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In part 6 of this 7-part series (almost done), we will dive deep into the impact taxes play on your real estate investment and how that impacts your overall IRR, then we will compare that to investing the same amount in the stock market for a final determination on whether the added risk associated with a real estate investment is work the headache.
Disclaimer: The information provided in this article is for educational and informational purposes only and should not be considered legal, financial, or tax advice. Please consult with a certified tax professional or financial advisor for guidance specific to your situation.
From Depreciation to Dividends: Navigating Taxes in Real Estate vs. Stocks
In 2022 I decided to sell my entire real estate portfolio. I was NOT going to reinvest in real estate till the market normalized, and I had a break from the 3-T’s (landlord slang for being tired of the headaches that come along with tenants, toilets and termites). I desperately searched for ways in which to avoid, defer, or minimize my tax obligations. I want to share what I learned because it was a long painful and expensive road. Maybe I can make it easier for someone. Maybe you?
These techniques are what “most” people typically use. In the section below this “The Next Level: Tax Strategies That Make Your Brain Hurt (But Save You Big)” I briefly discuss some of the lesser-known and used strategies I found on my journey.
Real Estate | Stock Market |
Depreciation: Depreciation deduction on the property over 27.5 years, which reduces taxable income from rental earnings. | Capital Gains: Profits are taxed as long-term capital gains (at 15%-20% depending on income bracket) if held for over a year. |
Capital Gains: When selling the property, capital gains are taxed (typically at 15%-20%) but can be deferred using a 1031 exchange. | Dividends: Stock dividends are either qualified (taxed at lower capital gains rates) or non-qualified (taxed as ordinary income) |
Depreciation Recapture: The IRS recaptures the depreciation claimed over the holding period and taxes it at 25% when the property is sold. |
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Tax Strategy Categories
1. Avoiding Taxes:
Real Estate:
Depreciation: One of the most powerful ways to reduce taxable income in real estate is depreciation. Even though the property value may appreciate, the IRS allows you to depreciate the value of the building (over 27.5 years for residential properties). This can offset rental income and, in some cases, make taxable income zero.
1031 Exchange: By using a 1031 exchange, you can avoid capital gains tax on the sale of a property by rolling the proceeds into another investment property, effectively deferring the tax hit indefinitely if done correctly.
Stock Market:
Tax-Deferred Accounts: Invest through tax-advantaged accounts like an IRA or 401(k), where gains and dividends grow tax-free or tax-deferred. You avoid paying taxes on capital gains and dividends while the investments remain in the account, which can provide significant savings over time.
2. Deferring Taxes:
Real Estate:
1031 Exchange: As mentioned above, this strategy allows real estate investors to defer capital gains tax when selling one property and purchasing another “like-kind” property. You can keep deferring taxes indefinitely, allowing your investments to compound without the drag of taxes.
Installment Sales: Another strategy is selling a property via installment sales. This spreads the capital gains tax over time rather than paying it all upfront, reducing the immediate tax burden.
Stock Market:
Long-Term Holding: By holding stocks for more than one year, investors defer taxes and qualify for the lower long-term capital gains tax rates (typically 15% or 20%, depending on income).
Tax-Loss Harvesting: This technique involves selling losing investments to offset gains from winning investments, deferring or reducing capital gains tax. You can also reinvest in similar assets to maintain your portfolio allocation.
Minimizing Taxes:
Real Estate:
Depreciation Recapture Strategies: While depreciation recapture is taxed at a higher rate (typically 25%), you can minimize this tax hit by continually using strategies like 1031 exchanges or reinvesting in new properties to delay the sale.
Interest Deductions: If you’ve financed your real estate investment, the mortgage interest is tax-deductible, reducing your taxable income each year.
Stock Market:
Qualified Dividends: By investing in stocks that pay qualified dividends, you can benefit from lower tax rates on dividend income (the same rates as long-term capital gains, 15%-20%, instead of being taxed as ordinary income).
