The Biggest Wealth Unlock in Real Estate, and No One Talks About It
How Real Estate Investors Make Millions and Pay Zero in Taxes
Welcome to The Saucetown Investor! If you’re new here or are enjoying what you’re reading, please consider subscribing below. It’s free, and I don’t send you ads or promotions. The only thing that happens if you subscribe is the blog is sent to your inbox each week.
Unless you’ve been under a rock since 2016, it’s likely you’ve heard a bit about the tax trials and tribulations of a certain former and soon to be current President of The United States. Before Trump became president, his story was centered around being a New York City real estate developer. Though he owns much less of “The City” than he claims, he is a major player in the NYC real estate space nonetheless. As far as his taxes go, he has been less than forthcoming over the years, notably breaking the norm of US Presidents sharing their tax returns with the public when he refused to do so during the 2016 campaign.
This was of course with good reason, as years later he was ordered to pay over 450 million in damages related to various financial crimes in New York State. Sharing his tax returns in 2016 would have put his business dealings under a microscope for anyone to look at, so it’s understandable he would not want this information out there. On the tax side of things, Trump’s maneuverings ranged from outright illegal (tax fraud) to sketchy at best (overvaluing his properties for banks, under valuing them for the IRS). All of that aside, there is one part of the tax code that Trump used to his advantage time and time again. The best part? It’s completely 100% legal, and you and I can use it too. Depreciation is the holy grail of real estate investing, and almost no one talks about it.
Pause. Here’s the part where I interrupt your regularly scheduled blog post to remind you that I am not a CPA and I am not qualified to give you tax advice. This piece is for informational purposes only. If you try this on your own and an IRS agent knocks down your door with his go go gadget pocket protector that’s on you, not me.
Ok, back to business. The IRS defines depreciation as “an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property.” The concept applies across the business world. A farmer can depreciate the cost of their tractor. A restaurant owner can depreciate their industrial oven. If only Aaron Rodgers could depreciate his rapidly depreciating right arm…..but I digress.
For purposes of this piece, we are going to focus specifically on how depreciation applies to real estate. In the context of personal finance, “gurus” will often talk about cutting your biggest expenses. The most common ones mentioned are generally housing and transportation. In most cases, neither of those is actually your largest expense. Your #1 expense is often good old Uncle Sam and his band of IRS agents.
One of the oldest and most overused tropes in finance is “it’s not what you make, it’s what you keep.” Aside from being old and overused, it’s also accurate. Depending on what state you live in, as much as 50% of your income may go toward taxes if you are a W2 worker. You’ve probably heard stories about “real estate investors don’t have to pay taxes”, but how does it actually work? Let’s look at an example:
-Donald buys an 8-plex in Salem, OR for a million dollars
-The building is “worth” $800,000 and the land is “worth” $200,000 (keep in mind, the way the building v land is valued is art not science, but an 80/20 ratio is reasonable)
-Over the course of the year, the building “nets” $25,000 from rents after all repairs, mortgage interest, taxes, insurance, etc are paid.
-Ok! Time to pay the IRS and State of Oregon right?! Wrong.
-In residential real estate (Note: must be investment property, not personal residence), property gets “depreciated” over 27.5 years (in commercial real estate it’s 39 years).
-So what does that ACTUALLY mean? The idea is that the building will depreciate (needs new roof, siding, upkeep, etc.). The simple way to think about depreciation is simply that it is wear and tear over the course of time that makes the building less valuable unless you fix it. For example, if you get a 20 year roof today for $20,000, it is most certainly not worth $20,000 anymore 19 years from now.
-Here’s how the numbers play out. Remember above when we determined that our building was worth $800,000? That “value” decreases (at least as far as the IRS is concerned) over the course of 27.5 years. We take $800,000/27.5 and we end up with an annual depreciation of $29,090. That $29,090 is now a “tax write off.”
-Again, remember above. Our 8-plex produced $25,000 in net income this. If this was W-2 income, it would be time to pay the piper. Instead, we make use of our $29,090 tax write off that was granted to us through that dark magic of depreciation.
-Instead of having $25,000 in taxable income, we now actually show a tax loss of $4,090. That’s right, we made a net of $25,000 and the IRS owes us instead of us owing them. As the great Michael Scott said, “how the turn tables…..”
A W2 worker might owe half of that $25,000 (“making it”) in taxes, leaving just $12,500 in the “keeping it” column. The owner of this 8-plex has the same $25,000 in the “making it” column, the difference is that every dime of it and then some ends up in the “keeping it” column. Your income is literally worth twice as much when it’s produced through the 8-plex in the example above as opposed to the high paying W2.
All of this same math applies whether you’re at 10x or even 100x these numbers. All the while, you are paying down your loan principal and hopefully watching the market value of your property go up. Do the math and sprinkle in a few decades and some good ole compound interest, and the results are astounding.
Every day, there’s a new strategy that’s being pushed by your favorite “guru" on Instagram. Today it’s wholesale. Tomorrow it’s house flips. The next it’s sub2. These are all good tools, and I use them myself. With that said, depreciation is the best “hack” in the game and it’s been around in the US since the 1830s. Buy and hold rental property, produce cash flow, pay no taxes on the cash flow, and watch the value of your property go up over time while you pay down your mortgage. Rinse Repeat.
In the world of taxes, you often hear the word “loophole” get thrown around. The US tax code is thousands of pages, which inevitably leads to ambiguity and grey areas. Depreciation is not one of those, in fact the IRS virtually requires you to make use of it. Whether you’re building skyscrapers in New York City, or buying your first duplex in Salem, OR, real estate not only can help you “make it”, it can ensure that you “keep it.”
You should have been a CPA :)