📈 How the rich use depreciation to avoid taxes and get richer

Ever wonder how the rich make millions of dollars per year in income and never seem to pay a single penny in taxes?

It all comes down to understanding an important concept: depreciation.

Learn how it works, and you, too, could acquire cash flow producing assets – like real estate – that may generate 100% tax free income.

But do it wrong, and you’ll likely be subject to some gnarly clawback provisions that erase your tax deductions.

That’s the topic of today’s issue of Private Capital Insider

-Jake Hoffberg

P.S. Today’s issue is a follow-up from last weeks’ issue, How the rich use debt to avoid taxes and get richer.

One of our readers asked a pretty good question I wanted to quickly respond to.

This comes down to a few key mechanisms:

• Canceled Debt: When the acquired company eventually declares bankruptcy, it can discharge or cancel its outstanding debts that were taken on as part of the LBO.
  
  This canceled debt does not count as taxable income, thanks to exceptions in the tax code for bankrupt companies.
  
  As majority shareholder, the PE firm can consolidate the target company's financials, and also benefit from this tax write-off on its own returns.

• NOL Carryforward: The canceled debt also creates a Net Operating Loss (NOL) for accounting purposes, by reducing net income. This NOL can be carried forward by the PE firm to offset income and gains from other investments, and thereby reduce its tax bills.
  
  Sometimes the NOL can also be purchased directly from the bankrupt target company during bankruptcy proceedings.

• Depreciation: The PE firm can accelerate depreciation of the target company's assets after acquisition. This reduces taxable income and provides another valuable deduction. The tax savings from depreciation then accrue to the PE investor.

And that sets us up nicely for today’s topic on how depreciation works.

How Insiders and Elites Pay (almost) Zero Taxes

On a regular basis, media outlets slam the many Fortune 100 companies that – despite record profits – pay barely any taxes…

And of course, the many billionaires – like Warren Buffet, Jeff Bezos, Michael Bloomberg, and Elon Musk – who also pay basically no taxes.

While these shocking numbers most certainly make for great headlines, the unfortunate reality of “the rich don’t pay their fair share of taxes,” is far more mundane: taxable profits (or losses) are determined by tax laws, whereas book profits (or losses) are determined by accounting standards.

And if you are looking for the ultimate example of “the devil is in the details,” look no further than the ~75,000-page-long tax code.

Source: Number of Pages in the Tax Code

With regards to the length of the tax code, it’s important to understand there is the actual U.S Tax Code – enacted in Title 26 of the United States Code by the U.S. Congress, 6,871 pages long – and the ever-expanding tax regulations, interpretations, and official tax guidance that brings the total to ~75,000 pages today.

These Treasury regulations, also referred to as Federal Tax Regulations, continue from where the Internal Revenue Code stops, by providing the official interpretation of the code by the U.S. Department of Treasury.

While these are not tax laws, they are critical to understanding how to use the tax laws to reduce tax liability.

This means that corporations (and people) don’t use some sneaky loopholes to avoid paying taxes. In reality, they are simply following the rules enacted by Congress (which are also influenced by lobbying efforts representing said taxpayers).

However, these rules – and the strategies used to take advantage of them – are not easily understood and implemented by the majority of businesses.

That’s why it’s no surprise to hear KPMG say that tax departments are every company’s hidden advantage.

And if you want to build generational wealth the way Insiders and Elites do, understanding how the tax code works is key (albeit, sometimes mind numbingly boring, and otherwise tedious to learn about).

The Tax Code as an Incentive System

In today’s political climate, “Tax the Rich” – and the resentment people feel towards the rich – is, in my opinion, plenty warranted when you consider historical tax rates compared to today’s.

If you’re a “history doesn’t repeat itself, but it sure does rhyme” type of person, we’re more or less in some future version of the infamous “Gilded Age” – a pejorative term for a time of materialistic excesses, combined with extreme poverty, post Civil War (~1865 - 1900).

For reference, this narrative is often supported by the share of income earned by the top one percent of income earners (called income inequality)...

And more to the relevance of this discussion, the “fairness” of the tax code as it relates to everyone paying their “fair share.”

Even in today’s divided political climate, the one thing it seems most of us can agree on is that we pay more than our fair share.

But in order to have any real discussion on what is “fair” and what isn’t, it’s important to understand what purpose tax deductions serve: as an incentive system to influence the behavior of corporations and individuals.

Why? Because even the almighty American government can’t do everything on its own…

And the penalty for not providing certain benefits to its citizens means they might decide to revolt and topple said government.

That’s why the government provides incentives for the private sector to help it accomplish certain objectives deemed important.

Most notably, governments are interested in stimulating the economy, encouraging job creation, and promoting socially beneficial activities.

These tax breaks are, in theory, supposed to be a net-positive activity in the form of desirable outcomes and future tax revenues.

With that in mind, let’s talk about how this logic applies to real estate, and why it has such incredible tax breaks

The government allows generous depreciation deductions and tax breaks for residential and commercial real estate investments for a few key reasons…

• Housing: Encouraging real estate development helps boost housing supply, especially affordable housing. Real estate tax incentives make it more attractive for developers to build residential properties. This also stimulates construction jobs.

