Depreciation does not cover rent. (50% land). Help

22 Replies

Hello,

when I make the cashflow spreadsheet of almost any house (SFH, MF) around here (San Diego, California) I cannot manage to deduct enough taxes to cover rent.

Am I doing something wrong?

Most of the properties here are 50%land / 50% building according to 2015-2016 tax assessments. 

After deducting:

- depreciation 1/27.5*50%

- mortgage interest (3.5% w 20% down)

- repairs/maintenance/capex 

- insurance

I am always left with about 35% of rent income being taxed. Am I forgetting something?

Hope this helps:

1. Interest

Interest is often a landlord’s single biggest deductible expense. Some examples of interest that landlords can deduct include mortgage interest payments on loans used to acquire or improve rental property and interest on credit cards for goods or services used in a rental activity.

2. Depreciation

The actual cost of a house, apartment building, or other rental property is not fully deductible in the year in which you pay for it. Instead, landlords get back the cost of real estate through depreciation. This involves deducting a portion of the cost of the property over several years.

3. Repairs

The cost of repairs to rental property (provided the repairs are ordinary, necessary and reasonable in amount) are fully deductible in the year in which they are incurred. Good examples of deductible repairs include repainting, fixing gutters or floors, fixing leaks, plastering and replacing broken windows.

4. Local Travel

Landlords are entitled to a tax deduction whenever they drive anywhere for their rental activity. For example, when you drive to your rental building to deal with a tenant complaint or go to the hardware store to purchase a part for a repair, you can deduct your travel expenses.

If you drive a car or truck for your rental property, you have two options for deducting your vehicle expenses. You can: deduct your actual expenses (gasoline, upkeep, repairs), or use the standard mileage rate (55.5 cents per mile for 2012).

To qualify for the standard mileage rate, you must use the standard mileage method the first year you use a car for your business activity. Moreover, you can’t use the standard mileage rate if you have claimed accelerated depreciation deductions in prior years, or have taken a Section 179 deduction for the vehicle.

5. Long Distance Travel

If you travel overnight for your rental activity, you can deduct your airfare, hotel bills, meals and other expenses.
Be aware that IRS auditors closely scrutinize deductions for overnight travel—and many taxpayers get caught claiming these deductions without proper records to back them up. To stay within the law (and avoid unwanted attention from the IRS), you need to properly document your long distance travel expenses.

6. Home Office

Provided they meet certain minimal requirements, landlords may deduct their home office expenses from their taxable income. This deduction applies not only to space devoted to office work, but also to a workshop or any other home workspace you use for your rental business. This is true whether you own your home or apartment or are a renter. Make sure you discuss with you account the correct amount to deduct. This is another deduction that IRS auditors closely scrutinize.

7. Employees & Independent Contractors

Whenever you hire anyone to perform services for your rental activity, you can deduct their wages as a rental business expense. This is true whether the worker is an employee (for example, a resident manager) or an independent contractor (for example, a repair person).

8. Casualty & Theft Losses

If your rental property is damaged or destroyed from a sudden event like a fire or flood, you may be able to obtain a tax deduction for all or part of your loss. These types of losses are called casualty losses. You usually won’t be able to deduct the entire cost of property damaged or destroyed by a casualty. How much you may deduct depends on how much of your property was destroyed and whether the loss was covered by insurance.

9. Insurance

You can deduct the premiums you pay for almost any insurance for your rental activity. This includes fire, theft, and flood insurance for rental property, as well as landlord liability insurance.

10. Legal & Professional Services

Finally, you can deduct fees that you pay to attorneys, accountants, property management companies, real estate investment advisors and other professionals. You can deduct these fees as operating expenses as long as the fees are paid for work related to your rental activity.

Also check out the link below it might give some answers

https://www.biggerpockets.com/renewsblog/2015/05/20/tax-benefits-real-estate-investing-rental-properties/

No.  Any good rental property will have a net income after depreciation, even with the typical 80/20 building/land ratios.

@Varinder Kumar , it is a local property. I might be able to deduct a little for gas/mileage/paperwork but I won't be reaching the extra $2500/month I need to deduct through that. 

@Wayne Brooks , the tax assessments around here are roughly 50% land/50% building. If i use 80/20 I am not sure how I could explain that to the IRS

@mike H. Is it a SFR or MF? Talk to your CA as well. But you can look at anything you include in the rental price and use that as a deduction.

You can deduct property taxes as well.

