Blog | Real Estate
Real Estate Investing Taxes: The Key to Becoming Rich
How the rich use the tax code to build their wealth, and you can too
Rich Dad Real Estate Team
April 02, 2024
Summary
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There are ways to use the tax code to your benefit
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Make sure you have a savvy tax advisor to help you understand the tax code
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Play by the rules, and you too can be rich
At Rich Dad, we love sharing how awesome investing in real estate is for saving money on taxes. But before we dive in, let’s first establish why the tax code is so important for the rich...and how the poor and middle class simply think differently about taxes than the rich do.
A few years ago, as a new tax law pushed through by Trump came into effect, you may have seen a number of articles pop up around who was benefiting and how.
It was good news for employees, or at least most of them. As FOX News reported, the average middle-income household got a tax cut of around $930 —a 1.6% increase in after-tax income.
The article shared some quotes from people on Twitter:
“I just checked my paycheck and I have $100 extra dollars! That money will go to my church and help pay a bill.”
“Looked at my paycheck today, took home $130 more than last paycheck.”
One woman who works as a secretary at a high school was “pleasantly surprised” that her pay went up $1.50 a week. She did the math and realized that equaled $78 a year, which would cover the cost of her Costco membership.
It was nice that these folks enjoyed a little extra money in their pockets, but most people’s reactions showed two mindsets when it comes to taxes—and ultimately money in general.
The employee tax mindset
The reality is employees have little control over their money when it comes to taxes. They are at the full discretion of the law, which gives them very little wiggle room.
So, it’s not surprising to see how the people responded. Though there was a mix of both positive and negative reactions at the time, there was one theme that was common: “I have to accept what the government gives me.”
The employee mindset might be bitter or it might be glad about their tax situation, but what is shared is a mindset that there is nothing you can do about it. After all, you can’t fight city hall, right?
The rich tax mindset
On the other hand, the rich were excited about the tax cuts. Not because they might make more or less in after-tax income (though the smart ones always will make more), but because they had new incentives built into the law to discover and take advantage of.
The rich understand that tax laws encourage certain behaviors and reward them for taking action. You can read more about this in the post “Are you doing what the tax code wants?"
At the time of Trump’s new tax laws, it’s no doubt that most rich people were in contact with their tax advisors looking for ways to make more money with the tax code, both by moving away from things that increase the tax bill and adopting practices and investments that are incentivized.
This shows a common mindset of the rich when it comes to taxes: “I go and take what the government gives me.”
How the rich make the rules and play the game of taxes
Rich dad said, "When it comes to taxes, the rich make the rules."
He also said, "If you want to be rich, you need to play by the rules of the rich."
The rules of money are skewed in favor of the rich, and against the working and middle classes. After all, someone has to pay taxes.
The middle class, of course, does not like this. That is why they get so mad when they find out that the rich can avoid paying taxes and when they find out that the rich often avoid paying taxes because they help write the rules.
A good example of this comes from an article by the publication “Recode” called, “The new hotness for tech billionaires? Do-gooder investments they can write off on their taxes.” The article talks about a tax law called “Opportunity Zones.” Essentially, these are low-income areas of the country where the rich can invest their money to spur economic development. By doing so, they can defer their capital gains taxes through 2026, and they can also pay no taxes on the profit they make from the in-vestments in these opportunity zones.
The article itself, from the title to many of the quotes, is filled with contempt for the idea of rich people saving money on taxes by investing in low-income areas. But perhaps most galling to folks is that the law was crafted by a rich person.
“Behind it all is another Silicon Valley billionaire: Napster founder and early Facebook executive Sean Parker, who is using his celebrity and Rolodex to schmooze the wealthiest people in town. He’s been chatting up people like his longtime friend Peter Thiel, LinkedIn founder Reid Hoffman and venture capitalist John Doerr, pitching them on the idea in the way only a true peer can.”
Again, as rich dad said, “When it comes to taxes, the rich make the rules."
The rich, taxes, and fairness
When it comes to conversations like this, most people appeal to some sense of justice. It’s not fair, they cry, that the rich get to make the rules when it comes to taxes. It’s unjust, they say, that the rich can avoid paying taxes while the middle class and the poor are stuck with the bill.
Okay, it’s not fair. But, as you’ve probably already been told, life isn’t fair.
Rather than focus on what’s fair and waste time complaining, consider learning the rules the rich make and play by them yourself. Of course, the government is in on this. They, after all, create the tax code to encourage certain behavior that they want people to do, like investing in poor areas. Here’s another post that talks more on this: “Why I’m Glad Donald Trump Paid $0 in Taxes.”
As Robert Kiyosaki wrote then:
In short, the many credits and breaks that are found in the tax code are there precisely because the government wants you to take advantage of them. For instance, the government wants cheap housing. Because of this, there are many tax credits for affordable housing that developers and investors can take advantage of that minimize their tax liability, put more money in their pocket, and in turn, create affordable housing. Everyone wins.
There are many scenarios like this in the tax code that incentivize investors and entrepreneurs to do activities the government is looking for while rewarding those who take those actions with lower-or zero-tax burden.
