Did you realize that inflation and taxation are the leading threats to your financial stability? The value of one dollar decreases when a nation’s inflation rate rises. When you spend more on necessities like food and petrol, you eventually end up with less savings at the end of the month. There will be less savings and hence less investment potential. Your potential to develop wealth will be limited if you cannot invest and increase your money’s value.
According to studies, our most significant monetary expenditure is typically for taxes. Research that the Tax Foundation performed revealed that the average American spends more money on taxes than on all of their other living expenses combined.
It’s safe to assume that our standard of living will improve along with inflation. Therefore, this mitigates the negative aspects, right? Now let’s examine this issue from a financial perspective. If you have an annual income of $150,000, the marginal tax rate you are likely subject to is around 24%. Let’s say that due to the impacts of inflation, you were lucky enough to see a rise in your income to $200,000. When prices rise faster than your income can keep up with, having $200,000 in the bank could seem like a wonderful deal since it gives you more purchasing power.
On the other hand, one thing you may not consider is the accompanying tax expense. If you increase your salary to $200,000, you can find yourself in the next tax rate, which is 32% more expensive. Therefore, your taxation will also increase even if you have a higher salary.
You might not be able to stop inflation, but you can have some power over your tax bill. Although the statement is true, the purpose of this article is to discuss a method by which you can protect yourself from the negative effects of inflation and taxes. A potential method for doing so is investing in real estate. First, let’s discuss the reasons why investing in real estate can be a good way to combat inflation. Then we’ll go on to discuss the ways in which real estate might help you save money on taxes.
The Value of Real Estate and Inflation
Some investors have continued to buy property quickly despite the rising cost of living. That causes the curiosity of others to ask why? Let’s wait till things calm down in the market, should we? Since predicting the timing of the real estate market is a little bit beyond the scope of our expertise, we recruited the assistance of our good friend and published author, J Scott, to help provide some clarity on this subject.
When compared to other kinds of assets, real estate has the potential to be a profitable investment during times of inflation. The cost of real estate will likely grow in line with the price of basic goods. Looking back over time, we see that real estate has a propensity to perform quite well during times of high inflation.
In periods of high inflation, real estate may be a profitable investment for many reasons, one being that the rental price tends to rise in tandem with the general cost of living. Inflation is associated with a rise in salaries, as was explained before. Because of this, it’s conceivable that people will have the financial ability to pay a higher rent. As seen, wages are a significant factor in determining market rents. This is fantastic news for you as a landlord. Remember that a landlord has the power to increase rent more quickly the shorter the period of the lease, so keep this in mind. For instance, if you have a rental available for a short or medium duration, you may be able to enhance your rental revenue before the next guest booking takes place. During times of inflation, this is an incredibly potent strategy.
In addition to its other benefits, debt is the main factor in why real estate is a solid inflation hedge. As everyone in this room knows, real estate investors are huge fans of the idea of leverage. When inflation is a problem, having debt, particularly long-term debt with lower fixed interest rates, may be useful. More specifically, we are talking about positive debt, such as the debt you have on an investment property that brings you revenue. We are not discussing negative debt such as credit cards or personal debt incurred to pay for goods beyond our financial means. If you have debt related to investments, your payments may remain the same even if the purchasing value of the dollar declines. Therefore, a monthly bill of $2,000 on a rental home may not affect your real bottom line as much as you would think. Inflation, it is believed, is a kind of economic equality that punishes savers while benefiting borrowers. In preparation for this, many investors are drawing down on their stock holdings and making other preparations to put themselves in a strong position to protect themselves from the negative effects of inflation.
Invest the time and effort to prepare well. You could even be able to turn inflation into an asset for your business. Others believe that fixed-rate long-term debt may be the most effective hedge against currently available inflation. When it comes to purchasing a home to use as a rental, some investors believe that the true asset is the loan rather than the house itself. Some investors, whether doing the right thing or not, will pay above the asking price for a home if they believe inflation will help them pay off their mortgage. Whether or not inflation is a factor, you must do the appropriate research and calculations to determine whether or not the potential investment opportunity makes sense and satisfies your investment requirements. Real Estate by the Numbers is the most recent book by J. Scott, and it was written in collaboration with Dave Meyer. If you are interested in making smart investments in real estate, we strongly suggest you read this book.
The deductions for general expenses
Let’s discuss the tax advantages that come our way as real estate investors now that we understand why real estate a suitable investment might be to manage against inflation. When paying taxes, the Internal Revenue Service will consider you if you own a company if you make a real estate investment. And what this indicates is that you are eligible to use the many tax incentives provided by the tax law to company owners like yourself. When we speak about “businesses,” we are not referring to legal organizations such as limited liability corporations or organizations, which is important to keep in mind. We are only referring to the fact that you are engaged in the real estate investment business. In other words, it doesn’t matter whether your property is managed by you personally or by a formal entity such as an LLC; you still have access to a significant portion of the common expenditures you may take advantage of.