Gifting Stocks: You can gift appreciated stocks to family members in a lower tax bracket to minimize taxes on gains when the stocks are sold.
The Next Level: Tax Strategies That Make Your Brain Hurt (But Can Save You Big)
You’ve made it through the basics of tax strategies like depreciation and dividends, but now we’re entering a realm where things get let’s just say, “mind-bendingly” complex. These advanced tax deferral options are like the financial equivalent of assembling IKEA furniture without instructions—potentially life-changing, but definitely not for the faint of heart.
If you’ve ever thought, “I want to defer taxes, but I also want a strategy that requires an entire team of advisors and maybe a brain massage,” then these options might just be for you. Just be prepared to crack open your piggy bank because these tactics are usually best suited for the big players in the game (think yachts, not dinghies).
Delaware Statutory Trusts (DSTs):
DSTs allow multiple investors to pool resources to invest in large, institutional-quality real estate properties. DSTs are often used as a way to defer taxes through 1031 exchanges, offering investors a passive role in the management of the property.
Two Types of DSTs: Equity DSTs, which invest in the property itself, and Debt DSTs, which are structured around the debt portion of the property, both offering different deferral mechanisms.
Deferred Sales Trust (DST)
This is different from Delaware Statutory Trusts. A Deferred Sales Trust allows property owners to sell their real estate without immediately recognizing capital gains. The proceeds are held in a trust, and payments are made over time, deferring taxes until the seller begins receiving distributions from the trust.
Whole Life Insurance:
Though more commonly associated with estate planning, whole life insurance policies can be part of a broader tax strategy. Wealthy investors can use the cash value component of whole life insurance to defer taxes on their real estate gains, leveraging the tax-deferred growth within the policy to shield part of their real estate profits.
Qualified Opportunity Zones (QOZs):
These zones, created to stimulate investment in underdeveloped areas, allow investors to defer capital gains taxes if they reinvest those gains into properties located in designated opportunity zones. If held for long enough, the gains from the new investment can be excluded from taxes altogether.
Who Should Consider These Strategies?
While these strategies offer powerful tax deferral mechanisms, they are typically more suited for high-net-worth investors or those with complex portfolios. Structuring these vehicles can be intricate, and they often require working with tax professionals or estate planners to ensure they meet IRS requirements.
Showdown: $50K in Real Estate vs. Stocks – Who Wins After Taxes?
Using the example from past segments of this series, let's take another look at the scenario where we have $50,000 to invest in either the stock market or a real estate deal, then let's look at how taxes affect the resulting gains,
Note: if math makes you want to stick needles in your eyes, or you just like spoilers, skip to the conclusion at the end.
Assumptions:
Real Estate Investment
Property Value: $250,000 (with a $50,000 down payment and $200,000 financed via a mortgage)
Mortgage Interest Rate: 6% over 30 years
Annual Rental Income: $25,000 in Year 1 (increasing by 3% per year)
Annual Property Appreciation: 3% per year
Expense Ratio: 30% of rental income for operating expenses
Capital Gains Tax: 20%
Depreciation Recapture Tax: 25%
Rental Income Tax: 37%
Investment Horizon: 5 years
Annual Mortgage Payment (P&I): Recalculated based on the 6% rate.
Mortgage Payment Calculation (6% Interest Rate):
With a 6% interest rate, the mortgage payment can be calculated as follows:
Loan Amount: $200,000
Annual Mortgage Payment (P&I):
Using the mortgage formula, the payment is approximately $14,462/year.
Adjusted Rental Income (with 3% Growth and 30% Expense Ratio):
We will reduce rental income by 30% to account for operating expenses.
