A colleague of mine looking at her paystub recently lamented “I need to find a source of income where the government doesn’t take 30% of it.”
The vast majority of income earned by lawyers is wage income (or self-employment income if they are owners in their law partnership). This type of income is subject to the highest federal taxes of any other source of income. It is subject to at least three and possibly four different taxes.
Taxes on Wages
- Income tax up to 37% in the highest bracket,
- Social Security tax 6.2% (on wages up to $160k),
- Medicare tax 1.45% (on all wages), and
- if you are fortunate enough to earn more than $250,000, an additional Medicare tax of .9%
This does not include state income taxes on wages which the highest bracket in Minnesota is 9.8%. Since 2017, state taxes that exceed $10,000 per year are no longer deductible for computing your federal income tax liability.
There is very little a wage earner can do to shelter or reduce taxes on wage income (without reducing actual cash such as giving to charity or paying medical expenses) other than to contribute to an IRA or 401(k). The maximum 401(k) deduction is $22,500 a year unless age 50 or older, then it’s $30,000.
Taxes on Investment
Investment income is taxed more favorably. For instance, while interest income from T-bill and bonds is still subject to income tax at the same rate as wages (up to 37%), it is not subject to social security and Medicare taxes. You can invest in stocks and mutual funds and receive dividends and capital gains that are subject to lower tax rates (maximum income tax rate of 20%) plus additional Medicare tax of 3.8% on investment income over $250k (if married filing joint). The interest, dividends, and capital gains are all taxable in the year that they are received.
What if there was an investment where you could receive the returns on investment without current tax liability and you could defer the tax on the sale by reinvesting the gains?
There is. That investment is real estate. Investors in real estate can receive positive cash flow while reporting losses for tax purposes. This means that the investor can receive a check for $10,000 for profits from operations (rental income) in a year and pay no income tax on it in the year received! The tax is deferred until the investment is sold. At that time, the investor can use part of the sale proceeds to pay tax on the income (at favorable income tax rates i.e., 20% rather than 37%) or defer the tax by reinvesting the proceeds!
To recap:
Investors in real estate can (i) defer tax on cash returns received for many years, (ii) eventually pay tax at a reduced rate, and (iii) further defer tax on gains by reinvesting.
The reason that you can receive positive cash flow with negative taxable income is because the Federal government permits real estate investors to take tax deductions for the cost of their investment over time (depreciation deductions). The theory behind depreciation is that a physical asset wears out, so the IRS allows you to write off (aka depreciate) the cost of that asset over time. So, in addition to cash expenses such as property taxes, insurance, and utilities, investors get a depreciation deduction for which no additional cash payment needs to be made.
Houses and apartments are depreciated over 27.5 years; other commercial real estates over 39 years. Investors can greatly increase the amount of their depreciation deductions through the benefits of a cost segregation study. Let me explain. Property other than buildings can also be depreciated. This other property includes furnaces, air conditioners, lighting, carpets, landscaping, etc. These assets can be depreciated over a much shorter period of time, such as 15 years, 7 years, and even 5 years! The benefit is higher deductions.
But wait, it gets even better!
Currently, investors can take bonus depreciation on certain assets (like furnaces and lighting). As the law stands today, investors can deduct up to 80% of such an asset’s cost in the year of purchase. Depending on the particulars of the deal, investors frequently enjoy tax losses in the first year of their investment equal to 60%–90% of the amount they invested!
Example
As the example demonstrates, the investor receives $200,000 of actual cash but reports a loss of $2.3 million. The net tax loss cannot be deducted against your wage income but it can be carried forward to deduct against the rental income in future years (so you pay no tax).
When the investment is ultimately sold there will be taxable gain on the sale, but there are two potential avenues by which investors may defer the tax on that gain.
First, the Internal Revenue Code contains a rule (Section 1031) that provides that the gain on sale will not be taxable to the extent the sales proceeds are invested into new investment real estate and certain timing and procedural requirements are met (known as a like-kind exchange).
Second, an even easier method is to make a taxable sale of the real estate and simply reinvest the proceeds in another piece of real estate or a real estate syndication and offset the gains with all of the bonus depreciation etc. on the new investment. Remember the tax losses in the first year of investment equal 60%–90% of the investment amount; those would be available to offset your gains if you reinvested in the same year.
If, like my colleague, you would like a source of income that is not immediately taxed at the highest rates before it even passes through your hands, real estate investments are an unparalleled alternative.
You may be thinking, ”I don’t have $5 million to buy an apartment building” or “I don’t have time to be a landlord and deal with tenants.” Totally understood, that is where real estate syndications come in.
In a syndication, you can pool your money with other investors to buy real estate which is completely managed by the general partner. All you need to do is cash the checks.
