Why Investing in Real Estate Just for the Tax Breaks Can Be Unwise (& Downright Dangerous)

by | BiggerPockets.com

In 2012, I told people I was going to invest in real estate. Most people told me it would be a bad idea. I bought my first investment, and it was one of the best/luckiest decisions I ever made. Now, real estate is back in vogue. Everyone is clamoring to get a deal because we’re back in a upward cycle.

Last December, I made an offer on a duplex that needed some TLC. The property needed about $30k worth of work, but when it was all said and done, it would make a decent return. Being I have a contractor on my team, I can now target TLC properties.

I made an offer after seeing it, and within two days, the property had about 20 offers. Some of the offers were above asking for all cash. A real estate agent told me I should have increased my asking price because the market is hot. That would be a trap.

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The Fear of Missing Out

Like it or not, we are social animals. We take our cues from the tribe to dictate what we should or shouldn’t be doing. You hear from your friend that she’s making a killing in real estate. Because you don’t want to be left behind, you feel anxious to buy a property, even if it’s a money loser.


Related: 6 Reasons You Should File an Extension for Your Taxes This Year

You’re starting to feel the fear of missing out (FOMO). This is a feeling I know well because I’ve acted on it before (and it cost me $25k). You forget that all great investments require knowledge, experience, and hustle to locate. Instead, emotion clouds your judgment. Your criteria takes the backseat. Investing turns to gambling.

Gambling comes in all different shapes and sizes

I see people gamble by buying in areas they are unfamiliar with so they can chase returns. I see people buying overvalued properties that aren’t breaking even. But the worst thing I’m seeing is people justifying buying money-losing properties for tax benefits.

refinance

Why Investing for a Tax Break Is a Bad Idea

Call me old fashioned, but I prefer all my investments to carry their own water, regardless of whether I’m working or not. I invest to work less, not work more.

The logic holds that instead of paying Uncle Sam taxes, one should buy a money-losing property and use the losses to offset your taxable wage income. On face value, it seems reasonable.

But there are a few assumptions being made:

  1. Your job is safe
  2. You will remain in a top tax bracket
  3. Other investors value the property the same way you do.

Your job isn’t safe.

With the shortening life span of companies and a changing economy, job security is not what used to be in America. With the onset of automation, which is a blessing for some and a potential disruption for others, it’s not guaranteed that your company will maintain its current headcount, that your role will be relevant 5-10 years from now, or that the division you work in will be relevant to the company in the near future.

You won’t remain in your current tax bracket.

While I want everyone here to become wealthy, odds are we will face financial setbacks in our lives. You might be in the top tax bracket now because the job market is good, but how stable is that job you have? How long do you think you’ll be able to maintain your current earnings?

Those of us working in the tech sector face the same job risks as those in the service economy. All it takes is for you to lose your job, and now you have a money-eating property on your hands. This can cause panic selling (see the 2009 financial crisis). But this isn’t just a bad idea for yourself; think of your family.

Let’s assume the worst—tomorrow you are crushed to death by Pikachu or this cat. What would happen to your significant other if they have to worry about a money-draining property?

work-from-home

Related: What Investors Should Know About Qualifying As a “Real Estate Professional” For Tax Purposes

You property valuation model is flawed.

The method you are using to value the property is flawed because it assumes the rest of the market is looking at the property the same way you are. While future buyers are basing the property’s value on future comps or cash flow, you are basing it on your personal financial situation. The mismatch of perception of value will cause you to overvalue a property. And if the market turns, you’ll might be forced to sell the property for a significant loss.

It’s Time to Put the Gambling Chips Down

Buying money losers for a tax break isn’t investing; anyone can do that. That’s considered shopping. Investing is the act of deploying capital for a expected financial return, not a tax shelter for W2 earnings.

