W-2 Income, Investment Real Estate, and Taxes.

“I’m going to invest in real estate and start an LLC because it will help me pay less taxes.”

It is easy to see where you might get this idea, given all the talk about “real estate investments” and “tax strategies” on the Internet, YouTube, and social media.

I hate to be the bearer of bad news, but owning an investment real estate property will not help you pay less taxes on your W-2 income.

Not only will it not help you pay less taxes against W-2 income, but this is the wrong reason to invest in real estate.

Here’s why.

Ordinary income vs. Passive income

As a W-2 employee, the income you generate from employment is categorized by the IRS as ordinary or “earned” income.

As a real estate investor, unless you or your spouse can prove to the IRS that the majority of your time, defined as a minimum of 750 hours per year, proven with detailed time logs, is spent directly on real estate activities, any gains, profits, or losses, are defined as passive from real estate.

The vast majority of retail investors cannot substantiate this claim with one or two properties. Setting up the property for rent on Airbnb or mowing the lawn once a week won’t get you there.

Passive Losses, like those generated from an investment property that costs more to operate than can be earned, cannot be used to offset ordinary W-2 income.

Additionally, when did it become a good idea to look for investments that lose enough money each year to offset income and gains from other sources?

David Tepper buying the Carolina Panthers as an investment into a business that loses money each year so he can offset millions of dollars in income from his other companies might be a good idea for a guy who can afford to spend millions to offset millions elsewhere.

But for 99.999% of investors looking to grow their wealth and manage taxes along the way, looking for investment opportunities that lose money, thinking the tax savings are worth more than a better profitable investment, is simply a poor investment decision.

Now, you might be thinking, but Rob,

What about depreciation?

What about the personal expenses I can write off?

Those are fair questions. However, no matter how many expenses you write off inside your real estate LLC, those losses will not pass through to help you reduce your ordinary income from W-2 employment.

Those losses will sit there indefinitely until you produce passive capital gains or income from the same or other similar sources. Those losses can then be used to help reduce the total gains or income that you will owe taxes on.

For example.

Say you own one real estate property that generates $10,000 annually in net income from rents after all expenses and depreciation are paid.

Say you purchase a second property. Say this property in the first year doesn’t get renters in right away, generating a loss for the year from expenses and depreciation. Say this loss totals -$10,000.

The -$10,000 loss from Property 2 can offset the $10,000 income from Property 1.

Alternatively, if Property 2 is the ONLY property you have and in Year 1 you have -$10,000 loss on the property, you cannot use this -$10,000 to reduce taxes on your W-2 income. You will carry forward the loss until it can be used to offset future gains/income from similar activities.

Conclusion:

Losses from Investment Real Estate will not help you reduce taxes on W-2 income.

Don’t get me wrong; I don’t particularly appreciate paying taxes either, but looking for investments that lose money in a manner that could hypothetically lead to a significant reduction in your tax bill is probably not the best path forward. Most of the time, an unprofitable investment = a lousy investment.

Instead, focus less on taxes and more on high-quality, long-term investment opportunities that are highly likely to produce profits and appreciate in value.

If tax planning opportunities arise from these investments (which they will), that’s a bonus.

Securities offered through LPL Financial, Member FINRA/ SIPC. Investment advice offered through IHT Wealth Management, a registered investment advisor. IHT Wealth Management and AutomotiveWealth are separate entities from LPL Financial. 

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