The following is a guest post by FMF reader Apex. He has been investing in rental real estate for more than four years and is authoring a Real Estate 101 series, posting every Friday, based on his experiences. (To read the series from the beginning, start here.) The series is designed to give prospective investors the basic tools they need to succeed.
Many people cite the tax advantages of real estate investing as one of the primary benefits. The tax advantages are real and they are certainly a benefit but I think many people give them more weight than they are worth.
The primary tax benefit that people refer to when they talk about the tax advantages of real estate is the depreciation of the property you purchase. When you purchase real estate for investment purpose you can depreciate any portion of the investment that is not land. Typical allocation to land is usually around 20-25%. This means that if you purchased a $100,000 investment property you could expect to be able to depreciate about $75,000 of the investment. This value is depreciated over 27.5 years for a residential property (39 years for a commercial property). That would mean each year for the next 27.5 years you would get a tax deduction against your earnings on the property of a little more than $2,700 per year. If the property had a profit of $5,000 for the year you would only have to pay taxes on $2,300 of that value.
To be sure this is a very nice benefit, but it is not exactly free money. For starters you will be paying $100,000 of cash towards this property either up front or over the course of a loan. You can deduct all of the interest paid on a loan but the principal payments are not tax deductible. The depreciation allowance lets you deduct about 75% of those principal payments over time, but not all of it. That means that over the course of 30 years you will pay $100,000 in real cash to own this property and only get to deduct $75,000 of it against your taxes. The other $25,000 you will have paid tax on, even though you no longer have that cash. It is tied up in your property.
Now to be fair if you invest in equities you do not get to deduct any of the cash that you use to purchase stocks, but it is also true that stocks are easily converted back into cash whereas real estate is not. It’s important to realize that you are not getting a $75,000 dollar tax deduction against profits without putting anything in. You will actually put in more cash than you get as a deduction. The deceiving and seductive part of the depreciation deduction is that in the beginning you come out way ahead. Your mortgage payment is mostly interest which is deductible as an expense so you are paying very little towards principal. This makes your taxable profit much lower and in addition you still get that $2,700 tax deduction. This is why your taxable profit is considerably lower than your actual profit or your cash flow in the early years. But as time goes on, this relationship will invert itself.
Sometime between years 15 and 20, this formula will cause your taxable profit to exceed your actual profit. By year 27 you will be paying almost all principle on your loan, which means hardly any of those payments will be deductible. That will make your taxable profit much higher. You mortgage payment will likely be considerably larger than your $2,700 depreciation allowance and very little of it will be deductible. The result is that your taxable profit will exceed your actual profit and your cash flow. What’s worse is on years 28-30 you will have no depreciation left and yet you will still be making those same mortgage payments. Again there will be hardly any of that mortgage payment that is deductible and without any depreciation left your taxable income will greatly exceed your actual profit and cash flow in years 28-30. If you blew the money that depreciation benefited you in the beginning, you may find yourself coming up cash short in the end.
The second reason this is not quite the benefit it might seem like is because all the deductions you received from the depreciation now become taxable income if you ever sell the property. You received the deduction while you owned it but the IRS will classify those as recaptured capital gains upon sale. They will be taxed at a minimum of 25% regardless of which tax bracket you are in. You may have been in the 15% bracket when you took the depreciation deduction but you will still pay them back at 25% when you sell.
This brings us to the second major real estate tax benefit known as a 1031 exchange. This refers to a section of the tax code that allows you to sell a real estate asset and transfer any taxable gains to a new asset without paying any taxes. There are a number of requirements that need to be met to do a 1031 exchange, but the key one is that the asset that you exchange into has to be a like kind asset. That means real estate must be exchanged into real estate and likely the same kind of real estate. You won’t be exchanging into stocks even if they are REITs and you probably won’t even be exchanging into a golf course even though it could be classified as real estate. Thus there is no getting out of the real estate business if you want to continue to avoid paying those taxes on capital gains and on past depreciation.
