One of the best reasons to buy and hold real estate is to save on taxes. Or so we’re told. Let’s look at a few examples of how much money can be saved in taxes with a sample real estate portfolio.
The table below is the current 2022 tax brackets for individuals. It ranges from 10% for the lowest income earners to 37% for the highest. “Total Taxes” is calculated as if you earned the top dollar amount threshold. “Pay vs. Take-Home” illustrates your before and after pay for each tax bracket. Effective tax rate is outlined in the example below.
Because you pay a different percentage of taxes for each dollar in the different brackets, the effective tax rate is different, and usually lower. In the case below, our sample individual paid $15,213 in taxes on $89,075 of W2 income. This amounts to a 17% effective tax rate because only 10% was paid on the first $10,275, 12% on the next $31,499, and 22% on the next $47,299. Total Taxes is calculated as if you earned the top dollar amount threshold.
Here’s the breakdown if you earned $89,075.
Looking back at the original chart, we’d be making almost $90,000 on paper but can only take home and spend $73,862.
Many real estate owners tout this difference between paper income and spendable income as a main reason for why you want at least a part of your personal wealth in real estate. How big of a difference does this actually make and when does it start to matter?
Real Estate Tax Shield
Real estate has what is called a “tax shield” because accounting math is slightly different than cash flow math. A real estate owner can deduct non-cash expenses from the actual real estate income in order to pay less in taxes. An example of a non-cash expense is depreciation. On your taxes you get a free deduction because your building wears out every year. This deduction does not have to be paid out of your cash flow.
A real deduction in your cash flow (that is also a deductible expense) is a leaky roof. The roof needs to be repaired and you need to pay the person doing the repair.
You can also deduct expenses such as insurance, property taxes, and mortgage interest.
To investigate the tax benefits of real estate, I’m going to use a very simplified example of a $100,000 property. (Sign Up below to get a copy of the spreadsheet I used so you can see all my assumptions and calculations.)
Cash Flows of $100,000 example property
Our example property will cash flow $6,973 after paying expenses that require cash. These include Debt Service (aka the mortgage), Property Taxes, and Insurance. Normally these three are bundled together as your PITI: Principal, Interest, Taxes, Insurance.
This means the property requires $9,827 each year to run. What’s left over is cash in my pocket.
(A glaring omission in this simplified model is that I have not set aside anything for CAPEX or maintenance. This is ok because both of these items come out of the cash flow, so until I have a broken toilet, I get to have the cash. Projecting this variability for my examples would be too complicated for the model so I left it out. However, best practice is to have reserves for both CAPEX and maintenance.)
Accounting vs. Cash Flow for $100,000 Property
Now let’s look at how accounting treats the same property.
Same property using accounting math rather than cash flow math
The big difference in accounting math is depreciation. For this property it is $2,909 per year. Annual Depreciation = Value of the Building / 27.5 years. Where I live, the value of the building is 80% of the whole purchase price or property value. For our example building, the math is
$100,000 purchase price * 80% = $80,000
Depreciation = $80,000 / 27.5 = $2,909
The other deductions are Interest, Property Taxes, and Insurance. After these deductions, you have $4,877 in taxable income. This is LESS than your cash flow. This means, according to the accounting math that gets sent to the IRS, you have less taxable income on paper and more spendable income in real life.
Let’s look at the two together and compare the difference. For just one property, I have shielded $2,096 from taxes. This represents 30% of my total cash flow! Impressive!
Real Estate Accounting vs. Actual Cash Flows
This means the tax benefits of real estate are tremendously unbeatable and I should liquidate my 401k and quit my job!
Not quite.
I have shielded $2,096 from taxes, but how much money am I actually saving? To answer this, we need to calculate the tax shield rate.
The tax shield rate comes from multiplying the percent shielded from taxes by the tax bracket rate. For the first couple of examples, I’m assuming a 12% tax bracket. A person in this bracket can earn up to $41,775, which I think is achievable for most readers.
30% shielded from taxes * 12% tax bracket = 3.61% tax shield rate
Multiply 3.61% by your cash flow to get your actual dollar tax savings.
