Will rental investments increase my W2 tax return?
Investor · Minnesota/Wisconsin/Iowa · Member since 2019 · 49 posts · 77 votes
Hello Bigger Pockets!
I will be closing on my first investment property next week, it is a 4-plex that will cash flow about $700 per month after all expenses including tax escrow, (etc. even including mowing services). I understand that on paper, when working with a CPA, I will have depreciation (etc.) make it so I'm actually operating at a near loss which correctly will reduce my taxes on that cash flow.
Here is my question, I currently work a salaried job and make <$100k per year. Will this job now bring in more money / tax return at the end of the year if a CPA sets up my taxes correctly?
Sorry to sound so fresh to this. Hope someone can provide some insight! Thank you all.
I'm a 2% W2 income earner and on pace to be at the bottom of the 1% level on W2 income by the end of this year.
Thus, Let's assume you earn $100,000 in your day job and pay $20,000 in taxes. Your effective tax rate is 20%. Now let's also assume you pick up a rental. It sports a net operating income (NOI) of $200 a month, but is being depreciated at a rate of $300 per month. Because depreciation is higher than your NOI, you'll report a passive loss for tax purposes, meaning the $200 monthly NOI is tax free.
If we add this $200 per month NOI to your $100,000 W2 income, your total income is now $102,400 for the year. Yet your taxes stay the same at $20,000 because only $100,000 is subject to tax as the $2,400 in net operating rental income is tax-free (technically they would decrease due to the passive loss which I'll touch on in a second). We've now decreased your effective tax rate to 19.5%.
Even better is the fact that the passive loss of $100 ($200 - $300) per month, or $1,200 annually, would decrease your income subject to taxes. Instead of having $100,000 subject to tax, you now only have $98,800 subject to tax. Assuming you are in the 28% tax bracket, your taxes owed will decrease by $336 to $19,664 ($20,000 - $336).
So now you are paying taxes of $19,664 on $102,400 of earnings for an effective tax rate of 19.2%. This decrease in your effective tax rate can be construed as additional return on your investment. You should strive to decrease your effective tax rate as much as possible.
The power of investing in real estate lies in the ability to offset your income with the passive losses generated by your real estate investments. That is why I will never understand people that leave the W2 world and lose that benefit.
When your Modified Adjusted Gross Income (MAGI) is below $100,000, you can take up to $25,000 of passive losses annually.
As your MAGI increases above $100,000, the $25,000 passive loss begins to phase out. The rate of the phase out is $1 per every $2 of MAGI increases. So, once your MAGI eclipses $150,000, you can no longer take any passive loss from real estate. Note that these MAGI thresholds and passive loss phase outs are always the same regardless of whether you are single or married. If you have ever heard of the “marriage penalty,” this is another great example of such penalty because when married, the thresholds stay the exact same as they were when you were single.
This poses a problem for high income taxpayers like me, especially when MAGI is above $150,000 (My gross is over $400k/year). High income taxpayers cannot tap into the passive losses their real estate generates unless they (or their spouse) qualifies as a real estate professional.
When your MAGI creeps (or explodes) past $150,000, you can no longer use your real estate losses to offset your ordinary income. Instead, the real estate losses simply aggregate and are carried forward into future years. Future passive income and sales of real estate will be offset by your accumulated passive losses.
The best way to tap into your suspended passive losses is to become a passive investor in a business. And no, I don’t mean become a passive investor in a real estate rental business. I mean become a passive investor in a legitimate, non-publicly traded business that produces solid net income for its investors.
The key here is net income. You need to invest in a business that is producing net income or has the ability to produce net income shortly after you invest. The reason is that you are trying to tap into your passive losses. You don’t need any more passive losses; you need passive income!
You will need to be a passive investor in the business, meaning you are not materially participating in the business, meaning you hand the business operator the money and sit back and wait for your quarterly reports. You don’t call the shots; you’re out of that game. This makes you passive and makes the income passive, which allows it to be used to offset your suspended passive losses.
You can invest in an LLC, a partnership, S-Corp, or sole proprietorship. You can't invest in a C-Corp, as the dividends and capital gains are classified as portfolio, not passive, income.
First, the passive business income you earn will be completely tax-free until your suspended passive losses are exhausted. In my example above, where we imagined you had $100,000 of suspended passive losses, this means that you can receive passive business income for a number of years completely tax-free.
Second, as you receive business income, you invest this tax-free money back into rental real estate to produce more passive losses. This way, as your private and passive business investments grow, your passive losses from your growing real estate portfolio are also growing, sheltering your passive business income.