The 1031 exchange allows you to transfer into different real estate assets and even into some kinds of managed partnerships which would allow you to take a hands off approach. That is a big benefit because it allows you to change the structure of the real estate you invest in and the level of your involvement without incurring taxes. But regardless of how you do it, if you want to use the 1031 exchange to avoid taxes you will forever remain invested in real estate.
The third tax benefit is simply that you can deduct every expense you incur for any reason as long as it is business related. I already mentioned the deduction for interest paid on your mortgages. In addition any repairs, maintenance, tenant acquisition costs, professional services fees, vehicle costs, tools, utilities, property taxes, dues of any sort, management costs, employee costs, and office costs are all deductible. However, this benefit is not unique to real estate, every business can deduct these costs against revenue.
In fact every business can depreciate capital assets the same way real estate does too. The thing that makes real estate depreciation unique is that real estate assets don’t really depreciate the way normal business equipment assets do. Depreciation is designed to spread the tax deduction of a depreciating asset over a time that approximates its useful lifespan. When most businesses depreciate a capital asset such as equipment, the asset has very little value left after it has been depreciated. With real estate assets this is generally not true. With a little bit of routine maintenance and upkeep the depreciable building asset actually retains or gains value. This is why there is a special rule about recaptured capital gains for depreciated real estate assets that taxes them differently than other depreciated assets.
One topic that always comes up is whether it is worth it to take the depreciation due to some of the recapture issues I mentioned here and if one has to take it. Let me assure you that the benefits you receive in the beginning will give you more capital for future investment making it very well worth it. But most importantly the IRS does not allow you to forgo your depreciation deduction. When you sell a property the IRS will determine what your depreciation schedule should have been for that property and they will require you to pay taxes on the amount that should have been depreciated whether you actually took the depreciation or not. Not taking the deduction for depreciation will result in you paying taxes twice and that is something you certainly do not want to do.
The tax advantages of investing in real estate do provide a nice added benefit to the investment. Properties that make very low profits will often have no taxable profits for many years, perhaps a decade or more. Some investors judge their returns by taking into account the benefits of depreciation. I will warn you to be very careful of using this metric. It can be used to justify a mediocre or even a poor investment. I would much sooner have a property that had considerable taxable income left after depreciation.
There is a reason my column on Running the Numbers did not account for any tax benefits from depreciation. Tax benefits are real but they come after everything else. If everything else looks good then the tax benefits just make them look a little better. If everything else looks poor then the tax benefits aren’t enough to make it a good deal. Success in real estate investing does not come from tax benefits. It comes from running a profitable business. Be careful not to over-estimate the value of tax benefits. No amount of tax benefits can make an unprofitable business, profitable.
Update: Click here to read the last post in this series.
Many people cite the tax advantages of real estate investing as one of the primary benefits. The tax advantages are real and they are certainly a benefit but I think many people give them more weight than they are worth.
The primary tax benefit that people refer to when they talk about the tax advantages of real estate is the depreciation of the property you purchase. When you purchase real estate for investment purpose you can depreciate any portion of the investment that is not land. Typical allocation to land is usually around 20-25%. This means that if you purchased a $100,000 investment property you could expect to be able to depreciate about $75,000 of the investment. This value is depreciated over 27.5 years for a residential property (39 years for a commercial property). That would mean each year for the next 27.5 years you would get a tax deduction against your earnings on the property of a little more than $2,700 per year. If the property had a profit of $5,000 for the year you would only have to pay taxes on $2,300 of that value.
To be sure this is a very nice benefit, but it is not exactly free money. For starters you will be paying $100,000 of cash towards this property either up front or over the course of a loan. You can deduct all of the interest paid on a loan but the principal payments are not tax deductible. The depreciation allowance lets you deduct about 75% of those principal payments over time, but not all of it. That means that over the course of 30 years you will pay $100,000 in real cash to own this property and only get to deduct $75,000 of it against your taxes. The other $25,000 you will have paid tax on, even though you no longer have that cash. It is tied up in your property.
