In my previous post I shared that we had borrowed $140,000 from rental properties to use as a down payment for our primary home. This loan will be paid back over a 10 year period covered by the rents. How long will it take you to earn $140,000, and how much in taxes would you have to pay if you were to earn that in a wage? I will use a 33% tax rate in my example (Federal and State income tax combined). If you make $140,000 you would owe $46,200 in taxes ($140,00 X 33% combined tax rate) = $46,200 in taxes owed.
Depreciation will offset any gains you earn,you won’t pay any taxes for years.
Every month I “earn” nearly a thousand dollars as the rent is paying down the loan amount by that much. If someone handed you a monthly check of $1000 at a 33% tax rate you will pay out $330 in taxes every month, reducing your resources. Depreciation is the natural wear and tear on a building or home, the government allows you to write the value of a building over 27.5 years. If I have a $500,000 property and the house itself is worth $350,000 I can write off $12,727 annually to offset my monthly gains. Done correctly when combined with other expenses at the end of 10 years I would gain $140,000 in equity and not pay any taxes on that gain annually. The depreciation is paid back when you sell the property. Based on a 33% tax rate on a $140,000 I would owe $46,200 in taxes when I sell.
Using a 1031 Exchange will defer your taxes owed and allows you to increase your net worth.
A 1031 Exchange is when you sell one property and roll all the equity into another property within six months. You don’t have to pay any taxes owed as long as you purchase another property, essentially deferring your taxes forever. Let’s say I sell my current property and do a 1031 exchange into a $500,000 property with the house valued at $350,000. I would use the $140,000 as a down payment and borrow the remaining $360,000. To keep it simple let’s say I paid off the house in 27.5 years (the number of years you can depreciate something), now my $140,000 paid by the renters has grown into a paid off $500,000 property! You would pay very little taxes thanks to the $350,000 in depreciation.
If you write off $350,000 (the “value” of the house) you would be on the hook at your 33% tax rate for another $115,500 in taxes plus the original $46,200 that was deferred. On this $500,000 paid off home the tax owed is $161,700.
You should never sell or give real estate to someone while you’re alive.
With real estate there is a step up option which upon the owner’s passing the property is valued a current market price. For this example when you pass away and you leave that paid off $500,000 property to your family member or favorite blog readers the house is valued at the fair market value of $500,000. The $161,700 in tax owed on the property disappears and never gets paid. The house can be sold that day and the entire $500,000 pocketed and not a single dollar in taxes will be paid on it.
There is no other asset class that will give you tax preference like real estate. If you inherit a 401K with its deferred tax option you still need to pay the taxes based on your tax rate. In real estate the step up option eliminates all taxes owed.
Cutting the cable cord will not bring you financial independence.
I’ve seen a ton of blog posts about how cutting cable saves so much money, money used to help achieve financial independence. I’m all for controlling your expenses, but saving $75 a month is not going to help you achieve financial independence. Having a $500,000 property paid for by others will. It’s not how much you save, it’s how much you invest and the amount of taxes you minimize.
I understand that learning about tax write offs and depreciation is boring and can seem intimidating. When I was writing this post I tried to keep it as short and simple as possible without confusing people. Get a good accountant or tax lawyer as they are worth their weight in gold. Spend just as much time learning about legal wealth building ideas to really grow your net worth as well as learning how to save money.
Have you ever done a 1031 exchange? What are some of the things you are doing to build your wealth? Do you take time to learn about different investing strategies?