How Do I Reduce Taxes on my W-2 Income?

If you are a high-income earner, you are likely looking for ways to reduce taxes on your W-2 income.

You have plenty of tax savings options, and we have both general and real estate-specific recommendations.

This article presents targeted strategies for those seeking to navigate the intricacies of the tax code effectively.

How Can I Reduce Taxes on W-2 Income?

1. Contribute to Retirement Accounts

The money you put into a 401k reduces your taxable income, which results in a lower payment of income tax.

For IRAs, you can also receive a deduction based on contributions if certain requirements are met.

For instance, if you are in the 32% income tax bracket, paying $6,000 towards your IRA could potentially save you $1,920 on your tax bill. Paying toward your retirement consistently throughout the year will save you come tax time.

2. Pay Into a Health Savings Account (HSA)

Putting money into a health savings account can save you money on taxes in a few ways:

• You receive a deduction for HSA contributions
• HSA funds used for qualified medical expenses aren’t taxed upon withdrawal
• Any interest or investment earnings aren’t taxed

Keep in mind, that money from an HSA must be spent for qualified medical expenses to not be taxed. You can deduct your HSA contributions, which reduces your taxable income.

3. Charitable Deductions

If you itemize deductions, charitable contributions can reduce your taxable income by being write-offs. The more you give, the more you can save.

4. Deducting Vehicles with a GVWR Over 6,000lbs

The IRS allows for an accelerated depreciation deduction for vehicles used in a business with a Gross Vehicle Weight Rating (GVWR) of over 6,000 lbs. This can include Section 179 deduction and bonus depreciation, and it can significantly lower taxable income in the year the vehicle is purchased and put to use.

Real Estate Strategies for Reducing Taxes on W-2 Income

1. Earn The Real Estate Professional Status

Let’s pivot to real estate-specific tax savings on W-2 income. These tactics have brought a lot of high earners into the world of real estate.

Regardless of whether you had any previous interest in owning real estate, the tax savings alone make these approaches attractive.

Real Estate Professional Status (REPS) is a designation that allows qualifying individuals to deduct their rental real estate losses against other sources of income.

To qualify as a real estate professional, individuals must spend more than 750 hours and more than half of their total working hours in real property trades or businesses in which they materially participate.

This is particularly beneficial for high-income earners, as it can significantly reduce taxable income.

However, it is particularly challenging to qualify for REPS if you have a full-time job or business outside of real estate. The good news is that if you are married filing jointly, if one spouse qualifies, then both spouses benefit. This is a common strategy for couples where one spouse generates a high income, and the other spouse focuses on real estate.

Key Benefits:

• Deduct Rental Losses: Unlike passive investors, real estate professionals can deduct losses from their real estate activities against other income. This will potentially reduce their overall tax liability significantly.

Considerations:

• Stringent Qualification Requirements: The IRS requires meticulous documentation of hours spent and activities performed to qualify as a real estate professional, which can be challenging to maintain.

Example:

• Sarah, a high-income earner, spends 1,000 hours in her real estate business, which exceeds the hours she spends in her other non-real estate business. This allows her to qualify for REPS, enabling her to deduct $50,000 in rental property losses against her other income, significantly lowering her tax liability.

2. Use the Short-Term Rental Tax Loophole

At The Real Estate CPA, we talk a lot about the short-term rental tax loophole and have helped people save thousands of dollars on taxes using this method.

The Short-Term Rental (STR) Loophole refers to a set of regulations in the tax code that, when met, allows the taxpayer to deduct rental losses from their STRs against other sources of income without qualifying for REPS.

The two notable exceptions are when the property has:

• An average period of customer use of 7 days or less or;
• 30 days or less, and substantial (i.e., hotel-like) services are provided.

Once met, income or loss from the property can be deducted against other sources of income as long as the taxpayer materially participates. While there are seven material participation tests, the following three tests are the most relevant:

• The taxpayer spends more than 500 hours on the property.
• The taxpayer does substantially all of the work related to the property.
• The taxpayer spends more than 100 hours and more than anyone else.

This strategy works well for short-term rental investors and can be a tax strategy for high-income W-2 earners who can’t qualify for REPS.

Key Benefits:

• Deduct Short-Term Rental Losses: The STR Loophole allows owners to deduct losses from their short-term rental against other income, potentially reducing their overall tax liability significantly without qualifying for REPS.

Considerations:

• Unlike many long-term rental properties, short-term rental properties are more management-intensive, often requiring ongoing time and effort to operate properly.
• STRs are facing unfavorable regulations in many states and local governments. Choosing markets unlikely to be impacted by these regulations is critical.

Example:

• John owns a short-term rental he rents on Airbnb for an average of 5.5 days per stay for the year. He spends 260 hours managing the property for the year and more time than his cleaner, who cleans between stays. The property generated a loss of $20,000 for the year. Because he meets the exception and materially participates, the $20,000 of losses can offset his active income.

3. Investing in Working Interests in Oil and Gas

There is a special carve-out in the tax code that makes losses from your investment in working interests in oil and gas non-passive, regardless of whether you are a passive or active investor.

Usually, you’ll see losses in the initial years due to the exploratory phases of an oil and gas investment.

The downside is that you may be exposed to unlimited legal liability, which could represent an ongoing cost or risk.

Direct investments in drilling projects can qualify for deductions from intangible drilling costs (IDCs), which can include labor, chemicals, and other non-salvageable costs. These deductions can be taken in the first year of investment, providing a significant tax break.

Key Benefits:

• Immediate Deductions for IDCs: Investors can deduct a large portion of their investment in the first year as IDCs, lowering taxable income.
• Potential for High Returns: Beyond tax benefits, oil and gas investments can offer the potential for high returns if the wells are productive.

Considerations:

• Risk Level: These investments carry a higher risk, including the potential loss of capital and variable returns.
• Complexity: The tax implications of oil and gas investments can be complex, requiring careful planning and advice from tax professionals.

Example:

• Alex invests $100,000 in an oil drilling project. 80% of his investment ($80,000) qualifies as IDCs, which he can deduct against his income in the first year. This deduction can substantially reduce his taxable income, providing a tax-advantaged return on investment.

4. Land Conservation Easement

If you own a piece of land, you could place an easement on that piece of land, restricting it from being developed.

Key Benefits:

• Deduction: You will receive a charitable deduction in the difference between the fair market value of the land (had it been developed to its highest and best use), less the value of the land with the easement on it.

Considerations

• Worth Preservation: The land should be worthy of being preserved and you will have to go through some measures to get a valuation and align with compliance guidelines.
• Avoid Syndicated: A syndicated land conservation easement is an approach where you invest money with partners and collectively pay for an easement on the land through the partnership. Each partner gets a piece of the charitable deduction through the partnership. This structure is under heavy scrutiny by the IRS, and we wouldn’t advise you to go this route.

Example:

•  To preserve its natural beauty, Jane, a physician, places a conservation easement on her 50-acre piece of land, restricting any future development. By doing so, Jane not only protects the land but also receives a charitable deduction. This strategic move aligns with Jane’s conservation values while offering her significant tax benefits.

If you’re a physician looking for guidance, read tax strategies for physicians.

Create a Strategy for Reducing Taxes on W-2 Income

Our overarching recommendation is that you enlist the help of a tax professional to create a strategy for reducing taxes on W-2 income.

There are plenty of spots in the tax code that you could take advantage of, and sitting with a real estate tax expert one one-on-one is your best bet for figuring out how both general and real estate-specific tactics can be optimized to save you money.

This kind of advice and partnership is a big part of what we do.