Episode 110: Ask Pancham? #5
Ever wondered how you can reduce your tax liability? Is it even possible to lower your taxes? The answer to both questions is YES. In today’s episode, we’re back with another Ask Pancham Show as he will share all about how you can keep your income rather than paying it for taxes!
As the tax season is fast approaching, tune in as the host himself will discuss the power of real estate investments in terms of keeping your wealth. Learn the efficient way to lower your tax rates so listen until the end of the episode!
Tune in to this show and enjoy!
- 0:37 – Question of the Day: How can you use depreciation to offset your W-2 income
- 2:31 – Classifying the 3 types of income
- 3:47 – How passive income can lead to a lower effective tax rate
- 7:05 – Why being a real estate professional can help offset your active income
- 10:02 – Misconceptions on what it takes to be a real estate professional
3 Key Points:
- Minimize your tax position by shifting your earned income to passive or portfolio income.
- Passive income is not subjected to high effective tax rates since these are covered by depreciation and amortization.
- If you’re a qualified real estate professional, you can use your passive loss to offset your active income and can save a lot of taxes.
Get in Touch:
Welcome to The Gold Collar Investor podcast with your host Pancham Gupta. This podcast is dedicated to helping the high-paid professionals to break out of the Wall Street investments and create multiple income streams. Here’s your host, Pancham Gupta.
Hi there, I’m Robert Helms host of The Real Estate Guys radio program and if you want to have better results in your life you gotta put better ideas in your mind. You’re in the right place. You’re at The Gold Collar Investor podcast.
Pancham Gupta: Hello. Welcome to another episode of The Gold Collar Investor Podcast. It’s a bright sunny day here in New York. This is your host, Pancham. Really appreciate you for tuning in today. We have another edition of Ask Pancham episode for you. It’s been a while since I’ve done this Ask Pancham episode. Last time I did this was with Rajan and I was, I think right after COVID. As the tax season is upon us, I would like to discuss a question that I get asked a lot, especially from people who are making high incomes in their jobs. They look at their high taxes every year and always wonder how they can reduce their tax liability. Usually, most companies do their year-end performance reviews around this time of the year as well. Some do in December, some do in January and February and depending on your performance, you get either 5,10, 15-20% raises in your salaries. Now, think about this. What if you’re able to reduce your taxes by 1,2,5-10%. You will be giving yourself a raise by that amount, you will be keeping more of your salary in your bank account, then paying it as taxes to the IRS right? So, I did a show with my CPA on this topic right when I launched the podcast, and you can check out the show if you have not listened to that show. It’s a really great show. It’s a show number four, you can actually get to the show by going to thegoldcollarinvestor.com/show4 , again, thegoldcollarinvestor.com/show4. Also, please note that I am not a CPA, please do not consider this as a professional tax or financial advice. Do consult a professional before you execute on any of these strategies. So, the number one question I get from the investors is around this time of the year. How can I use depreciation from these properties, the syndication that they are investing in all the active investments in real estate that they’re doing to offset their active W2 income. Before we get started, let me break the three broad categories of income. The three types of income are; earned income, passive income, and finally the portfolio income. This is how IRS categorizes three different kinds of income. So, what is an earned income? Earned income consists of income you earn while you’re working a full time job or running a business. Know that running a business does not include a rental, real estate business in most cases. The second kind of income is the passive income. Passive income is the income that is earned from rents, royalties, and stakes in limited partnerships. And finally, the third one is the portfolio income. Portfolio income is income from dividends, interest, and capital gains from stock sales. Portfolio income will not be discussed in this particular episode. So now, the earned income will always be subject to the high taxes. The earned income is the income that most high paid professionals have, which is the W2 wages. Earned income should quickly be used to build wealth but in order to minimize your tax position, your wealth should be moved into passive or the portfolio income streams like we discussed the second and number three. Earned income is subject to your full marginal tax rate and the FICA taxes. Okay, so now the passive income, which is a second kind of income, as we discussed, from the rental real estate is not subject to the high effective tax rates. Income from rental real estate is sheltered by depreciation and amortization and results in a much lower effective tax rate. You know, we will talk about an example here to make it clear. We’ve discussed this before and even in the show that I did with my CPA, but I’ll take a small example here to kind of talk about what this passive income is and how the effective tax rate is lower, and then we’ll discuss how you can go back to the question that I get asked the most. So, let’s say you own a rental property that nets $10,000 before depreciation and amortization. Let’s also assume that your depreciation and amortization totals about $8,000. This leaves you with $2,000. In net taxable income, if you are in the 37% tax bracket, you will pay a tax equal to $740. But when we compare that $740 to the amount earned, which is $10,000, you see the effective tax rate of only 7.4%. If you own that same $10,000 in earned income, which was the first category, you will need to spend money in order to reduce the amount subject to tax, otherwise, we’ll pay $3,700 on that $10,000 earned income assuming you’re in the 37% tax bracket. And for the W2 wage earners, like you cannot even spend more that’s for the business owners. But yeah, you know, if you’re in 37% tax bracket, and you own $10,000 more, guess what, you’re paying $3,700 in the taxes on that $10,000. So now with rental real estate, you don’t have to pay for depreciation each year. It’s a phantom expense on paper that you get to claim. So that’s the beauty and power of real estate. Now, it is common to actually have a passive loss overall from your rental portfolio or your investment in