Year | Gross Rental Income | Operating Expense (30%) | NOI | NOI After Mortgage Pmts |
1 | $25,000 | $7,500 | $17,500 | $3,038 |
2 | $25,750 | $7,725 | $18,025 | $3,563 |
3 | $26,523 | $7,957 | $18,565 | $4,103 |
4 | $27,319 | $8,196 | $19,123 | $4,661 |
5 | $28,138 | $8,441 | $19,696 | $5,234 |
Total NOI:
Before mortgage payments: $92,909
After mortgage payments (NOI - Mortgage Payments): $20,599
Property Appreciation Calculation:
The property appreciates by 3% annually:
Year 1: $250,000 * 1.03 = $257,500
Year 2: $257,500 * 1.03 = $265,225
Year 3: $265,225 * 1.03 = $273,182
Year 4: $273,182 * 1.03 = $281,378
Year 5 (Sale Value): $281,378 * 1.03 = $289,819
Taxes
Capital Gains Tax:
Sale price: $289,819 - Original purchase price: $250,000 = Capital gain: $39,819
Capital gains tax: $39,819 * 20% = $7,964
Depreciation Recapture Tax:
Depreciation on a $250,000 property: $250,000 ÷ 27.5 years = $9,091/year
Total depreciation over 5 years: $9,091 * 5 = $45,455
Depreciation recapture tax: $45,455 * 25% = $11,364
Rental Income Tax:
Net rental income after expenses and mortgage payments: $20,599
Rental income tax: $20,599 * 37% = $7,821
After-Tax Profit:
Total Income Before Taxes:
$289,819 (sale proceeds) + $20,599 (net rental income) = $310,418
Total Tax Burden:
$7,964 (capital gains tax) + $11,364 (depreciation recapture) + $7,821 (rental income tax) = $27,149
After-Tax Profit:
$310,418 - $250,000 (initial investment value) - $27,149 (taxes) = $33,269
Calculated IRR:
20,649 (5-years NOI) + $89,819 (sale proceeds) = 19%
Stock Market Investment with 10% Annual Growth (Same as Before):
Initial Investment: $50,000
Annual Return: 10%
Investment Horizon: 5 years
Stock Market Growth:
Year 1: $50,000 * 1.10 = $55,000
Year 2: $55,000 * 1.10 = $60,500
Year 3: $60,500 * 1.10 = $66,550
Year 4: $66,550 * 1.10 = $73,205
Year 5: $73,205 * 1.10 = $80,526
Capital Gains Tax:
Profit: $80,526 - $50,000 = $30,526
Capital gains tax: $30,526 * 20% = $6,105
After-Tax Profit:
Total Value Before Taxes: $80,526
After-Tax Profit: $80,526 - $50,000 (initial investment) - $6,105 (taxes) = $24,421
Final Comparison: Real Estate (with Mortgage) vs. Stock Market After Taxes
Real Estate (with Mortgage and Reinvested Rent): $33,269
Stock Market (with 10% Steady Growth): $24,421
Key Insights:
1. Real Estate Investment with Mortgage: Despite the higher expense ratio and mortgage payments, real estate still outperforms the stock market, thanks to asset appreciation, rental income, and leverage.
2. Mortgage Impact: While the mortgage payments reduce the net rental income, the overall value from property appreciation and tax benefits (like depreciation) boosts real estate returns.
3. Stock Market Simplicity: The stock market offers steady growth and a lower tax burden but doesn’t benefit from the leverage or additional cash flows from rental income like real estate does.
Conclusion: Crunching Numbers, Dodging Taxes, and Keeping More of What You Earn
At the end of the day, it’s not just about how much you make—it’s about how much you keep. Whether you’re in the real estate game chasing cash flow or riding the stock market’s steady growth, understanding the tax implications of each investment can mean the difference between a solid win and a missed opportunity. From depreciation to capital gains, it’s clear that taxes play a starring role in determining your final returns.
Teaser for Part 7:
In Part 7, we’ll discuss the common pitfalls of using IRR for decision-making and explore when to rely on other metrics like equity multiple and cash-on-cash return. Avoid common mistakes by knowing when to look beyond IRR!
Reminder:
Missed earlier discussions on IRR and how it compares to other investments? Go back to Part 5 for a deep dive into comparing investment options, and Parts 3 and 4 to understand the calculations and sensitivity of IRR.
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