Master These 6 Strategies to Never Pay Taxes Again

April 21, 2024

In past articles I’ve emphasized that leverage and taxes are the key advantages real estate has over other investment vehicles. I discussed leverage, both its positive and negative aspects, in this article. Now, let’s delve into the realm of taxes!

The most significant expense you’ll ever face isn’t a house, a car, or your children’s college education—it’s taxes, specifically income and capital gains tax. Structuring your investments, and in some cases your life, to minimize taxes can significantly accelerate your journey to financial independence. I wish I had known about these tactics years ago. The benefits are incredible.

Before we explore these strategies, a couple of caveats are in order. First, never let the tax tail wag the investment dog; prioritize sound investment decisions. Second, I am not an accountant, and everyone’s financial circumstances are unique.

If you are serious about real estate investing, consult an accountant specializing in real estate,as these advanced strategies may be unfamiliar to most generalist CPAs. Even tax savvy investors might not be aware of all of these strategies.

1) Meat and Potatoes Depreciation

Let’s start with the basics. If done right, real estate should allow you to avoid paying taxes on annual rental income (capital gains are another story, covered below). Although rental income is typically taxed as ordinary income, up to the 37% tax bracket in 2023, deductions—including mortgage interest, maintenance costs, and depreciation—can offset taxable income.

Depreciation involves deducting the value of an asset, such as your property and any improvements, against taxes over its useful lifetime. For residential rental properties, the useful life is 27.5 years, and depreciation is calculated by dividing the property value by 27.5. Combining depreciation with interest expenses usually offsets income entirely, although this might be insufficient without a mortgage. It’s worth noting that the depreciation deduction is essentially a loan from the IRS, repayable upon property sale.

2) Live, Rent, Flip. Rinse and Repeat

This strategy, often suitable for the young, mobile, and ambitious, involves moving frequently. If you’ve lived in your home for at least two of the last five years, capital gains tax on its sale is exempt—up to $250,000 for single filers and $500,000 for married couples. This makes it possible to do a live-in flip, dedicating two years to upgrade the property and force appreciation before selling it for a tax-free profit.

You could also convert the property into a rental for an additional three years before selling it. The key is meeting the requirement of residing in the property for two of the last five years to avoid capital gains tax (See section 121 of the IRS guidelines).

Imagine how doing this 5 times over a 10-year period could snowball your gains. One more advantage is that you benefit from mortgage rates for primary homes, which tend to be around 1% lower than mortgages for investment properties. The fact that you turn it into a rental later doesn’t matter to the lender.

3) Swap 'til You Drop with the 1031 Exchange

Another powerful tool, courtesy of Uncle Sam, is the 1031 Exchange. Any property held for an investment (not a primary residence) can be exchanged for “like-kind” property. For example, a single-family residence can be exchanged for a duplex, raw land for an office, a shopping center for an apartment. In doing so, you can defer those capital gains.

The 1031 rules can be tricky and have to be followed precisely. For example, you need to use a designated intermediary to coordinate the exchange and handle the money flow. The replacement property should be of equal or greater value than the one being sold, must be identified within 45 days, and be purchased within 180 days. This can get complicated.

But if you are looking at significant capital gains, the benefits could be worth it. It’s also a great tool to help ensure your capital is being productive. As discussed here,real estate investors should always be cognizant of how hard their equity is working for them. Rent increases often don’t keep pace with equity growth, so your “trapped” equity often gets less productive over time, and you also lose the power of leverage.

You might be better off exchanging that single family for a 4-plex, and then later the 4-plex for a 12-unit apartment. This way you can constantly recycle and compound your equity growth and build significant wealth in the process.

But don’t you have to eventually pay back all these deferred gains? Yes, but the good(ish) news is that someday you will die ;-). And just as your spirit leaves your body (or whatever you personally believe), so too does the tax liability of all that deferred capital gain.

Even if your heirs decide to sell the property, they can do so at a stepped-up basis, which wipes away capital gains deferral up to your death. So “swap ’til you drop” both accelerates equity accumulation and is a great estate planning tool.

4) Get on the "Golden Hamster Wheel" via Accelerated Depreciation

Also known as the “Lazy 1031” exchange, this strategy is my personal favorite since it’s both powerful and relatively low effort. The “Lazy 1031” is tailored for passive real estate investors, particularly those engaged in real estate syndications such as multifamily apartments.

