Did you know that inflation and taxes are two of the biggest killers of wealth? During inflationary times, the dollar is worth less. Spending more money on everyday things like gas and groceries means you have less money left over each month. Less money to spend on things you enjoy and less money to invest. Without the ability to invest and grow your money, that hinders your wealth building.
Research shows that taxes are often our biggest expense. In fact, the Tax Foundation conducted a study and found that Americans lose more money to taxes than they do on food, clothing, and shelter combined.
Now you might be thinking that with inflation, our income also increases. So that makes up for the downside, right? Well, let’s take a look at it from the tax perspective. If you make $150,000 per year, you’re probably paying about a 24% marginal tax rate. Let’s assume with inflation, you were fortunate enough to have increased your income to $200,000 as a result. Making $200,000 might seem like a great deal because you have more money to pay for things during inflationary times. But what you might not be factoring in is the associated tax cost. Increasing your income to $200,000 might put you in a higher tax bracket of 32%. So, although income increases, so do your taxes.
There is a saying that you can’t control inflation, but you can control your taxes. Although there’s truth to the statement, we want to talk about a way for you to protect yourself from both inflation and taxes. And one way to do that, spoiler alert, is real estate. Let’s first talk about why real estate can help you hedge against inflation, and later on, we will talk about how real estate can help you to reduce taxes.
Inflation and Real Estate
Even with inflation, many investors have still been aggressively purchasing real estate. That leaves others to wonder why? Why don’t we just wait until the market cools down a bit? Since real estate market timing is a bit above our pay grade, we enlisted the help of our friend and author, J Scott, to help shed some light on this topic.
Unlike other types of assets, real estate can be a good investment during inflationary periods. As the price of everyday items increases, so can the price of real estate. In fact, historically speaking, real estate has tended to do very well during inflationary periods.
Another reason that real estate can be a good investment during inflationary times is that as the cost of things goes up, so does the cost of rent. As mentioned above, wages typically increase during inflationary periods. This means that people may be able to afford to pay more for rent. What we can see is that wage is a major driver of market rents. So if you are a landlord, this is great news for you. Keep in mind that the shorter the lease term, the quicker a landlord can increase rents. For example, if you have a short-term or mid-term rental, you can likely increase rental income before the next guest booking occurs. This is extremely powerful during inflation.
Another reason why real estate is a good hedge against inflation is the whole concept of debt. As we all know, we as real estate investors love the concept of leverage. Having debt can be a great tool during inflationary times, especially long-term debt with lower fixed interest rates. To clarify, we’re talking about good debt, like debt you have on an investment property generating income. We are not talking about bad debt like credit cards or personal debt to pay for things we cannot afford. With investment debt, your payments may stay the same while the power of the dollar decreases. So a $2,000 monthly payment on a rental property can be less of an impact on your true bottom line. It has been said that inflation punishes savers and rewards borrowers. We are seeing a lot of investors tapping into their equity in anticipation of this and planning ahead to place themselves in a good position to hedge against inflation.
With proper planning, you may even be able to use inflation to your benefit. In fact, some may argue that fixed-rate long-term debt may be the best inflation hedge available. There are some investors who are of the opinion that when buying a rental property, the real asset was the loan, not the house. Right or wrong, some investors have been willing to overpay for a property simply because inflation would be beneficial with respect to the loans on the property. Of course, inflation or not, you need to exercise your due diligence and run the necessary numbers to see if the deal makes sense and meets your investment criteria. If you want to invest in real estate the right way, we highly recommend you check out J Scott’s newest book that he co-authored with Dave Meyer, Real Estate by the Numbers.
Run Your Numbers Like a Pro!
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Tax Deductions in Inflationary Times
Now that we’ve seen why real estate can be a good investment to hedge against inflation, let’s talk about the tax benefits that we as real estate investors receive. With real estate investing, you are a business owner in the eyes of the IRS. And what this means is that you can take advantage of the many tax benefits awarded to business owners under the tax code. Now it’s important to understand that we are not talking about entities, like LLCs or corporations, when we use the term “business”. We are simply talking about you being in the real estate investing business. In other words, many of the common expenses that you can utilize are available to you regardless of whether your property is owned individually or in a legal entity such as an LLC.
