never pay taxes again using rental properties

(GCC: People read everything I’ve written about Real Estate and automatically assume that I believe owning real estate in any form is a terrible idea. That is understandable, but is only mostly true :) When consciously entered as a real business and with a compatible personality, rental real estate can be a capital friendly, cash flow friendly, and tax friendly path to Financial Independence. In fact, this is the approach I recommended to my own brother. Today, Coach Carson enhances our Never Pay Taxes Again series, paying no taxes with rental properties.)

Jeremy set the bar high for early retirees. While most of us aim to minimize or optimize our taxes, he wrote an article that took it to another level entirely. His crazy idea was to Never Pay Taxes Again!

After reading Jeremy’s article, I began to look more closely at my own tax returns. I realized that most years I also paid little or no income taxes. And it turns out I used the same core principles Jeremy explained, except I did it with real estate investing.

So, this is my turn to show how to never pay taxes again (or at least keep them to a minimum). I’ll build on the core principles you’ve learned from Jeremy. Then I’ll explain the nuances that make real estate both beneficial and challenging.

How to Eliminate Taxes in Early Retirement

In Jeremy’s original post, he shared 4 simple rules to eliminate taxes in early retirement:

  1. Choose leisure over labor
  2. Live well for less
  3. Leverage Roth IRA Conversions
  4. Harvest Capital Losses AND Capital Gains

I have nothing to add or improve here. Whatever investment vehicles you use, these principles are valuable.

When you choose to live off of investment income (leisure) instead of working a job (labor), you automatically reduce your taxes. Right or wrong, the tax system is built to benefit investors more than those still working.

And when you live well for less money, you give yourself “tax bracket space” to implement powerful tax-saving strategies. These include Roth IRA conversions and capital gain or loss harvesting.

But rental property investors do have a couple of wrinkles to add to this situation. I’ll share them next.

Rental Property Tax Saving Strategies

If you want to super-charge your tax savings, rental properties have a number of techniques to help. But for now, I want to show how you can eliminate taxes as a real estate early retiree using just two simple strategies:

  1. Rental income
  2. Depreciation

Rental income is not classified as earned income. So, it is not subject to social security or medicare taxes. This is a savings of up to 15.3% compared to earning the same income at a job.

Unfortunately rental income isn’t quite as good as qualified dividends or capital gains income. Those can be earned tax free within certain tax brackets. But the next benefit, depreciation, helps off-set that deficiency.

The IRS allows a depreciation expense because a building wears down over time (27.5 years in the case of residential property). But this is a “paper” expense because you never actually write a check for it. On your tax return, depreciation simply offsets income (in this case rental income) in order to reduce how much you pay in taxes.

When you combine these two rental property benefits with the lifestyle choices of frugality and early retirement, you can avoid paying income taxes. Let me show you how with an example.

An Optimal Real Estate Early Retirement Portfolio

As you’ve probably guessed by now, my own strategy to retire early involved rental properties. My particular situation is a little more complicated because it involves a 50:50 partner. But our general strategy could be summarized as a three legged-stool:

  1. Free and clear (no debt) rentals for steady, low-risk income
  2. Leveraged rentals (with safe debt) for growth and an inflation hedge
  3. Retirement accounts for tax optimization and long-term wealth

My retirement accounts currently own a mix of real estate (using self-directed accounts) and index funds. The real estate is in the form of private mortgages and limited partnership rentals. Over time I plan to invest a larger percentage of my retirement accounts into stock index funds for asset-class diversification.

And one category I didn’t mention is cash. Because our real estate is relatively illiquid, we like to hold a significant cash reserve for both opportunities and cash emergencies. It served us well in the 2008 – 2010 real estate down turn!

Now let’s look at some numbers to show how this real estate retirement strategy can also eliminate income taxes.

A $1 Million Early Retirement Example

Let’s assume that this example involves a 40 year old couple. They’ve already climbed the financial mountain, built wealth, and reached financial independence. The couple’s investment portfolio in this case is worth ~$1,000,000.

