What are the tax benefits of investing in real estate? Ted Lanzaro, CPA and real estate investor shares his knowledge around tax planning while investing in real estate.
Tell us a little bit about you.
I am a real estate investor and CPA, I have been for the past 30 years. I run Lanzaro's CPA, which is a boutique tax strategy firm for real estate investors. We deal with investors all around the country and our clients are everybody from people who just have a small portfolios of single family properties all the way up to syndication companies that are buying 200 unit apartment buildings. I also do self storage, mobile home park, office buildings, shopping centers, everything around real estate, we do tax strategy on. I got started when I was working for a CPA firm serving the real estate department, and I saw how much money my clients were making in real estate. At about the same time a friend of mine handed me a book, Rich Dad, Poor Dad, and he told me, You should read this, we should start investing in real estate. And I said, my clients are killing it, I think you're right, and one day we went out and bought three single family rentals in Fort Lauderdale, Florida. And that was the beginning of my real estate investing career around 2000.
We purchased about 40, 50 units, we were buying some garden apartments, single families, and I started flipping houses, which led me to the local real estate investment clubs in the area, they found out I was a CPA and asked me to do a tax talk and I walked out of there with a few clients. I've been doing the exact same thing for the past 20 plus years on my own and helping them keep more of their money in their pockets and paying less taxes.
What are some of the benefits of investing in real estate from a tax perspective?
The biggest tax benefit of investing in real estate is that you can make net income from your investment, you get your rental income, you pay your insurance, mortgage interest, real estate tax, your other expenses, and you have money leftover. You can then apply what's called depreciation against the property. Depreciation is the rational allocation of the purchase price of the property that you can then deduct on an annual basis. Typically, residential apartment buildings depreciate over 27.5 years. For example, you pay $2,750,000 for an apartment building, you'll get $100,000 of depreciation expensive a year, which means that I could have $100,000 of net cash flow from that building offset the depreciation and have zero taxable income. But I still have $100,000 in my bank account that I get to keep that I don't have to pay taxes on.
The other benefit is that you can leverage your investment with debt. If I buy stocks, for example, in the stock market, and I want to buy $20,000 worth of stocks, for $20,000 I buy $20,000 worth of stocks. If I have $20,000 to buy real estate, I can buy a $100,000 property, you get a mortgage for the other $80,000. That gives me the ability to get a return on investment that is typically higher than what I could earn in the market, combine that with the fact that I'm not paying any taxes on it, and it's an even higher return on investment.
What defines a real estate professional?
In this scenario, you don't have to be a real estate professional to get to zero, you can just be an active investor, make this kind of money and not have to pay taxes on it. There are three different kinds of investors, passive investors, active investors, and real estate professionals. What it has to do with is your ability to deduct rental losses caused by depreciation on the property against your ordinary income.
A passive investor is only allowed to deduct rental losses against other passive income. A passive investor is somebody who either invests in somebody else's deal and doesn't have any control, or they could be active investors who earned more than $150,000 a year at their W2 job, which is the IRS's threshold for not being able to deduct rental losses. A passive investor can only deduct losses against other passive income, so the best they can do is get to zero net rental income. In the scenario where somebody had $100,000 of cash flow and $100,000 in depreciation, that actually works, that's a net zero scenario, that would be ideal for a passive investor.
If I'm an active investor earning less than $150,000 a year, I can deduct up to $25,000 of rental loss against my ordinary earned income. Take that exact same scenario, the exact same building, but we have $75,000 of cash flow and $100,000 of depreciation, and we have a $25,000 loss. If I was a passive investor, I wouldn't be able to deduct any of that loss, that would carry over to the following year, but as an active investor, I can actually use it to offset my earned income from my W2. Let's say I have $100,000 of W2 income, and a $25,000 rental loss, I only pay taxes on $75,000. So I was able to use the depreciation to not only offset all of the income of the building, but also to defer $25,000 of my salary. The way you qualify as an active investor is to be actively managing your own properties and putting in at least 250 hours a year.
If I'm a real estate professional, I can deduct all my rental losses, I'm not limited to 25,000 a year, I can deduct as much rental losses against my ordinary income. If I'm putting at least 750 hours into a real estate related business, brokerage, development, property management, landlording, and it's more than half of what I did. That's the other caveat. It's very hard for somebody with a W2 job to qualify as a real estate professional, because they're working 2,000 hours for example, so they would have to have 2,001 real estate business hours in order to qualify, which is next to impossible to do.
I have a client who's a real estate broker, he had a great year in 2020, he made $1M dollars in real estate commissions. Around June, July, he said I'm going to make a million dollars in commissions this year, what should I do? I said, you need to go out d buy another apartment building. He said, why is that? I said, go out and buy a big apartment building and we can cost segregate it and you can take all the depreciation against your earned income. So he went out and found a property of about $2 million, and bought it. He got about $400,000 in bonus depreciation on this property. Because he's a real estate professional, we were able to offset the $400,000 in depreciation, he gets a million dollars and he only ended up paying tax on $600,000. That's a big difference, that $400,000 difference in his bracket was $160,000 in taxes.