The key components involve leveraging bonus depreciation and cost segregation to generate substantial paper depreciation losses in the initial year of an investment (all handled by the operator of the syndication and shows up on your annual K1 statement without any effort from you).

By continuously reinvesting the proceeds from a property into new syndications, you can indefinitely defer capital gains from all the accumulated sales. If you time the sale and reinvestment right, this creates a perpetual cycle called the “Golden Hamster Wheel.”

Example: Let’s say you sell either a single-family rental or a passive apartment syndication, you made $200k in long-term capital gains, and now you owe the IRS $40k (20%) based on your taxable income. To defer that gain, you invest $200k in a new apartment syndication deal that has a first-year depreciation of 100% (not uncommon).

The $200k paper loss on the new deal lets you defer that $40k tax bill until that new investment is sold five years later (called depreciation recapture). However, five years later you reinvest the proceeds from that deal, get a new paper loss, and continue the cycle until you pass away.

The taxes you would have paid are now accumulating returns, compounding over time via the time value of money. Keep in mind you can’t use this strategy to offset your ordinary (active) income – although keep reading to find out how to do that too!

5) Reach the Holy Grail with “Real Estate Professional” Status

This strategy is the golden ticket, the creme de la creme of real estate tax strategies. It’s complicated and only applicable to specific situations. But the benefits are massive. All other strategies I’ve mentioned so far only enable you to offset passive income/gains from real estate. That’s because only passive losses can offset passive income (must be apples to apples).

Real estate professional status (REP), however, lets you apply losses from real estate to offset your ordinary active income (aka the 37% tax bracket stuff from your W2 job). Under the tax code, rental activity of a taxpayer who qualifies as a real estate professional is considered to be active, and therefore can be used to offset active income. This effectively turns an apple into an orange.

The trick is qualifying. Most people get confused by the term real estate professional. This does not mean becoming a real estate agent or passing any certification. It has everything to do with meeting the IRS’s stringent criteria for a REP, which has two key components:

More than 50% of the personal services performed by the taxpayer in all trades or businesses during the tax year are performed in real property trades or businesses in which s/he materially participates, and
The taxpayer performs more than 750 hours of service during the tax year in real property trades or businesses in which s/he materially participates.

There are lots of nuances you should discuss with a CPA. But the upshot is real estate has to be the main thing you do for a living. If you have a regular W2 job that’s not real estate related, you won’t qualify. And you have to spend a lot of time (750 hours or an average of 15 hours a week) on managing your real estate portfolio. If you own just a few units or you outsource all your work to a property manager, you won’t qualify. It has to be participation.

This is the perfect set-up for a married couple where one partner has a W2 job and the other partner focuses on managing the real estate portfolio. It’s also a great way to mix and match the other strategies above.

For example, one partner makes $200k in a W2 job. That year the couple also invested in the apartment deal above with a $200k depreciation. The partner’s spouse qualifies as a real estate professional based on the IRS rules, and on their tax return the couple elects to aggregate all interests in rental real estate for purposes of measuring material participation. Now that $200k loss can offset the federal income taxes on the $200k income, resulting in ZERO taxes. Yep.

But given this is such a lucrative strategy, this is also a highly audited strategy by the IRS. It’s critical that you keep complete and contemporaneous records that establish real estate professional status and material participation. And again, work closely with your CPA before you get started.

6) Capitalizing on the Short-Term Rental Tax Loophole

If you can’t qualify for REP status, there is an alternative worth considering that leverages a short term rental (STR) tax loophole. It also lets you offset active income but you can do so while maintaining a W2 job.

Assuming you have a short term rental, the first step is to meet at least one of the seven criteria to pass the IRS’s material participation test. Among those the top three are the most common: 1) Spend more than 500 hours on the short term rental business, 2) do substantially everything for the STR business, 3) spend more than 100 hours on the activity and no one other individual spends more time than you do.

Once you qualify, it’s smart to leverage depreciation on your property to offset your W2 income. For example, you are a doctor and you buy a $500k short term rental property. Your excellent CPA recommends you do a cost segregation study on the property, which allows you to accelerate 25% or $125k of the purchase price the first year. Now you can have $125k in paper losses that can be used to offset your W2 income.

Note that the benefits around accelerated bonus depreciation are phasing out from 2023 to 2027. (Congress is currently working on extending 100% bonus depreciation for tax years 2023 through 2025). So now is the best time to fully optimize this bonus depreciation benefit for multiple strategies outlined above.