At The Motley Fool, our primary investing focus is on individual stocks -- which we view as the most powerful tool out there for long-term wealth building. But there are other options, and one that's long been popular is real estate. For those looking to branch out from Wall Street to something near the corner of Elm Street and Summit Avenue, Motley Fool Answers cohosts Alison Southwick and Robert Brokamp have invited a special guest to join them for this podcast: Thomas Castelli, a tax strategist with The Real Estate CPA, who will take them and their listeners on an exploratory ramble through the world of real estate investing.

In this segment, they talk about one of the big benefits of real estate investing: how it affects your taxes. Between depreciation, 1031 exchanges, and other nifty tax advantages, you can earn a lot of profit from your properties without paying much to the federal government.

A full transcript follows the video.

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This video was recorded on March 5, 2019.

Alison Southwick: I'm going to lean back now, while we shift to talk about taxes. I always struggle when we talk about taxes because I want to know why the tax code is the way it is, and I need to remind myself that taxes are just this bear of a thing, like a Frankenstein monster that's created and influenced by tons of different people and interests. And you love talking about taxes.

Robert Brokamp: I wouldn't say I love talking about it.

Southwick: No, you love it! You love talking about taxes, so I am going to lean back a little bit and let Bro lean in a bit more to talk about some of the tax benefits of investing in real estate. Some of them just make my head spin. I'm like, "Really? Really?"

Brokamp: It is different than if you go out and buy shares of Amazon. Let's start with depreciation, first of all.

Thomas Castelli: A lot of people consider real estate as what they call "tax-advantaged" income and that really comes from depreciation. When you buy a property you buy a building and you rent it out to someone. You have cash flow. It's going to be considered rental income. And you're going to have your operating expenses; things like advertising, mortgage payments, property management fees, anything like that. And there's one of those operating expenses called depreciation, which is not a cash expense, so there's no cash that actually goes out of your pocket when you take depreciation, but it can be usually increased through various strategies so that you actually show a loss for tax purposes despite actually generating positive cash flow.

For example, you have $10,000 of rental income, $4,000 of actual cash operating expenses that left your pocket, and say you have a $7,000 depreciation expense. Now you have a net loss of $1,000, so you're paying nothing on that income, but you really pulled in $6,000 that you put into your pocket. That's kind of what the power of depreciation is and you can use cost surrogation studies to increase your depreciation.

With the Tax Cuts and Jobs Act, they actually came out with something called 100% bonus depreciation. That allows you to depreciate property with a class of less than 20 years, and generally, on real estate, anywhere from 20% to 30% of a property can be classified as five-, sevenp-, and 15-year property, so you can depreciate 20% to 30% of that property and take that expenses depreciation in the first year you buy it. That has a major impact on the amount of money and tax you're going to pay over the time you own the property.

Brokamp: It's kind of funny, because you're saying, "I own this asset that I want to increase in value, but I get to take this charge that assumes it's actually depreciating," but it's usually not.

Castelli: It's usually not. For the most part, real estate tends to increase in value. There is a dark side to depreciation. It's not all love. There's something called "depreciation recapture," which when you sell the property you have to recapture the amount of depreciation you took, assuming you have a gain, of course, up to 25%. It's taxed up to 25%, but generally the thought process behind that is the time value of money. You'd rather take the depreciation today, have the tax-free cash flow so you can reinvest it, put it back into your business, and then pay the taxes later on.

And by the way, you can't not take depreciation and avoid that. Some people will say, "What if I just don't take depreciation? Do I have to pay that tax?" The IRS will assume that you did take the depreciation and charge you that tax anyway, so you're better off taking it. There's no way to avoid it. There are ways to avoid that depreciation recapture tax and I think we'll talk about that in a little bit, as well.

Brokamp: That's basically getting a tax break along the way, but then there's the tax break you can get when you sell the property, otherwise known as 1031 exchanges. Why don't you talk a little bit about that?

Castelli: When you sell a property you're going to have a capital gain...

Brokamp: Hopefully!

Castelli: Assuming you're investing in the right way, you're going to have a capital gain. And part of that capital gain is going to be depreciation recapture. Now what a 1031 exchange allows you to do is defer that capital gain and the depreciation recapture by purchasing another property. What you have is 180 days from the day you sell your original property to roll over the entire sales proceed, so both the capital gain and your original principal, into another deal. This is normally called "trading up."