Now to be fair if you invest in equities you do not get to deduct any of the cash that you use to purchase stocks, but it is also true that stocks are easily converted back into cash whereas real estate is not. It’s important to realize that you are not getting a $75,000 dollar tax deduction against profits without putting anything in. You will actually put in more cash than you get as a deduction. The deceiving and seductive part of the depreciation deduction is that in the beginning you come out way ahead. Your mortgage payment is mostly interest which is deductible as an expense so you are paying very little towards principal. This makes your taxable profit much lower and in addition you still get that $2,700 tax deduction. This is why your taxable profit is considerably lower than your actual profit or your cash flow in the early years. But as time goes on, this relationship will invert itself.
Sometime between years 15 and 20, this formula will cause your taxable profit to exceed your actual profit. By year 27 you will be paying almost all principle on your loan, which means hardly any of those payments will be deductible. That will make your taxable profit much higher. You mortgage payment will likely be considerably larger than your $2,700 depreciation allowance and very little of it will be deductible. The result is that your taxable profit will exceed your actual profit and your cash flow. What’s worse is on years 28-30 you will have no depreciation left and yet you will still be making those same mortgage payments. Again there will be hardly any of that mortgage payment that is deductible and without any depreciation left your taxable income will greatly exceed your actual profit and cash flow in years 28-30. If you blew the money that depreciation benefited you in the beginning, you may find yourself coming up cash short in the end.
The second reason this is not quite the benefit it might seem like is because all the deductions you received from the depreciation now become taxable income if you ever sell the property. You received the deduction while you owned it but the IRS will classify those as recaptured capital gains upon sale. They will be taxed at a minimum of 25% regardless of which tax bracket you are in. You may have been in the 15% bracket when you took the depreciation deduction but you will still pay them back at 25% when you sell.
This brings us to the second major real estate tax benefit known as a 1031 exchange. This refers to a section of the tax code that allows you to sell a real estate asset and transfer any taxable gains to a new asset without paying any taxes. There are a number of requirements that need to be met to do a 1031 exchange, but the key one is that the asset that you exchange into has to be a like kind asset. That means real estate must be exchanged into real estate and likely the same kind of real estate. You won’t be exchanging into stocks even if they are REITs and you probably won’t even be exchanging into a golf course even though it could be classified as real estate. Thus there is no getting out of the real estate business if you want to continue to avoid paying those taxes on capital gains and on past depreciation.
The 1031 exchange allows you to transfer into different real estate assets and even into some kinds of managed partnerships which would allow you to take a hands off approach. That is a big benefit because it allows you to change the structure of the real estate you invest in and the level of your involvement without incurring taxes. But regardless of how you do it, if you want to use the 1031 exchange to avoid taxes you will forever remain invested in real estate.
The third tax benefit is simply that you can deduct every expense you incur for any reason as long as it is business related. I already mentioned the deduction for interest paid on your mortgages. In addition any repairs, maintenance, tenant acquisition costs, professional services fees, vehicle costs, tools, utilities, property taxes, dues of any sort, management costs, employee costs, and office costs are all deductible. However, this benefit is not unique to real estate, every business can deduct these costs against revenue.
In fact every business can depreciate capital assets the same way real estate does too. The thing that makes real estate depreciation unique is that real estate assets don’t really depreciate the way normal business equipment assets do. Depreciation is designed to spread the tax deduction of a depreciating asset over a time that approximates its useful lifespan. When most businesses depreciate a capital asset such as equipment, the asset has very little value left after it has been depreciated. With real estate assets this is generally not true. With a little bit of routine maintenance and upkeep the depreciable building asset actually retains or gains value. This is why there is a special rule about recaptured capital gains for depreciated real estate assets that taxes them differently than other depreciated assets.
One topic that always comes up is whether it is worth it to take the depreciation due to some of the recapture issues I mentioned here and if one has to take it. Let me assure you that the benefits you receive in the beginning will give you more capital for future investment making it very well worth it. But most importantly the IRS does not allow you to forgo your depreciation deduction. When you sell a property the IRS will determine what your depreciation schedule should have been for that property and they will require you to pay taxes on the amount that should have been depreciated whether you actually took the depreciation or not. Not taking the deduction for depreciation will result in you paying taxes twice and that is something you certainly do not want to do.
