How To Save $100k In Taxes By Making Your Non-Working Spouse A Real Estate Agent

Did you know you can use tax loopholes to save $100k on taxes and get the government to kickstart your real estate empire?

Yes, it’s true.

This is going to be a part of a series of posts on millionaire tax secrets. These are very widely known in real estate investment circles, but not common knowledge among high-income earners like physicians, attorneys, or sales or tech professionals.

Let’s start.

Every so often I meet prospective clients that meet a certain profile.

They’re a couple in their mid-30s to late-40s. One of them is successful in his or her career and earns $400-500k a year in earned income. The other spouse is a stay-at-home spouse with no earned income. They have invested most of their after-tax savings in real estate. They often own about $2-4 million worth of real estate in California, with $1-2 million in mortgage indebtedness. And they always complain about taxes.

Let’s look at some rough numbers to get a better idea of the situation:

2021 Income: $450k
Itemized Deduction: $35k
Federal Marginal Tax Bracket: 32%
Federal Tax: $97.2k
CA State Marginal Tax Bracket: 9.3%
CA State Tax: $32.7k
Total Tax: $129.9k

Federal Marginal Tax Bracket: 32%

Federal Tax: $97.2k

CA State Marginal Tax Bracket: 9.3%

CA State Tax: $32.7k

Total Tax: $129.9k

Amount left after taxes: $320.1k (actually a little less because there are always other taxes)

If they spend $240k, they’re left with roughly $80k a year to invest.

Let’s assume they saved up for a few years and bought a $1 million rental house with 20% down. Also, assume the value of the land is $400k and the value of the building structure (and structural improvements) is $600k.

At 5% mortgage interest (yes, these rates, or lower, were available up until the beginning of 2022), their monthly total all-in cost, called PITI (Principal, Interest, Taxes & Insurance) is $5,461, of which approximately $4,400 is deductible on his taxes as an expense. Let’s assume it rents for $4,500 a month so it’s basically providing $100/month or $1,200/year as cash flow.

Normally, this $1,200 would be taxed as ordinary income, or at his highest marginal rate of 41.3%.

But real estate investors get to claim a phantom loss called depreciation. To calculate depreciation, you take the value of the improvements and divide it by their expected lifespan. For residential buildings, this is 27.5 years, and for commercial buildings its 39 years.

We take the $600k in this example and divide it by 27.5, giving us $21.8k in annual losses for the next few decades. So the $1,200/year in cash flow is more than offset by this $21.8k in losses, resulting in a tax-free income of $1,200! This results in $20.6k in unused depreciation losses.

Any unused depreciation loss is carried forward indefinitely until you use it against other passive income, or you sell the property. (Once you sell the property, this depreciation is recaptured at 25% federal tax level plus state taxes, but there are ways to avoid this, so we’ll ignore this for now.)

This all sounds great until you realize this couple has been missing out on a large tax break.

Instead of just having the non-working spouse be a homemaker if you designate them as a real estate professional, you open up a lot of potential tax breaks.

For real estate professionals, instead of carrying the $20.6k in unused depreciation losses forward to the future, we get to deduct this against the working spouse’s W2 income. This results in immediate tax savings of $8.5k.

 It gets better.

Due to the changes enacted in the 2017 Tax Cuts & Jobs Act, you can claim 100% bonus depreciation on section 179 deductions.

What this means is we can conduct a Cost Segregation study, where an appraiser goes through the property and lists out all the appliances, fixtures, carpeting, irrigation, landscaping, etc. that might have a life expectancy of 5,7 or 15 years and assigns a dollar value to it.

On $600k of improvements, it can be possible to claim $200k or more in section 179 deductions. Claiming 100% bonus depreciation on this means you get to claim $200k in losses instead of the $20.8k we claimed above.

In a 41.3% marginal tax bracket, this can save you $83k in taxes, or about 40% of your down payment. If you’re in a 37% federal tax bracket and 12.3% state tax bracket, the benefit is even larger, and you’ll save nearly $100k in taxes or almost 50% of your down payment!

When the government is refunding 50% of your down payment, this can really help accelerate your property acquisition cycle.

So what’s the catch?

• You need to get a cost segregation study done, which costs a few thousand dollars.

• 2022 is the last year you can take a 100% bonus depreciation on section 179 expenses. In 2023, it drops to 80% and continues to drop 20% a year until gone. But keep an eye open for tax loopholes like these, which resurface periodically.

• One spouse must qualify as a real estate professional. This means getting a real estate license or working 750 hours in real estate, and deriving 50% or more of your income from real estate. This is usually difficult to do if you have a full-time job and is best suited to non-working spouses, or those that actually work in real estate.

That’s great, but what if both spouses work? Is there a way to benefit from this?

There is! But it relies on a different set of rules, one that applies only to short-term rentals. I’ll address that in a future post. (Sign up to get notified of new posts).

 Bear in mind I am not a CPA and this is neither tax nor financial advice. However, I run these types of analyses for my financial planning clients.

Also, all investments need to stand on their own as solid investments and not just tax breaks. This is getting harder to do when mortgage rates are 7%.

If you need help calculating the returns on a real estate investment, or other aspects of retirement and investment planning, click here to book an appointment.