Make Over $150K a Year? Excellent! Here’s a Strategy For You

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One of the most often heard comments during phone conversations with potential clients is, “I didn’t know that was possible.” Or something similar. The foundation for successful investing is doing things on Purpose with a Plan. Taxes and the sheltering thereof is a main cog for most real estate investors. More important, how does the investor blend tax shelter into their particular Plan, especially as it relates to the long haul?With very rare exception, buying property primarily or solely for tax shelter isn’t the way to go.

Factoring in tax shelter for maximum impact — when it matters most — is always a key factor in your retirement Plan’s ultimate performance. Forget that at your peril.

BawldGuy Axiom: In the long run, the investor who doesn’t know of all available strategies when creating and executing their Purposeful Plan pays a bigger price for inferior results.

Since we’re really talkin’ about depreciation, let’s define it first.

It’s what many call a ‘paper loss’ which allows for the aging and physical deterioration from usage, obsolescence, passage of time, or just simple wear and tear. There is no actual loss of money — which is why it’s often referred to as a paper loss.

Here are a few questions you should be able to answer for yourself, though they won’t all be answered in this post. (And the congregation said, ‘Amen!’)

  • How do you assimilate the tax shelter aspects of investment into your Plan?
  • Why can some folks ‘write off’ much of their job income while others are disallowed the same perk?
  • What happens to depreciation I haven’t used? Have I lost it?
  • How does tax shelter fit into the big picture as it relates to my retirement?
  • What happens to depreciation when I sell or exchange the property?
  • Why is there a tax on tax shelter? Are ya makin’ that up?!
  • What is ‘cost segregation’?

Before we get goin’ here, you must answer one burning question — Are ya going for Capital Growth or Cash Flow? This is what my 80 year old ex-fighter pilot uncle likes to call mission critical. The strategies will not be the same. Duh

Furthermore, if the Plan, as it is in most cases, is to grow your capital until it’s time for retirement, you wanna ensure tax shelter AT retirement was one of your primary goals. Sounds obvious, right? Most don’t have that dawn on ’em ’till it’s too late. They arrive at retirement the butt of a good news/bad news joke — except they’re not laughin’  much.

The good news? You’ve created a mountain of cash flow. The bad news? It’s a mountain of totally naked, taxable cash flow. And ya did it to yourself ‘on purpose’.

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Let’s talk a little about the playbook — also known as the Internal Revenue Code.

Make over $100K a year at work? The IRC begins reducing how much depreciation you can apply to your ordinary (job) income. Make $150K or more? Yer done. Not one dollar of depreciation can be employed to shelter any of that income. There’s one exception, but it probably won’t apply to you, and it’s for another post anyway.

Here’s the Strategy

So you earn over $150K and are barred from the Depreciation Club. The paradox is, most investors in my experience are better off this way. Here’s why.

Unused depreciation doesn’t go away, or disappear. It’s sits on the shelf collecting dust, growing each year. Some investors literally have several hundred grand sittin’ on the sidelines — and that’s a good thing. See, when the market tells you to make a change, a move in your portfolio, one of the decisions to be made is whether to execute a tax deferred exchange (IRC Section 1031) or not.

Let’s say you have $400K in unused shelter just sittin’ on the shelf. A couple nicely appreciated income properties are cryin’ to be moved, so as to turbo charge your capital growth rate. The gain will be just over $300K plus almost $100K in depreciation recapture. (Taxed at higher rate than cap gain — 25%. Just so ya know.)

My firm did this for a local San Diego client recently. Bottom line? The property is sold and the gain etc. that would have been realized is offset by the unused depreciation — in that guy’s case, almost $200K.

This has several very cool ramifications.

1. Though the net check from escrow is identical, (actually a tad higher cuz there’re no exchange costs) the IRS considers that you are what I’ve called, ‘a reconstituted virgin’. What the heck does that mean? Simply put, it means you’re not encumbered by an adjusted basis which would’ve followed you to your next properties if you’d executed a 1031. One of the unintended consequences of exchanges, is the significant reduction of annual depreciation vs the same property acquired through ‘normal’ purchase. Compound that negative affect over 2-3 decades and it’s not pretty or desired.

2. Much higher annual depreciation on your next round of properties — the same props, btw, that you wouda traded into anyway. After all, it’s the same cash, just not from an exchange.

3. This tends to snowball, as over the long haul, you own more and more property in terms of value and equity. How would it strike you to arrive at retirement with a boatload of unused depreciation at your disposal? Yeah, thought so.