The tax advantages of investing in real estate do provide a nice added benefit to the investment. Properties that make very low profits will often have no taxable profits for many years, perhaps a decade or more. Some investors judge their returns by taking into account the benefits of depreciation. I will warn you to be very careful of using this metric. It can be used to justify a mediocre or even a poor investment. I would much sooner have a property that had considerable taxable income left after depreciation.
There is a reason my column on Running the Numbers did not account for any tax benefits from depreciation. Tax benefits are real but they come after everything else. If everything else looks good then the tax benefits just make them look a little better. If everything else looks poor then the tax benefits aren’t enough to make it a good deal. Success in real estate investing does not come from tax benefits. It comes from running a profitable business. Be careful not to over-estimate the value of tax benefits. No amount of tax benefits can make an unprofitable business, profitable.
Update: Click here to read the last post in this series.
Complicated topic made simple. Good write-up, thanks.
Posted by: evilhomer | December 14, 2012 at 08:47 AM
In the instance that you sell a property for more than what you bought it for (and if you own it for years and years, that's probably likely just due to inflation), the gain over the original purchase price is treated as a long-term capital gain; e.g. it's not necessarily subject to that 25% depreciation capture rate.
Of course, we don't know what long-term capital gains rates are going to be in a few years, given we don't really know what they're going to be in 2013...
Posted by: Josh Stein | December 14, 2012 at 09:55 AM
@Josh,
That is correct. Recapture capital gains only apply to the gains that are due to depreciation. Normal capital gains rates apply to normal capital gains which would be the sales price minus your basis in the property.
Posted by: Apex | December 14, 2012 at 10:39 AM
Travel expenses are a good deduction. The IRS lets you deduct 55 cents per mile and that adds up. Just track and log all the miles you drive related to the rental.
You can do a home office deduction too if you have a legitimate home office dedicated to rental business, but thats hard to do legitimately since its supposed to be *solely* for business use. You can't just claim your kitchen table is your home office nor can you claim the den is a home office if the den is used for other purposes. And a home office deduction doesn't add up to too much so I don't know if its worth it.
I look at depreciation as tax deferral similar to an IRA. And the 1031 I look at like doing a IRA rollover.
Doing a 1031 does have a cost generally. You have to pay a 3rd party to do it and from what I've seen the charges are around $500 ballpark. Plus doing a 1031 on multiple properties gets complicated. Say you have 5 houses and want to sell them all and buy an apartment complex. We'll you'll have to sell 5 houses and then do a 1031 exchange within the period of a couple months. That can be tricky to pull off.
If you have a LOSS on your rentals then there is a maximum on the amount you can claim as a loss. The most you can claim as a loss is $25,000 which gets cut off if your income is over $150k. Of course you should hope and plan not to have a loss.
Here's an example of depreciation and taxes : My dad bought a house decades ago for $17,000. Today its worth about $80,000. Over the years he depreciated about $14,000 of it (3k land value). If he were to sell it today he'd owe depreciation recapture on the $14,000 and long term capital gains on the $63,000 increase in value. His tax bill would be 25% of $14,000 plus 15% of 63,000 = $12,950
That works out to about 20.5% effective rate on the gain but of course the effective rate will differ depending on the gain and situation. But he hasn't sold it yet so he hasn't paid any taxes yet and he deferred $14,000 back in the 80's and 90's. (he originally had a different depreciation schedule before the law changed in '86)
Posted by: jim | December 14, 2012 at 01:36 PM
I'd like more information about loss limits as Jim just touched on. Are there any pointers on dealing with taxes when your primary job hovers around the $150k income?
Also, if you were to call it quits with real estate, could you go back, live in property for awhile, sell and claim primary residence to avert any capital gains up to $250K?
