It’s that time of year again where I’m thinking about the “T” word. Taxes.
As someone who shows a lot of income on a 1099, I used to write huge checks to the IRS each year. Sometimes more than I made when I was a W-2 employee. This last year, we got a tax refund for the first time since I was a W-2 employee.
The reason we were able to do that is because the biggest tax saving strategies are for business owners and real estate investors. Here is what we did to knock down our tax bill substantially:
1) We elected to be an S-Corp on our taxes. An S-Corp is a tax election through the IRS. Our company is an LLC, which meant we were previously being taxed like a sole proprietorship. That made taxes easy to file, but meant we got hit with some nasty high tax rates. When we switched over, we began getting taxed like a pass-through corporation. We had to start paying ourselves a salary and running payroll. But the additional complication was worth it because it meant we were reporting a lot less income.
2) We qualified as “real estate professionals” for the purposes of taking real estate related tax deductions. Obviously, we’re real estate agents so this wasn’t super hard to do. But anyone who owns rental properties can do this if they spend enough time working in the field. The requirement is that you “materially participate” in real estate activities for at least 750 hours per year. That doesn’t have to be property management. It can be acquisition activities too like going on showings, making offers, etc. When you do this, you get to take 100% of all of the deductions related to real estate in the tax code rather than a percentage.
3) We sped up our depreciation on some properties using “cost segregation”. Usually real estate must be depreciated over 27 years for residential and 39 years for commercial. But with cost segregation you can separate out things like appliances, cabinetry, flooring, and other materials that would normally be depreciated faster from the building itself. It allows you to depreciate up to 30% of your property’s value in the first year. We did this with our Florida properties last year and it saved us a ton.
4) We maxed out our tax-deferred retirement accounts. Of course everyone has the ability to fund a Roth IRA either directly or “backdoor” through other investment accounts. We opened a SEP IRA account as well, which is a simple retirement plan for small businesses. We can contribute up to 25% of our wage income to that plan tax free, which we make sure we do every year.
5) Finally, we actually think about and plan for taxes each year. We work with a competent CPA that we meet with multiple times a year. We talk about how our year is going for income. We plan purchases like properties, large equipment purchases like cars, and discuss implementing different tax strategies. That way we know what our likely tax bill will be going into tax season and we can make adjustments accordingly.
Taxes are the largest expense in your income. It pays to learn how to reduce your tax obligations and implement some strategies to do so. A great book on the topic is “The Book on Tax Strategies for the Savvy Real Estate Investor” by Amanda Han. It will really get you in the mindset of thinking about your tax bill strategically.