Episode #087- How to LOWER Your Effective Tax Rate Using Commercial Real Estate!

Today hosts Braden Cheek, Brian Duck, and Joel Thompson discuss ways to save money on your taxes by utilizing various Commercial Real Estate tax codes!

Welcome back to how to invest in commercial real estate new week. What's up? What's going on, brian Joel? How was that? Ou game brian was fantastic. How is that? Ou game that's a little leading. Yeah, that was pretty ugly. It only took ou one quarter to beat o sus four quarter performance. Actually it only took two quarter to half of the first quarter. It was at 14 points. They had him beat. Yeah. I feel like if os you could have like showed up for the rest of the game, it was theirs theirs to win because you didn't show up for the rest of the game. Oh you just quit after the first quarter. Like we got it done after that. It was terrible. Oh well. All right. What else we got, Well I played a game of monopoly this weekend with the kids and that game got me thinking, You know, what's the first thing you do when you go to monopoly, you get all this money right? And then you start playing the game and you immediately land on a property and it's up for sale and nine times out of 10 you buy it by right?

Of course that's what you do. You buy it. Somebody else lands on it. They pay you rent. So no brainer. But when we're not in the game, people over complicated, they over think about it. They stop buying things. And and I saw this picture of this meme, It's like imagine playing monopoly and going round and round and round collecting $200 every time you pass go and never buying an asset that produces cash flow. Yeah, you would, you lose, you lose the game and it would suck. It would not be any fun. It doesn't matter how much money you accumulate sooner or later, you're gonna lose monopoly if you don't buy assets because you're paying all the rent To everybody else and it was just like this, you know, anecdote to life, right? It's so easy to get stuck in a job Pascoe, collect your $200 and then go pay it in rent, pay it in consumable things and never really advance. If anything, you're, you're losing money everything time. So just get out there and buy something that produces cash flow, right? Don't go buy something for your first investment where you're like, oh this is gonna go up, trust me, this is gonna go to the moon. Like buy something that pays you next month. That's, that's guaranteed If you're super wealthy and you don't need cash flow to live, then you can buy assets that produce no cash flow.

And with the hope or expectation that 10 years from now, 20 years from now they'll be worth, you know, double triple quadruple what you paid. But for the average person you can't take that risk because you need the cash flow to live and you just can't say, well I hope in 10 years it's worth more, what if you're wrong on that piece of property or that asset. But the problem is most people are doing what the world tells them to do with extra money is buy a boat or by a four wheeler or by a lake house or whatever they're buying. And uh, that's gonna end up bad or not bad, but it's just not going to maximize your potential long term. And speaking of what everyone else is doing, I forget who set up this famous quote. There's three things that are for sure in life, life, death and taxes, right? And today we're gonna talk about the third taxes. It's the most important thing. So for the average person, the average american, you know, will, will not cherry pick states here, but the average american pays 37% on ordinary income tax, 37%. I don't, I don't think that's accurate, right? The average is less than the average is less than that, But max is 37 and there's a lot of people, there's a lot of people that pay 37%.

Even though the average American may pay, you know, just for the show. So we don't get a bunch of hate mail. The average is going to be way less than that because there's a whole segment of the population that either pays little or no tax just because of their income is low. But yeah, a lot of people are over the 37% federal and that's and that's not including the state. So combined, they're going to be 45% of their income or more when you add in social security, Medicare, they may be close to 50% and that, you know, I hate to try to guess what that number is gonna look it up before the show. But if you're over, you know, 350,000 I think, or so you're gonna be in that top tax bracket. So if I told you I was gonna give you $100,000 free and clear. But the other option I was gonna give you, you know, $200,000, but you end up paying 50% taxes. It's kind of the same thing, right? So at some point, saving money on taxes is almost the same as making money. It's all about net cash flow at the end of the day how much you keep and if you're paying all that money in taxes, you're not keeping it. So this show is gonna be about how to keep more money through the power of real estate.

Yeah, let's do it. So what are the, I think we came up with three big ones that people need to learn about in order to reduce that tax burden with real estate. Yeah. So the first one is cost recovery or depreciation. And this is a beautiful thing because it's something that you get to write off every year as a negative, You get to subtract it from your taxable income and you didn't actually incur this expense. That's huge because the government is saying, hey, I mean will allow you to do this even though you didn't spend that money, that doesn't happen very often. And most taxable things were, I mean, you hear about people, I bought a new truck, why? So I didn't have to pay taxes like they spent $70,000 to do that to to write off $70,000. So this is the way to write off potentially hundreds of thousands of dollars without spending anything, right? And it's, it's depreciation. So why, why are we allowed to depreciate real estate? Well, I think the thought is that all these big capital items that you're gonna potentially have to replace, like the roof, the parking lot, you know, the framing, the plumbing, all of that is going down in value and will need replaced at sometime in the future.