It’s divided into my same three categories:

  1. $600,000 = equity in five free-and-clear rental properties at a cost of $120,000 each
  2. $125,000 = down payments of $25,000 on five rental properties bought for $120,000 each
  3. $250,000 = retirement account balances invested in low-cost index funds

never pay taxes again real estate

The couple’s living expenses are $40,000/year, and they pay for these expenses with rental income from their properties.

Each property rents for $1,200/month and has operating expenses (taxes, insurance, maintenance, management, etc) of $600/month. So, the five properties without a mortgage produce $600/month or $7,200/year in net income.

The properties with debt have 30-year mortgages at 5% with payments of $510/month. After deducting the mortgage payment, they produce $90/month or $1,080/year in net income.

Now let’s see what all of this rental income looks like put together.

Rental Income For Retirement

The total rental income before taxes looks like this:

Total Net Income – Rental Properties
Property Net Operating Income/Year Mortgage Pmt/Year (Principal/Interest) Net Income
Rental #1 (No Debt) $7,200 $0 $7,200
Rental #2 (No Debt) $7,200 $0 $7,200
Rental #3 (No Debt) $7,200 $0 $7,200
Rental #4 (No Debt) $7,200 $0 $7,200
Rental #5 (No Debt) $7,200 $0 $7,200
Rental #6 (Mortgage) $7,200 -$6,120 $1,080
Rental #7 (Mortgage) $7,200 -$6,120 $1,080
Rental #8 (Mortgage) $7,200 -$6,120 $1,080
Rental #9 (Mortgage) $7,200 -$6,120 $1,080
Rental #10 (Mortgage) $7,200 -$6,120 $1,080
Total: $72,000 -$30,600 $41,400

The taxable rental income is a little different. I’ll assume all properties have the same depreciation expense of $3,273/year. Here’s what the taxable income looks like:

Total Taxable Income – Rental Properties
Property Net Operating Income/Year Interest Expense (Year #1) Depreciation Expense Taxable Income
Rental #1 (No Debt) $7,200 $0 -$3,273 $3,927
Rental #2 (No Debt) $7,200 $0 -$3,273 $3,927
Rental #3 (No Debt) $7,200 $0 -$3,273 $3,927
Rental #4 (No Debt) $7,200 $0 -$3,273 $3,927
Rental #5 (No Debt) $7,200 $0 -$3,273 $3,927
Rental #6 (Mortgage) $7,200 $4,718 -$3,273 -$791
Rental #7 (Mortgage) $7,200 $4,718 -$3,273 -$791
Rental #8 (Mortgage) $7,200 $4,718 -$3,273 -$791
Rental #9 (Mortgage) $7,200 $4,718 -$3,273 -$791
Rental #10 (Mortgage) $7,200 $4,718 -$3,273 -$791
Total: $72,000 -$23,590 -$32,730 $15,680

So, the rental income the couple actually collect covers their $40,000/year of living expenses very nicely. And only $15,680 of that is subject to income taxes.

Let’s look at how this all fits together to help you eliminate taxes in early retirement.

Tax Optimization to Eliminate Taxes

As a couple filing taxes jointly, they get a $24,000 standard deduction (as of 2018). So, the $15,680 of rental income not sheltered by depreciation is completely free from tax.

But the couple still has $8,320 of their $24,000 standard deduction available. So, they follow Jeremy’s advice and do an $8,320 Roth IRA conversion. This will permanently move retirement funds from pre-tax 401(k) to non-taxable Roth accounts.

So in the big picture, the couple has:

  • paid their $40,000 of bills using $41,400 of rental income
  • grown their net worth as rental values increase and their mortgage balances decrease
  • set their 401(k) up to grow and become more tax optimized over time
  • paid no income tax in the mean time!

This is a good situation, isn’t it? The couple could live off their rental income, travel the world (like I did for 17 months with my family in Ecuador), and enjoy their lives for years to come.

never pay taxes again real estate

Carson Family on Horseback in Ecuador (photo credit: Coach Carson)

But in the spirit of the famous Go Curry Cracker passion obsession with tax reduction, there’s still more tax optimization left on the table. Let’s play around briefly with a few more tax optimizations this couple could do using real estate.

