We’ve been talking about real estate as an asset class all week. Today I’d like to wrap up our discussion by zooming out and looking at the big picture.
In every developed industrial country there is a glass ceiling of-sorts hanging over top of the middle class. This is certainly true in the U.S. Here’s what I mean…
When we add up all of the taxes across all levels of government, the average middle class person likely pays out half of their income in taxes each year.
It starts with the taxes that are typically withheld from our paychecks every two weeks. The Federal Income Tax… State Income Tax… Social Security Tax… the Medicare Tax – these taxes are each taken right out of our paycheck before we ever see the money.
Then we have to pay sales taxes on every good or service we purchase. And we pay excise taxes on things like gasoline and alcoholic beverages. We also have to pay property taxes on any real estate we own. Then we pay taxes and registration fees on our vehicles.
These are taxes that virtually all middle class people pay – year in, year out.
Then if we happen to make any money on our investments, we’re required to pay taxes on our capital gains. Unless we defer those gains through a qualified retirement account. If that’s the case, we’ll be on the hook for normal income taxes on our money down the road.
If we were to add up the dollar amount of all these taxes each year, I bet it would equate to roughly half of our income. Which begs the question – how does one get ahead this way?
That’s the glass ceiling.
Those who simply work a W2 job and save their money in retirement plans are pitting themselves against the tax code every step of the way. I wish it were different… but that’s just reality.
One of the best ways to shatter the glass ceiling is by leveraging the advanced tax benefits that come with rental real estate. This is where the asset class truly shines.
As we discussed yesterday, real estate’s big tax advantage comes from depreciation.
Depreciation is simply an accounting method that allocates the cost of a physical asset over its useful life expectancy. The Internal Revenue Service (IRS) says that single family homes have a useful life of 27.5 years. Thus, real estate investors can depreciate 3.636% of the property’s value every single year.
In other words, depreciation allows investors to expense a small percentage of future repairs every single year… even though they haven’t occurred yet. In this way, depreciation is really just a phantom loss. It’s a loss on paper for tax purposes.
For example, if we own a property worth $100,000, we can write off $3,636 in depreciation every year. This reduces our taxable income, even though we never incurred a real expense.
Not too shabby – right? Well, let’s kick it into hyper-drive.
What I just described is called straight-line depreciation. It’s what happens by default. Your CPA or tax professional will assume straight-line depreciation for your properties unless you take accelerated depreciation.
As the name implies, accelerated depreciation allows you to write off a larger percentage of your asset faster. Here’s how it works…
When it comes to real estate, the tax code acknowledges that certain parts of the home wear out faster than others. If we do a detailed analysis and document the specific value of each part of the home – how much are the windows worth… the flooring… plumbing… HVAC… appliances… and so forth – if we break out the value of each specific item, the tax code says we can write off a percentage of certain items much faster than the standard 27.5 years.
Here’s the best part – we don’t need to do this analysis ourselves. We can hire a professional to do a cost segregation report to accomplish this for us.
I use a company called KBKG to do my cost segregation studies. They charge $300 per study, and all they need is for me to fill out specific details from the property. I get most of these details right from the appraisal.
This $300 report allows us to write off tens of thousands of dollars on our tax return. Maybe more.
This is why we will likely never owe any taxes on our rental income. And with some advanced tax planning, we can use these big write-offs to offset other forms of income as well.
If we do that, the end result is a much bigger tax refund each year. And if we are wise, we will use those big tax refunds to buy even more real estate… thus creating a cycle that fuels itself. That’s how we shatter the glass ceiling.
Now, I want to stop right here and address a common reaction to this. I know some people will read this and think – that’s not fair! Shouldn’t everybody have to pay the same taxes on their income?
Here’s the thing – anybody who pays taxes in the United States can do this. It’s simply using the tax code as it’s written.
You see, the tax code is 100% fair.
If you follow the rules, you get the designated result no matter who you are. No matter what your net worth is. No matter what your political beliefs are. It doesn’t matter. The code is the same for everybody.
Sure, there are plenty of things about the tax code that I would rather be different. W2 wage earners absolutely get the short-end of the stick. That’s most people. This is a big reason why so many people are stuck in the rat race.
Unfortunately, there’s nothing that we can do about that. We can’t change the tax code.
All we can do is operate according to the rules as they exist. And as it turns out, those rules are designed to incentivize certain activities. That’s why real estate is favored.
-Joe Withrow
P.S. Rental real estate is a core focus of our new investment membership The Phoenician League. It starts with our robust financial training program. It conveys all the ins, outs, dos, and don’ts of real estate.
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