Buying real estate to offset other businesses
Real Estate Broker · Pittsburgh, PA · Member since 2012 · 46 posts · 15 votes
I have a general question about business and real estate. I keep hearing places that people often buy real estate to offset other businesses. Is this just for tax purposes? I need some more detail on this subject. Thanks in advance BP world!
But say you are a successful doctor - you make 400k/year and are in a very high tax bracket. All you short term gains are taxed at a very high rate - because they 'sit on top' of your income.
If you buy a million dollar property - each you can take roughly 30,000 in 'depreciation expense' - even though the cash is not leaving your pocket. You use that to offset your net income from the property and if the income is lower than that - it can offset other investment income, and eventually even 3,000 of your doctor income.
You get nailed on this when you sell - because deprecation reduces you 'cost basis' - so your 'gain' gets bigger - even if you sell it for the same 1 million after 30 years, instead of having no gain, you have depreciated it down to zero, so you have a million dollar gain. This can be avoided by dying and letting someone inherit it (the cost basis goes back up) - or by doing a 1031 exchange where you sell one property and re-invest. Often these investors keep 1031'ing into bigger and bigger properties as they use up the depreciation on each one.
Numbers are very rough - explanation probably has a few flaws - but this is the basics.
David,
That is not exactly correct.
Depreciation on a residential building is taken over 27.5 years. That means. 1,000,000 - 10% land value = 900k / 27.5 years = 32,727.28 of depreciation per year to offset the income on the building.
If you paid cash:
If the building is grossing 60k per year in rent. Half of that to expenses (50% rule) you will have 30k in net income. Minus 32,727.28 of depreciation. You will have a "loss" of 2,727.28 That will NOT be deductible if your income is over 150k.
If you income is between 100k and 150k. You lose .50 of a special 25k allowance for every dollar of income over 100k.
Depreciation will be recaptured upon selling This is capped at a maximum tax rate of 25%. Your long term capital gain over that will be taxed at 15 or 20%.
The part about 1031 exchanges and "step up" in basis upon death is correct.
@Matthew Ficorilli here is the correct information.
I suspect that they are talking about the benefit of depreciation expense.
disclaimer: not an accountant, not tax advice, not legal advice.
A % of the value of the property you are invested in can be taken as an expense on your taxes each year - this is somewhere around 1/30th of the value(I think you can't count the land, just the building) - and the years are probably tricker than 30 like 27.5 or different based on the property.
But say you are a successful doctor - you make 400k/year and are in a very high tax bracket. All you short term gains are taxed at a very high rate - because they 'sit on top' of your income.
If you buy a million dollar property - each you can take roughly 30,000 in 'depreciation expense' - even though the cash is not leaving your pocket. You use that to offset your net income from the property and if the income is lower than that - it can offset other investment income, and eventually even 3,000 of your doctor income.
You get nailed on this when you sell - because deprecation reduces you 'cost basis' - so your 'gain' gets bigger - even if you sell it for the same 1 million after 30 years, instead of having no gain, you have depreciated it down to zero, so you have a million dollar gain. This can be avoided by dying and letting someone inherit it (the cost basis goes back up) - or by doing a 1031 exchange where you sell one property and re-invest. Often these investors keep 1031'ing into bigger and bigger properties as they use up the depreciation on each one.
Numbers are very rough - explanation probably has a few flaws - but this is the basics.
But say you are a successful doctor - you make 400k/year and are in a very high tax bracket. All you short term gains are taxed at a very high rate - because they 'sit on top' of your income.
If you buy a million dollar property - each you can take roughly 30,000 in 'depreciation expense' - even though the cash is not leaving your pocket. You use that to offset your net income from the property and if the income is lower than that - it can offset other investment income, and eventually even 3,000 of your doctor income.
You get nailed on this when you sell - because deprecation reduces you 'cost basis' - so your 'gain' gets bigger - even if you sell it for the same 1 million after 30 years, instead of having no gain, you have depreciated it down to zero, so you have a million dollar gain. This can be avoided by dying and letting someone inherit it (the cost basis goes back up) - or by doing a 1031 exchange where you sell one property and re-invest. Often these investors keep 1031'ing into bigger and bigger properties as they use up the depreciation on each one.
Numbers are very rough - explanation probably has a few flaws - but this is the basics.
David,
That is not exactly correct.
Depreciation on a residential building is taken over 27.5 years. That means. 1,000,000 - 10% land value = 900k / 27.5 years = 32,727.28 of depreciation per year to offset the income on the building.
If you paid cash:
If the building is grossing 60k per year in rent. Half of that to expenses (50% rule) you will have 30k in net income. Minus 32,727.28 of depreciation. You will have a "loss" of 2,727.28 That will NOT be deductible if your income is over 150k.
If you income is between 100k and 150k. You lose .50 of a special 25k allowance for every dollar of income over 100k.
Depreciation will be recaptured upon selling This is capped at a maximum tax rate of 25%. Your long term capital gain over that will be taxed at 15 or 20%.
The part about 1031 exchanges and "step up" in basis upon death is correct.
@Matthew Ficorilli here is the correct information.
Thanks, that was very helpful
@Steven Hamilton II Lets just say in your example, it wasn't a loss. Say you came out +$100 in your depreciation. If your income was still over 100k could you still deduct that amount if it was positive?
If your income from the investment was positive after the depreciation deduction you have a dollar amount that will be added to your other income. Granted some of it will be tax sheltered. Remember the depreciation deduction is important as you will depreciate more in early years than your mortgage principal is being paid.
Even if you are 'net positive' and must pay taxes, you have a benefit from depreciation that year, because you still got to offset the income from the property with the 'non-cash' expense.
If you had chosen non-real-estate investments, and generated a similar return, you would not have the depreciation to offset it. For instance if you bought a million dollar temporary staffing business, and had a 30,000 profit, you would pay taxes on all the profit.
Just be careful and consult your CPA on tax advice. Real Estate Losses cannot offset all income (and usually doesn't offset any earned income at your level unless you are a real estate professional). The IRS defines what a real estate professional is so go look it up. There are of course other situations and loopholes but at your level, you need to involve a CPA here as even some of the loopholes I know of fade out after a certain amount of income (way below the level your at as a Doctor).