Physicians and other healthcare professionals are some of the most highly taxed professionals in America. The time spent becoming a doctor is time not spent earning, saving, and investing. Usually, it is a time of taking on yet more debt—debt that isn’t tax deductible. Once physicians have an income they are taxed heavily and must repay their debt with remaining funds. The cost of tuition, the length of training and the US tax code place physicians in a deceptive financial situation.
Once healthcare professionals are established, annual pay can be high. But even with the tax reforms enacted by the Tax Cuts and Jobs Act of 2017 (TCJA) in 2017 the nature of physician pay makes these professionals vulnerable to an unduly high tax burden. Indeed, the TJCA didn’t help everyone: healthcare practitioners earning more than $600,000 a year now pay more tax than they did before the Act. And even the breaks enjoyed by medical professionals earning less than $315,000 a year are themselves transitory. The TCJA was designed to be a temporary program and is scheduled to expire in 2025, not that far off.1
New tax policies may emerge. But the bottom line is irrespective of policy changes, income taxes will always place the highest burden on those earning high annual incomes. This seems to be one of life’s inevitabilities.
This is where investing in real estate comes in. Real estate investing is the best kept tax secret everyone knows about, but few take advantage of to the full. It hides in plain sight. Given the way most healthcare professionals earn their incomes, understanding which real estate tax investing benefits are available is one of the best ways that real estate investors can achieve actual wealth and mitigate their tax burden.
Here are a few of the most striking tax benefits available to real estate investors.
1 Robert McClelland and others, Tax Policy Center Study, “The TJCA: What Might Have Been”, Mar. 26, 2019. https://www.taxpolicycenter.org/publications/tcja-what-might-have-been.
Harness the Tax Saving Power of Depreciation
While the value of real estate appreciates, obviously much about buildings and property do not. Fences, roofs, windows, plumbing, wiring and all that goes into a house or commercial building simply age and decline in value. Everything that depreciates can be a tax write-off.
Depreciation is applied to both property and improvements. Depreciation isn’t applied all at once, though, because the value of property and improvements extends beyond a single tax year. For this reason, depreciation is applied over the useful life of a property or an “improvement”. I’ve put the latter in scare quotes because improvements are in fact a technical term for work such as new roofs, fences, windows, etc., and are not the same as repairs such as fixing a roof or fence.
In theory, the money saved through depreciation can be taxed when the property in sold, but there is a clever way that savvy real estate investors can ensure that does not happen. Let’s look at that, the “1031 Exchange”, right now.
What’s in a Number: The Power of the 1031 Exchange
The “1031 Exchange” sounds like a 1970s sci-fi movie title but in fact it is named after Section 1031 of the U.S. Internal Revenue Code. This handy provision allows investors to avoid paying capital gains taxes on the sale of an investment property, as long the proceeds are reinvested within certain time limits in a property or properties of equal or greater value.
Simply put, a 1031 exchange allows you to defer paying capital gains taxes and depreciation recapture. Think of it like a money manager buying and selling stocks in your 401(k) mutual fund.
Time plays a significant role in the 1031 exchange. After you’ve sold your property, you have around 45 days to find replacement properties. After that, you have 180 days to complete the purchase of those properties. 1
1 John Charin, JD, Like-kind exchanges of real property: New final regs. The Tax Adviser (AICPA), Apr. 1, 2021.
Capital Gains Tax Are Better Than Income Taxes
These are the taxes you pay when you sell a property, and they can often be assessed at a lower tax rate than your ordinary taxable income rate. The basics of today’s capital gains structure are straightforward:
- Property held for one year or less can incur short-term capital gains taxes between 10% to 37% depending on your income tax bracket.
- Property held for a year and one day or more can be taxed between 0% and 20%, depending on your income tax bracket.1
Chances are your income tax rate is currently far higher than 20%. A wise real estate investment strategy will always be designed to maximize your capital gains advantage.
