Introduction
High earning W2 individuals are often left disappointed when looking for ways to reduce their tax bill. Once all the traditional levers are pulled such as IRAs, 401ks, HSAs, and other “low hanging fruit”, they’re left with a significant tax bill. What these high performing individuals often overlook, however, is real estate investing! Real estate investing is one of the best options available to reduce your tax bill while building wealth. Real estate investments can provide a variety of tax benefits that can help lower your total tax burden and provide you with more of your hard-earned money. In this article, we will explore how to use real estate investing to reduce your tax bill as a high-earning W2 individual. We’ll discuss the types of investments available to you, how to analyze deals, as well as the different deductions and credits that exist that can help you save on taxes. Read on to learn more!
Depreciation Counting Against Ordinary Income
As a high earner, you’re probably looking for any way possible to reduce your tax bill. One way you can do this is by investing in real estate. When you purchase a property, you can depreciate the cost of the property over time. As long as you do things right, this depreciation will count against your ordinary income and help to reduce your overall tax liability.1
To take advantage of this, you’ll need to be sure to keep good records of all your expenses related to the property. You’ll also need to be aware of the different depreciation methods that are available and choose the one that will best suit your needs. With careful planning and attention to detail, you can use depreciation to significantly reduce your tax bill.1
Active Participation Rules & The Tax Breaks They Get You
In the field of real estate, active participation refers to the idea that individuals should be actively engaged in the management and decision-making processes of their rental properties in order to qualify for certain tax deductions.2
Some of the tax deductions that active participation in real estate may qualify individuals for include:
- Deduction of expenses related to the management and maintenance of rental properties, including things like repairs, utilities, and insurance
- Deduction of certain business-related expenses, such as advertising, professional fees, and supplies
- Deduction of depreciation on the rental property itself, as well as any improvements or renovations made to the property
- Deduction of losses incurred from the rental of the property, subject to certain limitations
There are a few key rules that can help individuals demonstrate active participation and qualify for these deductions.
First, it’s important for individuals to be involved in the day-to-day management of their rental properties. This might involve tasks like setting rental rates, screening tenants, and handling maintenance and repair issues.2
Second, individuals should be involved in the long-term decision-making processes for their rental properties. This might include things like deciding whether to make renovations or improvements, setting rental policies, and determining the best strategies for attracting and retaining tenants.2
Third, individuals should keep detailed records of their involvement in the management and decision-making processes for their rental properties. This might involve keeping track of meetings attended, decisions made, and tasks performed.2
Fourth, you also have to spend at least 750 hours working in real estate, and you have to work in real estate more than you work at any other job. For this reason, many high-income earners have found it beneficial to name their stay-at-home spouse as the “real estate professional” for tax purposes.
Overall, in order to qualify for tax deductions related to active participation in real estate, individuals need to be actively and meaningfully involved in the management and decision-making processes for their rental properties. By following these rules and keeping detailed records, individuals can help ensure that they are able to claim these deductions.2
Cost Segregation & Bonus Depreciation for Real Estate Investors
When you invest in real estate, you can take advantage of cost segregation and bonus depreciation to reduce your taxes.3
Cost segregation is the process of separating the costs of a piece of property into different categories. This allows you to deduct a portion of the cost of the property each year, rather than taking a one-time deduction when you sell the property. Bonus depreciation is an additional deduction that you can take for the cost of certain property, such as office equipment or machinery.3
By taking advantage of these deductions, you can significantly reduce your tax bill. In addition, if you invest in real estate through a partnership or LLC, you can further reduce your taxes by passing through some of the income to your partners or members. This can be an especially effective strategy if your partners are in a lower tax bracket than you are.3
If you are looking for ways to reduce your tax bill, investing in real estate is a great option. By taking advantage of cost segregation and bonus depreciation, you can save thousands of dollars each year.3
Material Participation Rule
The active participation rule may be too stringent for investors to meet, so there is the less-strict rule of material participation that you may qualify for easier. This is for working with short-term rentals such as Airbnb’s. For more information on this, read our blog on the material participation rule.
Conclusion
Real estate investing can be a great way for high earning W2 individuals to reduce their tax bills. It may seem intimidating at first but with the right approach and knowledge, you can get started on your real estate investing journey. From leveraging tax credits to understanding depreciation and refinancing, there are many tools that can be used to maximize your investments and minimize your taxes owed. With careful planning, real estate investing can be an excellent way to build wealth while also reducing the amount of taxes paid each year. This is very complicated and we recommend working with a qualified, knowledgeable advisor to help you make sure that you are doing everything correctly so that you can harvest losses against your w-2 income.
While shielding income is great, this strategy should not be the most important strategy in your investing decisions. Ultimately, you should seek to grow your wealth by also making your real estate business successful financially as well. Careful tax planning can maximize the tax law benefits to net you more money in your pocket.
Sources
1: https://www.whitecoatinvestor.com/two-ways-to-use-real-estate-losses-against-your-ordinary-income/
3: https://semiretiredmd.com/dreading-taxes-consider-cost-segregation-and-bonus-depreciation/
When Daniel is not giving financial advice or managing investments, he enjoys renovating properties, real estate investing, drinking coffee, hanging out with friends, spending weekend trips in his camper van, and exploring the outdoors on a hiking or biking trail in his hometown of Roanoke, VA and beyond.