• Business Infrastructure: Commercial real estate provides essential infrastructure for businesses to operate and grow. Deductions make it easier for investors to develop office buildings, industrial facilities, retail space, etc. This supports business activity and job creation.

• Economic Growth: A robust real estate industry has ripple effects across the whole economy, driving construction, finance, and other sectors. Real estate tax breaks keep investment flowing, and stimulate broader economic growth.

• Wealth Creation: For many middle-class investors, income-generating real estate provides an accessible means to build wealth and stability. Deductions help level the playing field vs. larger corporations.

• Property Taxes: Increased real estate development raises property values, which raises more tax revenue from property taxes for local governments.

When you look at it through the lens of the entrepreneurs and investors who finance these projects… We have to take into account that they are taking on some form of risk to build buildings, create jobs, and otherwise help to drive taxable revenue through the downstream impact.

In many ways, the positive impact they create in the economy could be considered “paying their fair share,” and a reasonable justification for why they pay a lower tax rate.

However, that’s not to say that all tax deductions produce fair and equitable outcomes, or that – thanks to lobbying – the tax code isn’t unfairly tilted in favor of the Elites (for example, the Buy, Borrow, Die strategy)

After all, if someone isn’t paying taxes on something, someone else has to pay for it in order to make up the shortfall.

But here at Private Capital Insider, we’re not in the business of armchair activism and otherwise complaining about how life isn’t fair.

Instead, we find it more useful to learn about how the system actually works, and how we can participate in these incentive programs that lower our tax burden by providing useful goods and services to others.

For many people, this means becoming a real estate entrepreneur and/or investor.

Debt, Depreciation, and Deductions:
How to Pay Zero Taxes with Real Estate

Real estate is often marketed to retail investors as a proven pathway to building generational wealth.

While, technically speaking, the majority of today’s billionaires built their fortunes through banking…

Real estate has been a cornerstone of the global financial system for thousands of years.

Why? Because real estate – whether it be for mining & minerals, oil & gas, agriculture, forestry, housing, commercial, or some other industrial use – is a capital asset that generates income (either in the form of rent or royalties).

But what really turns real estate into a potentially tax-free income producing asset is something called depreciation – an annual income tax deduction that allows you to recover the cost (or other basis) of a certain property over the time you use the property.

The kinds of property that you can depreciate include machinery, equipment, buildings, vehicles, and furniture.

You may depreciate property that meets all the following requirements:

1. It must be property you own.

2. It must be used in a business or income-producing activity.

3. It must have a determinable, useful life.

4. It must be expected to last more than one year.

5. It must not be excepted property, which includes certain intangible property, certain term interests, equipment used to build capital improvements, and property placed in service and disposed of in the same year.

Generally speaking, you cannot deduct the entire cost of the property you acquire, build, or improve in the year you buy it (although there are exceptions, which we’ll discuss later).

Instead, the deduction (called depreciation) is spread out over a period of time to take into account the wear and tear on the asset, as well as its maintenance and improvements.

This recovery period is then applied to the cost of the property (i.e., your cost basis), which in turn, is an expense that can then be used to offset the income generated by the property, to the point where you could show a LOSS on paper, and pay zero taxes on that income!

But how many years is that depreciation spread out?

Well, that depends on the asset being depreciated, and which depreciation method you choose. Under the Modified Accelerated Cost Recovery System, the IRS has specified two methods:

• General Depreciation System (GDS) - The IRS's primary depreciation system with recovery periods of 3-25 years. This allows for faster depreciation through declining balance methods.
  
  Most real estate uses GDS.

• Alternative Depreciation System (ADS) - Requires longer recovery periods of 10-40 years, and only allows straight line depreciation. Required, in some cases, to prevent overly fast write-offs.

These two systems depreciate property in different ways, such as by method, recovery period, and bonus depreciation.

Generally speaking, the GDS is the most commonly used format, and provides four different methods:

Straight line method - With straight line depreciation, you deduct the same amount each year, to depreciate the asset evenly over its useful life. This results in lower depreciation expenses in the early years.

Double declining balance method - With this accelerated depreciation method, you deduct twice the straight-line rate in the first year.

The method reflects the fact that assets are typically more productive in their early years than in their later years – also, the practical fact that any asset (think of buying a car) loses more of its value in the first few years of its use.

Units of Production Depreciation Method - The units-of-production depreciation method depreciates assets based on the total number of hours used, or the total number of units to be produced by using the asset over its useful life.

Sum-of-the-Years-Digits Depreciation Method - The sum-of-the-years-digits method is one of the accelerated depreciation methods. A higher expense is incurred in the early years and a lower expense in the latter years of the asset’s useful life.

In the sum-of-the-years digits depreciation method, the remaining life of an asset is divided by the sum of the years, and then multiplied by the depreciating base to determine the depreciation expense.