Third, all the while, as long as your real estate continues to produce passive losses, not only are you (hopefully) cash flowing from your rentals, but the cash flow is all tax-free. Couple that with your tax-free passive business income, and you’ve transformed yourself into a savvy wealth manager.
I'm a 2% W2 income earner and on pace to be at the bottom of the 1% level on W2 income by the end of this year.
Thus, Let's assume you earn $100,000 in your day job and pay $20,000 in taxes. Your effective tax rate is 20%. Now let's also assume you pick up a rental. It sports a net operating income (NOI) of $200 a month, but is being depreciated at a rate of $300 per month. Because depreciation is higher than your NOI, you'll report a passive loss for tax purposes, meaning the $200 monthly NOI is tax free.
If we add this $200 per month NOI to your $100,000 W2 income, your total income is now $102,400 for the year. Yet your taxes stay the same at $20,000 because only $100,000 is subject to tax as the $2,400 in net operating rental income is tax-free (technically they would decrease due to the passive loss which I'll touch on in a second). We've now decreased your effective tax rate to 19.5%.
Even better is the fact that the passive loss of $100 ($200 - $300) per month, or $1,200 annually, would decrease your income subject to taxes. Instead of having $100,000 subject to tax, you now only have $98,800 subject to tax. Assuming you are in the 28% tax bracket, your taxes owed will decrease by $336 to $19,664 ($20,000 - $336).
So now you are paying taxes of $19,664 on $102,400 of earnings for an effective tax rate of 19.2%. This decrease in your effective tax rate can be construed as additional return on your investment. You should strive to decrease your effective tax rate as much as possible.
The power of investing in real estate lies in the ability to offset your income with the passive losses generated by your real estate investments. That is why I will never understand people that leave the W2 world and lose that benefit.
When your Modified Adjusted Gross Income (MAGI) is below $100,000, you can take up to $25,000 of passive losses annually.
As your MAGI increases above $100,000, the $25,000 passive loss begins to phase out. The rate of the phase out is $1 per every $2 of MAGI increases. So, once your MAGI eclipses $150,000, you can no longer take any passive loss from real estate. Note that these MAGI thresholds and passive loss phase outs are always the same regardless of whether you are single or married. If you have ever heard of the “marriage penalty,” this is another great example of such penalty because when married, the thresholds stay the exact same as they were when you were single.
This poses a problem for high income taxpayers like me, especially when MAGI is above $150,000 (My gross is over $400k/year). High income taxpayers cannot tap into the passive losses their real estate generates unless they (or their spouse) qualifies as a real estate professional.
When your MAGI creeps (or explodes) past $150,000, you can no longer use your real estate losses to offset your ordinary income. Instead, the real estate losses simply aggregate and are carried forward into future years. Future passive income and sales of real estate will be offset by your accumulated passive losses.
The best way to tap into your suspended passive losses is to become a passive investor in a business. And no, I don’t mean become a passive investor in a real estate rental business. I mean become a passive investor in a legitimate, non-publicly traded business that produces solid net income for its investors.
The key here is net income. You need to invest in a business that is producing net income or has the ability to produce net income shortly after you invest. The reason is that you are trying to tap into your passive losses. You don’t need any more passive losses; you need passive income!
You will need to be a passive investor in the business, meaning you are not materially participating in the business, meaning you hand the business operator the money and sit back and wait for your quarterly reports. You don’t call the shots; you’re out of that game. This makes you passive and makes the income passive, which allows it to be used to offset your suspended passive losses.
You can invest in an LLC, a partnership, S-Corp, or sole proprietorship. You can't invest in a C-Corp, as the dividends and capital gains are classified as portfolio, not passive, income.
First, the passive business income you earn will be completely tax-free until your suspended passive losses are exhausted. In my example above, where we imagined you had $100,000 of suspended passive losses, this means that you can receive passive business income for a number of years completely tax-free.
Second, as you receive business income, you invest this tax-free money back into rental real estate to produce more passive losses. This way, as your private and passive business investments grow, your passive losses from your growing real estate portfolio are also growing, sheltering your passive business income.
Third, all the while, as long as your real estate continues to produce passive losses, not only are you (hopefully) cash flowing from your rentals, but the cash flow is all tax-free. Couple that with your tax-free passive business income, and you’ve transformed yourself into a savvy wealth manager.
@Jonathon Weber thanks for that detailed reply! I like your answer!
@Jonathon Weber thanks for that detailed reply! I like your answer!