And we were able to take another $200,000 and put it away in a special type of retirement plan for people who don't have any employees. And he actually only ended up paying tax on $400,000, not $1M. He deferred $400,000 over with cost segregation, depreciation, and another $200,000 with the retirements. We had a great plan for him and he ended up saving a lot of money, that's the power of depreciation and cost segregation. But it's also the power of being proactive about your tax strategies before the end of the year, and talking with your CPA during the year about what kind of money you're making, as opposed to coming to me in March of the following year and saying, I had a great year, I made a million dollars, what can we do about it? Nothing, not now. If you're proactive, you can save a lot more money. I always tell people, you should be calling me whenever you're buying, selling or renovating a building because there are tax strategies that would benefit them that we would implement in each of those scenarios. And there's record keeping that I'm going to want them to do also, because record keeping is the foundation of being able to use tax right offs.
When real estate professionals are able to deduct everything and pay no tax, there are some drawbacks. Can you elaborate on what some of those drawbacks can be?
The primary one is recapture when they sell the property. That guy for example, when he goes to sell that property, he has $400,000 of recapture tax. It's a deferral, it's not an avoidance. With cost segregation you make money on the time value of money, because you're going to pay that money back when you sell the property eventually, unless you do a 1031 exchange. In this scenario, I've already warned him that somewhere down the road, when you sell the property, there's going to be a big capital gain, because your cost basis is a lot lower.
And that's something that I'm talking with people all the time about, because everybody has been using bonus depreciation and taking huge offsets against their earned income, the ones that qualify as real estate professionals, and I keep telling them, when you sell that property, you will have to pay those taxes. Also, that bonus depreciation is actually set to phase out. Starting in 2023, it goes down from 100% bonus depreciation to 80%, then 60% in 2024, 40% in 2025, 20% in 2026 and in 2027 it's gone. The strategy now if you sell properties is I'll just go buy another, if I can't do a 1031 exchange, I'll go buy another property and just get new cost segregation and wipe out the gain on the property. That strategy has two more years of useful life, and then it's going to become a lot less valuable, and then it's going to be gone.
What about the fact that they might not be able to get a personal loan?
That's a really good point. I was just telling someone this exact same scenario, which is good tax strategy and good asset protection don't always correspond with good finance. Sometimes you can take so many tax deductions that you can't get a loan. Typically, banks will add back depreciation, it's not a cash flow issue. It's an allocation of the purchase price. But I've seen people have problems with getting financing. There's always that fine line between getting the next deal done, and maximizing the tax benefits. I have clients that want to deduct everything. And that's all well and good, and a lot of times you can find good rational explanations for deducting things, but then always understand and know that the banks are looking at that and if it reduces your cash flow, then that may be something that prevents you from getting that next loan, especially with the debt coverage ratios.
How would you recommend a real estate professional paying themselves with an LLC?
If you have your rental properties in an LLC, there's no difference if you're between being active, and being a real estate professional, it's your money. If you own the property, you will take the money out as a draw from the LLC. Being a real estate professional doesn't make you have to take the money out in a different way than an active iinvestor would. It's the exact same thing, it's only a classification that allows you to take losses. And what it means is, I'm already working in the real estate business, therefore, the tax code has afforded me certain benefits that other people don't.
What if they're trying to refinance that property, and they're paying themselves, how would that look from a bank's perspective?
The bank should be expecting you to take your profit out because it doesn't reduce your net income. If I have bought a rental property, and I have $100,000 in my LLC, and I take it out as draws, it's not an expense, it's net income. The bank may say, Where's that $100,000 that you made? And you say, I paid my bills with it. So they may not like that you took all of the cash flow out, they may even have cash flow reserve requirements. But outside of the reserve requirements, the money is yours. Take it, that's the whole point of being in that business.
As they say the tax laws are made so that people behave in the way that the government wants you to behave. So if it is for you to maintain and build real estate, great. It's available to every single person and whoever wants it should take advantage of it.
The tax code definitely incentivizes behavior.
Let's clarify a few things about deductions: personal business expenses should be under your personal income, because that will not look good on the business expense side if you need to use a P&L on the business side, is that correct? Or it does not make any difference?
We were just talking about trying to get a loan, I'm a big believer in trying to allocate as much personal expense, thing I'm things I've already paid for, and trying to convert them into business expenses. As an example, I want to go to dinner, so I go to dinner with a client. I feel like going out to a nice restaurant, I'll take a client with me, that way I'm able to deduct the dinner. Most of that is legitimate, if you have a legitimate business purpose, it's a legitimate expense, and I'm all for taking those expenses. But the more you do that, the less likely it is that you're going to have the kind of net income that is going to make a bank want to loan you money. That's what we're talking about balancing that out. I've seen people want to try to deduct every expense they can. You have to have a business purpose for it. And if you're going for a loan, the fact that you're running a rental property, and you've $10,000 worth of meals and entertainment expense on it, it just doesn't look right, it doesn't look good to the bank. I can make an argument for somebody who's the marketing person for a CPA firm, or your financial advisor, real estate brokers picking up clients, but you have to watch the kind of personal expenses you take, because some of them are going to be normal expenses and some of them are going to be over and above. And while you can make a legit argument about the business usage of them, you may not be able to get a loan if you take too many.
Is there anything else that you think is important for our listeners to know?
From a tax standpoint, you always want to make sure that you're keeping good records, and that you're telling your accountant what you're doing during the year, I think that's the most important thing. Because being proactive about reaching out to your accountant, and saying, I'm buying a property or selling a property, those things are going to make a big difference in what can be done to help you save money on taxes, being proactive is the most important thing to save you money.