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Most people focus on the size of their tax refund rather than on lowering their tax liability. It’s common thinking, so no one is at fault, but it’s time to learn the true value in reducing your taxes versus getting that ‘big fat check’ at tax time.
Getting a large refund means one of two things:
- Your taxes were calculated incorrectly
- You didn’t plan for your taxes correctly and the IRS held your money throughout the year instead of your money working for you.
The performance of your CPA or tax professional shouldn’t be based on the size of the refund you get. Instead, it should be focused on your overall tax liabilities and strategies to reduce them, of which real estate could be one.
Real Estate and Lowering your Taxes
So now that we’ve talked about the importance of lowering your taxes, not expecting a large refund, here’s a tried-and-true strategy to lower your tax liability.
Real estate is a great strategy to make this happen. Here’s why.
When you look at your tax liabilities, you should focus on your tax rate which is your total tax/total income. You’d think that by increasing your income, your tax liability would increase, but there’s a loophole for real estate.
You can write off real estate depreciation. If this results in a loss on paper, you can reduce your tax liability by reducing your taxable income. The net operating loss reduces your income and therefore your tax liabilities. Essentially, you receive tax-free rental income.
Here’s an example.
You earn $75,000 at your day job and added a rental property to your portfolio that brings in $300 a month in rent but depreciates at $400 a month. This gives you a $100 a month loss or $1,200 a year.
This $1,200 decreases your $75,000 taxable income to $73,800 and yet you are making more income, just not on paper.
If you’re in the 28% tax bracket, you’d pay $20,664 in taxes with an effective tax rate of 25.8%.
Phasing Out Depreciation
As your income increases, your ability to write off depreciation decreases. At $150,000 income it becomes obsolete.
This doesn’t mean you lose them though. The passive losses you show become suspended. You can use them when you have more passive income in the future. When you figure out how to use those passive losses, you’ll decrease your tax rate in the future.
Focusing on your actual taxes owed versus how much you receive as a refund can help you understand the true value of reducing your tax rate. Rental real estate is a great way to have passive losses that help you lower your taxable income and effective tax rate.
If you have any questions about how real estate can help lower your effective tax rate, contact us today!