No problem. Once you become "rich" you have so many tax maneuvers you can do to avoid taxes or reduce your tax liabilities. What I laid out above takes a while to do but it works. Obviously you will need to work with the professionals to put it all into place as the years go by.
For myself, notes investing, for example, a note for $5K has a balance of $10K. The interest rate is 12%. I collect $1,200 and a principal of $1K in one tax year. I purchased the note at a 50% discount. As the payor makes the contractual payments, half of each principal dollar paid is your investment coming back and half is profit. So on your income tax return, with $1K of annual principal paid, I would show $500 of “discount earned” and $1,200 of “interest,” both of which are taxable as income. The other $500 of the cash flow is your investment coming back, termed “return of capital,” and is not taxable.
Do you see how having $1M of "return of capital" can be extremely powerful in purchasing an investment asset? That is how the rich get super wealthy.
A different example, assume you bought a $10K note at a $3K discount, for a purchase price of $7K. As each principal dollar was collected, 30% would be taxable “discount earned” and the remaining 70% is your untaxed “return of capital.”
Let’s say it was priced to yield 18%. You can print an amortization schedule showing your $5K investment at 18%.
The principal column, although it won’t match the payor’s schedule, is your money coming back and the “interest” column, which also does not match the payor’s, is really your total taxable yield. The reason this is not selected often by investors — although the IRS unsurprisingly is happy for you to use it — is that more taxable income appears in the early years with more untaxable “return of capital” in the later years.
For real estate investing I only focus on the city that I live. I know the market. My primary focus out side of my professional career is to focus on debt investing. For note investing, it allows me to have an asset-backed investment (and student loans have to be paid back). There is less liability than going full scale into real estate investing.
By pooling all of my income streams together into one "fund", I can purchase mortgages in bulk, which gives me access to wholesale pricing.
I have the money to start out with performing notes so my risk should end up being a bit lower than starting out with non-performing notes.
My goal is to become THE dominate player in debt investing (not just mortgages) in my state and help out the residents in my state by getting them to pay their loans.
I'm a 2% W2 income earner and on pace to be at the bottom of the 1% level on W2 income by the end of this year.
Thus, Let's assume you earn $100,000 in your day job and pay $20,000 in taxes. Your effective tax rate is 20%. Now let's also assume you pick up a rental. It sports a net operating income (NOI) of $200 a month, but is being depreciated at a rate of $300 per month. Because depreciation is higher than your NOI, you'll report a passive loss for tax purposes, meaning the $200 monthly NOI is tax free.
If we add this $200 per month NOI to your $100,000 W2 income, your total income is now $102,400 for the year. Yet your taxes stay the same at $20,000 because only $100,000 is subject to tax as the $2,400 in net operating rental income is tax-free (technically they would decrease due to the passive loss which I'll touch on in a second). We've now decreased your effective tax rate to 19.5%.
Even better is the fact that the passive loss of $100 ($200 - $300) per month, or $1,200 annually, would decrease your income subject to taxes. Instead of having $100,000 subject to tax, you now only have $98,800 subject to tax. Assuming you are in the 28% tax bracket, your taxes owed will decrease by $336 to $19,664 ($20,000 - $336).
So now you are paying taxes of $19,664 on $102,400 of earnings for an effective tax rate of 19.2%. This decrease in your effective tax rate can be construed as additional return on your investment. You should strive to decrease your effective tax rate as much as possible.
The power of investing in real estate lies in the ability to offset your income with the passive losses generated by your real estate investments. That is why I will never understand people that leave the W2 world and lose that benefit.
When your Modified Adjusted Gross Income (MAGI) is below $100,000, you can take up to $25,000 of passive losses annually.
As your MAGI increases above $100,000, the $25,000 passive loss begins to phase out. The rate of the phase out is $1 per every $2 of MAGI increases. So, once your MAGI eclipses $150,000, you can no longer take any passive loss from real estate. Note that these MAGI thresholds and passive loss phase outs are always the same regardless of whether you are single or married. If you have ever heard of the “marriage penalty,” this is another great example of such penalty because when married, the thresholds stay the exact same as they were when you were single.
This poses a problem for high income taxpayers like me, especially when MAGI is above $150,000 (My gross is over $400k/year). High income taxpayers cannot tap into the passive losses their real estate generates unless they (or their spouse) qualifies as a real estate professional.
When your MAGI creeps (or explodes) past $150,000, you can no longer use your real estate losses to offset your ordinary income. Instead, the real estate losses simply aggregate and are carried forward into future years. Future passive income and sales of real estate will be offset by your accumulated passive losses.