As you well know by now, yours truly is conservative when he invests. While others are willing to pump themselves with investing steroids to crush a home run, yours truly is like Cal Ripkin, fine with a hit here and there. So long has he can coast into Cooperstown (retirement) in one piece without risking losing money in real estate, bankruptcy, or steroid-induced man-boobs.

Wealth building is not about who builds their nest egg the fastest. It’s about who is able to survive the ups and downs of the market while others are losing their minds. That’s where the experience is gained. That’s where you learn to spot good deals. And that’s where the wealth lies.

What do YOU think?

Let me know with a comment!

About Author

Jordan Thibodeau

Jordan Thibodeau is a contributor for BiggerPockets.com blog. He works a full time job and invests in Buy and Hold Real Estate in the Sacramento Area. Jordan is dedicated to helping people become better real estate investors by helping them clarify their investment criteria and goals. He was also featured in BP Podcast Show 74. Also, Jordan is the author of a personal development blog titled Growwithjordan.com. You can learn more about Jordan here or reach out to him in the BP Forums.

26 Comments

  1. Annabelle Dilworth on

    I am a real estate broker and an appraiser and I don’t know why peole think real estate is so magical. Proven you can do better in the stock market. An appraiser friend of mine who’s done it all said it so succinctly when he said that one is basically just a janitor for other people unless you can pay for professional ,management and for being a janitor you should figure out what your janitorial and maintenance and other miscellaneous work time is worth — and it sure as hell is not for what the IRS considers basically in the passive investment category (I think & I own plenty of real estate & have for last 50+ years & done OK with very conservative investment formulas —- one definitely does not want to be riding the waves of word of mouth trends coming from novices — not to be harsh — I agree with the author & feel he was not harsh enough — and you could say that all of this is just the tip of the iceberg.

    • Jordan Thibodeau

      <3 Amanda. I'm still lol'ing from our Google interview. Remember when I asked the softball question of, "Should I buy a money loser for a tax break?" Your eyes almost popped out of your head.

      I hope all is well with you, and send my best to your family.

  2. kris patel

    I had an investment foreclosed, only good news was had a big loss to carryover.
    Trump write off was in billions at investors expense, he came out ahead by deal making with banks. Banks do not want to own and are ready to make a deal.

  3. Christopher Smith

    When I read the first part of your article it was like DeJa Vu “all over again”.

    During the 2011 to 2013 time frame, SFR prices in my area dropped dramatically, many around 65% or more, and so there were great deals out the kazoo everywhere. But amazingly enough most folks thought I was totally crazy to begin buying then because of the almost hysterical selling that was going on at the time. It was “my god man, can’t you see everyone else is selling, why in the earth would you be buying anything!!!”. Now its 2017, and those same folks who were in full panic mode selling, are standing in line to pay those grossly inflated prices again. The heard mentality at its best.

    On the tax front, I would absolutely agree to NEVER make any investment based upon tax benefits ALONE. If the deal can’t justify itself on solely economic grounds, it should NOT be bought. This not only makes sense from a practical investment standpoint, its also a fundamental principal of Federal Tax Law. The US tax code is absolutely replete with provisions that will DENY you your planned tax benefit if the investment itself was not made with the intent to make a PROFIT on that investment BEFORE ANY TAX considerations.

    These income tax provisions are far too numerous to mention them all here, but just a few are the hobby loss rules, the passive activity loss rules, the at risk and basis rules, the economic substance doctrine, and on and on and on they go, almost indefinitely. Each one these specific rules (and please note many of them are targeted directly at Real Estate activities), can take back any tax benefit you thought you had securely pocketed, if the investment had no economic justification or rationale of making a PROFIT BEFORE TAXES from the very outset.

    Additionally, when the income tax return that you must file is scored by the IRS’s tax software program that identifies high risk returns and your return has these non economically justifiable activities, your return is likely to score a few extra points (and scoring extra points here is a bad thing), so you are more likely to be selected for audit. Now you may need professional help to justify what you did, and that can sometimes be an expensive and painful process.

