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Real Estate Investors Get Different Tax Breaks From Homeowners - 2008-04-20 |
Last week we looked at the tax benefits that residential homeowners get to take, just for owning and living in their real estate.
But what about tax breaks for those who invest in real estate? Well, your Congress has gifts for them, too. This week we'll look at some of the best tax breaks available for real estate investors. I define them as those who own rental real estate which they plan to hold at least several years.
* Mortgage interest expense is perhaps the largest expenditure real estate investors make. And just as homeowners do, investors get to deduct against income the costs of borrowing money to pay for the property.
But the deduction gets better from there. Because you are now in the business of renting your house to a tenant, you may also deduct the cost of property taxes and hazard insurance, both of which are often included in your monthly loan payment. In fact, about the only thing you can not deduct is that portion of your payment designated as "principal reduction."
This explains why many investors tend toward long term financing, or even interest-only financing. There is less benefit in paying off the loan, as it doesn't lower the payment and it isn't tax deductible.
* Normal & necessary business expenses are also deductible against the income generated by the property.
This would include things like cleaning, maintenance, all utilities, management fees, advertising, office supplies, auto and travel expenses, and legal and other professional fees.
The IRS expects these costs to be reasonable in relation to the income generated by the investment, and it also expects that your goal should be to make a profit, not perpetually lose money.
But the underlying concept here is that "you have to spend money to make money," and the IRS wants you to make money so that you can pay more tax dollars.
* Another major tax benefit of owning a real estate investment is the deduction you get for depreciation.
Depreciation is a way of accounting for the deterioration of an asset over its useful life. In other words, if we are talking about a refrigerator, we can agree that it probably has a useful life of seven years. After that time in rental service, it will likely need to be replaced.
So instead of getting a complete deduction for the full cost of a new refrigerator today, the IRS wants you to spread out the deduction over the 7 year life of the refrigerator. The IRS has set statutory useful lives for different types of assets, including refrigerators and houses.
Thus, the IRS has decreed that the useful life of a house is exactly 27.5 years. So if you bought a rental house for $100,000 and placed it in rental service on January 1, and if you determined that the value of the lot was about $18,000 (from tax records and comparable sales), then the value of the improvement (the house) would be fixed at $82,000.
And if you left that house in rental service for a full year, you would show a "non-cash" expenditure on your tax return for that year of ($82,000 divided by 27.5 years) almost three thousand dollars.
Why, you might ask, is this helpful? It's because many rental property owners find that their income from rent almost exactly equals their out-of-pocket expenses for the year. And in the early years of rental ownership, that is not unusual. It's called "break even" cash flow, and it means you are just breaking even.
But by adding a three thousand dollar depreciation deduction to the mix, the investor can show a "paper loss" for the year, and possibly apply that loss against other taxable income. It's a way of lowering the amount you have to pay in income taxes, and it's called a "tax shelter."
Adjusting the years allotted for depreciation is a way of rewarding (or
discouraging) real estate investment. So in the early 1980's when Congress wanted to jump-start the economy, it introduced accelerated depreciation, designed to give investors much bigger tax deductions for depreciation in the early years of ownership. This explains why many high income taxpayers quickly decided to invest in apartment buildings.
Today, depreciation on residential houses is limited to 3.63% of the improvement (the house only) per year. So, here is a rule of thumb that many investors use to predict the amount of their tax shelter:
If all my property breaks even on a cash-flow basis, and if I get about a $3,000 tax shelter for each $100,000 of real estate that I place into rental service, then I can zero out my tax bill on $24,000 of regular job income by owning approximately eight rental houses that I purchase for about $100,000 each.
There are limitations on the amount of losses you can take unless you are a "real estate professional" as defined by the IRS, in which case there are no limitations to sheltering the family income. This explains why many a high-income individual might encourage their spouse to become a real estate agent.
NEXT WEEK: Tax-deferred Exchanges for Investors Only
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In all the years I have been investing in real estate, I have never seen opportunity like this. The moon is in the seventh house and Jupiter is aligned with Mars, and for the next 12 to 18 months, you have a window of opportunity to buy quality investment houses at discounts that were simply unheard of a couple of years back.
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