The best way to tap into your suspended passive losses is to become a passive investor in a business. And no, I don’t mean become a passive investor in a real estate rental business. I mean become a passive investor in a legitimate, non-publicly traded business that produces solid net income for its investors.
The key here is net income. You need to invest in a business that is producing net income or has the ability to produce net income shortly after you invest. The reason is that you are trying to tap into your passive losses. You don’t need any more passive losses; you need passive income!
You will need to be a passive investor in the business, meaning you are not materially participating in the business, meaning you hand the business operator the money and sit back and wait for your quarterly reports. You don’t call the shots; you’re out of that game. This makes you passive and makes the income passive, which allows it to be used to offset your suspended passive losses.
You can invest in an LLC, a partnership, S-Corp, or sole proprietorship. You can't invest in a C-Corp, as the dividends and capital gains are classified as portfolio, not passive, income.
First, the passive business income you earn will be completely tax-free until your suspended passive losses are exhausted. In my example above, where we imagined you had $100,000 of suspended passive losses, this means that you can receive passive business income for a number of years completely tax-free.
Second, as you receive business income, you invest this tax-free money back into rental real estate to produce more passive losses. This way, as your private and passive business investments grow, your passive losses from your growing real estate portfolio are also growing, sheltering your passive business income.
Third, all the while, as long as your real estate continues to produce passive losses, not only are you (hopefully) cash flowing from your rentals, but the cash flow is all tax-free. Couple that with your tax-free passive business income, and you’ve transformed yourself into a savvy wealth manager.
This was great, thank you
any examples of passive income businesses?
I'm a 2% W2 income earner and on pace to be at the bottom of the 1% level on W2 income by the end of this year.
Thus, Let's assume you earn $100,000 in your day job and pay $20,000 in taxes. Your effective tax rate is 20%. Now let's also assume you pick up a rental. It sports a net operating income (NOI) of $200 a month, but is being depreciated at a rate of $300 per month. Because depreciation is higher than your NOI, you'll report a passive loss for tax purposes, meaning the $200 monthly NOI is tax free.
If we add this $200 per month NOI to your $100,000 W2 income, your total income is now $102,400 for the year. Yet your taxes stay the same at $20,000 because only $100,000 is subject to tax as the $2,400 in net operating rental income is tax-free (technically they would decrease due to the passive loss which I'll touch on in a second). We've now decreased your effective tax rate to 19.5%.
Even better is the fact that the passive loss of $100 ($200 - $300) per month, or $1,200 annually, would decrease your income subject to taxes. Instead of having $100,000 subject to tax, you now only have $98,800 subject to tax. Assuming you are in the 28% tax bracket, your taxes owed will decrease by $336 to $19,664 ($20,000 - $336).
So now you are paying taxes of $19,664 on $102,400 of earnings for an effective tax rate of 19.2%. This decrease in your effective tax rate can be construed as additional return on your investment. You should strive to decrease your effective tax rate as much as possible.
The power of investing in real estate lies in the ability to offset your income with the passive losses generated by your real estate investments. That is why I will never understand people that leave the W2 world and lose that benefit.
When your Modified Adjusted Gross Income (MAGI) is below $100,000, you can take up to $25,000 of passive losses annually.
As your MAGI increases above $100,000, the $25,000 passive loss begins to phase out. The rate of the phase out is $1 per every $2 of MAGI increases. So, once your MAGI eclipses $150,000, you can no longer take any passive loss from real estate. Note that these MAGI thresholds and passive loss phase outs are always the same regardless of whether you are single or married. If you have ever heard of the “marriage penalty,” this is another great example of such penalty because when married, the thresholds stay the exact same as they were when you were single.
This poses a problem for high income taxpayers like me, especially when MAGI is above $150,000 (My gross is over $400k/year). High income taxpayers cannot tap into the passive losses their real estate generates unless they (or their spouse) qualifies as a real estate professional.
When your MAGI creeps (or explodes) past $150,000, you can no longer use your real estate losses to offset your ordinary income. Instead, the real estate losses simply aggregate and are carried forward into future years. Future passive income and sales of real estate will be offset by your accumulated passive losses.
The best way to tap into your suspended passive losses is to become a passive investor in a business. And no, I don’t mean become a passive investor in a real estate rental business. I mean become a passive investor in a legitimate, non-publicly traded business that produces solid net income for its investors.
The key here is net income. You need to invest in a business that is producing net income or has the ability to produce net income shortly after you invest. The reason is that you are trying to tap into your passive losses. You don’t need any more passive losses; you need passive income!
