Many investors don’t realize that commercial real estate is not just a good investment over time, but it can also reduce your tax burden. Here I want to show you just how you can take advantage of a tax saving tool used by millionaires to create unbelievable wealth.
How to Maximize Tax Deductions with Commercial Real Estate
Step One: Everyone Starts Somewhere
Step one is where all beginner investors start: you are working full time, and you may own your own home, but you don’t have any commercial real estate investments. When you are at this place in life, you pay lots of taxes and have few write offs. Your money comes from your job, and the IRS takes a huge chunk away from you. This is not the place you want to stay! What I want to show you is how to move from step one, making money and watching Uncle Sam siphon it all away to step two where the government takes less and you keep more of your hard earned cash in your own pocket. So, the smart thing to do in step one is get out and move to step two and buy commercial real estate!
Step 2: Invest in Commercial Real Estate
Step two where you are still working full time, own your own home, and now you have purchased your first small apartment building. Now you qualify for some completely legal tax loopholes. For example, if you make $100,000 a year, you may qualify for a $25,000 reduction in your tax burden, something impossible back in step one. Let’s say your income goes up to $15o,000 a year, then the $25,000 deduction will begin to phase out. Solution? Buy more commercial real estate.
This takes discipline, but the returns are well worth it. Twenty years ago, a lot of my friends and family members bought large expensive homes and cars while I stayed disciplined and invested in commercial real estate. Today I still live in the same house I had all those years ago, but because I was disciplined I also have multiple vacation homes around the US. My old friends and some of my family members are stuck with the one big home but I can work from six or seven different locations, and my commercial real estate investments paid for it all! Literally none of it came out of my own pocket. I call that freedom. And you can do it too if you stay disciplined in step two and continue to invest in more commercial real estate. Doing this leads to step three, the final stage of being a smart commercial real estate taxpayer.
Step 3: Become a Real Estate Professional
The ultimate goal when you invest in commercial real estate is to grow your portfolio and as you do become a real estate professional using the IRS rules, which can further reduce your tax burden. To be a real estate professional the IRS rules require you to:
- Own rental property.
- Quite your full-time job and spend a minimum of 50% of your professional time must be spent on real estate activities.
- You must take and pass the 750-hours test. This test requirement is that you spent at least 750 work hours dealing with your real estate properties during the calendar year.
- You must also pass the material participation test. This test shows that you are personally materially participating in your own commercial real estate business.
Tax Benefits of Real Estate Professional Status
Once you are legally a real estate professional, you get unlimited write-offs. You can literally write off everything! You can write off hundreds, thousands, and perhaps millions of dollars every year. If you are a high paid full time professional making a million dollars a year, your income tax burden will be substantial. But as a smart commercial real estate professional with the same income, you should be paying very little if any income taxes every year. You guessed it. This is how so many of the people worth so much get wealthy and pay no taxes. And the truth is, either you, or if you are married, your spouse, can qualify to become a real estate professional, and the other keep their full-time job.
Let’s Compare Tax Benefits: A Real-World Example
Look, commercial real estate investors are taxpayers like anyone else. We simply take advantage of the legal loopholes that insure we don’t leave any money on the table. Understand, I am not an attorney, and I am not a CPA. I hire these professionals to handle my affairs. They study my commercial real estate portfolio and advise me on the best ways I can maximize my tax savings. Having professionals in the know evaluate your properties costs money, but they save me hundreds of thousands of dollars each year. Here is a real example of how you can reduce your taxes using the benefits of owning and being a commercial real estate professional can bring.
Starting Out as an Investor
As mentioned before, everyone starts somewhere, and most begin in step one. They have a full-time job, own their own home, and are just starting commercial real estate investing. For example, I know someone who works in the transportation industry making $100,000 a year who owned his own home. He could deduct his mortgage up to $25,000, and write off $5,000 of his IRA contributions. He also had another $7,000 in deductible expenses for the year, bringing his taxable income down to $63,000. Not bad, but if he were to invest in commercial real estate and move to step two, he would be able to further reduce his taxable income.
An Example of a Real Estate Professional
Now, as I mentioned before, the goal is to build your commercial real estate portfolio to the point that you can pass all the tests and meet the IRS requirements to become a real estate professional. Now, in time the man above working in the transportation industry continued to invest in commercial real estate. He kept his full-time job, but his wife became the real estate professional.
Between his full-time job and their commercial real estate investments, together they made $300,000 for the year, which is $25,000 a month. Now that his wife qualifies as a real estate professional, their deductions have increased. They can write of the $25,000 mortgage on their home and the $5,000 IRA contribution as before. But, now that they own commercial real estate, and have professional status, they can deduct $75,000 in depreciation of their multiple properties. As well, as a real estate professional there are $70,000 in other legal write offs for the year. These included having a home office, their car, eyeglasses, trips to the properties, and other business expenses. And since they are married, the deductions apply to both the husband’s income and the real estate business as well. In fact, a cost segregation study that they had done on ene of the apartments found an additional $100,000 in write offs that year.
So, let’s do the math. Their total income for the year was $350,000, but their legal write offs and deductions totaled $350,000 meaning they lost $50,000 for the year. This is not a negative cashflow, but a paper loss. In other words, they pocketed the entire $300,000 in income that year and paid zero income tax! Not only that, but they can apply that -$50,000 to the next year. If they are able to cost segregate a second property, they could get another $100,000 deduction in the next year, and not pay taxes then either.
Two Powerful Tax Saving Tools
In the example there were two powerful tax saving tools at work: depreciation and cost segregation. Both worked together for huge deductions on my friend and his wife’s taxes.
What is Depreciation?
On a commercial real estate property, IRS rules allow you to depreciate the building, not the land, and spread that depreciation over a period of twenty-seven and a half years.
So, in the case above, my friend purchased a million-dollar property. 30% of the property is the land and cannot be depreciated, but the other 70% can be. To calculate the depreciation, you simply take the $700,000 remaining value of the building, divide it by 27.5 and you get the yearly depreciation, which in this case is about $25,000. If you are disciplined in step two of investing and purchase more than one property, then you can deduct the depreciation of all of them annually.
What is Cost Segregation?
This is another powerful tax tool commercial real estate professionals can capitalize on to lessen their tax burden. What it does is allow you to accelerate the amount of depreciation you can claim on your taxes in the first few years you own the property. The way this works is that cost segregation allows you to add up parts of the building, from appliances to the draperies, and instead of writing it all off over a 27-and-a-half-year period, you can write them off over five years, or even all of it in the first year using bonus depreciation. Bonus depreciation is being slowly faded out by the IRS, so if you can do it, you need to do it now. Either way, depreciation and cost segregation are powerful tools for the commercial real estate professional.