4. How does pullin’ out $500k to a million tax free dollars at retirement sound? But that’s merely the tip of the iceberg. Remember, it’s about planning. Doing things on Purpose. What would you do with that after tax gift from Heaven? Glad you asked.

Many folks decide to take most or all of that money and put it into another income generating basket — tax free income. This basket will, in 10 years or so, begin spinning off crazy cool tax free (not tax sheltered, tax free) income. This income will be in addition to your real estate income, which, thanks to your stellar Planning, is 50-100% sheltered.

Then again. some decide to attach sails, or lake views to that money. 🙂

The tax deferred exchange is a wonderful tool. It’s not to be worshipped though, as so many seem to do. They arrive at retirement with impressive cash flow. But, as noted earlier, it’s pretty much naked when it comes to April 15th. A truism we never wanna forget is that we spend after tax cash flow, right? Before tax cash flow is a worthless figure — critically so to a retiree. Why would anyone plan to arrive at retirement with impressive cash flow that’s, by design, totally naked to the IRS?

This only scratches the surface of the subject.

Just for fun, think about a client for whom I was executing a tax deferred exchange a few years ago. He never wanted to know any of what he called the ‘technical’ stuff. Anywho, his wife called me and asked if there was any way I could exit $50K or so from the exchange — she was willing to pay the taxes. $100K had already been OKed by his CPA via unused depreciation, but had been earmarked for properties, as per his Plan. She was sick and tired of his ancient pickup truck, and told him it was her or the truck. After I told her she could have $50K and it’d be tax free, I thought for sure she was gonna add me to her will.

This strategy saved a marriage! 🙂

Next — To what was I referring when talking about a separate retirement basket generating tax free income?

Photo: Allerina & Glen MacLarty

About Author

Jeff Brown

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.

14 Comments

  1. Well Jeff, you’ve presented us with yet another article that requires a slow, methodical read, followed by a re-read, and yet another after that. Anyone and everyone in the income category that you’ve defined, needs to read this article, and it would behoove all visitors to follow all of your works. There are few with the depth of knowledge that you’ve got, and the experience to put it all into practice. Again, it is beyond my pleasure to have you on the team!

    Make sure you read this one, folks!

  2. Jeff Brown

    Joshua — Thank you. The thing about most real estate investment concepts and strategies is how layered most of them are. Just when you think you’ve surrounded one, there’s another layer to inspect. Grandpa once told me the big picture is often better viewed standing back a bit — seems the layers blend together better that way.

    Seeing the big picture almost always reveals the myriad brush strokes of concepts/principles/strategies it took to paint the dang thing. Standing back a bit seems to help that process some. Hope that makes sense to you. Thanks again.
    .-= Jeff Brown´s last blog ..Munchin’ On The Numbers =-.

  3. Jeff,

    This was a solid article. I am going to have to print this one off and re-read it again! 🙂

    Perhaps you may have touched on this in some manner in your article. However, if you did not, I would be interested to hear how capital gains roll over would come into play here.

    It is my understanding that you are allowed to do that in the U.S. (capital gains roll over).

    In Canada (where I am), we are not allowed to do such a thing. Our recent government said that they would introduce the concept…but they did not.

    Is the topic of capital gains roll over relevant to this discussion? If so, what are the experiences of investors in this area?

    Best Regards,
    Neil.
    .-= Neil Uttamsingh´s last blog ..Canada’s Most Versatile Investor =-.

  4. Jeff Brown

    Neil — If by ‘roll over’ you mean to defer capital gains taxes on an investment profit, yes we have that option here. It’s only relevant here as it relates to the avoidance of the capital gain itself through the application of potentially stockpiled, unused depreciation (phantom loss).

    Here, a roll over would be called a tax deferred exchange — that is, if I understand your question.
    .-= Jeff Brown´s last blog ..How To Quadruple Your Money With NO Appreciation =-.

  5. Hi Jeff,

    Thanks for the feedback. Yes, that is exactly what I am referring to.

    Yes, we do not have any sort of similar concept here. Here the slang that we use for it is Capital Gains Roll Over.

    In theory, this sounds like an amazing concept, as one would be able to defer their capital gain and/or loss by reinvesting their gain/loss into a subsequent investment.

    If I am understanding the concept, as articulated above, then it is pretty cool.

    Regards,
    Neil.
    .-= Neil Uttamsingh´s last blog ..Canada’s Most Versatile Investor =-.

  6. Eric in Silicon Valley on

    It’s always great to hear the “other side of the story”. While I don’t have personal experience with exchanges, what I do know about them leaves me wondering why somebody would ever NOT do an exchange if they could. Thanks for the education.

