When was the last time you took a look at your actual pay statement?
Most of us working W-2 jobs have direct deposit, meaning our paychecks are automatically deposited into our bank accounts. On pay day, all we have to do is wake up, open our banking app, and confirm we got paid.
When we do this, all we see is our net pay, or take-home pay. Our net pay is what we earn after all deductions are subtracted from our gross pay.
Deductions may include voluntary contributions, like to our 401(k) and HSA, as well as other benefits, like health insurance.
That’s all nice so far.
Not so nice is that our paychecks are further reduced by mandatory tax withholdings.
For high earning lawyers and professionals, taxes can easily reduce our W-2 income by 25%-40%.
This is not groundbreaking news to anyone, right?
As employees, we are accustomed to having significant taxes withheld from our paychecks.
We’ve become so accustomed to paying taxes as W-2 employees that none of this should surprise us. Taxes are just part of the bargain when you’re an employee.
Well, what if I told you that automatically paying taxes every month does not have to be part of the bargain?
In fact, I know of a way to make money where taxes can be reduced or deferred for a long time, if not eliminated altogether.
And, that means you get to keep and benefit from more of your hard-earned money each month.
This leads us to the fourth main reason I invest in real estate:
Real estate offers massive tax benefits.
I earn income through W-2 employment and rental properties.
As a W-2 employee and a real estate investor, I know firsthand that not all income is created equal.
My W-2 income is heavily taxed every month.
My rental property income is not.
Today, we’ll introduce some of the main reasons why real estate investors pay less in taxes than W-2 employees.
Before we talk about these tax benefits, let’s review the first three reasons why I invest in real estate. Each of these reasons has accelerated my journey to financial freedom.
Note: I am not an accountant or tax professional, so please be sure to consult with an expert for tax advice for your personal situation.
1. Rental property cash flow is king.
With cash flow, you can cover your immediate life expenses. For anybody hoping to reach financial freedom, it is essential to have income to pay for your present day life expenses.
For my money, cash flow from rental properties is the best way to pay for those immediate expenses.
If your present day expenses are already covered, you can use your cash flow to fund additional investments.
That might mean buying another rental property or investing in another asset class, like stocks.
2. Long-term wealth through appreciation.
Appreciation simply refers to the gradual increase in a property’s value over time.
While cash flow can provide for my immediate expenses, appreciation is all about the long-term benefits.
Like investing in stocks over the long run, real estate tends to go up in value. The key is to hold a property long enough to benefit from that appreciation.
To benefit from appreciation, all I really need to do is make my monthly mortgage payments, keep my property in decent condition, and let the market do the rest.
Now that we’ve reviewed how cash flow and appreciation work together to generate long-term wealth, we can look at the additional benefits of debt pay-down.
3. With rental properties, other people pay off my debt.
When I buy a rental property, I take out a mortgage and agree to pay the bank each month until that mortgage is paid off. At all times, I remain responsible for paying back that debt.
However, I do not pay that debt back with my own money.
Instead, I rent out the property to tenants. I do my best to provide my tenants with a nice place to live in exchange for monthly rent payments.
I then use those rent payments to pay back the loan.
As my loan balance shrinks, my equity in the property increases. Equity is just another way of saying ownership interest.
When my equity in a property increases, my net worth increases.
On top of monthly cash flow, appreciation, and debt pay-down, the tax benefits offered to real estate investors is another way to generate wealth through real estate over the long run.
Let’s take a look at some of these massive tax benefits.
What are the primary tax benefits to investing in real estate?
When you earn rental income, you must report this income on your tax return. Rental income is treated the same as ordinary income.
However, the major difference between rental income and W-2 income is that there are a number of completely legal ways to deduct certain expenses from your rental income.
Common rental property expenses may include mortgage interest, property tax, operating expenses, depreciation, and repairs. We’ll touch on a few of these deductions below.
With all of these available deductions, the end result is that most savvy real estate investors pay little, or nothing, in taxes on their rental income each year.
Yes, you read that right.
I’ll say it again, just to be clear:
Most savvy real estate investors legally pay nothing in taxes on their rental income each year.
Would you rather have rental income or W-2 income?
This post is not meant to be a primer on income taxes, but we can use a very basic tax bracket calculator to highlight the distinction between rental income and W-2 income.
I currently receive both types of income so readily appreciate the difference in how each form of income is taxed.