And so they allow you to do a general depreciation of real property every year. And and that way you get to take advantage of that, uh that that loss that you're not incurring, but you may have to incur in the future. So you said real property, you can't appreciate everything, you can't depreciate land, right, Because the improvements on the land or the buildings, let's say on the land, is that the only thing you can't depreciate is the land, um the buildings. You can, but is there anything, I mean, that's all there is building and lands. Right? And so that's that's the dividing point is you have to figure out how much of it is the land worth and how much the rest of it's worth. Is that right? That's all your accountant can help you do that. The appraisal will take that into effect as well, appraisal might might segregate, segregate that out and say how much the land is worth and how much the building's worth. Okay. And so they give you a schedule. And so for residential property which could include single family duplex all the way up to large multi family. To my understanding, if you're going to take the I.

R. S. Code, it's 27 a half years if I remember right? And so what you would do is take, let's say you bought a $5 million building and the land is, you know, 15%. And so then you're going to four and a quarter million you're gonna be able to appreciate. So you divide it by 27 or 27 a half and that's your yearly depreciation. So let's say you have your we've gone over a profit and loss and you have uh, you know, you're all your income and all your expenses. So let's say the investor is making a 10% return on the $5 million 8020 loan. So they put on a million bucks And the property they're expecting, you know, 10% return on that. So they're making $100,000 a year in cash flow, depreciating improvements are four and a quarter. Right? So take a, take a guess. I've done the math, take a guess at what the first year depreciation is going to be. Mm, No idea. I'm gonna say 180,000, 180,000. That's good guys. So it's 100 and 5454. You made $100,000 in cash flow. So you put $100,000 in your, in your pocket, You put $100,000 in your pocket and you got to write off $154,000.

So you now have a lost credit of $54,000 on your tax return. And you can get on, you know, sooner care if you wanted to because you, you lost money. But really you just put $100,000 in your pocket. Okay, Every investor can do that. There's no limits on that. Great. You, you guys and your technicality. It is a good question and everybody can write off 100,000, what happens to the other 50, you get 50,000 more than you can write off that will go stay on that tax return for that property and you'll carry forward that to the next year. But, and then also isn't there accelerated depreciation. There is, there's that straight line depreciation. So what you're talking about is doing a cost segregation study on a property. And we've mentioned this, I'm sure several times throughout the podcast, but a cost segregation study is exactly what it sounds like they go and segregate all of the costs associated with building that building, because they say that the different parts of the building, like a light switch may have appreciable life of five years.

So now you can write off 1/5 of that light switch every year. So they go and study the building and say, hey, this stuff is actually going to deteriorate like 5 to 7 years, whereas the majority of it's gonna deteriorate a lot longer. So it allows you to appreciate way more up front. So if you're looking at 27 a half years for a residential property, the first year is about 3.5% of the value of the improvements that you can write off the first year, and with the commercial property, so that's nonresidential. Commercial property is 39 years. And so the first year it turns out, you can write off about just under 2.5% in your first year. And then every year after that, by using the cost segregation study, you can get that up to 89% or more, the first year. Is there any reason you wouldn't want to do cost segregation method, it seems like you would want to, because then if you sell the property, uh and you've depreciated more, then that's to your advantage in it because the depreciated value is less. So you're so your gain is less, right? I mean, I think it really depends.

It'll be a, you know, a decision that each person has to make based on the the the other parts of their tax situation. But uh the depreciation, so you get to write it off this year. But when you sell the property, you got what's called a recapture that if you, you know, so so you'll have to catch that back up and that you you recapture depreciation at 25% say that again and again. You recapture depreciation when you sell at 25%. So if you are, you know, paying, let's say you don't make a lot of money uh in addition to your, you know, apartment investing and you're at a 10% tax bracket, you're not, you wouldn't necessarily have to depreciate the property in order to take advantage of the situation. But if you're at a high tax bracket, well now you can get the benefit of keeping a ton more of your income. And then when you like, let's say you're at a 40% tax bracket or 35% total tax bracket. Now when you recapture your only recaptured at 25 and you got that basically interest free loan from the government while you held that property.

So most people are, it's gonna benefit in some way or another interest free loan from the government. So, yeah, that is, that is exactly what it is they're saying, you can keep your $100,000 don't pay taxes on that will allow you to appreciate 100 $50,000 will do the same next year. We'll do the same. We'll continue to allow you to write off depreciation against your actual cash flow that they know you're taking and we'll tack Lower than you're probably lower right, because most real estate investors, let's face it, they probably have excess cash that they're being taxed on to then invest in real estate. So they're probably paying a higher tax rate than 25%. So there's a net savings for them. They're allowed to take it now and they pay less tax later. That makes no sense. How do they say you can pay us less taxes now and less taxes later? It seems like they should get you at some point, but they don't, And so the depreciation that you're taking, you can count that again offset capital gains and income, both with that depreciation on your taxes. Um, You can offset capital gains with depreciation, I believe so, yes, yes, because they're both passive forms of income, I believe.