You have the ability, as an investor, to write off any regular and necessary costs that are associated with the real estate investment activities you engage in. Therefore, in addition to the typical expenditures such as interest payments, tax payments, and insurance premiums, you are also allowed to deduct extra costs associated with your real estate. Have you been to any real estate events recently? If this is the situation, some or all of your travel expenses, including airfare, lodging, and meals, may be tax deductible. A broad range of expenses may be deducted from the rent or other revenue you get from your rental property. As an investor, you must check to see that you are recording and appropriately keeping track of these expenditures throughout the year.
This is of utmost significance during periods of inflation since your tax rate may climb in tandem with your rise in income if inflation remains. Since you are now at a higher rate of taxation due to your increasing earnings, deducting a business trip that cost you $2,000 might now save you 32% of the taxes that it used to save you back when you were in a lower tax bracket.
Depreciation is an essential component of any discussion on the tax advantages of property ownership.
One of the clearest advantages of investing in real estate is the ability to take advantage of depreciation. The question now is, what precisely is depreciation? The Internal Revenue Service (IRS) enables investors to deduct the cost of the building’s acquisition from their taxable income. The fundamental principle upon which the tax law is based is that the structure you own will experience some level of wear and tear over time. Consequently, you are authorized to deduct a part of the original purchase price from your taxable income over a certain number of years. When it comes to residential real estate investments, depreciation gives you the opportunity to write off the property after 27.5 years. The Internal Revenue Service permits us to depreciate the cost of commercial assets such as office buildings and retail complexes over a period of 39 years.
Let’s look at an example to understand this better.
John puts a $30,000 deposit toward purchasing a rental property that costs $150,000 in total. Let’s say the building has an estimated value of $100,000. John may spread the cost of depreciation of the $100,000 property over 27.5 years, leading to an annual loss of around $3,600. It is essential to bear in mind that John might take advantage of this depreciation, despite the fact that the amount of his initial deposit did not affect its availability. To put it another way, he would have been entitled to the same amount of depreciation even if he had bought the property completely in cash. If, on the other hand, John had purchased this home with zero down payment, he would have been liable for the same amount of depreciation. You can see how the government provides a tax break for us when we use the borrowed money.
There is an option available to boost the effectiveness of this tax advantage for the current year. This is accomplished by combining the use of two different methodologies, namely, cost segregation and bonus depreciation. By doing a cost segregation analysis, you may speed up the process of depreciating your rental facility such that it takes place over a shorter period than the standard 27.5 years. During a cost segregation analysis, your financial advice team will work with you to determine the worth of the structure of the building and then break that value down into its individual components. Consequently, you will be able to speed up a portion of the depreciation over the first few years that you hold the asset. First, let’s look at a specific example of how this happens.
Let’s imagine you spent $100,000 to purchase a home that cost $500,000. Assuming the building portion of the purchase cost is $400,000, your ordinary annual depreciation may be about $14,500. You may be able to expedite a significant portion of that depreciation by doing a cost segregation study, which could result in as much as $120,000 worth of depreciation in the very first year. That translates into the possibility of offsetting $120,000 of your rental income from the taxes you owe for this year by using that deduction.
Now let’s put inflation into perspective by looking at an example of it. It’s possible that your previous income put you in the 24 percent marginal rate. This indicates that the $120k in depreciation enabled you to avoid around $28,000 in taxes that were owed on the revenue from your rental property. On the other hand, since inflation has caused a rise in the purchasing power of your money, the real tax rate you pay can be 32%. Therefore, a reduction in taxes equal to 32% of $120,000, or $38,000, is achieved. As can be seen, a rise in your tax rate results in a corresponding increase in tax savings.
What happens if you don’t have enough money from rent or other passive income sources to cover a significant portion of the depreciation expenditure you paid this year? It’s excellent news that you won’t have to miss these financial benefits. Rental losses considered passive might be carried over into subsequent years to offset the tax impact of other forms of passive income. In addition, if you’re like many investors and have other forms of passive income (besides rents) this year, you may use the extra rental losses to reduce the amount of those other forms of passive income. If either you or your spouse can earn a living as a real estate expert, you’ll have a significant advantage when it comes to investing in real estate. The rationale for this is that as a real estate professional, you may be able to utilize rental losses to offset the taxes owed on income from other sources, such as W-2 wages, stock profits, cryptocurrency gains, and distributions from retirement accounts.
You are free to put the cost segregation plan on hold indefinitely if you cannot take advantage of the associated tax advantages at this time. You can plan to integrate the execution of this approach into a future year to get the best benefit from it, which is an excellent point to consider when doing any kind of planning. In other words, start preparing in advance so that you may use it in a year in which you are not limited in the number of passive losses you can sustain.
