprecation mainly does two things for you, an interest free loan from Uncle Sam and an opportunity to get some tax rate arbitrage. The former is nothing more than a time value of money play so you need to account for it when doing any analysis. 

You hit the nail on the head about the counter argument from sponsors, but I think that's a lot like asking your barber if you need a hair cut. Deprecation recapture is a feature not a bug to their business model. Most of us hate paying taxes and the longer you cycle your investments the larger the recapture becomes and we will roll our money into less and less profitable deals to avoid paying the tax man. I think if investors aren't careful this will lead them to step over a dollar to pick up a dime, but that's just me. 

I agree 100% about the red flag. If I had a high paying W2 and a spouse as a RE Pro, I'd keep my account on speed dial lol. 

[Basit Siddiqi]

DIY Cost Segregation studies are very affordable for $150K homes.

Working with an accountant also means expecting them to connect you with competent connections.