As an investor, you’re able to deduct all of the ordinary and necessary expenses related to your real estate investing activities. So in addition to common expenses like interest, taxes, and insurance, you also get to deduct other expenses for your real estate. For example, did you pay for a BiggerPockets Pro membership? If so, that may be tax-deductible. Did you attend a real estate conference? If so, your travel costs like flight, hotel, and food may also be tax deductible. There is a whole slew of things that could be tax-deductible against your rental income. As an investor, you simply need to make sure that you are tracking and capturing these expenses correctly during the year.
This is especially important during inflationary times because as your income increases, so could your tax rate. So writing off a $2,000 business trip that once saved you 24% in taxes could now be saving you 32% in taxes simply because you’re in a higher tax bracket with increased earnings.
We can’t talk about real estate tax benefits without talking about depreciation.
Depreciation is one of the biggest benefits of being a real estate investor. So what exactly is depreciation? The IRS allows investors to take a paper write-off on the purchase price of the building over a number of years. Essentially the tax code operates under the premise that there is wear and tear on the building that you own. As a result, you are allowed to write off a portion of that initial purchase price over a stated number of years. For most residential investments, depreciation allows you to write off the building over 27.5 years. For commercial properties, like office buildings and shopping centers, the IRS allows us to write those off over 39 years.
Let’s go over an example.
John buys a rental property for $150,000 using a $30,000 down payment. Let’s assume the building is worth $100,000. John can depreciate the $100,000 building over 27.5 years resulting in ~$3,600 of depreciation each year. It’s important to keep in mind that this depreciation is available for John regardless of how much of a down payment he made. In other words, had he paid all cash for this property, he would have received the same amount of depreciation. Alternatively, if John had used no money down for this property, he would’ve still received the same depreciation. As you can see, this is an example of how the government is allowing us to take a tax benefit on leveraged money.
In the current year, there is a way to supercharge this tax benefit. This is done with two strategies working together: cost segregation and bonus depreciation. Rather than depreciating your rental building over 27.5 years, you can actually accelerate your depreciation by doing a cost segregation study. A cost segregation study is where your tax advisory team works with you to break out the value of the building structure into different components. The result is that you can accelerate part of the depreciation in the first few years of ownership. Let’s go over an example of how this works.
Let’s say you used $100,000 to buy a $500,000 property. Assuming the building part of the purchase price is $400,000, your regular depreciation per year may be ~$14,500. With a cost segregation study, you might be able to accelerate a lot of that depreciation resulting in up to $120,000 of depreciation in the first year. What that means is that you could potentially offset $120,000 against rental income from your taxes this year.
Now let’s add inflation to the picture with an example. With your previous wages, maybe you were at a 24% tax rate. This means that the $120k depreciation helped you to save ~$28,000 in taxes from your rental income. Alternatively, because your earnings increased as a result of inflation, your actual tax rate might be at 32%. So saving 32% on $120,000 is ~$38,000 in taxes. As you can see, when your tax rate increases, so do the associated tax savings.
What if you do not have enough rental or passive income to use up a large depreciation expense this year? The good news is that you do not lose out on these tax benefits. Passive losses from rentals are carried forward into future years to help you offset taxes from other passive income. Or if you were like many investors who have other sources of passive income (besides rentals) in the current year, then any excess rental losses can help offset that other passive income as well. If you or a spouse can claim real estate professional status, that makes real estate investing even more powerful. The reason is that as a real estate professional, rental losses could also be used to offset taxes from other sources of income such as W-2, stock gains, crypto gains, and retirement distributions.
If you are unable to use the associated tax benefits today, you can simply delay using the cost segregation strategy. A great planning point is that you can coordinate the implementation of this strategy into a future year so that you can get the maximum benefit. In other words, plan ahead to be able to utilize it in a year where you are not subject to passive loss limitations.
As you can see, with inflation and higher earnings, our tax burden also increases. This makes tax planning more important because every dollar of deduction that is generated helps us to save money at a higher tax rate.
