‍Making Profits While "Losing Money": The Hidden Incentives in the Tax Code

‍Imagine this: A close friend, Sarah, an active stock market investor, is having coffee with James, a seasoned real estate investor. Sarah looks puzzled as James explains that his properties often show a loss on paper, yet he's making a profit. How can this be?

 Losing money while making money might seem contradictory, but it showcases the power of tax benefits in real estate. Through strategic planning and the utilization of tax advantages like depreciation, real estate investing can reduce your taxable income or, in some cases, even show a loss on your tax documents despite the investment generating positive cash flow, appreciating, and reducing debt. This article aims to explain why.

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A Primer on Depreciation

Depreciation, simply put, is the decrease in the value of an asset over time. For tax purposes, real estate investors can deduct this "theoretical" loss against their income. This process differs depending on the nature of the asset:

·     Real Property (Buildings and Structures): Typically depreciates over 27.5 years for residential properties and 39 years for commercial.

·     Personal Property (Furniture, Equipment, etc.): This varies but can be as short as 5-7 years.

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Delving into Bonus Depreciation

Bonus depreciation is an extra amount of deductible allowance. It allows businesses to front-load the depreciation on certain assets. In essence, it enhances your regular depreciation, allowing a significant portion of the asset's cost to be deducted in the initial years.

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💡 Pro Tip: This tactic often results in notable paper losses in the early years of an investment, magnifying the "losing money while making profits" phenomenon.

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Depreciation in Action

Scenario 1: The Everyday Investor

Suppose you put down 25% (or $250,000) on a $1 million property. Using straight-line depreciation, you can deduct around $25,000 annually from the structure's depreciation. However, with bonus depreciation and after a cost segregation study, you could potentially see an upfront deduction of $100,000 to $150,000 in the first year, followed by reduced amounts in subsequent years.

Larger Real-Life Scenario

Consider an investment our company made in a $17 million apartment building. With total equity placed of around $4 million from a group of investors, a cost segregation study enabled this group to pull forward shorter-lived assets. The outcome? A nearly total depreciation of the entire $4 million equity in the initial years, resulting in a sizeable tax deduction.

Realizing the True Potential of Real Estate Investments

When breaking down returns from real estate investments:

·     Consistent Cash Flow: Often, returns range from 4% to 8%.

·     Predictable Debt Paydown.

·     Likely Long-Term Appreciation: According to NCREIF, real estate consistently appreciates over time, providing an edge over other volatile assets.

·     Tax Benefits: Depreciation and bonus depreciation can notably reduce tax burdens.

📈 Comparison Corner: Let's say you invested $10,000 both in the stock market and real estate. While both might yield returns, the real estate investment could offer consistent cash flow, appreciation, AND tax benefits, while the stock primarily provides potential dividends and appreciation.

🌟 Expert Insight: Many real estate experts anticipate total returns, including appreciation and cash flow, to potentially reach mid-teens percentages, distinguishing this asset class in a portfolio.

"Real estate investing changed our family's trajectory. We shifted from anxiously asking 'will we profit?' to confidently projecting 'how much will we profit?'" - Jason Weimer, founder of Gratūs Funds.

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The Bottom Line

With real estate:

1.   You typically enjoy consistent cash flow.

2.   You benefit from predictable debt paydown.

3.   You often take advantage of substantial tax incentives.

While your tax documents might suggest a loss, the bigger picture reveals a different story. In real estate, these paper losses often represent strategic steps leading to genuine financial growth. The goal isn't merely to reduce tax burdens but to lay the groundwork for lasting wealth accumulation. There's often more to real estate investment than meets the eye. Understanding the unique benefits can open up new avenues for building wealth.

Gratūs Funds focuses on opening access to institutional-quality real estate for everyday investors. Our funds empower you to become a direct owner, harnessing real estate's tax advantages and earning potential. Reach out to our team to discover more about our investment opportunities.

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