Let's say you have a property you bought for $100,000. Ten years pass, and now it's worth $150,000. You have a $50,000 capital gain. Break it up in between capital gain and depreciation recapture however you want. You're still going to have to pay tax on that $50,000. So when you pay tax on that $50,000 of capital gains, you're going to have less money you can reinvest. What a 1031 allows you to do is invest that entire amount so you're not paying the taxes today, and you can purchase a larger property.

You could continually purchase larger and larger properties and continue to use the 1031 exchange pretty much forever. And if you really wanted to -- I'm just going to be honest as it's easier said than done -- you can eventually leave the property to your heirs and they'll receive that property at the fair market value on the date of your death by eliminating all of this capital gains depreciation recapture that you should have paid during your lifetime. In theory, you can just keep purchasing larger and larger properties, making more and more cash flow, but never actually paying any taxes on that property.

Southwick: This is crazy to me! This is one of the reminders of how it's easier to get richer when you're already rich. If you're already wealthy then there's all these ways for you to easily make more.

Castelli: I'll say something on that, too. These days I feel like the internet, Google, a podcast like this; there's a lot of ways to access information, and as long as you're willing to put in the work and do the research and pull things together...My motto is "Figure it out." As long as you're willing to figure it out, you're going to be able to put a lot of things together, and you can use these same strategies that the "rich" are using. There's no one stopping you from using it. It's just in the past there wasn't as much access to this information.

Southwick: You'd have to join a country club. You'd have to be on the links to learn about real estate deals.

Castelli: You'd have to be paying attorneys and tax accountants a ton of money to figure this stuff out, but today it's all there. It's all there for you.

Brokamp: You mentioned opportunity funds. This is a very new thing. I'm not going to even try to describe it. I'm going to leave it to you because it is so new, but it is another way to defer and maybe even eliminate some of your capital gains. And it doesn't have to start with real estate. It could be you want to sell some shares of your Amazon. You have a capital gain. Here's a way to at least defer some of that.

Southwick: Can you define for us what an "opportunity fund" is?

Castelli: Absolutely! Before we talk about opportunity funds, you have to understand what an "opportunity zone" is. There's 87,000 opportunity zones across the United States, and they are low-income communities that were designated by the state governors as opportunity zones and then approved by the treasury. An opportunity fund is the investment vehicle you can [use to] invest in an opportunity zone. And [when] investing in these opportunity zones through this opportunity fund, you have these tax incentives.

The way the opportunity funds work is you can defer the capital gains tax on any capital asset. That's usually stocks, bonds, mutual funds, real estate, and things like that. If you're not sure, you could always ask your CPA. They could let you know. Basically what you can do is roll it into an opportunity fund within 180 days of sale -- very similar to a 1031 exchange there -- but the difference there is you only have to roll over the capital gain. You could take the principal back that you invested and put it in your pocket and do whatever you want with it.

Then if you hold that capital gain in the fund for five years, you're going to receive a 10% stepped-up basis in that gain. Let's just say you have a $100,000 capital gain and in five years you receive the 10% step-up; you're only going to pay tax on $90,000 of that capital gain. If you hold it for another two years for a total of seven years, it's going to step up [an additional] 5% for a total of 15%, and you only pay tax on $85,000 of that gain.

Now, if you hold that investment in the fund for 10 years, your investment in the actual fund itself will be tax-exempt. Just, say, that $100,000 you put into the fund; 10 years from now it's now worth $150,000. That $50,000 capital gain is completely exempt from tax. Now, this is a little longer-term play. You have to keep your money in there for at least five years to see any benefit from it. I think there's over $7 trillion or some crazy number of appreciated gains in the United States. So all of those appreciated gains are technically eligible for opportunity funds, and I think the background behind this is they want to take those appreciated assets and move them into low-income communities that need renovation and raise the status of those communities and opportunity zones. Opportunity funds are the way to do that.

Brokamp: So this isn't a situation like a mutual fund. You don't go to Fidelity and say, "I want your version of the opportunity fund."

Castelli: No. I think you're going to see, because of the requirements to have an opportunity fund, that you have to substantially improve these assets, which means doubling the property's basis. Essentially it's the building's basis, but just think about it, I guess for this purpose, as the purchase price. You have to add as much as the purchase price basically in capital improvements, so it's substantial. Or you have to develop the property from the ground up and you have to hold it for 10 years.

So for individuals this might be a hurdle, but I think you're going to see more institutional-level people doing it. You're going to see more of the crowdfunding sites doing it. Will somebody like a Fidelity do it? I don't know. I wouldn't think so. I think Goldman Sachs announced something, but you're going to see more of the professional side probably on crowdfunding.

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