Lately, I’ve been focused on how to pay no taxes on rental income. This was prompted by my recent 2023 tax filing, which revealed that my Detroit rental portfolio netted $86,000 in cash flow.
At first glance, this sounds like a great “problem” to have—but it’s not.
Ideally, a rental portfolio should show little to no taxable income. If yours does, you’re leaving money on the table and paying more to the IRS than you need to.
I wrote a lot about different tax strategies in last week’s article: 6 Real Estate Tax Benefits You Need To Understand.
I know the topic of taxes can be boring and feel intimidating, so this post is a follow up to that one.
I’m going to walk you through the steps I’m taking to reduce net income on my portfolio, focusing on the Dougie Fresh Duplex as a real world example.
We’ll look at three key factors that are helping me reduce taxable rental income without losing cash flow or growth potential.
Background: The Dougie Fresh Duplex
In 2020 I purchase The Dougie Fresh Duplex. You can read all about that acquisition, the challenges, and performance numbers if you’re interested.
In short, it’s performed extremely well over the years.
Today, the Dougie Fresh Duplex produces $1,900 in gross cash flow each month. After accounting for expenses, the net cash flow is approximately $1,000 per month, totaling $12,000 annually.
That means that’s all taxable income.
And The Dougie Fresh Duplex isn’t an outlier. My entire portfolio is similar in the regard that all of my properties yield strong net cash flow each year.
I want to reduce this as much as possible in an effort to reduce my tax liability.
I’ll be using the Dougie Fresh Duplex’s numbers as an example of how I’m approaching a more tax focused strategy for my entire portfolio.
Here are the steps I’m taking for how to pay no taxes on rental income.
Refinancing To Lower Taxes On Rental Income
When I first purchased the Dougie Fresh Duplex, I financed it with a 30-year fixed-rate mortgage for $100,000 at 4.5% interest.
My monthly payment was $507, of which approximately $375 went toward interest and $132 went toward principal in the early years.
Values in the area, and Detroit as a whole, have increased significantly since my initial purchase.
So I decided to do a cash out refinance in an effort to increase my interest expenses and chip away at my net cash flow.
Dougie Fresh just appraised for $201,000 and I’m able to do a 75% loan-to-value (LTV) debt service coverage ratio (DSCR) loan at 7.25% on a 30-year term.
Here’s what an amortization schedule will look like for the new loan:
For easy numbers, let’s call my interest payment about $900. That means my interest expense is going up $525 (from $375).
That’s $525 in extra monthly deductions which means my $1,000 in monthly net cash flow decreases to $475 per month.
Yes, my payments are going up. I’m totally fine with that.
I’m also putting a bunch of tax-free cash in my pocket.
I’ll be writing more about the specifics of the cash out refi in an upcoming post. So make sure you’re subscribed to the newsletter 👇🏼
Refinancing can be a powerful way to reduce taxable rental income. By refinancing, I’m resetting my debt clock and increasing interest expenses, which are deductible.
Unfortunately, refinancing alone doesn’t get me to a full tax neutral position by itself.
There’s more work to do to try and eliminate the remaining $5,700 in net annual income that Dougie Fresh will continue to generate.
Reducing Rental Income Tax Through Immediate Repairs and Maintenance
Another effective way to reduce taxable rental income is by looking for repairs and maintenance opportunities.
Remember, these expenses are fully deductible in the year they are incurred, unlike capital expenditures.
I have recently found several maintenance opportunities in Dougie Fresh, including tuck-pointing the porch and fixing some small plumbing issues, that were worth doing this year.
Overall, I spent about $2,000 on these small repairs and fixes, which will bring my net annual cash flow down to $3,700.
That said, it’s important not to force unnecessary repairs just for the sake of deductions.
However, it’s worth evaluating the property, especially toward the end of the year, and addressing any potential issues.
This approach ensures you maximize your deductions without spending money on unnecessary items.
I also avoid large capital expenditures (capex) until absolutely necessary, like a new roof.
Given the depreciation timeline, I’m unlikely to get enough deductions from these items to justify doing them sooner than required.
Finding deferred repairs may be tough every year though. You’re usually doing repairs as they come up because they tend to be more urgent.
So I’m not banking on this part of my tax strategy every year.
That’s why I’m heavily considering a cost segregation and bonus depreciation approach as well.
Zeroing Out Rental Income Tax With Cost Segregation and Bonus Depreciation
I’m still learning about cost segregation studies and bonus depreciation. My knowledge here is better than average but I’m far from an expert.
As a result, I’ll keep this section short but it’s likely my best shot at how to pay no taxes on rental income for now.
The idea here is it would allow me to accelerate depreciation on parts of the property, maximizing my deductions in the short term.
For the Dougie Fresh Duplex, I’m currently in discussions with a cost segregation company to do a study.
This will allow me to reclassify components like appliances and fixtures to shorter depreciation schedules—making it possible to take significant deductions all at once.
I talked a lot about this in last week’s article. My understanding is that I’d be able to take anywhere from $10,000 – $15,000 in bonus depreciation deductions on my 2024 taxes.
That means I’d completely wipe out my $3,700 in projected net rental income on this property. And I’d still have deductions that would carry forward to future taxes years.
The catch? You’re paying for this service and there’s a bit of work on your end as well.
The question I’m grappling with is whether or not doing this is worth the time, effort, and cost given this is such a cheap property.
This part of the strategy really starts making more sense on larger acquisitions.
Recap: How To Pay No Taxes On Rental Income
Reducing taxable rental income is all about being strategic and making the most of available options.
For the Dougie Fresh Duplex, I’ve taken a multi-step approach: refinancing to boost my interest expenses, identifying immediate repairs to maximize deductions, and considering a cost segregation study for bonus depreciation.
The refinancing move increased my monthly interest expenses, putting more cash back in my pocket tax-free and significantly reducing my net income.
The small repairs, while modest in cost, have helped bring down taxable income even further.
Finally, cost segregation could allow me to accelerate depreciation and completely eliminate taxable income from this property for 2024, with extra deductions to carry forward.
At the end of the day, the goal is to legally minimize tax liabilities while still maintaining cash flow and growing the value of the portfolio.
These strategies are not without cost or consideration—there’s a balance to strike.
However, by staying proactive and exploring different tax strategies, I’m positioning myself for long-term success.