Tax Tactics That Only Rich People Know
Do you ever feel like the rich just keep getting richer? Well, allow us to let you in on a little secret: Part of the reason they keep on raking in dough is that they take advantage of real estate tax strategies that many ordinary homeowners have no clue even exist. So what are they, exactly—and can we ordinary mortals take advantage of them, too?
For starters, most of these strategies involve investment properties—in other words, not your primary residence. So if you have a cabin in the woods or a beach house that sits empty most of the year, you might be in luck. Read on to follow in the well-heeled footsteps of the wealthy and maximize your tax savings this year.
Strategy No. 1: Take advantage of ‘safe harbors’
Smart investors don’t let second homes lie vacant, but rent them out, says Crystal Stranger, president of 1st Tax and author of “The Small Business Tax Guide.”
Not only will you make extra cash, you can deduct expenses such as repairs, insurance, real estate taxes and mortgage interest, says broker and attorney Bruce Ailion of RE/MAX Town and Country Commercial in Atlanta, GA.
Even better, the IRS has what’s known as a “safe harbor” rule for rental property expenses that, after Jan. 1, 2016, was expanded from $500 to $2,500. Here’s what that means for you: Let’s say the cost to replace the roof on a rental property is $4,500. Ordinarily, this would be a capital expense you’d have to deduct over the life of the roof (so, $180 per year for 25 years). But if you break the cost of the roof into two smaller bills (let’s just say $2,400 for materials and $2,100 in labor), since they’re both under $2,500, the IRS allows you to deduct these expenses all in their first year, in their entirety—and added together! So that ends up being a massive first-year deduction of $4,500.
One red flag: If you personally use the property for more than 14 days during the year, your tax implications can change, so check with your accountant to make sure you’re in the clear.
Strategy No. 2: Depreciate your rental property
The IRS views a rental property as a business expense and expects it to depreciate over time. Ka-ching! You can deduct a portion of the cost of the home—what are called deprecation losses—for upward of 27.5 years (the amount of time the IRS thinks is the deductible life of a single-family home).
Tom Wheelwright, CPA and author of “Tax-Free Wealth,” gives this example of how depreciation works: Suppose you buy a duplex for $400,000 this year with 20% down ($80,000) and a $320,000 bank loan. Let’s say the duplex produces an annual cash flow—after expenses and mortgage payment—of $24,000. According to the IRS, the depreciation deduction for this property should be about $32,000 for the first five or six years. Since that depreciation ($32,000) amounts to more than your cash flow ($24,000), this actually produces a tax loss of $8,000 a year ($32,000 to $24,000). With proper planning, that tax loss can offset your other income, saving you a bundle.
Strategy No. 3: Depreciation is actually a ‘phantom deduction’
The rich know that these depreciation losses for rental properties—defined by the IRS as an allowance given to property owners for the “exhaustion, wear and tear (including obsolescence) of property”—is, in fact, a “phantom deduction.” Phantom because, as Than Merrill, CEO and founder of FortuneBuilders.com, points out, while the IRS compensates landlords for the depreciation of their assets, homes tend to do the opposite and appreciate in value. And therein lies the true value of depreciation losses: If the value of your property rises, the loss the IRS allows never actually takes place. So you save money on taxes and make a profit at the same time.
Strategy No. 4: The 1031 exchange
When it comes time to sell an investment property, wealthy folks never worry about paying taxes on their profits. Why? Because they take advantage of what’s known as the 1031 exchange. This tax rule allows people to sell an investment property for a profit and move the proceeds directly into another investment property while deferring the tax liability. If done right, you can ratchet up the value of your holdings in real estate without eroding your capital by paying capital gains tax, says Ailion.
Let’s break down how it works: If you sell a property for $500,000, you then have 90 days to find a replacement property of equal or greater value (while a qualified intermediary holds the proceeds) and then 180 days to close on that property. As long as you don’t touch the money in holding before closing, no tax will be due on the original sale.
Strategy No. 5: Leave more money to your heirs
If you use the 1031, your heirs will be left with real estate that has a much lower tax basis than its actual value when you die. This is because the tax law specifies that when someone passes away, the gain inherent in their investments disappears, says Wheelwright.
For example, that property you bought under the 1031 exchange for $500,000 might be worth $1,000,000 when you meet your maker. Your heirs can immediately sell without paying a cent of capital gains tax. While they may pay estate or inheritance taxes, the overall tax savings are massive.
Want to take some cash out of the property while you’re alive and kicking? Simply refinance the property and take out a home equity line of credit (HELOC). The rich also know there is no tax on debt, so a HELOC is an easy way to get cash flowing without having to pay up (at least to Uncle Sam).
Need more tips on how to be smart with your taxes like a pro? The original Realtor.com article from which this post was based can be accessed here.