As can be seen, the size of our tax burden rises along with both the rate of inflation and the level of our wages. Because of this, engaging in tax planning is even more vital since every dollar of deductible that is produced enables us to save money despite the higher tax rate.
Benefits to Taxpayers Associated with Appreciation
One of the tax advantages of investing in real estate during periods of inflation is that appreciation is often exempt from taxation. Because you haven’t made a profit from selling the property, no tax will be due. Take, for example, the acquisition of a rental property that you made for the value of $150 000. The property’s value has increased to $250,000 due to the high level of inflation seen in the current real estate market. Because of the appreciation of our property, we are not required to make annual tax payments due to this gain. That money is increasing for our benefit despite the absence of any tax burden.
Let’s go one step further with this. Let’s imagine you’ve wished to take advantage of the substantial amount of equity that has accrued in your rental property as a direct consequence of price increases over the years. You may execute a cash-out refinancing on this property, and you won’t have to pay taxes on the money you take out of it at this time. What would happen, for instance, if you decided to use the sixty thousand dollars you obtained from a cash-out refinancing to purchase more real estate? Not only do you not have to pay taxes on that $60,000 right now, but you also can deduct the interest expenditure linked with it from the revenue you get from renting out your property.
Let’s discuss some of the future tax advantages of employing real estate during times of inflation now that we’ve focused on some of the existing tax advantages of doing so.
Real Estate 1031 Exchange Sales
As property investors, one of the major tax benefits that have traditionally been popular is the potential to sell valued rental properties while simultaneously deferring payment of capital gains taxes via a 1031 exchange. This is a technique in which the investor sells one valued rental home and then reinvests the proceeds from the sale into another rental property, delaying the payment of any related capital gains taxes (or properties). There are a few guidelines that must be followed in order to be eligible for the tax deferral advantages that are available.
- You have a period of 45 days, starting on the date of the sale, to choose the property that will serve as your replacement.
- You have one hundred eighty days from the day of the sale to complete the transaction on your replacement property.
- The cost of purchasing the new property (or properties) must exceed the amount the previous property was offered for sale.
- You must have more or equivalent equity in your replacement property than in the one you’re selling.
You can delay paying any taxes related to the sale of your home if the agreement is managed properly. You are able to delay the payment of any applicable taxes, including the federal capital gains tax, any applicable state capital gains tax, and even the net investment tax.
First, let’s look at a practical example.
1031 Exchange Example
The investment home in Long Beach that Kyle owned and rented out cost him $200,000 when he bought it. Due to the unexpected market conditions, the property’s value has increased to $500,000. Because of the impending implementation of new rent control regulations, Kyle has decided that he no longer wants to reside in Long Beach. Kyle may likely owe more than $100,000 in taxes if he decides to sell the rental property via the traditional channels. Instead, Kyle engages in what’s known as a 1031 exchange via the use of proactive preparation. He receives $500,000 for the sale of the property in Long Beach. He spends that money on purchasing a modest apartment complex in Florida. Because Kyle followed all of the regulations regarding the money and the timeframe, he was exempt from paying any taxes on this transaction. Over one hundred thousand dollars’ worth of taxes has been postponed for Kyle.
The 1031 exchange is a fantastic approach that has proven successful for many investors. But how precisely does this factor into the picture when times are marked by inflation? The purpose of a 1031 exchange is to delay the payment of any applicable taxes on capital gains to a later date. After five years, Kyle would be responsible for paying capital gains taxes if he decided to sell the property for a profit. Because of inflation, Kyle could make his tax payments using inflated currency. This indicates that in precise terms, the amount that he will have to pay five years from now will be less expensive than the amount that he would have to pay using dollars from today. This is just another illustration of how tax preparation using real estate might be very effective during times of high inflation.
If Kyle decided to sell in year five, he could always perform another 1031 exchange into a new home if he wanted. This is an excellent method that enables investors to indefinitely postpone the payment of taxes on capital gains while at the same time wealth accumulation. An investor is not restricted in either the amount of cash they can exchange or the number of times they may do so by using the 1031 strategy.
Robert Kiyosaki, the author of the best-selling book Rich Dad, Poor Dad, is known for sharing the valuable lesson that it is not about how much money you earn but how much you get to retain. He emphasizes the important role of this point. We are conscious that taxation and inflation are two of the most significant factors that damage our wealth. We also know that the best times to make money are when you least expect it. Although some individuals are developing irrational levels of anxiety due to what they are experiencing today, it is essential to be aware that considerable wealth may be accumulated even during periods of inflation. Inflationary times provide many unique opportunities.
Make sure you give yourself enough time to participate in some preventative preparation. If done properly, it can assist in ensuring that you not only survive but really flourish during times of rising prices by ensuring that you have a cash reserve to ultimately depend on.