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About two years ago Brian Davis wrote a post for Can I Retire Yet? about Using Rental Properties to Create Retirement Income. That post was very popular among readers, and I learned a lot from it.

So I’m welcoming him back to share the tax advantages you can create to accelerate your path to financial independence and keep more of your income in retirement. We have no financial relationship.

Take it away Brian…

The more of your income that you manage to keep rather than losing to taxes, the faster you can build wealth and reach financial independence. So while not everyone frets about taxes, slashing your tax rate by 5% each year can mean an extra 5% towards your annual savings rate, which adds up to real money when invested and compounded over time.

Block of taxes falling on house

Real estate can accelerate your retirement planning. Between ongoing passive income, inherent adjustment for inflation, leverage, and appreciation over time, you can reach financial freedom faster with real estate in your portfolio. But in addition to all of its other perks, real estate comes with enormous tax advantages. 

As you plan your route to financial independence and retiring early (FIRE), consider how real estate can slim your tax costs in early retirement.

Ways to Avoid Taxes on Rental Income

The IRS taxes rental income at ordinary income tax rates. But that doesn’t mean you pay taxes on every dollar of cash flow you earn. 

To raise your annual income without raising your taxes, take full advantage of rental property tax deductions and depreciation. 

Rental Property Tax Deductions

One early lesson most landlords learn is that nearly every cost you incur as a landlord is tax deductible. Those that aren’t, you can depreciate over time. 

Consider the following a non-exhaustive list of rental property tax deductions:

  • Mortgage interest 
  • Property maintenance and repairs 
  • Property taxes
  • Landlord insurance
  • Property management fees
  • Accounting and bookkeeping fees
  • Legal fees
  • Marketing expenses
  • Travel expenses
  • Some closing costs

Best of all, these are “above the line” deductions. They come off your taxable rental income for each property, on a separate schedule from your personal deductions. In other words, you can deduct all of the costs above and still take the standard deduction.  Note that “property maintenance and repairs” are not the same as “capital improvements,” which must be depreciated. Likewise, some closing costs must be depreciated rather than deducted in the same year you purchase a property.

Rental Property Depreciation

Real estate investors must spread some tax deductions over several years, instead of taking them all at once. The IRS refers to this as depreciation. 

When you buy a rental property, you can depreciate the cost of the building itself over the next 27.5 years. But not the land value — only the proportion of the purchase price considered the building value, as land does not deteriorate and lose value over time. 

Likewise, you can depreciate the cost of any capital improvements made to the property. While the line between “repair” and “capital improvement” gets blurry at times, in general a repair fixes a specific broken item, while a capital improvement extends the working lifespan of the building. 

For example, replacing a broken window constitutes a repair. Replacing all of your aging windows with new energy efficient windows is a capital improvement. 

As noted above, some closing costs must be depreciated rather than deducted. An accountant can review your settlement statement and let you know which costs you can deduct immediately and which get added onto the property’s cost basis for depreciation. 

We offer a free rental property depreciation calculator so you can get a sense for exactly how it works. 

Ways to Avoid Capital Gains Taxes

As you build a property portfolio for early retirement, you’ll inevitably want to sell the occasional property. When you do, the IRS hits you with capital gains taxes on your profits. 

Or not, depending on how well you plan for taxes in your investments. Because real estate investors have far more options to reduce, eliminate, or defer their capital gains taxes than they do to lower their rental income taxes. 

Hold Properties for at Least a Year

To begin with, you must understand the difference between short-term and long-term capital gains taxes. When you hold an asset for less than a year and sell it for a profit, the IRS taxes that profit at your regular income tax rate. And bear in mind that it gets added to your taxable income, and thus can push you into a higher tax bracket. 

Profits on assets held longer than a year are taxed at the lower capital gains tax rate. In tax year 2021, for example, single people earning up to $40,400 and married couples earning up to $80,800 pay 0% in capital gains taxes. Those earning more pay 15% on capital gains — lower than their regular income tax rate. (A few high earners pay 20%, but you have to earn more than $445,850 to pay that rate.)

Live in the Property for 2 Years

If you’ve lived in a property for at least two of the last five years, you probably qualify for the Section 121 exclusion, better known as the primary residence exclusion. With it, you don’t pay capital gains taxes on the first $250,000 of profits as a single filer, or $500,000 of profits as a married couple. 

Buy a property, get a cheap owner-occupied mortgage with a low down payment, move in for two years, then convert it to a rental for the next three years. Sell it and avoid capital gains taxes. 

Or buy a rental property, hold it for as long as you like, then move into it for two years before selling. 

Invest Through a Self-Directed IRA

You can invest in rental properties and other real estate through your IRA or Roth IRA. If you invest through a self-directed IRA, that is. 