Also, if you're buying multi in Southern California, chances are the property is older, so don't be shy with your repairs budget.

By the way, you aren't married to the assessor's land/building allocation...there are other reasonable methodologies that may yield a better tax answer...

@Mike H. I was referring to the "national" norm of 80/20.....wasn't implying it applied to you.

@Logan Allec , I did forgot to mention property taxes but was actually deducting them. 

I think your suggestion of using a different land/building a location than the assessor's is the only way I can reach that difference. Thanks!

And yes you're right, the building is old (1920)

Also, @Mike H. , I'd double check your numbers, especially on a SFR in San Diego. I'm just throwing numbers out here, but let's say you buy a $600,000 house that you could rent for $3,000 a month. Student rental, you may be able to get more in rent because you could charge per room, but let's set that aside for now just to do a back-of-the-napkin calculation.

Income

Annual Rents (12 x $3,000) = $36k

Expenses (before repairs/maintenance/capex/miscellaneous)

Annual Depreciation ($600,000 x 50% / 27.5) = $11k

Property Taxes ($600,000 x low estimate 1%) = $6k

First-Year Mortgage Interest = $17k

Insurance (just throwing a number out) = $1k

Total expenses = $35k

$36k - $35k = $1k taxable income before repairs/maintenance/capex/miscellaneous.  And I guarantee your repairs/maintenance/capex/miscellaneous will knock out this $1k.

If you're talking multis, then obviously you'd probably be getting better cash flow and therefore higher taxable income.

Anyway, would you mind sharing your back-of-the-napkin calculation so perhaps we could see how you're arriving at your numbers?

Depreciation is not supposed to cover rent.  Heck, depreciation and other expenses also should not cover rent.  What would you prefer, a mediocre property that has no taxable income, or a highly profitable property with taxable income?  I would choose the highly profitable property every single time.  

1. Great response by @Daniel Chang
2. Why not use your insurance companies replacement cost for the building value? That'll be higher than the assessor and highly defendable.

@Mike H. You're doing something right if the property (and I'm speaking about investments here locally) shows a paper profit in year 1.  Here's an example of a property we bought two years ago in 92105, with numbers rounded for simplicity and using your 3.5% interest rate example (an investment property rate you won't get today w/o big points, BTW):

Duplex purchase price $400k - 60/40 building/land split.

  • Depreciable basis = $240k ~= $8700 depreciated per year
  • Rent = $2800/m = $33600/y
  • Mortgage = $300k ~= $10300/y interest (year 1)
  • Maintenance = 8% gross rents ~= $2600/y
  • Property Taxes = 1.1% = $4400/y
  • Insurance = $700/y
  • Utilities ~= $2400/y ($100/unit/m water+sewer)
  • Vacancy and Loss = 5% = $1700/y
  • Misc Stuff = $500/y (mileage, other soft and hard expenses to be claimed)
  • Total Income: $33,600         /         Total Expenses: $31,300
  • Y1 Retained Earnings (P&L Profit): $11,000
  • Y1 Tax Reported Profit: $2,300
  • Y1 Mortgage Principal: $5,800
  • Y1 Balance Sheet Delta: $8,100  (8.1% Y1 ROC)

A couple notes:

  1. Capex is not included here because depreciation has been taken on the balance sheet (in theory, they are equal values - in reality, that capex cost will very likely be less than the depreciation in a market like ours).
  2. This is year 1.  For my money in a market like ours, the game is all about starting with a safe floor and exercising excellence in management to increase returns.  Drive the Year2 returns up a couple percentage points (in this case, through a $10k capital expenditure + some management changes to increase effective rents).  Then, use the wind at your back to keep bumping up that annual return.  Value the appreciation card sitting in your back pocket and hope you can play it in the future.
  3. I have absolutely zero interest in engaging in a(nother) rehash conversation pitting the merits of a cash-flow driven investment style against a total-return driven one. My only claim here is that the OP is doing nothing wrong if the Y1 tax reported income is positive.

And, nit in your wording, but you can't deduct your capex expenses (though that's a bit of a muddier conversation now - see https://goo.gl/7SYsx7 ).

Good luck!

@Justin R. those are strong numbers, especially for San Diego.  That should be a goal/model fro the OP... IMO.

@Chris Martin I never know what people are including (or not including) when they say "cash flow" on a property.  I see you've been in the game a while and I'd love your opinion - in the example above, what would you say the "cash flow" is in Y1?

