How to Reduce Taxes: W-2 Employees (Single and Married Scenarios)
How can you reduce your taxes if you are a W-2 employee that is single, or a W-2 employee with a spouse that doesn't work? This is a topic we have been wanting to cover for a while and Tim Gertz, CPA and Partner at Provision Wealth will be discussing different scenarios with us today.
Tell us a little bit about you. I've been in public practice for more than 22 years now. I'm always working in a niche, working with entrepreneurs and high net worth individuals. My entire career has been focused around practice planning around that niche market, looking at alternative investments, whether it's oil or gas, and real estate has been a huge area of my concentration. I work with people that want to control their own destiny, people that are not looking to just have a W-2 job, to put money into a 401k, or people who work until they can retire. We're looking for people that are trying to make a difference in what they're doing so they can build or generate their own wealth as efficiently as they want to.
Tax can be extremely confusing and we all want to reduce our taxes. There are many different ways to go about it or invest in different things. Let’s break it down into different scenarios: W-2 employees that are high earners and are not married. Some would ask: what's the best tax planning advice for someone that single and a high W-2 earner, the joke is to get married! The tax laws incentivize you to: grow industry to create products, create revenue, create workforce that can be taxed. Unfortunately, as a W-2 employee, you are in this little box where your opportunities are very minimal.
But there are still some opportunities such as: oil and gas investing if that’s the right investment for you. Oil and gas can be very advantageous from a tax perspective because it is outside of the material participation rules of the passive activity loss rules. You can invest in an oil and gas fund and have no involvement in it and be able to offset W-2 income. It's one of the few carve outs in code section 469 that gives us that opportunity.
Another thing to look at is the huge benefit with the Inflation Reduction Act that was passed in August. It bumped up tax credits for energy efficiency. It reinstated the 30% tax credit on solar on residential properties. It increased the tax credits for vehicles, used vehicles, various energy efficient systems, whether it's HVAC, or things of that nature. Those are definitely things that you can look at to offset tax on W-2 taxable income.
One of the other opportunities if you are an individual that does itemize deductions, an opportunity is called deduction stacking. Especially with charitable contributions. For example, instead of giving $10,000 every year, you give $20,000 this year, then nothing ($0) the next year, then $20,000 (again) the following year, and you flip flop between itemized and standard deductions.
Can they take advantage of the depreciation, if they invest in real estate? They would have to be active in that. If they have a full time W-2 job, chances are, they'll never be a real estate professional, which would give them the opportunity to take depreciation on real estate.
A lot of people don't realize that they cannot take advantage of depreciation when they're investing in a syndication passively, because they're not a full time real estate professional. There are 3 main buckets of income: Active, Passive, and Portfolio income. Active Income is W-2, retirement income, things of that nature. Passive Income is investing in an LP real estate deal, or investing in someone's car wash, and you're passive in that car wash. Portfolio Income is interest, dividends, capital gains from equities, things of that nature.
They don't offset each other. If you invest in real estate as a passive investor, and you have a huge passive loss, you can offset other passive income, but you can't offset ordinary income with that. They don't commingle with each other. Something to be aware of as a W-2 employee: you will get a passive loss, but that passive loss will not be able to offset your W-2 income because it's in a different bucket.
Can it offset that investment, once the property is sold? It definitely can. It can be utilized to offset other passive gains. In a year, when you have a property that sells, if you invest in another investment that has losses from depreciation, the two can offset each other because they're in that same bucket.
Let’s move on to: W-2 employee with a spouse that does not work. What are their options? This scenario opens up a huge opportunity. There are different things that you can utilize the spouse for, if the spouse wants to be involved in activities, they can look at: What is it that they want to do? Do they want to open a business? Do they want to operate a business? Do they want to invest in real estate and become a real estate professional?
One of the nice things about being married is that your income is combined, and your income and losses are combined. If you've an individual that's a W-2 high wage earner, and you have a spouse that is a real estate professional, and you invest in real estate that throws off half a million dollars of losses every year. Because they spouse is active in real estate, that loss is active. Going back to what we’ve discussed: now we have an active loss, and we have active income from W-2 that are married to each other, then they will offset each other. It doesn't have to be a real estate professional because that's where a lot of people are investing in. It can be any activity, it can be any business that someone materially participates in. It could be: coin laundry, things of that nature, things that are highly capital intensive, that have a lot of equipment on the upfront that can be depreciated. That can create a loss that will create an active loss. If they're active in it and materially participate in that activity, it will offset the W-2 income.
What is a real estate professional? Code section 469 is the passive activity loss rules that came out of the 1986 tax act. It said that if you don't materially participate in an activity, you're passive. They also lumped rental real estate into a category of being inherently passive no matter what. The issue is: we have rental real estate that is passive no matter what, but in that tax code, they created a carve out and they said if you hit these tests, then we're going to allow you to treat that rental real estate as a business. And if you materially participate in that business, then it will be active. In order to be a real estate professional for tax purposes, you have to hit two things:
1. You have to hit 750 hours in rental real estate related activities: that's anything dealing with real estate, it can be investing, managing, developing, construction, all of those will give you an hour of work that can add to that 750 hours.
2. The next test is you have to do that (real estate activities) more than any other income producing activity. You've got 1,000 hours in real estate related activities? Great! If you do real estate related activities more than any other income producing activities, in tax speak, you are a real estate professional. What that really does is it just says Okay, now this activity is a trader business. Now we have to look at the trader business and see if you materially participated, in most cases, if you're spending that much time, you've materially participated. And now that real real estate becomes an active trader business.
And that includes brokers and real estate agents? The only thing it doesn't include is loan brokers, loan originators, things in that industry.
It's really important for people to look at the numbers: let's say the husband makes $2 million a year. And the wife also has a W-2 job; she makes $200k a year. It's clear that she should become a real estate professional. A lot of times people are on the fence. If someone is working simply because they think they have to work, and if you run those numbers, and I do that a lot with my client base, we look at that exact same scenario, and we say Does your spouse really like what they're doing? Do they want to do something else? Are they interested in this? Yes, they make $100,000 a year, but if we were able to get them into something that they enjoy doing, and they were able to give you a $600,000 loss, that would be more than they're earning on an annual basis, and they would probably be happier. And that's the most important thing, to be happy.