How The Wealthy Pay Less Tax

Traditionally, when you earn money, you pay taxes on those earnings. For w-2 employees, your tax liability is effectively prepaid through automatic withholding from your paycheck. Taxes are a major expense so this is convenient as to ensure your taxes are paid in full in a timely manner. One less thing for you to worry about.

But should you worry? Or at least pause and give some thought as to the amount of taxes you pay in relation to others? Is there a way for you to reduce your tax burden while still functioning in your role as an employee?

In relation to Robert Kiyosaki’s concept from his book Cashflow Quadrant, w-2 earners fall under the Employee category. Seldom are employees able to deduct expenses from their salaries to reduce their tax burden.

The next quadrant is Self-Employed. As of 2018 over 17% of taxpayers in the U.S. received self-employed income, a number that is likely higher today. The benefit of being self-employed is now you can deduct certain expenses against your income to reduce your tax liability (ie: vehicle, business travel, business meals etc). The downside is similar to employees, you’re trading your time for money. Stop showing up to work, stop getting paid.

Following Self-Employed is the Business Owner quadrant. The notable difference is now you have other people working for you, thus leveraging your time better and increasing your potential income and impact.

Finally, we have the Investor quadrant. Here your money is invested and works for you, night and day.

As we proceed through the quadrants, the ability to reduce or defer taxes increases. While there are many forms of deductions available, one of the primary sources is through what’s called depreciation.

Depreciation sounds unsexy, but once you grasp its potential impact of keeping more income in your pocket, your affinity towards this drab term may increase.

As a business owner and investor, where I, together with a group of private investors (aka: a syndication), purchase large apartment buildings, we have the ability to reduce the taxable income the building generates through, in part, depreciation.

Depreciation is, in my words, the acknowledgement that the building, and all of its many components, are getting older every day, ticking closer to the end of their useful life. Once that occurs, capital has to be invested to replace those worn out components.

The IRS assumes an apartment building by default has a 27.5 year useful life. If, for example, the total value of the building improvements (not the land value…land cannot be depreciated) is $1,000,000, a depreciation expense of $36,364 ($1,000,000 / 27.5) can be used as a deduction to reduce taxable income. This is called the straight line method.

If this same building was generating $50,000 of net cash flow (Income - Expenses - Debt Service) that year, which could be distributed to investors, your taxable income is only $13,636 ($50,000 - $36,364), after reducing your net cash flow by the depreciation expense.

As a w-2 employee, when you earn a $50,000 salary, you generally pay taxes on all $50,000. Do you see the difference?

Furthermore, the IRS enables multifamily owners to accelerate depreciation through a method called cost segregation.

Instead of the straight line approach of 27.5 years, cost segregation breaks the building into its individual components, allocating shorter useful life spans to certain components of either 5, 7 or 15-years.

For instance, flooring is considered by the IRS to have a 5-yr useful life. If $100,000 of flooring exists in this building, that amount could be depreciated over 5 years ($20,000/yr) as opposed to 27.5 ($3,636/yr), thus further reducing your taxable income by $16,364/yr for the first 5 years of ownership.

To add rocket fuel, the IRS allows, through the end of 2022, for apartment owners to accelerate all depreciation over the 27.5 years into year 1 of ownership, through what’s known as Bonus Depreciation.

As a real life example, a 14-unit building we own had a cost segregation study completed in 2021, generating a bonus depreciation expense deduction of over $525,000 against the building’s income year 1.

This substantial tax loss can then be used by investors to offset other passive income gains they incurred that tax year. If no other passive income gains exist, that tax loss would simply roll over into future tax years, to offset future passive gains. No taxes will be paid on this building likely until disposition, which in this case is projected 5+ years from now.

For those considered Real Estate Professionals in the eyes of the IRS, you can offset active income (ie: real estate agent commissions) with the passive losses. This may be a strategy to consider if one spouse or partner is the breadwinner and the other considers earning this designation. Not only can you make money as a self-employed real estate agent or investor, but you can reduce your tax liability on that income through the passive losses generated from your multifamily investments.

Are there downsides?

Not all investors benefit from depreciation, for instance, anyone investing through a self-directed Roth IRA, which is already a tax advantaged vehicle, cannot “double-dip.” The taxes you defer today eventually become due usually at a higher tax bracket later as the IRS charges what’s called Depreciation Recapture upon receipt of capital gains of the asset. Instead of being charged at the lower capital gains tax rate, you’re charged at your ordinary tax rate for any portion of income deferred as a direct result of depreciation.

Despite the downsides, the benefit is you keep more money in your pocket today, which, in theory, is worth more than a dollar in your pocket 5+ years from now. To truly benefit from the tax deferment, you should invest those dollars into other cash-flowing passive investments to compound your returns over time. Keep the velocity of your dollars moving as you step your way towards a life of financial freedom.

While there is absolutely no shame in working in a w-2 or self-employed capacity, the key is thinking like a Business Owner and Investor and putting your money to work for you day and night, just like the wealthy do.

* This is not tax advice and may contain unintentional inaccuracies or omissions. Consult with your tax professional.