It comes with its own costs and complications, and I only advise it for experienced real estate investors. Still, those who know what they’re doing can earn outstanding returns and never pay a dime on them through a self-directed Roth IRA.

Defer Taxes with a 1031 Exchange

A 1031 exchange allows you to sell one property, then use the profits to buy a replacement property. All without paying capital gains taxes. 

The strategy behind using 1031 exchanges is simple: you keep upgrading your properties for greater cash flow. For instance, say your first property is a single-family rental. You sell it after a few years, and put the proceeds towards buying a three-unit property that produces $1,000 per month in cash flow rather than $200. A few years later, you sell that and put the proceeds toward an eight-unit property, which cash flows $2,500/month. And so on indefinitely, while never paying a cent in capital gains taxes.

It comes with some restrictions, such as the timeframe within which you must buy the replacement property. Within 45 days of selling the old property, you need to declare a replacement property (or up to three potential properties). Within 180 days of selling, you need to settle on the new property. 

The new property must also be of equal or greater value, or else you end up paying some capital gains taxes. You also need to bring in a “qualified intermediary” to hold your profits from the sold property in between selling the old one and buying the new one. Read up on the IRS rules for 1031 exchanges and speak with a tax expert before attempting it.

Coincide Losses & Gains

Your capital losses offset your capital gains, come tax time. For instance, if you sell a property for a $10,000 profit, and also sell long-held stocks for a $10,000 loss in the same year, they offset each other and you pay no capital gains taxes. 

One way to approach this is by selling a property to collect the gains in a year when you’ve already lost money. If you’ve been thinking about selling off a property anyway, you might as well do it in a year when you’ve lost some money as well. 

Or you can do the inverse, and harvest losses in a year when you’ve sold real estate for a strong gain. Again, only do it if you’ve been thinking about cutting some losses on bad investments anyway — don’t take losses on investments you think will turn around and start performing for you. 

Pull Out Equity by Borrowing, Not Selling

Imagine you own a rental property for 15 years, and pay off your 15-year mortgage. You could simply sit back and enjoy the extra cash flow: it will certainly come in handy as an early retiree. 

But imagine you run into financial hardship, and need some cash quickly. You could sell the property of course, killing the golden goose and taking a one-time payout. Alternatively, you could take out a new mortgage, cashing out your equity that way. 

You get to keep the property, and continue earning cash flow on it just like before. It keeps appreciating in value, and once again, your tenants end up paying off the mortgage for you. 

You can rinse and repeat this process for as long as you live, then pass the property on to your heirs when you kick the bucket. 

Pass the Property to Your Heirs

If you never sell a property, you never pay capital gains taxes on it. 

Rental properties produce excellent ongoing income. Enjoy it while you’re working, enjoy it in retirement, and then pass your properties to your children.

Sure, they might pay estate taxes on your properties. But the first $11.7 million in assets that you pass along to your children is exempt from estate taxes, so they may not pay a cent. Include your properties in your estate plan so Uncle Sam never touches your profits. 

Give the Property to Charity

For that matter, you can give the property to a registered 501(c)(3) nonprofit so that neither of you pays capital gains taxes on the profits. 

After all, you can’t take your property with you when you shuffle off this mortal coil. If you have other assets to bequeath to your children, consider giving your real estate to charity. It saves your heirs from having to hassle with the nuts and bolts of either liquidating it or managing it themselves.

Final Thoughts

Depending on your income and wealth, you may not consider taxes a significant expense, but taxes do matter in your retirement calculations

Imagine that you can save $5,000 per year on your taxes through better tax planning. Invested at 10%, that compounds to over $286,600 over 20 years. Which could mean retiring five years earlier. Or semi-retiring ten years earlier, especially as you factor in the income and tax benefits of semi-retirement

Taxes are an expense like any other. The better you streamline and optimize expenses like taxes even as you grow your passive income, the faster you can retire. And real estate combines high income yields with tax benefits for the best of both worlds. 

Does real estate play a role in your early retirement planning? Why or why not?

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Thanks to Brian for sharing his knowledge. G. Brian Davis is a real estate investor and founder of SparkRental.com. Check out SparkRental’s free landlord software, free real estate investing video course, free webinars, landlord lender comparisons, and more.

You can also check out the conversation Brian and I had about The Formula to Retire Young on the Spark Rental podcast. (Spoiler Alert: There is no one formula!) I enjoyed exploring how we apply similar principals to achieve financial independence quickly, while taking different career and investment paths. It will offer value to others who may be stuck trying to find their own path to financial independence.

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Valuable Resources

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at chris@caniretireyet.com.]

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