There is a wise motto that it is best to be intentional, and estate and tax planning are no exception. Real estate investing offers significant tax benefits (discussed in my previous articles and more to follow in the coming weeks and months), and it is best to proactively craft a strategy to maximize these benefits. In this article, I detail each area of the tax return, and exclusively focused on the federal tax return.
Overall Outlook on Tax Rates
Based upon our best knowledge, will tax rates rise or fall in the next 5-10 years? Depending on which way you think it might be, you would want to ask one of the below questions:
If tax rates are expected to rise, how can we (yourself and the tax advisor) defer deductions until later years/increase income now to pay less tax in the future? As a result, you will be biting the bullet and paying more taxes today.
If tax rates are expected to fall, how can we accelerate deductions/decrease income to pay less tax now?
Wage Income (W-2)
Assuming you have a job (commonly referred to as W-2 income), do you expect to be making more or less in the future?
If you project less, will there be other income streams below that will offset the loss in W-2 (for tax purposes)?
If you project more, are you open to maximizing the retirement vehicles at work or would you prefer to use that money for additional real estate purchases?
Interest Income and Dividends (Schedule B)
What is the nature of my interest income? Examples would include money market funds (more like a stream of income) or sign up bonuses that banks offer (one-time).
For dividends only – Are these qualified (meaning they’re taxed at preferred rates) or ordinary ( meaning they’re taxed at marginal rates)?
For preferential rates, qualified dividends are taxed at 0% tax if you’re in the 10% and 12% brackets, 15% tax for the 22% - 35% tax brackets, and 20% for the tax brackets that in the highest bracket)
Marginal tax rate is defined as the tax rate paid on the next dollar of income.
If the dividends are ordinary dividends, is there an opportunity to switch these to qualified (to pay less tax)?
How much are you making now and is this a significant portion of my income?
Do you expect to make more or less in 5-10 years?
Sole Proprietorship (Schedule C)
Do you have or anticipate having a sole proprietorship (not including real estate)? Two real estate examples could include real estate agent and home inspector.
Assuming the answer is yes to #1, you will want to ask the following:
What are my current revenue and expenses?
What deductions am I not taking that I am legally entitled to (i.e. phone, internet, home office, qualified business income deduction, etc.)
How long do you intend to keep this business? Will it grow in the future or shrink?
Are there other planning opportunities to reduce taxes such as opening a Solo 401(k)?
Due to the nature of various items with Schedule D, I’ve divided this section into non-real estate and real estate items.
Non Real Estate
Do you have any mutual funds that have capital gains distributions? If yes, is there another possibility to put money in an asset that has more favorable tax treatment?
Do you plan to sell any securities in the current or future years? (This is to be evaluated annually).
If yes to #2, are they short term or long term gains?
Do you expect any sales in the year for any rental properties?
Will you be executing a 1031 exchange? Do you understand all the steps necessary to complete a 1031 exchange? (Note: this will be discussed in a later article)
Will you instead be taking the money and not utilizing a 1031 exchange? What additional taxes will be owed? This will also be discussed in a future article.
How many properties do you currently own?
How many properties do you plan to acquire in the next 5-10 years?
What do you think will be the typical price point and what does the typical deal look like from a numbers standpoint?
Would you like to show more income in the current and/or future years to increase the likelihood of obtaining bank financing?
If yes, In what ways can you show more income/reduce expenses?
Are there any deductions that can be taken that you’re not currently taking? Examples include health savings, funding of an IRA, student loan interest, and alimony.
What tax credits are available and how much do they reduce tax liability (the amount owed to the government)? The most common examples include child and dependent care, child tax credit, education credits (American Opportunity and Lifetime Learning), and the foreign tax credit (usually applies if you own foreign stocks).
Putting It All Together
As shown with all of the different categories of income, deductions, and tax credits, there are many moving parts. In order to truly proceed with your tax strategy, you need an understanding of where you are now and where you are going. From there, you can best plan using the above questions with your tax advisor. Should you want the questions in excel format, feel free to use THIS RESOURCE.
If you have questions on your real estate tax strategy, you can reach me (Aaron Zimmerman) at firstname.lastname@example.org.