Here is a graph showing the book value of an asset over time with each different method:

Under GDS, each property type has a different recovery period. For example:

• Automobiles: 5 years

• Computer equipment: 5 years

• Office furniture: 7 years

• Residential rental property: 27.5 years

• Non-residential real property: 39 years.

Why should you care about this? Because you can accelerate your depreciation schedule if you implement what’s called a Cost Segregation Study – which allows a taxpayer who owns real estate to reclassify certain assets as Section 1245 property instead of Section 1250 property.

There are four structural components taken into consideration during cost segregation:

• Personal property, such as furniture and carpeting, will be depreciated over the next five to seven years

• Land improvements like landscaping, paving, or sidewalks are depreciated over a 15-year period

• Structures and buildings are depreciated over 27.5 or 39 years, according to the specific kind of property being dealt with

• Land assets are not depreciated at all (as land is considered to have an infinite use of life)

The primary goal of a cost-segregation study is to identify all construction-related costs – like lighting fixtures, electrical wiring, HVAC, flooring, and exterior improvement – that can be depreciated over a shorter tax life (typically 5, 7 and 15 years) than the building (either 27.5 or 39 years).

To make this even sweeter, in addition to accelerated depreciation, you can also claim something called bonus depreciation – a government incentive program that allows for a higher depreciation deduction in the first year, with the intention of providing relief to new businesses.

In order to take advantage of bonus depreciation, businesses must meet certain requirements.

• The asset must be placed in service by the business. This means that regardless of when it is purchased, you cannot take the bonus depreciation until it is in use.
  

• The asset must also be new to the taxpayer (but does not need to be “new”). If you personally own a vehicle and decide to start using it for business purposes, the car would not qualify for bonus depreciation, since you already own the asset.
  

• The asset must be owned. You cannot depreciate assets that you are leasing or renting, as you would have no cost basis to do so.

Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), only 50% of property improvements could be deduced. After that, it increased to 100% through 2022, with the deduction decreasing by 20% each year starting in 2023, phasing out completely in 2027.

And as crazy as this sounds, thanks to the bonus depreciation under TCJA, you could depreciate 100% of the value of car washes and gas stations in the first year!

According to B+E broker, Jim Ceresnak:

But deductions aren’t the only incredible tax break you can get with real estate…

As a real estate entrepreneur/investor, not only do you own the property, you also own a real estate management company (often an LLC filing as an S-Corp).

This means you can deduct businesses expenses related to the management and maintenance of the property, which may include:

• Property taxes

• Insurance

• Management costs

• Maintenance

• Utilities

• Repairs

PLUS! You can deduct any expenses related to your business, which may include things like advertising, legal and accounting fees, and equipment needed to operate the business.

PLUS MORE! If you have Real Estate Professional Status you can get some additional benefits – most notably, you can use deductions to reduce not just your passive income (which rent would qualify as), but you can use it to deduct up to $25,000 of losses per year against your active income as well!

PLUS EVEN MORE! You can deduct the interest payments on the money you borrow. This includes any interest paid on unsecured loans or credit cards used for expenses related to your real estate (definitely talk to your CPA about this).

Best of all, if you continue to improve the property value, you can borrow even more money against that asset, and the debt-servicing cost is tax deductible.

This is what makes real estate an excellent asset for the Buy, Borrow, Die strategy.

But let’s say you do decide you want to sell the property, what happens then?

One of the things you’ll need to be mindful of is something called depreciation recapture – the gain realized by the sale of depreciable capital property that must be reported as ordinary income for tax purposes.

Depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis. The difference between these figures is thus "recaptured" by reporting it as ordinary income (and not the more favorable long-term capital gains rate).

But don’t worry, the tax code has got you covered with something called a 1031 exchange (named for IRS Section 1031 of the IRS’s tax code).

A 1031 exchange allows you to defer taxes on the sale of any real property, so long as it is exchanged for “like-kind” property.

If you have not done any depreciation or cost segregation, a 1031 may be a straightforward swap.

However, the tax code doesn’t let you “double dip” on depreciation, so you will need to depreciate the new property in order to avoid the depreciation recapture.

Definitely talk to a qualified tax professional about this as there are a lot of moving parts to this, and plenty of ways to mess things up.

Final Thoughts: Tax Knowledge is Power

I’ve said it before, and I’ll say it again: the single easiest way to improve your investment returns is to reduce fee drag.

In almost all situations, taxes are the single largest “fee” you pay on all income you earn.

That’s why I always have an issue when people talk about “performance, net of fees and taxes.”

While many people try to chase outsized returns by investing in high risk opportunities…

I’ve found it way simpler to focus on assets that deliver “normal” returns but offer some sort of tax advantage.

Remember: one of the best investments you can make are in the people you know, and the knowledge you acquire.

It might seem like you’re spending a lot of time and money upfront to hire the right team of advisors, set up the correct corporate entities and tax strategies, and improve your Financial IQ.

But if you want to build generational wealth the way Insiders and Elites do, all you have to do is get over that initial learning curve and just get started.

As you build confidence in the asset class – and get more comfortable with how debt, depreciation, and tax deductions work – you can start scaling-up the investment strategy.

And that is how generational wealth is built!