From the BiggerPockets Blog

 BiggerPockets Blog »

Jump to Forum View All

Click a category below to view different forum categories.

BiggerPockets

General Info

BiggerPockets Q&A, Site Questions, & Announcements

1504 topics, 14360 posts — Last Post 04/16/14, 07:25AM

BiggerPockets Exclusive PRO Area

116 topics, 835 posts — Last Post 04/16/14, 01:04PM

New Member Introductions

10845 topics, 85259 posts — Last Post 04/16/14, 02:49PM

Real Estate Success Stories

392 topics, 6101 posts — Last Post 04/16/14, 02:48PM

General Real Estate

General Real Estate

Buying & Selling Real Estate

5905 topics, 46567 posts — Last Post 04/16/14, 02:35PM

Renters

640 topics, 5788 posts — Last Post 04/15/14, 06:49PM

Get Foreclosure Help - Help Stop Foreclosure Forum

316 topics, 2557 posts — Last Post 04/16/14, 03:58AM

Home Owner Association (HOA) Issues & Problems Forum

237 topics, 1604 posts — Last Post 04/16/14, 01:33PM

Do it Yourself

653 topics, 6257 posts — Last Post 04/16/14, 09:21AM

Reviews & Feedback

Real Estate Deal Analysis and Advice

3655 topics, 29316 posts — Last Post 04/16/14, 02:53PM

Real Estate Guru, Book & Course Reviews and Discussions

1129 topics, 11532 posts — Last Post 04/16/14, 09:34AM

Ask About A Real Estate Company

736 topics, 7286 posts — Last Post 04/15/14, 02:45PM

Real Estate Investing

Real Estate Strategies

Wholesaling

5586 topics, 43651 posts — Last Post 04/16/14, 02:21PM

Rehabbing and House Flipping

3321 topics, 30891 posts — Last Post 04/16/14, 02:26PM

Real Estate Development & New Home Construction

551 topics, 4678 posts — Last Post 04/14/14, 01:02AM

Innovative Strategies

699 topics, 5992 posts — Last Post 04/16/14, 12:50PM

Tax Liens, Notes, Paper, & Cash Flows Discussion

863 topics, 6654 posts — Last Post 04/16/14, 02:24PM

Rent to Own a.k.a. Lease Purchase, Lease Options

690 topics, 4856 posts — Last Post 04/16/14, 01:57PM

1031 Exchanges

142 topics, 1051 posts — Last Post 04/16/14, 01:24PM

Foreclosure Investing

General Foreclosure & Pre-Foreclosure Forums

1686 topics, 11281 posts — Last Post 04/15/14, 03:20AM

HUD, VA, and Tax Sales

414 topics, 3085 posts — Last Post 04/14/14, 06:29PM

REOs

1212 topics, 10563 posts — Last Post 04/15/14, 01:08PM

Short Sales

1533 topics, 13117 posts — Last Post 04/15/14, 07:10PM

Landlord & Tenant Forums

Landlord & Rental Property Questions

7186 topics, 70502 posts — Last Post 04/16/14, 02:38PM

Mobile Homes & Mobile Home Park Investing

636 topics, 5127 posts — Last Post 04/15/14, 09:59PM

Investor Basics

Starting Out

7674 topics, 60268 posts — Last Post 04/16/14, 02:51PM

Investor Psychology

430 topics, 6092 posts — Last Post 04/14/14, 06:53PM

General Real Estate Investing

4710 topics, 37142 posts — Last Post 04/16/14, 02:42PM

Real Estate Investor Marketing

1728 topics, 14073 posts — Last Post 04/16/14, 02:05PM

Commercial Real Estate

Commercial Real Estate Investing Forum

1408 topics, 8971 posts — Last Post 04/16/14, 02:36PM

Multi-Family and Apartment Investing

1101 topics, 9165 posts — Last Post 04/16/14, 12:58PM

The Business of Real Estate

Real Estate Technology and the Internet

Real Estate Technology, Social Media & Blogging

638 topics, 4883 posts — Last Post 04/15/14, 01:41PM

Business Basics

Goals, Business Plans & Entities

827 topics, 7526 posts — Last Post 04/15/14, 07:32PM

Real Estate Finance & Legal

Financial, Tax, and Legal

Tax, Legal Issues, Contracts, Self-Directed IRA

2782 topics, 19979 posts — Last Post 04/16/14, 02:23PM

Property Insurance

309 topics, 2041 posts — Last Post 04/16/14, 02:16PM

Personal Finance Discussion