Posted by: Luis | December 14, 2012 at 02:54 PM
Good post. A few quick adds:
* Look around for a good CPA with specific real estate investor experience. The REI's are great for this. I recommend finding one there who also has properties of their own. This one step will pay huge dividends over the years. But the run of them mill cpa does not have the deep experience in the areas you need.
* Mileage deduction is great suggestion, it really adds up, and you just need a log if you get audited.
* If you can claim 750 hours a year in your real estate business, it puts you in a much better class for several categories. Again, you need a log in case of audit.
Posted by: CoolMouseLuke | December 14, 2012 at 02:59 PM
@CoolMouseLuke,
The 750 hours is used to claim you are a real estate professional. That is mostly beneficial when trying to get around the passive activity loss rules that limits losses to 25K and to zero if you make over 150K from non-passive activities. There are not many other tax benefits than this one that I am aware of. So if you don't have significant passive losses that you are unable to deduct this isn't really that important.
It's also worth noting that 750 hours is not enough. It also has to be more than half of all your working hours. So if you have a full time job not related to real estate working 2000 hours you need 2001 hours in real estate, not 750. It's an impossible hurdle for anyone who is not full time in real estate.
Posted by: Apex | December 14, 2012 at 03:33 PM
@Luis,
You can deduct up to $25,000 of passive losses against active income (wages).
At any income above 100K this begins to phase out. You lose $500 of this deduction for every $1000 above 100K. At 150K you cannot deduct any of the loses against active income.
However these loses are not lost to you. They are carried forward until they can be deducted, either against future profits or if your income were to drop then you could use them.
As CoolMouseLuke alluded to you can deduct all loses if you can meet the hurdle to be a real estate professional. This requires documented work of 750 hours in the calendar year in your real estate business and more than half of all your working hours in real estate. If you have a full time job this is not realistically attainable.
As to pointers, if you make too much income you simply cannot deduct loses. Your only options are to make less wage income (probably not a goal) or to make your rental properties more profitable so that they do not have loses. The easiest way to do that at this time is to purchase more properties that will be strongly profitable in this market to offset the loses from your less profitable properties.
Baring that you will simply have to defer the loses until a future date.
As to living in a former rental, you can do that and you can avert part of the gains based on a percentage of time used as a rental and used as a residence. I do not know how this impacts recapture gains. I am guessing you have to pay full taxes on those but I am not certain. You would need to see a real estate CPA to get the final word on this exactly how this would all work out.
Posted by: Apex | December 14, 2012 at 03:46 PM
Apex -- great article, and very much in line with my philosophy about taxes on my 3 rental properties. Tax savings are a bonus, and you shouldn't count on them as part of the equation that makes a house a good rental. The depreciation just seems like deferring taxes to me, so I'm not sure why people make such a big deal out of it (though you have to take it or you'll double-pay). The biggest benefit to me (besides deducting interest as a business expense) has been deducting many of the repairs that I made to the houses before renting them out. Although you are supposed to depreciate any improvements that you make to the property, many things can simply be deducted, and that adds up (and yes it carries forward if you can't take it all in one year)! If anyone is really interested (and does their own taxes like me), Nolo Press has a great book on tax deductions for landlords.
Posted by: SteveD | December 14, 2012 at 06:19 PM
Trying to hit the qualification as a 'real estate professional' in the eyes of the IRS to qualify your rentals as an active investment is not feasible for most people. Even if you do nothing else hitting 750 hours is quite a lot.
My dad runs 20+ units all alone including mowing lawns and all repairs and I don't think he does that much.
Most people shouldn't be too worried about the passive loss rule. You don't want to be losing >$25000 in a year to start with. And if you do have a large one time loss you can carry it forward like Apex said. If you're losing $25k then your bigger worry isn't the tax limit, its the $25k loss.
Keep in mind the 'loss' is your rental balance sheet loss on schedule F. So its all your income minus the deductions. It shouldn't be typical to have such high losses. Factoring in depreciation some good cash flow properties may show a loss on paper but hopefully not that high.
Posted by: jim | December 14, 2012 at 06:59 PM