One of the biggest eroders of wealth is taxes. Many people tie themselves in knots trying to reduce, eliminate and avoid taxes. Others are careful not to let the tax tail wag the dog. The tax code is written to incentivize investments in different areas of the economy, and passive investment in real estate receives a great number of these tax advantages. Conventional financial opinion would put most of your tax burden into Bucket One and Bucket Two. Passive investors looking to reduce their tax burden prefer to maximize their investments to be taxed in Bucket Three. We will cover all three buckets below.
Bucket One – Active Ordinary Income
Most passive investors have a W-2 income that they receive for exchanging their time for money – i.e. they have a job that pays a salary. That salary is often taxed at the state and local level, but is always taxed at the federal level. For the purpose of this discussion, we will focus on federal taxes. This is tax Bucket One – Active Ordinary Income. This is money that you earn, either on a W-2 or a 1099, actively working at your job. This income is taxed at the highest marginal rate. The more you make, the higher your tax rate.
The way Bucket One is taxed is one of the reasons the 401k is so popular because, as conventional wisdom says (i.e. what the financial industry wants you to think and do) – you should max out your 401k in order to lower your current taxable income. That’s a great idea if tax rates are high now and will be lower for you in retirement, but what many people don’t understand is that taxes may not be lower when you retire.
Left Fielders use Bucket One income to purchase assets that produce income in Bucket Three in order to reduce their overall tax burden as well as to replace their W-2 income with true passive income.
Bucket Two – Portfolio Income
Many passive investors, especially when they are first starting on the passive investing journey, also have money in the “market”. This could be stocks, bonds, mutual funds and other assets from which you collect interest, dividends and capital gains. This is often taxed at a rate lower than Bucket One and is often thought of as passive – i.e. you are not actively engaged in earning this income. This is where it gets confusing because although this bucket is technically “passive income”, it is not the type of passive income that the tax code treats most favorably. Losses from Bucket Two, usually in the form of losses on stock and mutual fund sales, can be used to offset gains – but only gains from Bucket Two.
Left Fielders often divest from many of their Bucket Two assets in order to buy assets that will be taxed in Bucket Three.
Bucket Three – Passive Income
This bucket is the most advantageous from a tax perspective and deals with passive investments in real estate, typically rental real estate, capital gains from the sale of real estate and passive syndications. This bucket allows any loss, including depreciation, to be offset by any gains in the bucket. If the losses exceed the gains, then the losses can be carried forward indefinitely to offset gains in the future. The gains (and losses) can come from the sale of a property or syndication or the cash flow from a property or syndication.
The tax law passed in 2017 enhanced this bucket with the concept of bonus depreciation and cost segregation. Usually when a syndicator purchases a new property, they do a cost segregation which basically separates real property from personal property and allows the purchaser to depreciate different parts of the property on an accelerated schedule. Bonus depreciation allows the purchaser to accelerate the schedule even further by allocating a large chunk of the depreciation to year one.
The effect of this for passive investors is a large paper loss in year one of the investment that usually far exceeds the cash flow gain in the first year. For example, if you invested $50,000 in a syndication, it is not uncommon for the syndicator to deliver 70% of your investment as a paper loss in year one (using cost segregation and bonus depreciation), so that would be a $35,000 loss in Bucket Three. If you received a 10% cash-on-cash return in year one, you would have received $5000 in cash flow from the investment. You would be left with a $30,000 loss you can use to offset any other gains in Bucket Three. As always, there is a downside – when the asset is sold, you must recapture the depreciation and pay tax on the amount recaptured. In effect, the benefit of the depreciation is to defer tax on the depreciated amount. However, if you invest in a new syndication in the same tax year as the sale of the previous syndication, your new depreciation can offset the depreciation recapture of the sold asset. This is what some investors call the “Golden Hamster Wheel” – you continue buying new syndications in order to continue deferring taxes.
The depreciation strategy can also be used as a “Lazy 1031”. A 1031 Exchange is where you sell one property and defer the capital gains tax if you use those funds (within a certain time frame and under specified conditions) to buy a new, similar asset of greater value. If done properly, the capital gains tax is deferred. 1031 Exchanges can be complicated and force you to buy a larger asset when that might not be the best use of your sale proceeds. The “Lazy 1031” is where you sell a property and use the proceeds to invest in passive syndications that will produce paper losses that can offset the capital gains.
Left Fielders seek to have a significant portion of their assets and income in Bucket Three which can result in a significantly lower overall tax rate than they had when they were conventional investors (Right Fielders).
Passive investing brings tax benefits and understanding the different buckets is extremely important. However, as with all tax situations, it can get complicated so be sure to seek advice from your financial adviser and CPA to translate the advantages to your particular situation.
Jim Pfeifer is one of the founders of Left Field Investors. He is a full time investor living in Dublin, OH. He has invested in over 30 passive syndications in his quest to become financially free through the acquisition of real assets that produce real cash flow. You can connect with him at firstname.lastname@example.org.
Nothing on this website should be considered financial advice. Investing involves risks which you assume. It is your duty to do your own due diligence. Read all documents and agreements before signing or investing in anything. It is your duty to consult with your own legal, financial and tax advisors regarding any investment.