328 topics, 2704 posts — Last Post 04/16/14, 02:14PM

Loans, Mortgages, Credit Lines

Private & Conventional Lending Discussion

2824 topics, 19659 posts — Last Post 04/16/14, 02:29PM

Creative Real Estate Financing

1206 topics, 8758 posts — Last Post 04/15/14, 02:21PM

Crowdfunding Real Estate

35 topics, 455 posts — Last Post 04/14/14, 02:14PM

Real Estate Professionals

Real Estate Professionals

Real Estate Agents

1204 topics, 7945 posts — Last Post 04/16/14, 01:41PM

Bankers, Lenders, and Mortgage Brokers

440 topics, 1917 posts — Last Post 04/15/14, 07:37AM

Contractors

261 topics, 1656 posts — Last Post 04/16/14, 06:23AM

Local Real Estate

Local Real Estate

Local Real Estate Networking & Recommendations

1981 topics, 11561 posts — Last Post 04/16/14, 02:21PM

Americans & International Real Estate

161 topics, 566 posts — Last Post 04/14/14, 11:19AM

Foreigners Buying in the USA

62 topics, 409 posts — Last Post 04/10/14, 06:27AM

Canadian Real Estate

64 topics, 426 posts — Last Post 04/16/14, 08:34AM

Marketplace

Real Estate Marketplace

Real Estate Marketplace

14982 topics, 53855 posts — Last Post 04/16/14, 01:08PM

Real Estate Events and Happenings

162 topics, 2437 posts — Last Post 04/16/14, 02:44PM

Off-Topic

Off Topic

Off-Topic

2901 topics, 32397 posts — Last Post 04/16/14, 10:12AM

Housing News & Real Estate Market

913 topics, 8339 posts — Last Post 04/16/14, 01:11PM

BiggerPockets Real Estate Investing Summit

97 topics, 1751 posts — Last Post 04/10/14, 02:27PM

BiggerPockets Resources

Forums » Tax, Legal Issues, Contracts, Self-Directed IRA » rental property tax example - please advise!

rental property tax example - please advise!

31 posts by 10 users

Signup

Real Estate Investor · Queens, New York


I am still a bit confused about the whole topic of tax benefits from having rental property. Can anyone take a look at this example, and let me know if I am doing this correctly?

An investor has a full-time job making 60k. He buys a 2-family property for $60,000; the mortgage payment including tax and insurance is $550/month. The total rent he collects between the two apartments is $750/month. (so the profit is $200/month.)

For the sake of this example, let's just assume that in the beginning, of that $550 payment, $300/month is going toward interest on the mortgage.

So my calculations would be that the rental profit is 2400 for the year, which is considered a capital gain.

The interest paid would allow the investor to deduct 3600.

Furthermore, the building can be depreciated over 27.5 years. So, 1/27.5 * $60,000 = 2181.81, which should be the amount he can deduct for depreciation each year. So in fact, between the interest deduction and the depreciation deduction, he can actually deduct 3600+2181.81, or 5781.81. Subtract the 2400 profit he made by collecting rent, and you have $3381.81 that he can deduct - so essentially just by having this rental property he is shielding 3381.81 of his salary from his regular job, from being taxed. And on top of that, he makes $2400.

Am I correct or am I horribly misunderstanding how this all works? Also, did I miss out on any other potential tax benefits the investor could be getting in this example?

Thanks!



Real Estate Investor · Ellicott City, Maryland


First, I'm not a CPA or an accountant, so if anyone disagree with me, seriously consider the fact that they may be right and I may be wrong... :)

Depending on how the property is held (business entity or personally) will impact this analysis a bit. But here are the basics assuming he owns the property personally and all income/expenses go right onto his personal 1040...

