The One Time Taxes are a Love Note from the Gov't
The tax law is a series of stimulus packages for business owners and investors. Nowhere is this truer than for real estate investors. I’m not talking about people who fix and flip real estate. They are not investors. I’m talking about those who buy, improve, and hold on to real estate for long-term investment.
As an incentive for investors to buy, improve, and hold real estate, the government gives two primary tax benefits.
The first and largest is depreciation. I talked about depreciation in a previous letter and how Jared Kushner and his family company used depreciation to pay zero in taxes. Depreciation is a deduction you receive over time for the cost of the property, whether you bought it with your money or with someone else’s money (debt). Here is how it works.
Say you purchase a rental property for $200,000, 10% of your own money and $180,000 or 90% of the bank’s money. What did you really buy? You bought land worth, say, $40,000 and improvements, including a building, landscaping and fixtures, of $160,000.
The government lets you take a deduction, called depreciation, for the wear and tear on the building. If this is a residential property, your deduction is about 3.64% per year in the United States. (It’s more in some other countries.)
That means that you get a deduction on your tax return of almost $6,000 per year for depreciation ($160,000 x 3.64%). Let’s say your cash flow is 1% per month on your initial investment of $20,000. That means you will have cash flow of $2,400 per year. With a tax deduction of $6,000, you will show a loss on your tax return of $3,600 per year ($2,400 minus $6,000).
Now, this $3,600 loss can be used to reduce your taxes from your salary, your business or your other investments. Depreciation protects your cash flow from taxes and produces an additional tax benefit by lowering your taxes from your other income.
If you’re interested in learning about how to protect and even increase your cash flow, I strongly suggest you check out my brand-new Weekly Cash Flow broadcast. In it, I explain to the audience why everyday folks like you face roadblocks on their quest to get rich. I also reveal a never-before seen way to collect passive income, boosting your cash flow every week…
But in the meantime, remember that you get depreciation, not only on the dollars you invest, but also on the money the bank loaned.
You get a similar benefit called amortization, which refers to your costs of borrowing money from the bank, such as points and loan-origination fees.
You get to take the deduction for amortization even if the bank loaned you the money to pay the fees.
These tax benefits are yours even though the property may be appreciating or going up in value. So real estate gives you benefits through depreciation, amortization, and through appreciation in value.
There are additional tax benefits as well for real estate investors. When you sell your real estate, you have a choice on what you pay in taxes. If you decide to cash out, you can pay tax at the low capital-gains rate on any appreciation in your property. If you decide instead to use the proceeds from your sale to invest in another property, you can pay no tax. This is called a “like-kind” or 1031 exchange.
What’s more, if you sell your property at a loss, you get to take the loss as an ordinary loss. This means that you can use the loss to offset any other type of income. This is quite different than if you were selling a stock or mutual fund, where a loss would be limited to offsetting gains from other capital assets.
So, if your property appreciates, you pay little or no tax, and if your property loses value, you get to use the losses to offset your ordinary income. Many countries have similar rules and tax rates on the sale of real estate and other business assets.
Can you begin to see how the tax laws provide stimulus to real estate investors and business owners? (By the way, in the United States, flippers get none of these benefits and in fact, have to pay an additional tax, called self-employment tax, that investors don’t have to pay.)
The tax laws are directions from your government on how they want you to use your money to improve the economy. This is especially true when you are using debt to invest in real estate and business.
Unfortunately, due to a lack of financial education in schools, most people blindly turn their money over to people they believe are financial experts: people such as bankers, financial planners, and stockbrokers.
Unfortunately, most of these “experts” are not really investors in the I quadrant. Most are employees in the E quadrant working for a paycheck, or they are self-employed financial advisors in the S quadrant working for fees and commissions. Most “experts” cannot afford to stop working, simply because they don’t have investments working for them.
Warren Buffett said, “Wall Street is the only place where people ride to work in a Rolls Royce to get advice from those who take the subway.”
If people do not have sound financial education, they cannot tell if a financial advisor is a salesman or a con man, a fool or a genius. Remember, all con men are nice people. If they were not being nice by telling you what you want to hear, you would not listen to them.
There is nothing wrong with being a sales person. We all have something to sell. Yet, as Warren Buffet says, “Never ask an insurance salesman if you need insurance.” When it comes to money, there are many people desperate enough to tell and sell you anything, just to get your money.
Interestingly, the vast majority of investors never meet the person taking their money. In most of the Western world, employees simply have their money automatically deducted from their paycheck, in the same way the tax department collects taxes. Many workers in America simply allow their employer to deduct their money and put it into their 401(k) retirement plan, possibly the worst way to invest for retirement.
Taxes work against you with a 401(k). Long-term capital gains are taxed at a lower rate of around 15%. But the 401(k) treats any gains as ordinary income. Ordinary income is taxed at the highest rate, sometimes as high as 35%. And if you want to take the money out early, you’ll have to pay an additional 10% penalty tax.
Change Your Future
The financial crisis of 2007 actually began a long time ago. It started in 1913 when the Federal Reserve Bank was created. In 1913, the Internal Revenue Service was also created when the Sixteenth Amendment to the U.S. Constitution was ratified. Both acts violated the spirit of the Constitution of the United States.
Money is no longer money. Money stopped being money in 1971. Today, money is debt.
Today, for every dollar printed, the IRS must tax the taxpayer to pay for the principal and the interest on that printed dollar. This was the plan in 1913. Print money, and tax the taxpayer for every dollar printed.
Today, the taxpayer pays two taxes: One is direct taxes, and the other is inflation. And taxes and inflation are increasing.
This is why financial planners always advise, “Live below your means.” You will have to live below your means just to pay your taxes and compensate for inflation.
This is also why there is no financial education in schools.
The government and the rich need people to pay the taxes and pay for inflation.
At the end of the day, there are two groups who pay the least in taxes: the poor and the ultra-rich. If you don’t want to pay taxes, but you’re also not interested in being an entrepreneur or an investor, then your only choice is to become poor.
But if you want to be independent money-wise and pay little-to-nothing in taxes, you’ll need to choose the path of the ultra-rich.
Speaking as one who has walked that path, it is one of the most rewarding journeys you can take. Because at the end of the day, it’s not about how much money you make, but how much money you keep.
Editor, Rich Dad Poor Dad Daily