Because of this, limiting your tax liability actually means you're doing what the government wants you to do through the tax code. And that is the most patriotic thing you can do.
Many people won’t agree with this, but that’s OK. They can keep complaining and paying their taxes. These rules won’t go away, so the real players will continue playing by them.
Taxes: playing by the rules of the rich
There are many ways that the rich make a lot of money and pay little to no money in taxes, and anyone can use them. As an illustration, here's a real-life situation in which Robert Kiyosaki played by the rules of the rich and minimized my taxes:
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Robert and Kim Kiyosaki put $100,000 down to purchase 10 condominiums in Scottsdale, Ariz. The developer paid them $20,000 a year to use these 10 units as sales models. So, they received a 20 percent cash-on-cash return, on which they paid very little in taxes because the income was offset by the depreciation of the building and the furniture used in the models. It looked like they were losing money when they were in fact making money.
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Since the real estate market was so hot, the 380-unit condo project sold out early. Their 10 models were the last to go. They made approximately $100,000 in capital gains per unit. They put the $1 million ($100,000 x 10 units) into a 1031 tax-deferred exchange. They legally paid no taxes on our million dollars of capital gains.
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With that money, they purchased a 350-unit apartment house in Tucson, Ariz. The building was poorly managed and filled with bad tenants who had driven out the good tenants. It also needed repairs. They took out a construction loan and shut the building down, which moved the bad tenants out. Once the rehab was complete, they moved good tenants in and raised the rents.
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With the increased rents, the property was reappraised and they borrowed against their equity, which was about $1.2 million tax-free, because it was a loan—a loan which our new tenants pay for. Even with the loan, the property still pays them approximately $100,000 a year in positive cash flow.
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Robert and Kim then invested the $1.2 million in another 350-unit apartment house in Flagstaff, Ariz., a hot property market, all tax free.
Don’t park money, move it
This is an example of an investment strategy known as the velocity of money. As we’ve discussed before, moving your money makes more sense than parking it in cash, bonds, equities, or mutual funds—the strategy most financial advisors recommend.
Take the above example, for instance. Robert and Kim started with $100,000 that they earned tax-deferred from another real estate investment. The $100,000 eventually allowed them to borrow over $20 million from banks, tax-free. How long would it take you to save $20 million by parking your money somewhere, as most financial advisors recommend.
Real estate tax benefit: the best way to take advantage of the tax code
If you refer to the CASHFLOW Quadrant (which divides people into four types of income earners: Employees, Self-employed, Business Owner and Investors), you’ll realize that our government purposely rewards people for being on the left side of the quadrant — owning a big business or being an investor. These two quadrants pay the least amount in taxes, between 0% and 20%. If you compare that to employees and those who own small businesses — who pay between 40% and 60% taxes — you’ll see the right side of the quadrant takes the biggest tax hit.
And one of the most powerful ways of using taxes to get richer is through real estate investing taxes. Let’s examine some of the other ways investing in real estate can help reduce your taxable income:
- Deductions
Did you know that you can deduct certain rental expenses — such as mortgage interest, property tax, operating expenses, depreciation and repairs — from your tax return? Make sure to keep track of deductible expenses, such as receipts, in case you are audited. Also, keep track of any travel expenses you incur for rental property repairs. The IRS is a great place to read more about real estate deductions.
- Pass-through entities
Thanks to the Tax Cuts and Jobs Act of 2017 (TCJA), residential landlords who operate as pass-through entities (a special business structure, such as sole proprietors, LLCs and S corps, that eliminates the burden of double taxation) can now deduct 20 percent of net rental income right off the top. Yes, you read that right: this essentially makes 20 of your profits tax-free. There are some limitations and exceptions, so be sure to consult your tax advisor before assuming you qualify.
- 60% bonus depreciation
In 2017, the rules allowed for 100% bonus depreciation, meaning landlords could deduct 100 percent of the personal property for rental units. After slowly ramping down, the law changed again in 2024, to a 60% bonus depreciation. Still, these rental unit improvements could include appliances, a new roof, upgraded HVAC systems, fire protection and alarm systems, and even furniture.
- Low income housing tax credits
The Low Income Housing Tax Credit program provides tax incentives to encourage developers to create affordable housing. As an incentive to make equity investments in affordable rental housing, private investors receive a federal income tax credit.
- Historic building tax credit
There’s a federal tax credit for investors who rehabilitate qualifying historic buildings — they can claim 20 percent of eligible improvement expenses against their federal tax liability. Note: With the new TCJA, taxpayers must now take this credit over five years instead of in the year they placed the building into service.
Other real estate tax advantages
While these are some of the big tax advantages, there are also a few tax loopholes that successful investors know about — Rich Dad Advisor Garrett Sutton shares a few of those loopholes here.
And even more in his book:
It is paramount to choose the right tax advisor to ensure you’re complying with the law when it comes to these tax advantages and loopholes — and that you’re taking advantage of every real estate tax benefit you can! Don’t miss these tips on how to choose the right tax advisor, from Rich Dad Advisor and CPA Tom Wheelwright.
If you’re ready to get your feet wet, refer back to this blog about getting started in real estate — the tax advantages, cash flow and freedom are second to none!
Original publish date:
March 14, 2019