The property equity, any rehab costs (prior to renting) and capital expenses are all considered Fixed Assets and go right to the Balance Sheet (in other words, they don't count towards income or expense until sold).

All rents, application fees, late fees, etc (basically, all income) are considered Income in the year it was received and gets added to the top line of your tax return.

All expenses -- taxes, insurance, maintenance, property management, interest on your loan payments, etc -- are considered Expenses, and are subtracted from your top-line income before your tax is calculated.

Likewise, depreciation is an Expense and is subtracted from the top line income. But, remember, you're only allowed to depreciate the cost of the dwelling, not the land -- so make sure you subtract out the land value (generally 10-25%) before determining depreciation amounts. Rental property is depreciated over 27.5 years.

So, in your example, the gross rents for the year are about $750 * 12 = $9000 (this assumes no vacancy loss). If he collected any other money -- late fees, application fees, etc -- these would be added in to the income as well.

So, $9000 is added to the person's top line income.

Let's assume 33% of the gross rents went to expenses (the 50% Rule would indicate more, but remember that includes vacancy and capital expenses, which aren't really Expenses in this calculation). That means $3000 was spent on expenses.

Additionally, he paid $550/month in mortgage, of which a percentage is interest. Let's say an average of $400/month of that payment went to interest. So, there is an interest expense of $400 * 12 = $4800.

Lastly, let's say that of the $60K property, 80% is the dwelling and 20% is the land value. So, he can depreciate 1/27 of ($60K * 80%) = $1777.77. For this example, let's round to $1800 for depreciation. That as well is considered an Expense.

So, total Expenses are:

$3300 + $4800 + $1800 = $9900

In total, we have $9000 in Income and $9900 in Expenses, so the net loss for this property would be $900. That $900 would come off his total income, and if he were in the 25% tax bracket, would result in a tax savings of about $225 for the year.

Hopefully I did that right...I'm sure someone else will check my work... :)

And again, I'm not a CPA or a tax professional in any way, shape or form...


Small_lishproplogoJ Scott, Lish Properties, LLC
E-Mail: [email protected]
Telephone: 770-906-6358
Website: http://www.123flip.com
CHECK OUT MY BIGGERPOCKETS BOOKS: http://www.biggerpockets.com/flippingbook


Landlord · Seattle, Washington


J Scott did a good job in explaining it. Your expenses may include an in home office. You don't want to forget that if you are managing the units to take your auto deductions as well.



SFR Investor · Wheat Ridge, Colorado


That's sort of how it works. But the math isn't quite correct.

In reality your profit is nowhere near $200 a month. There are many other expenses in addition to taxes and insurance. You never have 100% occupancy over the long term. Your example is really the best possible case, and most years you would have numerous other expenses.

You get the idea of the depreciation and interest about right. But you subtract those from the gross rents to determine your taxable income. You can also subtract other expenses, but you're assuming only taxes and insurance.

Depreciation is based on only the improvements, not the entire property. Knowing nothing else, the usually assumption is that 80% of the value is the improvements and 20% are the land.

P&I on a $60K, 6%, 30 year loan would be $359.73. So, I'll assume the other $190.27 a month is taxes and insurance. That seems rather high.

Total rent: $9,000
Interest: $3,579.96
Taxes & Insurance: $2,283.24
Depreciation: $1,745.45
Total deductions: $7,608.65
Taxable income: $1,391.35

In this case, your taxable income is positive, so this property generates a tax bill.

If the property was more expensive and had higher depreciation and interest, the taxable income might be negative. In that case, and with your $60K income assumption, that could be used to offset some of the ordinary income.

However, that offset is limited to a max of $25K a year. Further, it only applies if your AGI is under $100K. For AGI over $150K this offset (called the "special allowance") goes away, and it phases out between $100K and $150K.

