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

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’.

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

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.