Real estate is among the most tax-advantaged classes of investment assets.  There are three important tax advantages are important to consider:  depreciation, long- term capital gains tax treatment, and the ability to defer paying taxes altogether through a 1031 exchange.   This series of three blog articles will address each of these advantages separately.

Depreciation – An Immediate Benefit

Depreciation is one of the immediate advantages you receive when investing in positive cash flow income property.  Of course there are other tax advantages as well, but those are more long term benefits. The IRS defines depreciation as

“an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.”

When you own investment property and receive cash flow, you have an opportunity to shelter the majority cash flow and defer the taxes. This is best illustrated by looking at an example.

The Numbers – A Case Study

Most often, financing investment properties can yield strongest returns.  In the current investment market, typically banks want 20% down on financed properties.  To illustrate the depreciation advantage, let’s use round numbers.

  • Imagine a 100K house with 20K down
  • The bank loan is 80K
  • The interest rate on the $80K loan is 6%

The investor receives rents and pays expenses including principal and interest (P&I), taxes, insurance, property management fees, and set aside a reserve amount (usually 10% of rents received) for maintenance and vacancy.

Typically, on a $100K home, our investors are receiving approximately $3K annually in positive cash flow after paying all of these expenses.

Calculation of Depreciation

Suppose that same $100K house that sits on land where 80% of the value is the house and 20% is the land.  Land is not depreciable, but the structure is.

The IRS tax code (IRS Pub. 527) says that the structure depreciates with a life of 27½ years.

So $80,00 divided by 27.5 years = $2909 Per Year

With $3,000 in net cash flow offset by $2,909 in depreciation, all but $91 can be written off for that tax year.  The income taxes on the cash flow have been virtually eliminated.

 

Tax Deferred Vs. Tax Free

It is really important to understand that you are not receiving your $3000 tax free, but tax deferred.  This means you owe the tax, but you just won’t have to pay it until sometime in the future. Eventually, when the house is sold, the cumulative depreciation that was written off is subject to a 25% recapture tax under current law.  (However, this depreciation recapture tax can be postponed indefinitely by taking advantage of another tax benefit, the 1031 exchange, the subject of Part Three of this series.)

Why is tax deferral advantageous?  By not paying taxes today, you can take that full $3,000 and invest it versus paying income tax.  For example, an investor in the 33% tax bracket, would normally owe 33% of $3,000, or approximately $1,000 in income taxes and would have net income of $2,000 to keep or reinvest.  But because of the depreciation deduction, the investor would be able to keep or reinvest the full $3,000 in cash flow.

When comparing investment real estate to other investment asset classes whose returns are subject to ordinary income taxes, the returns of the taxable investment must be adjusted to make a proper comparison.   For example, if an investor in the 33% tax bracket receives a 10% cash-on-cash return on his investment real estate, he or she would have to receive nearly a 15% return on a comparable taxable investment, like in a CD, in order to receive a net 10% return after taxes are paid.

Depreciation allows you keep your cash flow in hand to keep or reinvest in the short term. As a tax advantage, depreciation is the most powerful and immediate benefit of holding real estate as an asset class.

To refer back to our series please see the links below:

Part 1: Shield Your Investment

Part 2: Capital Gains & Depreciation

Part 3: 1031 Exchange