Summary: Many of our readers already know that Real Estate Professional Status is one of the best ways for high-income professionals to shelter earned income (W2 or 1099). However, those who have decided to pursue Real Estate Professional Status often delay becoming one. In this article, we quantify the cost of delaying the decision to achieve REPS.
If you’ve been following our blog, you probably already know about the benefits of Real Estate Professional Status (REPS). For those who don’t, you can get up to speed by reading this article.
Despite the compelling benefits, in our experience, those who do want to achieve REPS often delay becoming one.
This is understandable for some. REPS is certainly harder for those who are single, burdened with school debt or have financial challenges.
What is inexplicable are those who are perfectly set up for this status. These are the married couples with either dual incomes or with one spouse who is stay-at-home. In both of these scenarios, it would be very easy for the couple to achieve REPS with only a few rental properties.
These couples often tell us that they plan to become a real estate professional in the next three to five years.
One of the most common reasons we hear from our readers is that they can’t afford to quit.
When we hear this, we often tell people that they can’t afford to wait. This is especially important for those who are already desperate to cut back at work.
So this is the purpose of this article. We wanted to understand the cost of delaying the decision to achieve REPS.
The Analysis
We analyzed three different scenarios:
- Scenario 1: you achieve real estate professional status in the first year you start investing in real estate.
- Scenario 2: you achieve real estate professional status after waiting three years.
- Scenario 3: you achieve real estate professional status after waiting five years.
This analysis assumes a salary of $300,000, an effective tax rate of 33% and an annual return from real estate investing of 25%. We also assumed that you are able to shelter all of your income each year using REPS.
Here are the results. The following is the amount gained from the tax savings and reinvesting the tax savings each year.
- Scenario 1: $1.38 million
- Scenario 2: $0.80 million
- Scenario 3: $0.49 million
Discussion
Let’s discuss how we came up with these numbers.
The main benefit when you achieve REPS is the tax savings.
When you completely shelter $300,000 at a 33% tax rate, you receive $99,000 in tax savings the following year.
For Scenario 1, we added up this $99,000 in tax savings over a period of 9 years for a total of $891,000.
There is an additional benefit from reinvesting the $99,000 that you receive each year back into real estate. Assuming a 25% return and taking into account the compounding growth, this totals $491,000. When you add these two amounts up, you get a total of $1.38 million.
For Scenario 2, you claim REPS in Year 4. However, you don’t get the tax savings until Year 5 when you file your taxes. You start generating a return on the reinvested tax savings in Year 6.
It’s even worse for Scenario 3. You don’t get the tax savings until Year 7. You get a return on the reinvested tax savings in Year 8.
The Cost of Delaying the Decision to Achieve REPS
Calculating the cost of delaying the decision to achieve REPS simply requires you to subtract the amounts gained.
Waiting three years will cost you approximately $580,000 ($1.38 million minus $0.80 million).
Waiting five years will cost you $890,000 (1.38 million minus $0.49 million) over the same 10 year period!
The thing to remember is that the $1.38 million is tax-free income because it is in the form of tax savings. It is equivalent to making over $2 million in earned income over the same time period, assuming the same 33% tax rate.
So even in a two-physician household like ours, one spouse would make $300,000 and the other would average $200,000 when you average the amount gained over 10 years.
Not bad for the second spouse who could make $200,000 and not work clinically at all.
And that’s not all. Assuming you reinvest the tax savings each year by buying new properties (let’s say a $400,000 fourplex with each $99,000 you receive in tax savings), there will be a significant difference in the number of units you would own at the end of 10 years.
In Scenario 1, you’d own 9 fourplexes or 36 units. In Scenario 2, you’d own 6 fourplexes or 24 units. But, in Scenario 3, you’d only own 4 fourplexes or 16 units.
That’s a huge difference.
So if that’s the case, why wait?
**Ready to get started? Download our free Quick Guide to Real Estate Professional Status to help you achieve REPS!**
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