Let’s say you live in Illinois and are a high-earning lawyer or professional making a gross annual income of $250,000. Based on 2024’s federal tax rates, you will owe $53,015 in federal income tax. That’s 21% of your income.
Illinois is one of the 42 states that also levies a state income tax. Illinois levies a flat state income tax of 4.95%. For our example, that means an additional $12,375 in taxes each year.
In total, a W-2 employee earning $250,000 in Illinois pays $65,390, or nearly 26%, in income taxes each year.
Again, this is not meant to be a tax primer. And yes, most W-2 employees take the standard deduction, meaning they’ll get a small refund when they file their tax returns.
Still, there’s no getting around the reality that when you’re a W-2 employee, you have limited options to reduce your taxable income.
In the end, you will pay a significant percentage of your income to the government every year.
On the other hand, real estate investors have a number of legal tax deductions at their deposal.
That means a real estate investor earning $250,000 in rental income likely pays very little, or even nothing, in income taxes.
How is that possible?
Let’s find out.
How is it that real estate investors pay so little in income taxes?
The federal government has long encouraged investment in real estate. People need places to live, work, and socialize. The government long ago decided to reward investors who take on the risk of providing these opportunities.
The key way the government incentivizes real estate investors is through tax deductions.
To accomplish its goal, the government allows real estate investors to deduct certain rental property expenses from their income.
As mentioned above, common rental property expenses may include mortgage interest, property tax, operating expenses, depreciation, and repairs.
When properly tracked and reported on your tax return, these expenses can oftentimes negate all the rental income you earned.
For today’s purposes, I’ll highlight one key deduction that shows just how much the government wants to encourage real estate investment:
Depreciation.
What is Depreciation?
Depreciation is an accounting method that allows real estate investors to deduct some of the cost of owning a property over time.
This accounting process is not a trick and is completely legal.
Calculating your property’s depreciation can get complicated and is best left to the tax professionals.
In general terms, if you own residential rental property and use standard depreciation like me, you can deduct the cost of owning that property over 27.5 years.
Each year, you can then reduce your rental income by that annual depreciation.
Here’s an example to help illustrate how depreciation works.
Let’s say you buy a rental property for $500,000, and the closing costs are $10,000. The property’s in excellent shape so no capital improvements are needed.
That means your total initial cost for this rental property is $510,000.
When you buy a rental property, you are actually buying the land and the building. Your city, county or town’s assessor typically attaches a value to each the land and the building.
For depreciation purposes, only the value of the building is depreciable. The land is not.
In our example, let’s say the land was valued at $110,000. You are not allowed to depreciate the value of the land.
So, your depreciable basis is the initial cost of the property less the land value:
Initial Cost – Land Value = Depreciable Basis
$510,000-$110,000=$400,000
For residential rental properties, you can spread out that depreciable basis over 27.5 years to figure out the annual depreciation.
Depreciable Basis / 27.5 = Annual Depreciation
$400,000 / 27.5 =$14,545.45
What this means is that you can deduct $14,545.45 from your rental income each year.
Combined with the other available deductions, you can see why real estate investors end up paying very little, or nothing at all, in rental income taxes each year.
Note: If you sell your rental property, you are responsible for paying depreciation recapture tax, which is a topic for another day. To keep it simple, depreciation recapture is a non-factor for this conversation for many reasons. The most important reason for that is because you have to pay this tax even if you never claimed depreciation on your tax return.
Your tax professional will help ensure you get all the tax benefits for owning rental properties.
Fully understanding taxes is not easy. That’s why we have licensed professionals to help us.
A concept like depreciation can be very complicated. Rest assured that your tax professional will help you benefit as a real estate investor from all the available tax breaks.
The point of today’s post is to introduce you to the definitive truth that the tax code favors real estate investors.
While we barely scratched the service today, hopefully you can start to see why it is so advantageous from a tax perspective to own rental properties.
I personally earn rental income and W-2 income.
When you legally deduct your rental property expenses, it’s likely that your taxable rental income for the year will be reduced to nothing.
Compare this reality to that of a high-earning W-2 employee, who regularly pays between 25% and 40% in income taxes each year.
The W-2 employee needs to earn significantly more money to take home as much as the rental property investor.
I personally earn rental income and W-2 income.
One source of income hits my bank account in full on the first of every month. I never worry about taxes.
The other source of income gets drastically reduced by taxes before I ever see a dime.
Which type of income do you think I prefer earning?
How about you?
Leave a Reply