One of the main reasons people invest in real estate is for the beneficial tax break it provides. The tax breaks are most substantial for middle-income investors who are their own property managers. The value of tax relief depends on your annual income and what type of job you have. Even though the breaks are most significant for the middle class, there are also tax shelters for income produced by passive investors and high-income earners.
An example of the tax benefit for real estate investors is that the maintenance costs and marketing costs associated with a rental property can deducted from the income on a property, no matter what tax bracket the owner is in. Other expenses that can be deducted are interest on the mortgage, property insurance, utilities, general maintenance and repairs, management fees, marketing costs for renting the property, and depreciation.
Depreciation is the fact that tangible assets diminish in their value over time. For example, if you buy an oven for a rental house, it’s assumed that it will wear out over the upcoming years. The value of the oven can be claimed over a five year period as a deductible expense on your taxes.
Depreciation is used by some people to shelter taxable income so that it is not taxed. Here’s what they do: The rental property owner depreciates the value of the rental house’s structure. Land does not depreciate because it doesn’t wear out. So if the owner claims that the value of his rental is going to go from its purchase price down to $0 over 27.5 years, the annual amount is sheltered as depreciation, which can be deducted from property income before paying taxes.
Consider the following example of depreciation:
You invest in a four-family house for $500,000, finance $400,000 and put down a $100,000. The $400,000 mortgage is at a 7% interest rate, which costs about $2,662 in interest per month. Add in the additional costs that are $500 per month and include management fees, repairs, insurance, and advertising costs.
Monthly rent income is $1,000 per unit, for a total of $4,000 for the property. The positive cash flow (income minus expenses) in this situation is $838 per month. This totals $10,056 annually. Usually this would be taxable income, and at a 30% tax rate, that would cost you about $3,000.
The money saving tip here is that you can depreciate the building over time, thus reducing the amount of taxable income that you will need to pay taxes on. First subtract out the appraised cost of the land – in this example it’s $75,000. This means the cost of the structure is $425,000. Divide that out over 27.5 years, and you’ll have an annual depreciation expense of $15,454. This eliminates your tax obligation on the $10,056 in rental income.
The next logical question would be, “What happens to the remaining depreciation expenses totaling $5,398?” Well, if you are “materially participating” in the management of the property, you can claim that loss against other income, which reduce your taxes. These losses, however, are limited by two other factors: (1) What you make in total income, and (2) Whether you are a bona-fide “real estate professional” (you work 750 hours per year or more in real estate trades or professions).
Also, keep in mind that the depreciation deduction is only “borrowed”. That is, when you sell the property, you must “recapture” the depreciation you took. This recapture is taxed at a flat 25%, which can be in addition to any capital gains tax you may owe.
As with any tax issue, always consult with a qualified tax professional about you particular situation if you are unsure of the ramifications.