  4. Jerome Kaidor

    We bought our first fourplex in 1996 – my wife wanted a tax write off. She dragged me in, kicking and screaming. “Why should I buy a flat investment and have people call me about upchucking toilets when I can earn 15% in a high-tech mutual fund?”

    Whatever, we bought it, it did OK, We doubled down and tripled down, and by the time I got laid off in 2003, we had 60 units.

    Now we have 74 units, and every single property makes money. I wouldn’t have it any other way. Last year, at great personal sacrifice, we got rid of an underperforming property. Gave another investor an excellent deal, and got out from under it. He’ll make money because his loan is smaller than ours was.

    That being said, I did indulge in some tax tricks last year. I moved all possible expenses from 2017 into
    2016. Paid all our April property taxes in December, paid my full workers comp bill for 2017 in December….

    • Christopher Smith

      It depends upon whether the depreciation is economic or non economic. In other words, does the depreciation reflect true diminution in the actual value of the property, or merely have tax effect. If it represents actual diminution in the economic value of the underlying property, then you are losing money on at least that element of the deal.

      If it merely has tax effect (i.e., the economic value of the property is not reduced, or at least less than the tax depreciation claimed), then yes you have a temporary cash flow tax benefit. Of course even if the economic value of the property is not reduced, the cash flow tax benefit may reverse itself when you sell the property (if you do sell it), and at that point you must recapture those tax benefits and that will cost you cash at that point. So the tax benefit from taking tax deprecation often ends up being merely a temporary benefit that gets fully or partially recaptured at sale.

      Of course you could die holding the property and perhaps than avoid the depreciation recapture, but then you’re dead. 🙂

  5. Mike Dymski

    Thanks for taking the time to write.

    Taxes and leverage are two of the best and most misunderstood benefits of real estate investing. Many commercial investors use cost segregation and accelerated depreciation and never pay any taxes (and also use this to offset earned income). Couple it with leverage and you have 3-4x the depreciation deduction you otherwise would have for the invested capital (plus 3-4x market value appreciation). This is a huge part of many investors returns, especially commercial investors.

    • Christopher Smith

      Of course leverage is a two way street, something I think far more people woefully misunderstand. It can just as easily cut against you as it can for you, and if you are invested in property that ends up being NOT “economically” profitable then there is a really good chance it will cut against you.

      Segregation merely categorizes property correctly to permit a shorter recovery life assuming the property does in fact qualify for it (i.e., then you do get a quicker tax write off). However, regardless of the period of write off short or long, the tax depreciation taken must be typically fully recovered for tax purposes upon sale (if you do need to sell the property).

      So neither leverage, cost segregation nor accelerated tax depreciation are usually going to save you from a economically non-profitable property. I think this is the author’s primary point.

      • Mike Dymski

        “However, regardless of the period of write off short or long, the tax depreciation taken must be typically fully recovered for tax purposes upon sale (if you do need to sell the property).”

        Negative, just 1031 or die. There is a lot of talk on BP about what is “typical” when in reality how BP members invest is a small subset of how most real estate is purchased or held. And even if you decide to recognize the gain, deferring the tax for many years has a massive compounding impact.

        Many BP SFR investors could run circles around owners of commercial properties and improve their after tax IRR or have access to more properties because the after tax returns take what you are describing as an economically unprofitable property into one that is.

        • Mike Dymski

          Chris, if you don’t sell, there is no depreciation recapture. If you sell, you can 1031. Or, you hold and die and get one of the best benefits in the entire tax code…stepped up basis. I know that you know all of this and what you have made clear is that it is not that important to your investing and that you don’t feel these strategies are typical. I don’t disagree with the author. I disagree with you on the significance of the tax benefits of real estate and your discounting of it by discussing depreciation recapture, depreciating properties, improperly leveraged properties and what you feel is typical in real estate. There are many successful strategies in real estate and some of them include significant tax benefits.

