Last week I talked about how we can eliminate income taxes in my blog post with some scenarios. In one of the scenarios, I talked about a couple that owned rental real estate but not all their income was considered in the taxable income. Today, I want to quickly talk about those ‘magic’ deductions we get with real estate. This is true for a lot of different types of real estate investing but I am going to stick to long term buy and hold residential real estate investing in this article. Again, this is a US centric article, but this framework applies to many different countries.
You don’t need an LLC to get the tax benefits
The first and fundamental misconception I want to clear is around having an LLC to take advantage of the tax benefits. I get this question a lot and want to be clear – you don’t need an LLC to take advantage of any tax benefits of rental real estate (I am referring to long term buy and hold residential rental real estate here). An LLC is needed purely for asset protection. You can still enjoy all of the tax benefits without the LLC.
Real estate as passive income
One additional assumption for this article is that the real estate rental income is considered passive income, and not active income. What that means is that you don’t work on real estate as a fully time profession but it’s truly passive – meaning majority of your time is spent doing something else. Why this matters is because the tax treatment changes considerably if your rental income is considered active or passive. So, lets assume you have a W2 income and a side gig of earning rental income. Your tax deductions you enjoy on your passive income cannot be offset with your active W2 income. Essentially, you cannot mix and match active and passive income from a tax perspective. The criterion to call real estate as active is very stringent and you cannot simply say you spend a few hours on real estate and call it active income.
With those points behind us, let us explore the tax deductions that allow real estate to be so great!
The big daddy of the rental deductions – depreciation
If you are not a business or accounting major, the word ‘depreciation’ makes eyes glaze over typically. Let me first explain what depreciation is. Whenever you buy something tangible, it goes through wear and tear with usage over time. This is called depreciation. Now, in a rental property, you have 2 components – the land and the actual building. Land does not really go through depreciation, but the building does. Intuitively, that makes sense. So, the accounting rules therefore allow for the building portion of a rental property to have a certain amount deducted each year as depreciation. Let’s look at a basic example:
- You purchase a 2 bed 1 bath single family rental property for $150K. You estimate based on the county records that the land portion of the property value is $50K and the building portion of the property value is $100K.
- So, the simplest and basic form of depreciation allows you to deduct an amount each year for 27.5 years for the building portion (why 27.5 years? Because the IRS determined that is the life of a property). So $100K/27.5 = $3636.36 each year for the next 27.5 years.
- You get to deduct this amount from the rental income each year as if it were an expense. And this deducted amount is exempt from tax.
- Now, you actually pay for all this at the back end when you sell the property which I will explain.
- In year 0, when you buy the property, the value of the property of $150K is called the cost-basis. This is the starting value of the property.
- In year 1, you incur depreciation of $3636.36. So, by the end of year 1, the cost basis or the value of your property goes down by $3636.36 or basically down to $146,363.63. And this happens each year.
- Based on this depreciation, by year 25, the cost-basis or value of your property is now around $59,000.
- If you were to sell the property at year 25, you now must pay long term capital gains tax on this. So, by year 25 if the property value has appreciated to $300K, the gain on this property is $300,000 – $59,000 = $241,000. Note that you subtract it not from the original purchase price of $150K but the updated cost-basis at year 25 of $59K. So, this is called depreciation re-capture. It’s the IRS’s way of making sure you pay for all this benefit you enjoyed all these years. You will pay long term capital gains tax on this $241,000. But there are ways to offset this that is beyond the scope of this article.
Now, if you add value to the house as you own it, you get to add the value of that addition to the cost-basis. This can be adding a room or even making capital repairs like putting a new roof. These can tend to get depreciated at different time periods other than 27.5 depending on the nature of the additions. There is a more advanced way to accelerate depreciation in the initial years, but I am not going to go into that here.
Hope you are still with me. If you got depreciation, then the rest of this stuff is a cake walk 😊
Other deductions
Rental properties incur many other expenses, almost all of which is eligible for a deduction. These include expenses for repairs and maintenance, supplies, marketing/advertising, property management – basically any expense you incurred. I am yet to encounter an expense you cannot deduct. Another big one along with depreciation especially in the initial years tends to be mortgage interest.
Let’s bring this together with an example
I am going to show an illustration of a single-family home that receives annual rent of $15,000.
Annual rent | $ 15,000.00 |
(-) Mortgage interest | $ 4,000.00 |
(-) Depreciation | $ 6,000.00 |
(-) Repair expenses | $ 400.00 |
(-) Property taxes | $ 2,000.00 |
(-) Insurance | $ 300.00 |
(-) HOA Fees | $ 2,760.00 |
Total expenses to be deducted | $ 15,460.00 |
Net Profit / Loss | $ (460.00) |
You can see in the above example that while you made a profit during the year, you showed a loss due the depreciation amount on this property. The depreciation is not a real cash expense but as I explained earlier, you get to deduct that expense each year for 27.5 years.
The final icing on this cake is that when you show a loss, you can carry forward this loss each year indefinitely until you sell the property across your entire rental property passive income – meaning, if you have other rental properties that make a profit, you can offset it with this loss. This can really get amplified once you have multiple properties.
The above is a simplistic example but close to reality from my own tax return.
Concluding thoughts
Rental properties, if you buy them right, are great investments for a variety of reasons I have explained in earlier blog posts. I know a lot of folks will scream from the top of a roof that rental properties are the next best thing since sliced bread thanks to their tax advantages. As explained above, they come with tremendous tax advantages. But don’t buy rental properties/real estate for the tax advantages. That would be the wrong reason – buy it if the numbers tell you it is a good investment. Read my blog post ‘should I be investing in real estate’ to first determine if this is truly an asset class you want to invest in. Once you do decide to invest in real estate, then you can read my other article on ‘Am I making a good return on rental properties’ to determine if the numbers make sense. Once you have clearly established that real estate is for you and the numbers make sense, then go about truly enjoying and optimizing your tax situation on rental properties.
Thank you for reading and I wish you success in your personal finance journey!
Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.