  7. Angie Menegay on

    Hi Jeff,
    My husband and I are now at this $150K limit and I’m a bit confused on the exact details on this rule. Is it that we cannot claim ANY depreciation (based on your post) or that we cannot claim ANY passive losses? From various other IRS articles, I thought that we just simply cannot claim losses, i.e. we can still claim depreciation against our rental income. So as long as the net number comes out positive, “depreciation” still still in use. Is my understanding correct? Sorry I’m not a CPA so all of these rules are causing me headaches.
    Furthermore, if we can’t indeed claim any depreciation, is there a limit on how long the “unused depreciation” can sit?
    Thanks,
    Angie

  8. Jeff Brown

    Angie — Depreciation is always allowable when sheltering cash flow from property held for long term gain. It’s only barred from use once the income from your job (ordinary income) AGI (adjusted gross income) hits $150k or higher. So if you and your husband file jointly, and your AGI is $173k, you will not be able to apply any available depreciation you might have to your job income.

    Example: You have a total of 35k in available depreciation. Total cash flow from your property(s) = 20k. You can apply 20k to that cash flow. Since your AGI is 150k or higher the remaining 15k will remain unused, but available for some future use. As long as you have depreciation, it should be able to be used at some point in the future.

    Make sense?

  9. Angie Menegay on

    Hi Jeff,
    Yes thanks. That makes sense. You clarified what I was pondering – that we can still claim part of the entire depreciation (the $20K in your example).
    Angie

  10. First off, this was a great article Jeff. In researching this topic online, you’ll find that there is very little information out there (i.e. it is not very well understood). I’m pretty certain you understand this concept better than many CPAs. Anyways, I’ve got two questions:

    1.) To clarify, can anybody (read: someone NOT considered a “real estate professional” by the IRS) whose AGI is <$100K take up to $25,000 a year against their normal income?

    2.)If one took depreciation against his passive income, but did not utilize excess depreciation against his ordinary income, can THAT depreciation be considered "unused depreciation", or should that person start filing amended tax returns?

  11. Jeff Brown

    Hey Kyle — Great questions.

    1. With less than $100k AGI, the taxpayer/investor should be able to take the full $25k a year allowed, against their ordinary income.

    2. Last time I checked, (a good while ago) you don’t have a choice. If you’re allowed to used the depreciation against your ordinary income, and you have available depreciation, it must be used.

    Don’t accept that as gospel though. If I had to bet real money, that’s how I’d roll. I’ll double check for ya, and get back.

  12. Jeff,

    I’m a big fan of your posts (hence why I’m reading up on some of your older ones). I’m a bit confused though on this concept. I believe the example cited above is an issue of ‘when’ you are paying taxes not paying less or more. If you are applying the depreciation to your ordinary income each year you own the home you are getting the tax savings sooner rather than waiting to claim unused depreciation at the point of an exchange (you would have to be performing a 1031 excahnge to make good on the unused depreciation- b/c if it is a sale depreciation is recaptured anyway, right?).

    In your example above concerning the $50k that was tax free, that same income could’ve been tax free over the years of ownership of the home (so long as one could qualify for the RE Pro status).

    To me it seems better to take the depreciation each year you own the home (for example if you make >$150k you could accomplish this by perhaps having your spouse qualify as a real estate professional).

    What do you think?

    • Jeff Brown

      First off, Charles, becoming a bonafide ‘real estate professional’ ala the IRC is a whole bunch easier said than done. Make sure your wife is a no-brainer easy qualifier. The IRS loves to see new ‘professional investors’ as they often then make the taxpayer document their qualifications. It’s not something anyone should try if they don’t VERY easily qualify.

      The CS approach used when the taxpayer earns more than $150k and not a pro investor, ends up with unused depreciation most of the time. The exception is when their motivation is to shelter exceptionally high cash flow for about 5 years. Truth be known, that’s not really the exception, but the rule. 🙂

      Upon sale, the taxpayer with lotsa unused depreciation will owe both cap gains and depreciation recapture taxes. The ‘offset’ becomes reality when the unused depreciation in the year of sale is then able to be used on the taxpayer’s personal income tax return, regardless of his ordinary income being over the allowed amount. This then results in tax savings which is often what my CPA calls ‘significant’. The degree to which those personal income tax savings offset the property sale taxes will differ from investor to investor based, of course, upon the specific circumstances of each. HOW the tax return in the year of sale is structured in concert with the purposeful structuring of the property’s sales contract can further reduce recapture taxation. But in the end, it allows the investor/taxpayer to greatly lower the net impact of taxes owed on property sold. Make sense?

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