    • Christopher Smith

      Well the first point I would make is that a 1031 transaction is not a sale of any kind, stripe or variety, its a “tax deferred exchange” (in tax parlance – and to me those are the terms we are using). Another point to note, and unlike death where recapture effectively disappears permanently, in a 1031 deferred exchange the recapture amount normally carries over fully to the exchanged property received so you still are again faced with the same dilemma should you need to sell the property – tax depreciation recapture. When I say sale, that is what I mean a transaction where all rights, title and interests in real estate are conveyed in return for money or monies worth – a fully and currently taxable event.

      With regard to the effect that taxation has on return, I’ve never indicated that it wasn’t important as an element of overall return. What I said is that a person investing in a property that knows the property does not make sense economically, should ever attempt to rationalize that acquisition by asserting tax benefits alone will be sufficient to justify the deal. A deal that an investor knows in advance will lose money economically, and therefore the person is relying solely on tax benefits to make the deal profitable is very likely precluded under the tax law (e.g., the Economic Substance Doctrine and other provisions) from claiming those tax benefits. So if those tax benefits are then denied all that would remain is an unprofitable albatross around the property owner’s neck.

      I would also add that from a broader policy perspective it makes little sense to allocate resources to projects that don’t make sense economically (i.e., are not profitable BEFORE consideration of any tax benefits). This is one of the reasons for the existence of the Economic Substance Doctrine and a number of other provisions within the tax code that by one means or another take aim at transactions that can only be rationalized by factoring in tax benefits alone.

      I have several properties of my own in different states across the country and of course I claim depreciation on all of them and it benefit me tremendously, but the investment must make sense economically first. No tax magic alone is going to make a bad economic investment a good one.

      To me this is really all the author is really saying, and to which I obviously agree.

      • Mike Dymski

        Forget regular depreciation, I’m talking about cost segregation and accelerated depreciation. And forget what you are doing for the purpose of this dialogue…there is a much different way for many investors…real estate investing is not a one-size fits all strategy. For example, take a $1 million property, 75% leveraged, no cost segregation, $25k per year return (after interest expense) and you have a 10% pre-tax return on your invested capital…say 8% after tax return for conversations sake. Take that same property, use cost segregation, use the extra 2-4 times depreciation to offset ordinary income and your after tax return can jump to north of 15%…a significant increase. This is real cash…not paper gains, and deferred, reinvested and compounded over many years is substantial.

        Said another way, you can buy a 4% pre-tax return property and have an 8% after tax return using cost segregation.

        You are a very thorough and articulate investor. I just trying to help the membership understand that there is another way and it’s, common, tax compliant and some would argue, magic.

  6. Christopher Smith

    I am familiar with cost segregation studies I use to perform them years ago as part of consulting engagements for various clients. Not sure exactly what you mean when you say “regular depreciation” (true economic depreciation?). Regardless, there is no magic about tax accelerated depreciation it merely means a rate of depreciation in excess of straight line. OK so you temporarily reduce your tax liability some over straight line in the early years and that provides some present value benefit that will enhance a given rate of return. That doesn’t justify acquiring a property that can’t stand on its own economics, it at best can only lessen the burden of an uneconomic property.

    So sure derive all the depreciation tax benefits you can legally, and enhance your yield accordingly – no problem with that. And not to beat a dead horse. but if you think you can take a property where it is known from the outset that it will only generate economic losses, and somehow make it viable exclusively via tax benefits, you can’t because the law simply does not permit it. Not to mention that it would be a very poor investment strategy even if the tax law did permit it.

    I think the author is simply telling those beginning their real estate activities not to buy into the notion (which you hear all the time, often from those who know the least) that you can go out into the market and simply buy what ever you want at what ever price you have to pay and it will all somehow work out in the end because of all those wonderful tax benefits. The last thing newbies need is to be encouraged to go out and overpay for properties under the severely misguided notion that tax benefits will be there to bail them out of any bad deal that they make – it won’t work.

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