Another gotcha is that the depreciation generates recapture tax, So, that $1,745.45 becomes taxable when you sell, at the "depreciation recapture tax rate". That's the same as your ordinary income rate, but is (currently) capped at 25%.


Jon Holdman, Flying Phoenix LLC


Landlord · Seattle, Washington


Jon, you would certainly have more in deductions than the 7,608 you are listing here. If I saw this tax return come in, I would recommend the client amend their return because it is clear something has been left on the table.



Real Estate Investor · Queens, New York


Then I really don't understand why so many people talk about the tax benefits of owning rental property like it's some huge deal... ???



Real Estate Investor · Burlington, Vermont


I thought that J Scott's example was extremely close to what I see on my tax returns in terms of expenses and depreciation.

The largest benefit is that you can deduct up to $25,000 from your tax income on your personal taxes. So if you accumulate a few properties and have $60k per year in income, that's reduced to $35k which is a big reduction in taxes. "Up to" is the catch - if you only have one property it may be much less. It also phases out starting at $100k in income.

You deduct the depreciation now, so the key effect is taking tax deductions now. In general, any time you defer taxes it's beneficial.

Also not a tax advisor but I have owned rental property for 9 years.

Hope that helps.
- Tom



Real Estate Investor · Queens, New York


Also, what exactly happens with the depreciation when you go to sell those properties later on... and what if you do a 1031 exchange to upgrade say from several SFR's to an apartment building?



Landlord · Seattle, Washington


There are great tax advantages to owning real estate. Depreciation is one. A home office deduction can be one. There are are a number of other business related deductions that can be taken as well.

If you are a w-2 wage earner there is not much you can do to decrease your tax hit. If you own real estate or have a business you open the door to many possible deductions.

Without knowing your exact situation it is hard to detail any tax advantages. It is not uncommon for real estate to show a paper loss even though there is income in your pocket.



SFR Investor · Wheat Ridge, Colorado


Yes Charles, I agree. I got distracted in the middle of posting, and Jason's post beat mine. He gives a better take on the true expenses. The 50% rule would predict "expenses" of $4500 a year rather than the $2,283.24. Now, a chunk of that is vacancy, which is part of the $9000 you just never get, and part is capital which actually goes to increase deprecation. Using $4500 brings the taxable income to -$825.

Corey, this actually isn't too bad of a deal. Not great, because the rents are so low, but better than many. Consider a $150K house that rents for $1000 a month. That's a payment of $899, which is $8950 for interest the first year. Depreciation is $4364. Now, lets assume taxes and insurance are the only expense, as is commonly done when a crummy deal is promoted. That makes PITI $1099, meaning you're cash flow negative $99 a month. Your total deductions for the year are $15,713 (above numbers plus $2400 for taxes and insurance). With $1200 in rent, you have $3714 in negative taxable income. At 28% marginal tax bracket, that offsets $1040 in taxes for the year or $87 a month. That makes you just about break even. So, with the unrealistic expense assumption and the "tax benefit", this ugly pig has enough lipstick that it looks OK. In reality this is probably losing you $400 a month and getting $170 a month back in tax benefits. And that benefit is all coming from the depreciation, which becomes taxable when (if) you sell.


Jon Holdman, Flying Phoenix LLC


Real Estate Investor · Austin, Texas


Originally posted by Corey Demuth:
Also, what exactly happens with the depreciation when you go to sell those properties later on... and what if you do a 1031 exchange to upgrade say from several SFR's to an apartment building?

This is a fantastic question! The answer is that the "recapture tax" that is higher than capital gains can be deferred indefinitely with the right exchange strategies. The rub is that in order to monetize this equity you either have to refinance the property and incur high transaction costs or eventually sell and incur taxation. There is "boot" for all of this and you may want to read about it a bit:

Boot Primer

There are likely better articles...I just grabbed one so you can make sure you know what to search for.

You can also monetize this deferred gain by purchasing property with greater cash yields. Commercial property benefits from economies of scale and will have greater capitalization rates that SFRs in most instances. The ROE is higher and it will be a better investment.

Hope that helps some...