You will need to be a passive investor in the business, meaning you are not materially participating in the business, meaning you hand the business operator the money and sit back and wait for your quarterly reports. You don’t call the shots; you’re out of that game. This makes you passive and makes the income passive, which allows it to be used to offset your suspended passive losses.
You can invest in an LLC, a partnership, S-Corp, or sole proprietorship. You can't invest in a C-Corp, as the dividends and capital gains are classified as portfolio, not passive, income.
First, the passive business income you earn will be completely tax-free until your suspended passive losses are exhausted. In my example above, where we imagined you had $100,000 of suspended passive losses, this means that you can receive passive business income for a number of years completely tax-free.
Second, as you receive business income, you invest this tax-free money back into rental real estate to produce more passive losses. This way, as your private and passive business investments grow, your passive losses from your growing real estate portfolio are also growing, sheltering your passive business income.
Third, all the while, as long as your real estate continues to produce passive losses, not only are you (hopefully) cash flowing from your rentals, but the cash flow is all tax-free. Couple that with your tax-free passive business income, and you’ve transformed yourself into a savvy wealth manager.
This was great, thank you
any examples of passive income businesses?
Young corporations that are in a growth stage or raising money is your best bet. Mature companies are more challenging to get into.
One thing I didn't mention is the importance of using 1031 exchange when you have everything built out that I outlined. If you sell a property for $300,000 without a 1031 exchange and pay $35,000 in capital gain and depreciation recapture taxes. By avoiding these taxes using a 1031 exchange, you would keep that $35,000 invested. At 10% for the next 20 years, that $35,000 would grow to over $235,000!
And you can keep using 1031 up to your death. Only real property (the real estate building and land) can be exchanged. Any personal property (appliances, furniture, etc) can not be exchanged. For large apartment complexes with furnished apartments, this could mean significant taxes paid on a transaction.
So do the 1031 until death and here is why. For example, let’s say you bought a rental house for $100,000. Forty years later you die and the house is worth $500,000. When your heirs sell the house, they would not pay capital gains tax on the $400,000 gain. Instead, their basis would be $500,000, which means they could sell it for $500,000 and have no capital gains tax to pay.
Keep in mind that inherited assets are still subject to estate taxes. $11.18 million of assets are exempt from any estate taxes. So, your heirs would inherit a lot of property before paying any taxes unless you are talking about a very large apartment complex or a very large commercial deal.
That's one hell of a goal. I appreciate your replies to my question it helped me understand more questions to ask my CPA when working on tax returns / deductions. I wish you a lot of luck moving forward with that endeavor! We are clearly in different stages in our investing journeys and I envy you in a lot of ways! Thanks again! :)
That's one hell of a goal. I appreciate your replies to my question it helped me understand more questions to ask my CPA when working on tax returns / deductions. I wish you a lot of luck moving forward with that endeavor! We are clearly in different stages in our investing journeys and I envy you in a lot of ways! Thanks again! :)
I've spent my entire adult life building my professional career to the level it is now. It was a living %^&& to get to this point, but now that I am finally here it is actually easy now to continue to grow my income. I have no interest in letting the government take all of the tax it could take from stupidity on my own end so I am learning everything I can about wealth creation, risks, and movement that rich people can make to decrease their tax liability.
The reason Trump doesn't realize tax returns is because he doesn't pay much in taxes. Rich people that are smart do what they can to avoid paying taxes since it's completely legal to do it.
The reason I have little interest in buying homes is two fold - low returns and having to deal with a lot of crazyness (toilet issues, people not paying rent, etc). Instead I would rather take the skills that I have developed all of my adult life and take that into note investing and build a generational legacy of wealth for my family. I will easily be able to relate to people are have a non-performing note and I'm confident in my skills that I will get some people to get the note back to performing and save their lives.
I'm not doing this to be one of the "I just want to replace my income so I can leave the rate race". F that! For how much work it took to get here I am NOT leaving that and have no interest in talking to people who want to do note investing or real estate to replace a job.
I'm more than happy to talk about tax and financial moves to lower tax liabilities for a person that is maximizing their income potential.
This is how you can convert ordinary income from a business into passive income. For this it’s not how much you own that matters, it’s how much you control. This is the rule to use to convert at least part of your business income into passive income. All we have to do is to give part of your business to a member of your family who doesn’t work in the business. When we do this, their share of the income from the business is passive income. Then, we also give them a part of the real estate that has passive losses. Now, their share of the real estate losses will offset the passive income from their share of the business.