1 Internal Revenue Service, Topic 409, Capital Gains and Losses. https://www.irs.gov/taxtopics/tc409
Contributing to the Community While Enjoying Tax Savings: Opportunity Zone Investment
Another creation of the Tax Jobs and Cuts was a category of special investment called Opportunity Zones. An Opportunity Zone is a disadvantaged community or neighborhood where new property investments, under specific conditions, may be eligible for tax incentives. The goal of this program is to encourage long-term private sector investment in low-income neighborhoods by providing a way to invest unrealized capital gains. Since its implementation, the program has sought to foster job creation and economic stimulus in undercapitalized areas. Twelve per cent of America’s census tracts are opportunity zones, so there is a lot of choice.
Where are Opportunity Zones? They are both urban and rural, industrial and residential, right across the country. In the cities where we focus our investments, examples include the Hialeah and Seaboard Industry Center parts of Miami, the Park Hill and Clayton neighborhoods in Denver and, here in Austin, the area around the Circuit of the Americas (COTA), among many other parts of all three cities.
A Qualified Opportunity Zone investment can lower your tax liability by 15%. So, if you made $100,000 investing and put the unrealized gain in a Qualified Opportunity Zone, you might ultimately pay taxes on only $85,000. Best of all, you are both saving money and helping the community.
Opportunity Zones also require you to invest in and improve the property. That’s our goal, as well, and high growth opportunities in these Zones can be exceptionally attractive.
According to the Tax Policy Center, there are three primary tax benefits for investing unrealized capital gains in Opportunity Zones:
- Temporary deferral of taxes on previously earned capital gains. Investors can place existing assets with accumulated capital gains into Opportunity Funds. Those existing capital gains are not taxed until the end of 2026 or when the asset is disposed of.
- Basis step-up of previously earned capital gains invested. For capital gains placed in Opportunity Funds for at least 5 years, investors’ basis on the original investment increases by 10 percent. If invested for at least 7 years, investors’ basis on the original investment increases by 15 percent.
- Permanent exclusion of taxable income on new gains. For investments held for at least 10 years, investors pay no taxes on any capital gains produced through their investment in Opportunity Funds (the investment vehicle that invests in Opportunity Zones).1
While various sorts of initiatives qualify for Opportunity Zone benefits, most investments have been focused on commercial and industrial real estate, housing and infrastructure. Given the nature and needs of Opportunity Zone communities, meeting the “substantial improvements” threshold required by the program is straightforward and axiomatic.
For Ballard’s real estate investment initiatives in Austin, Miami and Denver, there is one caveat to Opportunity Zones that must be considered. If Some or all of an investment in a Qualified Opportunity Zone is sold without the investment being held for at least ten years, any gain on the sale of the investment is subject to federal income tax. Most Ballard real estate investments will reach their full potential and maximum yield in a shorter timeframe, so Opportunity Zone benefits may not be applicable to current Ballard offerings as other benefits will likely apply.
1 Tax Policy Center, Briefing Book 2021, Opportunity Zones: https://www.taxpolicycenter.org/briefing-book/what-are-opportunity-zones-and-how-do-they-work
And That Just Scratches the Surface
Investors who set up LLCs or have an established company can also benefit from a myriad of other deductions related to real estate investments, including Section 179 purchases, work done to owned properties, and a variety of many other expenses right down to travel to the property site.
To paraphrase those irritating pharma commercials, ask your accountant if real estate investing is right for you. Working with the right professionals at Ballard Built, real estate investing unlocks tax advantages that can make the difference between just making money and truly building wealth.
Ultimately, tax savings should always be an important consideration when investing in real estate. In addition, the ownership of property is a central part of the American Dream, and a desire as old as the country itself. Public policy over the centuries has always leaned in favor of encouraging investment in real property, and these tax benefits will continue irrespective of political or economic changes. There is no equivalent investment. As President Franklin D. Roosevelt said over 80 years ago, “Real estate cannot be lost or stolen, nor can it be carried away…It is about the safest investment in the world.”