@Justin R. , wouldn't your "cash flow" be answered in this line item:-

  • Total Income: $33,600 / Total Expenses: $31,300 (ie. = $2,300, = $191.66/m)? Cheers...

@Mike H. - what @Daniel Chang said! Why would you WANT to earn zero positive return?

Meantime, I hope you realize that when you wrote: "I am always left with about 35% of rent income being taxed" - that's NOT the same as paying 35% tax on your rent? 

BIG difference! Cheers...

Originally posted by @Brent Coombs :

@Justin R. , wouldn't your "cash flow" be answered in this line item:-

  • Total Income: $33,600 / Total Expenses: $31,300 (ie. = $2,300, = $191.66/m)? Cheers...

 I do not include depreciation in my cash flow analysis but I do include an estimate for cap expense.  I agree with Justin that in San Diego typically depreciation is larger than even my conservative (I.e. Large) cap expense estimate.  So I would likely be having this property reflect higher cash flow than the $192/month.  Likely closer to $400/month.  I have purchases from a couple years ago with similar numbers but finding such purchases in San Diego today is getting more challenging. 

@ Justin R.  

Sorry if my question seems elementary, but in your P&L breakdown you mention Maintenance 8%, Vacancy 5% and Utilities $2400/y.  I understand that if you have the documents to back it up, you can write off specific instances of maintenance on your taxes, but are you saying that you write off each of these as a "blanket" dollar amount?

Sorry for the newbie question. I am just trying to understand how investors can target 30% cash flow on a house when they end up having to pay 30% in federal income taxes. I am depreciating, using mileage and any repairs completed on the house, but my income taxes still reduce my monthly cash flow by 50%.

@Brent Coombs I don't know - when everyone (even newbies and turnkey operations) say that a property "cash flows" $X per month, are they really including depreciation in that calculation?  I doubt it.

I suspect that most people use "cash flow" to mean what they think will be left in their bank account at the end of the year since they're not really concerned with accounting principles.  So, exclude paper expenses like depreciation.  In this case, that'd be:

  • Y1 Retained Earnings (P&L Profit): $11,000

I would love it if the use of the terms Operating Cash Flow and Free Cash Flow instead:

"Free cash flow (FCF) is a measure of a company's financial performance, calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base."

Maybe too nuanced for most people to care about, but much clearer to communicate.

@Dan Heuschele Agreed.

@Eric Cossey You only write off on your taxes actuals that you can prove you spent.  And, all common investment performance metrics are calculated prior to the impact of income taxes.  Obviously it's important to understand what income taxes will do to your investment income in order to pick the best investment(s).

50% of value is the land? Makes sense in a place like SD I guess, but unfortunate for IRR.

Didn't know how good we have it here, so thanks for the discussion.  My land values are only 3% where I have half my portfolio 30 mins away and 10% here in my 'metro' area lol.  No wonder I've had a negative effective federal tax rate for years.  Cheers!   

If you are paying taxes it means you are making money. Unless you are Trump you should be happy.

Originally posted by @Justin R. :

@Brent Coombs I don't know - when everyone (even newbies and turnkey operations) say that a property "cash flows" $X per month, are they really including depreciation in that calculation?  I doubt it.

I suspect that most people use "cash flow" to mean what they think will be left in their bank account at the end of the year since they're not really concerned with accounting principles.  So, exclude paper expenses like depreciation.  In this case, that'd be:

  • Y1 Retained Earnings (P&L Profit): $11,000

I would love it if the use of the terms Operating Cash Flow and Free Cash Flow instead:

"Free cash flow (FCF) is a measure of a company's financial performance, calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base."

Maybe too nuanced for most people to care about, but much clearer to communicate.

@Dan Heuschele Agreed.

@Eric Cossey You only write off on your taxes actuals that you can prove you spent.  And, all common investment performance metrics are calculated prior to the impact of income taxes.  Obviously it's important to understand what income taxes will do to your investment income in order to pick the best investment(s).

I agree that the way Dan does it IS the common understanding of "cash flow" when working out whether a "deal" is to be had or not ie. the tax implications are a separate, later consideration.

Yes, perhaps your newly defined "cash flow" variations are a bit "too nuanced" (for me)!

Depreciation is a non-cash expense. It does not impact cash flow. Regarding "If you are paying taxes it means you are making money. Unless you are Trump you should be happy." Yes, that's largely true. But I know many other REI who, if their holdings are generating taxable income, will be looking for tax credits (LIHTC or other ITC) or deductions like depreciation to push cash flow up and current tax liability down.

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