Small_bullseye_capital_logoBryan Hancock, Bullseye Capital
E-Mail: [email protected]
Telephone: 1-800-577-0401
Website: http://bullseyecapital.capitalgroupkit.com/fund/
Join Our Fundrise Network To See Our Deals: https://fundrise.com/networks/inner-10-development/view


Landlord · Seattle, Washington


If you sell the property you will probably have capital gains and the depreciation will be recaptured. Meaning that you will pay tax on depreciation deductions that had been taken in the past. A note here is property is subject to depreciation recapture regardless of whether you claimed depreciation or not. Any selling costs will be added to your basis in the property.

A 1031 exchange defers and gains recognition. It also means that you will have a lower basis in the new property for which to base your depreciation expenses.



Real Estate Investor · Austin, Texas


Charles...Can you give us a short lesson on boot? How does it apply for most investors that exchange up from smaller properties to larger ones?


Small_bullseye_capital_logoBryan Hancock, Bullseye Capital
E-Mail: [email protected]
Telephone: 1-800-577-0401
Website: http://bullseyecapital.capitalgroupkit.com/fund/
Join Our Fundrise Network To See Our Deals: https://fundrise.com/networks/inner-10-development/view


Landlord · Seattle, Washington


Basically boot is any cash taken out of a transaction. Boot can also be a reduction in ones mortgage.

In a 1031 exchange any boot received is tax at capital gains rates in the year received.



Real Estate Investor · Austin, Texas


So how do you determine what is considered boot and what is considered "recapture"? This is quite confusing to me. Why would some of the gain be taxed at capital gains rates and some be taxed at recapture rates?

I am sure there is a logical explanation for this and it may be complicated, but a simplified example may serve to illustrate the point for the OP.


Small_bullseye_capital_logoBryan Hancock, Bullseye Capital
E-Mail: [email protected]
Telephone: 1-800-577-0401
Website: http://bullseyecapital.capitalgroupkit.com/fund/
Join Our Fundrise Network To See Our Deals: https://fundrise.com/networks/inner-10-development/view


Landlord · Seattle, Washington


Not sure what your question is. Boot is actual cash received. I haven't heard of any transactions where you receive money in the form of recaptured depreciation.

Here is the basic idea

Selling price - basis of property sold-selling costs+recaptured depreciation =taxable income. This is the amount that capital gains will be computed on.

Some investors are not allowed capital gains tax treatment. An investor that is considered a dealer for instance most of the time anyone flipping homes will be ineligible for capital gains tax treatment and will be taxed at ordinary income tax rates and will pay self employment tax.

Basis in property:

Original price paid plus many of the closing costs when the property was purchased.
Add capital improvements made over the years



Real Estate Investor · Austin, Texas


So this doesn't apply if the property is refinanced....right? That is not a taxable event from what I understand. Does boot apply here? I don't think that it does, but I wanted to confirm.


Small_bullseye_capital_logoBryan Hancock, Bullseye Capital
E-Mail: [email protected]
Telephone: 1-800-577-0401
Website: http://bullseyecapital.capitalgroupkit.com/fund/
Join Our Fundrise Network To See Our Deals: https://fundrise.com/networks/inner-10-development/view


Landlord · Seattle, Washington


Boot doesn't apply when you are refinancing property. If you take cash out this is essentially a loan to your self and is in no way taxable.



Real Estate Investor · Austin, Texas


So the moral of the story is not to sell your properties! Just exchange and/or refinance. The only reason to sell long-term product is if you HAVE to get access to cash in excess of what exchanging up and refinancing would yield.

Anyone disagree?


Small_bullseye_capital_logoBryan Hancock, Bullseye Capital
E-Mail: [email protected]
Telephone: 1-800-577-0401
Website: http://bullseyecapital.capitalgroupkit.com/fund/
Join Our Fundrise Network To See Our Deals: https://fundrise.com/networks/inner-10-development/view


Landlord · Seattle, Washington


It is especially unwise to sell one property then turn around to buy another when you are reducing your available money paying capital gains taxes.





Sign up