syndications even though you have actually made money during that year, so that Phantom loss from your depreciation is far more than the income that you actually make on those investments. So that would actually create a passive loss. So now getting back to the question, can you use your passive loss to offset your active income? So, your passive loss, which is from your passive activity in rental real estate, to offset your earned income, which is the active income? The answer is yes if you are a real estate professional. Now, what is a real estate professional, that is an IRS term. And it is actually, it gets very complicated the definition of it, if you want to talk about the real definition, it can be best explained by a CPA and I will have a CPA to discuss this topic in detail. But for now, I will keep it very high level and simple. And for the people who want to go into the nitty gritty, please don’t pick on this because this is at a very high level just to explain the concept. So, you can become a real estate professional if you spend more than 750 hours during the tax year in real estate. And that is more than half of your total time spent. So, if you can prove that, that you are working on real estate stuff for more than 750 hours, and that is more than your you know, half of the total time spent on your total activity in that year, then you are qualified as a real estate professional as far as the tax status goes. Now, once you qualify as a real estate professional, then your passive losses become active losses. They can offset your active income. Now imagine, if you invest in a syndication deal with $100,000, let’s say and you get a passive loss of $50,000 at the end of the year. And guess what? This is actually not uncommon at all, this is actually very common that you are getting about $50,000 loss and you make about $8,000-$10,000 that year, and you have that much Phantom loss, a passive loss. Now, if that loss is converted to active loss because you are a real estate professional, then you can offset your W2 income with that $50,000 loss. Guess what can do to your overall tax liability, your income bracket will go down, potentially, and also you will save a lot in taxes just by that reduction. So now imagine if you had invested in two or three or four different syndications or rental properties in just one year, one tax year, you know, and that passive loss can become active, and it can go higher and higher and hence lowering your income even further. A few things to note here though, you know, guys, this is extremely powerful, you know, I made it very, very simple, very simple explanation. To qualify for real estate professional, it’s a lot of work. But here are a few things to note; First, it’s not easy to become a real estate professional if you have a full time job. Likely, one person has to be working on it full time. So, if you’re married, you know, your spouse has to be working on it full time or at least 750 hours, what I just discussed in real estate stuff, okay, so for you to qualify as a real estate professional. Second, a lot of people think that being a real estate professional means that you have to be a real estate agent, or you have to have a license, some kind of license. That is not true. Being a real estate agent does help with the real estate professional status, but it is not a requirement. For example, I mean, I can take my example, I am a real estate professional, but I don’t have any license, any real estate license, you know, I’ve not taken any real estate exam. So yeah, so that’s another kind of, you know, misconception. And number three, you have to also know that all of this depreciation, this bonus depreciation that you get from real estate gets recaptured at the time of sale of the property. And you have to pay taxes on that money at a depreciation recapture rate. At the time of in that year, when whenever you sell it. So, it is more like you’re deferring your taxes to a later date, depending on whatever your income tax bracket is, at the time of the year of the sale, you will pay, actually, that’s not true, you will pay basically the depreciation recapture on that sale, like when you sell it. So however, you know, you don’t even have to pay that if you do your tax planning every year like you should, you can invest in a new syndication the same year the old, syndicated property gets sold. That way the depreciation from the new property that you had invested in will offset the gains from the old property that was sold, right? Because, you know, hopefully if the gains are a lot more than the loss, then yeah, you will have to pay tax, but you know, potentially that can be done where you are offsetting your gains from the sale with the investment in the new property. Again, it’s not easy, you have to really be strategic and plan for it. But it can be done because properties are not sold overnight, just like stock, you know, you wake up one day, it’s not like you know, the property sold by the time you are done, you know. In the day you open your account, and you don’t click a button, it takes about two three months, solid two three months to actually sell anything when it comes to real estate. So, you know, if you have invested passively in a deal, hopefully you know, the sponsors will tell you that we are planning on selling this property and you know, they are going to prepare for the sale and it will take 2,3,4 months to sell it so you have enough plenty of time to actually plan for investing in another syndication or you know, buying a property by yourself whatever you want to do. So, there you go. This is my little, you know, answer to the question that I get asked a lot around this time of the year, which is how can I make my passive losses to offset my active income which I get from my W2? So hopefully that answers part of the question. This can be a good strategy for some people it can really work out. For some people, let me know if you do think about doing anything about this. I would love to hear from you. I would end up by saying this though. I’m not a CPA, please talk to your CPA before you take any action on the things that we discussed today. With that, I really appreciate you. Thank you for listening. If you have questions, do not hesitate to reach out, you can email me at firstname.lastname@example.org. That’s p as in Paul @thegoldcollarinvestor.com. Until next time, take care.
Thank you for listening to The Gold Collar Investor Podcast. If you love what you’ve heard and you want more of Pancham Gupta, visit us at www.thegoldcollar investor.com and follow us on Facebook@thegoldcollarinvestor. The information on this podcast are opinions as always, please consult your own financial team before investing.