3.61% * $6,973 = $251.52
This is the same as multiplying the Income Shielded from Taxes by your tax bracket
12% * $2,096 = $251.52
Real Estate Tax Shield for 1 Example Property
Higher Revenues (Rent) and Higher Tax Bracket Drive Tax Shield Savings
Ok. Small potatoes. Does it get any better at scale?
What if I make just over $40,000 in cash flow and compare it to making the same amount from a W2 job? This would put me at the top of the 12% tax bracket. This means I’m paying the IRS 12% of $40,000 for a W2.
If we have a portfolio of 6 of my example properties, we make $41,839 in cash flow. This is $63 more than the highest income in the 12% tax bracket. I added a -$64 maintenance charge just to have the dollar amounts match up for easy comparison.
If I have roughly the same $40,000 of income from real estate, how much of that cash will be taxed? ALL $40,000 of my W2 is taxed, not adjusting for 401k, HSA, and other deductibles.
Real Estate Cash Flows of $41,775 are taxed the same as $29,260 of W2 Income
The right side has our real estate cash flows, equivalent to the highest threshold of your 12% tax bracket. The left side has our accounting math of those same cash flows and how much of those cash flows are taxable.
Earning $41,775 in real estate CASH FLOW leads to $29,260 in TAXABLE INCOME. Earning $41,775 in W2 CASH FLOW leads to $41,775 in TAXABLE INCOME. See the difference? You’ve shielded $12,514 from taxes. For the 12% tax bracket, you’ve saved
$12,514 * 12% = $1,500
Over the life of your 27.5 years of depreciation savings, this amounts to a sum total of $41,296 in tax savings. Investing your annual tax savings of $1,500 in an index fund that returns a conservative 5% per year becomes $86,952 in 27.5 years. (Sign up below for spreadsheet to see this math).
So, at least for me personally, aiming to make at least $41,775 in real estate cash flow so that I can replace a W2 job making the same $41,775 in income is where I really start to see the tax benefits in my example.
The higher you go in the tax brackets, the better the tax shield. For our previous example, if you are in the 22% tax bracket instead of 12%, your annual tax savings nearly doubles to $2,767.
The math is the same as above. Multiply dollars shielded by the tax rate
$12,514 * 22% = $2,767
In this case, the higher tax bracket drives a greater savings. This makes sense because you’re shielding the same amount of rent from a higher percentage of income paid in taxes. An individual with a high salary, paying 30%+ in taxes, will save a lot of money by owning real estate.
Total Tax Shield Calculations
Instead of doing the step-by-step math, we can do some basic multiplication to get our overall tax shield. In my example, the % of cash flow shielded from taxes is 30%. We can multiply this by each of the tax brackets to determine the total tax shield.
Total Tax Shield baseline estimates using example property
You can also work backwards using the table above to determine what amount of savings is worth it to you. If you know you will make $80,000 in cash flow and are in the 22% tax bracket then
80,000 * 6.6% = $5,280
That’s basically the max annual contribution for a Roth IRA. You can put your real estate tax savings into a tax-free Roth and compound your tax savings over a lifetime. Now we’re talking. With this in mind, you can target a portfolio with a 6.6% tax shield rate and cash flow of $80,000.
The Verdict: Big Benefits at Scale
At the 22% tax rate, the total tax savings is 6.6% and starts to look pretty enticing, especially if cash flow is anything near $40,000. If you are a landlord with only a couple of properties then the tax shield probably doesn’t yield tremendous benefits for you yet. However, notice that the benefits grow as you scale. Many landlords replace their W2 income with a LOWER level of cash flow because they lose less of the income to taxes.
A final note is that the drivers of the tax shield (Taxes, Insurance, Interest, Depreciation, and other deductions) can be highly variable. The benefits of the tax shield are greater with interest rates at 7% than 3%, but cash flow is also lower. Depreciation deductions are also much higher for commercial buildings than the residential properties I used in my example. Let this serve as a starting point as you consider investing in rental properties.
If you’re interested in seeing how tax shields can benefit you, sign up below to receive the excel spreadsheet I used in this article. With it you’ll receive a Tax Savings Calculator that you can use to estimate your real estate tax goals.