Real Estate 101: Taxes (Free Money Finance)

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.
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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.
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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.?
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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.?
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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.
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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.
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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.?
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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.
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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.
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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.
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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.
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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.?
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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.?

Source: http://www.freemoneyfinance.com/2012/12/real-estate-101-taxes.html

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