Five Basics to Warm Up To

By Jason Watson, CPA
Posted Tuesday, August 27, 2024

Before we get into which tax deductions and tax moves you can take, there are some basic concepts to help formulate your thinking.

Marginal Tax Rate

Quick lesson on rental property tax deductions. When you write a check and it has a tax savings element (repair, office expense, 401k, IRA, charity, etc.) it is not a dollar-for-dollar savings. For example, if you are in the 22% marginal tax bracket, you must write a check for $4,000 just to save $880 in taxes. Keep this in mind as you read this information on tax deductions. Also keep in mind that cash is king, and that perhaps paying a few more taxes today with the added flexibility of cash in the bank can be comforting.

Tax Deductions versus Tax Deferrals

Tax deductions generally reduce taxes today, and you are done. Tax deferrals, on the other hand, are little IOUs to the IRS. They are tax savings today but you might owe the money back. A 401k deferral is a great example- you lower your taxable income today, but when you pull the money out during retirement, it will be taxable income.

Rental property depreciation is similar since when you sell the property you will have depreciation recapture. This permits the IRS to take back (i.e., “recapture”) some of the tax benefits you received over the years through depreciation deductions. As such, depreciation is like a 401k deferral and might be a little tax bomb later on. Sure, you can do a series of 1031 like-kind exchanges and pull cash out with refinancing, but you get the idea.

Cash Savings or Tax Savings

You can save $50,000 today! Yes, today! You just need to write a $150,000 check to your church. Huh? That might not sound like the best idea to a lot of people since so much cash is leaving their checkbook. Another way to look at this is this- most people say, “I want to save taxes” but really what they are saying is “I want to save cash.” Who doesn’t?

In other words, most people are in the cash-saving business not the tax-saving business. If we can do both, great. However, most tax-saving moves take cash, and cash is what you want to keep. Having said that, the biggest weapon to a rental property owner is depreciation, especially accelerated depreciation. Unlike most other tax savings strategies, depreciation can be viewed as a cashless tax deduction although cash is used to purchase the rental property. Why? You get it back when you sell the property.

Said differently- if you travel to your rental property, the cash you spend is lost forever although it might provide some tax benefit. Therefore, you want to ensure the travel expense is necessary for operational considerations. Conversely, when you depreciate a rental property, you are not writing a check or swiping your credit card directly. This makes the deduction cashless in a sense.

Please keep cash savings versus tax savings in mind as we get into the rental property deductions below.

Building Wealth

At the end of your life, you’ll measure your financial success on the wealth you built not the tax you saved. We agree that a part of wealth building includes tax savings or deferrals. For example, you purchase a cost segregation study that creates a big tax deduction yielding a nice chunk of accelerated cash flow. This in turn is redeployed to buy another rental property. Tax deferral (because of depreciation recapture) used to build wealth. Beauty!

However, be careful not to sacrifice wealth for the thrill of a tax deduction (or deferral). Here is an example- let’s say you stuff all your available cash into a tax-advantaged retirement account such as a 401k. A few years go by, and a great rental property comes on the market, but your cash is all tied up in a 401k. So, you sacrificed potential building of wealth by not having an intermediate investment strategy that is not tax-advantaged for the sake of tax deferrals.

Let’s really drive this point home- to reduce taxes by spending cash just to have tax savings bragging rights at the party tonight is silly. To reduce taxes by spending cash to turn around and use the savings to build wealth is ideal. The 401k deferral isn’t all bad if the tax deferral is used to build wealth elsewhere.

Moving on…

The Trick

Here’s the trick. The Holy Grail if you will. You need to find a way to deduct money you are already spending. Read that again. For example, if you have a travel budget then you are already comfortable with a certain amount of money leaving your person. Let’s find a way to deduct it through your business or rental property activity.

Automobile depreciation? Same thing. You are already comfortable with automobiles losing thousands of dollars in value especially in the early years, so let’s find a way to make this degradation in value a tax windfall.

Remember that the greatest trick the devil ever pulled was convincing the world he didn’t exist. The second greatest trick was finding a way to deduct the expense. You gotta love The Usual Suspects. Classic!