Get advice from a tax accountant. What you can't use that, let's say extra depreciation to write off against is ordinary income or active income. Uh So the only exception of that, we've talked about it before, and we may have even done a podcast on it is if you qualify as a real estate professional, then any law, any losses that you make on, any investing activities in real estate can be, can offset any income that you make. And, and so that's the only exception is if you can qualify as a real estate tax, but otherwise, if you're an restaurant, a deal and you are getting cash flow from a deal and you have more depreciation, then you have cash flow. It just stays in that deal and rolls to the next year and you get to you get to use it again against future income because maybe your income will go up and and your, your depreciation may stay the same if you haven't cost segregated the than the study. And so that way, as the cash flow increases, you have depreciation sitting there in your tax return that you can offset for future years. Okay, Real Quick one More question, who does the cost segregation study?

There's a bunch of companies out there that you cost segregation studies, just type it in google, put a little bit of effort, You'll come out with some knowledge. Okay, that's the first one is depreciation and it's so valuable with real estate, it's really what sets real estate apart from some of the other asset investments that you can look at second, It's arguably why the real estate designation was created is depreciation. Right? So, so the active big active income earners weren't just buying depreciation from anyway. So to figure out your tax liability, you take your sale price honestly adjusted basis, which is just the cost you paid for the property plus any cost that took you to buy that property. And then you subtract your depreciation again, because you're paying depreciation. Recapture on that. And this is your capital gains or the amount that's subject to capital gains. And capital gains is an even lower tax bracket than depreciation. Recapture. Capital gains is 20%. Well, depends, depends. Right here we went and wrote this down. Just so you'd have an idea if you're married filing jointly and there's, there's for, you know, you can file single, you didn't, you didn't single out single people.

But what about the head of households out there? Uh, those are less than married filing jointly. So I just went with that. But you can look it up and they're actually pretty similar. But the capital gains tax percent Is 0% for any capital gains, uh, from zero to about $90,000 in a given year, married couple. That's free. So once again, that's the reason you should be buying assets, not just real estate is any asset that, that you get capital gains on. Uh, you get a free $90,000, you don't have to pay income on. I mean, come on, that's a great deal people that that makes 70, 60, 5090, they're all, you know bitching about the taxes they pay well here. If you invest in assets you can get free 90,000, then it goes from uh it goes to 15% from about 90,000 to about 550,000. So 15% is lower than most people are paying. But you know, it's really lower than is an active income earner making 400,000. They're gonna be in the 35% tax bracket.

And so here if you make another 400,000, you're not paying 35, you're paying 15. And then the last bracket is anything over five, about 550,000, you go to 20%. And so that's why people focus on assets because you can make an infinite amount of money and you're only getting taxed at 20% not paying half of your income like most high-income earners. So it's a real big advantage. Theoretically, you could make what like 17, less. If you're only making money in capital gains instead of active federal level. Yeah. So you could be 17% less productive or less there. You could Miss 17% of days at work and just buy assets. I mean it's crazy. Most for most people, their tax bill is the most, it's the most expensive thing they have to pay. It's the biggest expense they have in a given year. And so people spend money all or spend time trying to reduce expenses, trying to save money, They do it all the time. But most people don't spend any time educating themselves on taxes and how they can lower that bill even though it's their biggest expense.

So the effective tax you're paying on real estate, we're going to assume not average, we're going to assume you're in the max tax bracket, you're paying 35 37% on active earned income. If you made that money in real estate where you started investing in real estate and started making money through real estate, your average, you know, average tax rate or effective tax would not be 37% on that real estate investment would probably be like 26 27% after you take in The depreciation recapture at a max of 25, the long term capital gains at a max of 20, you're paying way Less between 20 and 25, Right? It wouldn't be over 25, It wouldn't be over 25 appreciation recaptures 25 capital gains, which is most likely going to be bigger than your depreciation recapture is at 20. So it'll be could be 20 to 23 that's if you're paying all the taxes that you owe on real estate. But the last thing we want to go over today. Don't make this show a little bit shorter is the 10 31 exchange.

