Real estate investing is one of the best ways to pass down generational wealth.
How so?
Well, when you pass down both property and an income stream – or, use net cash flow from your property to pay for your child’s college tuition, you give the next generation a financial head start.
Not only can real estate investing help you and your family reach financial freedom, the IRS tax code has an abundance of deductions, credits and other tax strategies specifically for real estate investors.
Since federal and state income tax is one of life’s largest expenses, the tax benefits of real estate make it a powerful investment tool.
To learn more about these tax benefits, I interviewed an experienced real estate investor and tax consultant, Larry Pendleton, Jr., CPA.
Interview with Larry Pendleton, Jr. CPA
Larry Pendleton, Jr. CPA is the co-founder of P.C. Financial Services, LLC., a financial service firm that provides nationwide tax consulting and planning for professionals in real estate.
As the owner of several rental properties, he understands the tax implications of real estate investing as both an advisor and an investor.
Here is what Larry had to say about the three major tax saving strategies every real estate investor should know –
1031 Exchanges (a.k.a. Like-Kind Exchanges)
Normally, taxpayers are required to pay tax on the gain from the sale of property.
For instance, if you purchased an investment property for $100K and sold it for $150K, you would have to pay capital gains tax on $50K.
[The above example assumes no improvements were done on the property to increase cost basis].
IRS Code Section 1031, however, turns real estate investing into a game of Monopoly. By that I mean, in Monopoly, you can trade 4 green houses for a red apartment.
In real life, Section 1031 allows you to use the gains from the sale of an investment property to purchase a comparable property(ies) of equal or greater value within a certain timeframe.
Real estate investors can use this part of the tax code to increase their wealth by –
- Selling their properties,
- Delaying the tax liability on the gains, and
- Acquiring properties of greater value that produce more cash flow.
Opportunity Zones
Under the 2017 Tax Cuts and Jobs Act, the law established another capital gain avoidance strategy –
Opportunity Zones are areas across the country the government has identified as economically challenged.
In order to incentivize investors to pour money into these areas and revitalize them, the government created The Opportunity Zone Program. The program offers tax breaks to investors who invest in these areas.
Some consider these types of investments as 1031s on steroids.
Why?
Well, because real estate investors can not only delay paying taxes on any capital gains, they also have the opportunity to discount the taxes on those gains.
Furthermore, investors can take advantage of tax-free appreciation of the investment purchased within the Opportunity Zone.
Although the Opportunity Zone Program is similar to 1031 exchanges, one key difference is capital gains from the sale of any type of investment can be used to invest in an Opportunity Zone.
In other words, your investment does not have to be a like-kind exchange. Investors looking to get into real estate can use the gains from sale of stocks, businesses, cryptocurrency, etc. to invest into an Opportunity Zone and take advantage of the tax benefits.
Cost-Segregation
Real estate investors who purchase multi-family properties and commericial properties can benefit from a cost-segregation study.
(Note from The Little CPA: When you purchase a property, you normally cannot deduct its full cost on your tax return.
Instead, you deduct a portion every year for a specified number of years.
This deduction is called depreciation.
Let’s say you purchase an office building with 10 fully furnished offices.
IRS depreciation tables allow you to deduct a portion of that building over 39 years.
With a cost segregation study, however, you can identify additional components to deduct over their own specified period.
For instance, in addition to the 39-year building depreciation, a cost segregation study might identify office equipment that can be depreciated over 5 years.)
Larry: Imagine being able to take a cake and break it back down to its original ingredients in order to know how much flour, sugar, and eggs were used and how much those ingredients cost.
That’s essentially what a cost segregation study does for properties.
It is an analysis done to break up the components of a building into smaller assets (i.e. appliances, cabinets, countertops, fences, etc.) and determine the cost of each of the components.
By knowing how much each component of a property costs, it allows real estate investors to accelerate the depreciation expense of the property and have larger deductions in the first few years of owning the property, saving on taxes.
Final Thoughts
Similar to Trump, most investors want to make a bunch of money in real estate and pay little-to-no taxes.
However, it is important to keep in mind that Trump and other major real estate investors did not start saving thousands of dollars in taxes overnight. Instead, they maintain a team of tax advisors to help them navigate through the tax code and put a plan together to minimize or eliminate their annual tax bill.
Put another way, if aspiring investors want to reduce how much they pay in taxes, they’ll need a CPA, Enrolled Agent, or tax advisor who specializes in real estate like myself to help them reach that goal.
Larry Pendleton Jr. has been a CPA for nearly a decade with experience in tax consulting & preparation, accounting, and financial statement auditing. He co-founded P.C. Financial Services, LLC., which provides nationwide tax consulting and planning for professionals in real estate. He also brings over 6 years of real estate experience as a multifamily investor involved in syndications, joint ventures, asset management, tax strategies, investor relations and underwriting. Larry holds key finance and accounting positions for several real estate investment firms, such as CP Realty, RIZE Equity and Chavis Capital to name a few, overseeing $10MM+ in assets. Not only does he oversee the finance and accounting for these organizations, but he also adds value by implementing the same tax strategies that he recommends to his clients in order to maximize their investors’ returns. Most importantly, Larry is married to his beautiful wife, Whitney, and the proud father of their 2 handsome sons, Larry III and Wesley.
