How The Wealthy Use Real Estate to Eliminate Taxes

Last week, a client texted me a screenshot of their $0 tax return. They made $847,000 last year. Here's the $5,000 strategy that eliminated their entire tax bill.

The Strategy

Generate cash and tax income from service business.

Generate cash and tax loss from real estate (as a pro).

End up with all cash and no tax.

Sounds Great, How?

The IRS divides income into three buckets:

• Active Income (business/W-2)
• Portfolio Income (investments)
• Passive Income (real estate)

Passive losses can't offset business income, unless you're a real estate professional.

Qualify by:

• 750+ hours in real estate annually
• More than 50% of your time in real estate
• Material participation in properties

Material participation means being involved in operations on a regular, continuous, and substantial basis. There are 7 IRS tests, you only need to pass 1 of them. Often once you meet the pro test, material participation comes along for the ride. See IRS Publication 925 for the nitty gritty details.

The Math Is Beautiful

$500K business income
$1.5M property ($400K down)
$450K bonus depreciation from cost segregation
$450K paper loss
​Tax on $500K income: ZERO
​Monthly cash flow from property: $2,500
​
You just eliminated $185K in taxes while building wealth.

What Gets Depreciated

Oftentimes around 30% of your property qualifies for immediate write-off:

• Appliances, carpeting, fixtures (5-year)
• Furniture, equipment (7-year)
• Parking lots, landscaping (15-year)

The building itself (foundation, framing, core electrical, plumbing roof, etc.) is depreciated over 27.5 years (residential) or 39 years (commercial).

With leverage and 100% bonus depreciation post One Big Beautiful Bill, this can allow you to take losses above and beyond the cash invested in the property. Money that won't be paid for years gets deducted today.

Want to see your numbers? We built a free calculator that shows exactly how much you can save on your next property purchase. Takes 30 seconds:

So How Much Can I Deduct - The Seven Bonus Levers To Maximize Benefits

1. Land vs. Improvement Ratio: Properties with lower land value percentages yield higher depreciation benefits. That rental shack on the beach won't treat you so well, but a commercial building in Middle America will do great!
2. 1245 vs. 1250 Property: Section 1245 property (personal property) gets better treatment than 1250 property (real property). More fixtures, appliances, and specialized systems = bigger deductions.
3. Property Leverage: Higher leverage magnifies your return on investment. 80% LTV creates 5x more depreciation per dollar invested than 20% LTV.
4. Tax Bracket: The higher your tax rate, the more valuable depreciation becomes. A 37% taxpayer gets nearly double the benefit of a 20% taxpayer from the same deduction.
5. Bonus Percentage: The OBBB Act made 100% bonus depreciation permanent. This is a game-changer that supercharges this strategy indefinitely.
6. Cost Segregation Report: A quality study typically costs $3,000-$10,000 but identifies hundreds of thousands in deductions. RE Cost Seg offers exceptional value here.
7. Exit Strategy Planning: How you exit determines recapture tax consequences. 1031s defer recapture, installment sales spread it out, and death eliminates it entirely.

Don't Forget About Recapture

This is tax deferral, not elimination. When you sell, the IRS "recaptures" your depreciation deductions:

• Depreciation recapture on the Building is taxed at 25% (higher than capital gains rates). Recapture on the Bonus Property is at Ordinary Rates
• This can apply even if you sell at a loss

This is why exit strategy planning is critical. Smart investors either:

1. 1031 exchange to defer recapture indefinitely
2. Use a 'Poor Man's 1031' - sell the property and work to replace the gain with a loss from another property purchase in the same year.
3. Die owning the property (step-up in basis eliminates recapture)
4. Use installment sales to spread recapture over many years

Can't Be A Real Estate Pro? Three Powerful Workarounds

1. Buy your business building: Doctors, lawyers, CPAs all do this. Your business pays rent, you get depreciation. No 750 hours needed.
2. Short-term rentals: Average stay under 7 days + material participation = active losses that offset W-2 income. No real estate pro status required.
3. Marry a real estate pro: Your spouse's real estate losses offset your income on joint returns. I've seen this save couples $200K+ annually.

Important clarification: You CAN have a W-2 job and still be a real estate professional. The work you do as a W-2 employee can count toward your time if you are a 5%+ owner of the company. Keep detailed time logs to document your real estate hours.

Case Study: The Forever Strategy

John, a tech executive earning $750,000 annually, implemented this strategy in 2020. His wife is a real estate pro.

Year 1: Purchased $1.2M duplex ($240K down)

• Cost segregation identified $360K in bonus depreciation
• Created $360K paper loss while property cash flowed $3,000/month
• Saved $133,200 in federal taxes (37% bracket)

Year 3: Added $1.8M fourplex ($360K down)

• Generated another $540K in depreciation deductions
• Continued paying zero tax on growing business income
• Monthly cash flow increased to $7,500

Year 7: Used 1031 exchange to upgrade to $5M apartment building

• Deferred all capital gains taxes and depreciation recapture
• Reset depreciation clock on larger asset
• Created new tax shelter for continued business growth

This compounds brilliantly until eventually passing to heirs with a stepped-up basis, erasing all deferred taxes forever.

Critical Warning

Track. Every. Hour.

One IRS audit without documentation destroys everything. This is tax deferral, not evasion. Do it right or don't do it.

The wealthy don't have secret loopholes. They just understand the tax code better than most CPAs. Now you have their playbook.

All the best,

Mitchell Baldridge, CPA, CFP®

P.S. If you made it this far, forward this to a friend who still thinks they can't offset W-2 income with real estate losses. And make sure they know about our August 13th webinar.

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