And so Brandon. What is it? Yeah, the 1031 exchange is what they do to help incentivize reinvestment back in real estate. So when you sell a real asset, you're allowed to take that basis and exchange that basis of equity into a new property while deferring the tax. So when you sell the new property, you pay the tax on that basis from the old property. Alright, So let me give you guys a little bit of an example. I like to use five million because it's kind of an average commercial real estate site. So we could use a million. Does't matter. But let's use $5 million. You buy this property, you hold it for a long time. And let's say you did the cost segregation study and you've held it for 10 years, 15 years now, you've appreciated that down to $1 million. Uh Your your basis down to $1 million. But in that 10 years, the value of that property has gone up to uh let's say you got really lucky. He went up to $10 million. Yeah. Well, I mean it's it's happened in in the last 10 years. You're lucky. You're So now we go to sell it. What what would be my tax burden?

Well, I've saved money on taxes the whole 10 years I've owned it. But now I've got to recapture that $4 million $4 million 25%. So that's $1 million dollars in tax burden. And then on the $5 million I owe another million 20% on the capital gains from the five million I bought it to the 10 million I sold it sold it for. That's another million. So my tax burden is $2 million. Now. You could say, well you know you you paid your mortgage down over that 10 years. So you only owed, let's say three million when you sold it and you sold it for 10. So you're coming out with seven million Joel. And you can pay two million in taxes. But what if I wanted to invest the whole seven million. Getting that working on a bigger property. But what if I didn't if I didn't want to pay tax? Yeah. What if you didn't want to pay any taxes? Well the 10 31 exchange says as long as you take whatever you come out of that property with five million. Seven million. Two million. As long as you reinvest that into a building or two or three buildings equal size equal value of $10 million building within six months.

Within six months. Then you defer that tax invest the total amount. You couldn't just take some out put in the bank and whatever you take out is uh is taxed and and it's taxed heavily. You have to I can't I don't want to speak to um How much? But I think if you only kept two million then I think that that that may all go for that two million that you owed. We haven't we haven't done it. But yeah there would be. You can actually take some but you would owe a significant amount of tax on the small portion that you kept. And on the flip side of that you just said you have to buy a similar sized deal. You can't just put that seven million in and then go grab another seven million. And of course you wouldn't get you'd be. I mean there's no tax savings on that second. Seven million. But you could buy something much bigger. Couldn't you do that? As long as the value of the properties that it can be one. I think up to three. Or maybe even more. Um As long as you're buying properties that that are equal to or Greater than the 10 million that you purchased that property or that you sold that property for your good.

And then how similar do the properties need to be? I mean not at all really. I mean there's a lot of latitude it needs to be real property. Okay. Can't be ownership interest in L. C. That trips most people up right there. You can't you can't add new partners. I mean it's it gets kind of hairy. But there may be specific examples that you could do, um, like stock purchase if you sold it to a public company. But I don't want to really get into that. It's pretty complicated. But generally speaking, it's any real property that, that you are the owner of. Or let me say this, the seller of the property needs to be the buyer of the new exchange property. That actually makes way more sense. Yeah. So it could be an LLC sold here. That LLC needs to be the buyer. Uh, if you're the seller, you need to be the buyer. Yeah. Don't sell something. Take all the money from the title company and then go to your account and say, hey, I just got all this money from closing and I want to do a 1031 exchange because you already messed it up already. You want to know. So could you say, I'm not sure if I'm gonna be able to do a 1031, but you go ahead and make provision for it and then if you don't find a property, then then That's a good point exactly what you do.

I don't want to make this show because you could do a whole show on 1031 exchanges. But yeah, basically ask your accountant, your attorney and Your title company when you're about to sell a property. Hey, I want to do a 1031, what steps do I need to take? But generally the title company or some other intermediary a needs to hold those funds while you're out looking for your property of 45 days to identify a new property, you have six months to close on that property. So if you try and you don't find anything to exchange into, then you just take the funds and pay your taxes. Okay. Like you said, we could talk about 10 31 exchanges, um forever because it truly is a wonder of real estate, but we're going to cut it there. I I think this helps a lot because we've always talked about the tax advantages, but just conceptually thinking, you know, going from 35 37% active income tax rate to potentially 20 to 25% being invested in real estate? That's a real delta. Their income today on cash flowing properties that you do not have to pay income on or you'll have to pay on a, on a lower amount than you're actually getting.

That's a huge benefit along the way that people need to know anyway. If you're interested for this video to your accountant, they'll probably say we're idiots and correct this bunch. But it will at least prompt you to start thinking about how do I get more depreciation in my life. How do I start paying capital gains taxes instead of ordinary income taxes? How do I exchange the basis in my assets to potentially defer taxes. These are some questions you need to be thinking about when you're making your next investment, when you have your next meeting with your C. P. A. When you have your next meeting with us, because you're interested investing in commercial real estate. All great questions anyway, we will catch you next week on how to invest in commercial real estate.