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I always found accounting and taxes to be insanely boring, extremely complicated, super annoying, frustrating, daunting, and basically just a painfully un-interesting necessity of life which I begrudgingly had to be involved with once a year…
You should see how many tax strategy books are on my shelf now! I read blogs on tax strategy, follow the latest tax law updates, and get excited about talking to tax experts for advice and strategy.
Property taxes, insurance, property management fees, and repairs (not capital improvements) are all deductible.
Mortgage interest is also deductible. If you make interest-only payments on your loan that means your entire mortgage payment is deductible.
The government allows you to ‘depreciate’ your property, even if it is going up in value! They do not let you depreciate land though, so you need to break out the cost of the land and then you can depreciate the structure of your residential investment property on a 27.5 year straight-line schedule. Let’s say you buy a new or completely renovated rental property for $170,000. And let’s say you determine the land to be worth $30,000. Subtracting the cost of the land, you are left with $140,000 as the value of your structure, which you can depreciate over 27.5 years. So, if you divide 140,000 by 27.5, that comes out to just over $5,000 per year that you can take as a loss against your income from the property. This is often referred to as a “phantom loss” because, of course, you didn’t actually lose anything.
Sticking with our example above:
- Taxable Rental Income = $0
- Left Over Phantom Loss: $1,400
Now imagine if you scaled this and got 10 properties that were doing the same thing.
Now your numbers would look like this…
- Taxable Rental Income = $0
- Left Over Phantom Loss: $14,000
Try doing that…mmmm….pretty much anywhere else.
While the basic structure of your property can be depreciated on a straight line over 27.5 years, there are a number of “personal property” items that can be broken out and depreciated on accelerated schedules.
For example, let’s say you have a brand new stove, microwave, HVAC, flooring, etc. in your rental property. These items can be depreciated over a much shorter period (7-15 years).
By doing a cost segregation analysis of your property, you can actually accelerate some of your depreciation and legally take those benefits sooner so that your initial paper “losses” are even greater.
The IRS says that you can take up to $25,000 per year of real estate losses against other forms of income (such as earned income from your job), but that is only if you make $100,000 per year or less.
So, in our example above, you generated a $14,000 loss from your real estate (after writing off all your cash flow from your rental property).
Continuing with this example, if you made $100,000 per year at your job, you would be allowed to write off that $14,000 against your earned income, reducing your taxable earned income from $100,000 down to $86,000.
So, if you were in the 28% tax bracket that would be an annual tax savings of over $3,900!
In this example, your numbers would now look like this:
- Taxable Rental Income = $0
- Money in Your Pocket from Tax Savings on Other Income: $3,900/year
Try doing that…mmmm….pretty much anywhere else.
Oh, but we are not done yet…..
Your ability to take $25,000 of real estate losses against other forms of income phases out as your income rises from $100,000 to $150,000 and if you make over $150,000, you cannot take any of your real estate losses against your other forms of income….
UNLESS, you can qualify as a “Real Estate Professional” for tax purposes.
Qualifying for the “Real Estate Professional” status for tax purposes is the holy grail of real estate tax benefits. The IRS is making it tougher to qualify, so make sure you are working with a qualified CPA to ensure you have proper documentation if you want to try.
Here are the Benefits:
The basic requirements are that one spouse spends at least 750 hours a year (15 hours a week) on qualifying real estate activity, and spends more time on real estate than any other job. But there are important “material participation” and other requirements that you must meet as well. It is important to always consult with a qualified CPA to ensure that you meet and document all the requirements properly.
Section 1031 of the U.S. federal tax code allows you to do a "like kind exchange", where you put all of the proceeds from the sale of your property into buying another one or multiple "like-kind" properties of equal or greater value.
The government allows you to "replace" or "exchange" properties in this manner without triggering the capital gains tax and depreciation recapture that would normally be due on sale.
You can continue to exchange and exchange and exchange for your entire life and then at death, according to the "step up in basis" rule in the U.S. federal tax code, the deferred depreciation recapture and capital gains are both automatically wiped out and your heirs inherit the property with a brand new depreciable basis based on current market value!
There are very specific formalities for executing a 1031 exchange (including the use of a Qualified Intermediary) and time-frames that you must adhere to, so always ensure you are working with a professional to execute the transaction properly.
When you combine all 7 of these tax benefits, you can start to see the full impact and understand why the asset class of residential investment property stands alone in terms of tax advantages for the individual investor.Let us know in the comments about which of these tax advantages you have taken advantage of and how they have worked out for you.
WE ARE NOT LEGAL, TAX, OR FINANCIAL PROFESSIONALS. THE CONTENT ON THIS PAGE IS FOR INFORMATIONAL PURPOSES ONLY AND SHOULD NOT BE CONSTRUED AS INDIVIDUALIZED ADVICE. IT IS YOUR DUTY TO CONSULT WITH YOUR OWN TAX, LEGAL AND FINANCIAL PROFESSIONALS ABOUT YOUR INDIVIDUAL SITUATION, APPLICABLE LAWS, AND THE SUITABILITY OF ANY INVESTMENT PROPERTY FOR YOU PERSONALLY. ALL REAL ESTATE INVESTING INVOLVES RISKS, WHICH BUYER ASSUMES, AND NO SPECIFIC RETURNS CAN EVER BE GUARANTEED BY ANYONE.
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