Short-Term Rental Ladder For 0% Capital Gains

One of the glaring opportunities with this couple’s situation is the extra $77,400 of tax bracket space that could be filled with 0% long-term capital gains. So, if I were them I would set up what I call a short-term rental ladder.

Basically this would start by purchasing one more property each year. This would likely be a higher price single family house that they could buy $30,000 to $75,000 below full value. Then 1 or 2 years later, they’d sell the property to their tenant who has been prescreened as a potential buyer.

How do you find this kind of deals? Hustle. Creativity. Networking. Looking for vacant houses during your jogs in neighborhoods. You can find good deals in any real estate market if you get serious.

The rental income would probably break-even at best. And the short 1 to 2 year holding time would nullify depreciation expense benefits with depreciation recapture tax of 25% at the time of sale.

But in the end, a gain of $30,000 to $75,000 would be added to the couple’s bank account for reinvestment. And the tax rate would be 0% because the couple would still be in the 10% or 12% tax brackets.

How’d you like that nitro added to the wealth building fire?

But the couple could still do more.

Live-In Flips For Massive Tax-Free Gains

Because the couple is out looking for real estate deals anyway, they might as well move into one of these good deals. This is what’s known to real estate nerds (like me) as a live-in flip. Carl and Mindy at have used this strategy better than anyone I know.

In the U.S. (and many other countries as well) the tax code gives the sweetest deal to homeowners who live in a property for at least two of the next five years. Even renters for life might choose to own a hot real estate deal in order to make a tax-free profit of up to $500,000 (for a couple)!

Even after short-term rental ladders and live-in flips, there is still more tax-free real estate fun this couple could have.

Use 1031-Exchange to Grow Income and Wealth

I admit that selling real estate isn’t always easy. And on top of the hassle and high costs of liquidation, Uncle Sam hits rental owners with a 25% depreciation recapture tax on all prior depreciation expenses (even if you are in lower tax-brackets for 0% capital gains).

So, a powerful strategy used by savvy real estate investors is something called a section-1031 tax-free exchange. Named after its section of the tax code, this type of property exchange allows you to defer all federal income taxes due at the time of the sale. You basically sell one property and move your equity to a new property without touching the funds yourself.

There are plenty of rules to follow and specialized intermediaries needed to help execute the transaction. So, study up if you plan to do one.

So, the couple in this example could sell some of their existing 10 rentals if they found properties that performed even better. In this way they could grow their income and wealth tax free over time.

But what happens if they need big chunks of cash during all of this long-term wealth building?

Tax-Free Borrowing For Cash Needs or Reinvestment

As I said in the previous section, selling real estate isn’t always easy. But if you own a good long-term property, selling isn’t always necessary.

Our couple’s equity in real estate will continue to grow over time as prices appreciate and their mortgages get paid down. That combination of equity building magic is how real estate fortunes are built.

At some point the couple may want to use this equity to fund their lifestyle or to reinvest somewhere else. But rather than selling, they could refinance their property and pull out funds tax-free. As long as the net rent covers all expenses (with a cushion!), it’s a reasonable thing to do.

This is actually how I plan to help pay for college for my two young daughters.

Die With Your Real Estate

Don’t laugh. When it comes to real estate investing, the tax code all but screams at you to keep your properties until you die.

Why? Because your heirs receive a stepped up basis when they inherit your properties. In regular language, this means they could sell your properties right away and avoid a big tax hit.

So after doing a few 1031 exchanges into comfortable, easy-to-manage long-term rentals, the couple in the example keeps their rentals for life. When they die, the properties pass on to their children or worthy charities.

Tax Optimization For Life

There you have it. A plan to invest and live tax-free for life using real estate.

Will you be able to use all of these strategies at once? Maybe…

I look at any tax optimization strategies like tools in a toolbox. You learn to use and apply a tool or two that apply to your life right now. Then you carry around your toolbox for the rest of your life and pull out the appropriate tool when needed.

I hope this article has filled up your head and your toolbox with new strategies to use now and in the future!

Have you used any of these real estate tax optimization strategies? How do you plan to eliminate or reduce your taxes?

Enjoyed this article? Check out these other great posts on taxes and real estate:

And BE SURE to check out Coach Carson’s NEW BOOK: Retire Early with Real Estate