Appreciation Tax Benefits
Another tax benefit of real estate investing during inflationary times is the fact that appreciation is typically not taxable. It’s not taxable because you have not yet sold the property. For example, you purchased a rental property for $150,000. As a result of inflation in the hot real estate market, the property is now worth $250,000. As real estate investors, we do not need to pay taxes each year as a result of this appreciation. That money is growing for us without the tax drag.
Let’s take it a step further. Let’s say that you wanted to tap into all of that equity that has now been built up in your rental property as a result of inflation. You can do a cash-out refinance on this property and not have to pay taxes on that cash currently. For example, what if you decided to take out $60,000 from a cash-out refinance and utilize that to buy more real estate? Not only do you not pay taxes on that $60,000 currently, but you also would be able to deduct the associated interest expense against your rental income.
Now that we’ve touched on some of the current tax benefits of utilizing real estate during inflationary times, let’s talk about some of the future tax benefits.
Selling Real Estate Tax Efficiently
As real estate investors, another historically popular tax benefit has been the ability to sell our appreciated rentals and be able to defer capital gains taxes using a 1031 exchange. This is a strategy where the investor sells one appreciated rental property and defers the associated capital gains taxes by reinvesting it into another rental property (or properties). In order to receive tax deferral benefits, there are a couple of rules to keep in mind.
- You have 45 days from the date of sale to identify your replacement property(ies).
- You have 180 days from the date of sale to close on your replacement property(ies).
- The purchase price of the new property(ies) must equal or exceed the sales price of the sold property.
- The equity in your new property(ies) must equal or exceed your equity in the sold property.
If the transaction is done correctly, you can defer all of the taxes on the sale of your property. You can defer federal capital gains tax, state capital gains tax, and even the net investment tax.
Let’s go over an example.
1031 Exchange Example
Kyle owned a rental property in Long Beach that he purchased for $200,000. The market has been insane and the property is now worth $500,000. Kyle no longer wants to be in Long Beach because he is anticipating new rent control rules to come in. If Kyle sells the rental property in a regular transaction, he could be looking at over $100,000 in taxes. Instead, with proactive planning, Kyle enters into a 1031 exchange. He sells the Long Beach property for $500,000 and reinvests the money in a small apartment complex in Florida. By following all of the required money and timeline rules, Kyle pays no taxes on this transaction. Kyle is able to defer over $100,000 in taxes.
The 1031 exchange is a great strategy that has worked for countless investors over time. But how exactly does this come into play during inflationary times? With a 1031 exchange, the goal is to defer the capital gains tax into the future. If Kyle holds the property for five years and then decides to sell and cash out, Kyle would pay the capital gains taxes at that point in time. With inflation, Kyle could be paying taxes using inflated dollars. This means that in real terms, it is costing him less to pay five years from now than he would by paying in today’s dollars. This is another example of how tax planning using real estate could be extremely powerful during inflationary times.
Don’t forget, if Kyle wanted to, he could instead do another 1031 exchange into a different property in year five, should he decide to sell. This is a great strategy that allows investors to continuously defer capital gains taxes while building their wealth. There is no limit to the dollar amount or number of times that an investor can utilize the 1031 exchange strategy.
Famous Rich Dad, Poor Dad author Robert Kiyosaki talks about the important lesson that it’s not about how much money you make, but how much of it you get to keep. We know that inflation and taxes are two of the biggest erosions of our wealth. We also know that money is often made when you least expect it. While some people are becoming very fearful of what they are seeing today, it is important to understand that significant wealth can also be built during inflationary times. In fact, there are many opportunities that only exist during inflationary periods.
Make sure to take the time to do some proactive planning. If done correctly, it can help to ensure that you don’t just survive but actually thrive during inflationary times.
Dreading tax season?
Not sure how to maximize deductions for your real estate business? In The Book on Tax Strategies for the Savvy Real Estate Investor, CPAs Amanda Han and Matthew MacFarland share the practical information you need to not only do your taxes this year—but to also prepare an ongoing strategy that will make your next tax season that much easier.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.