Tax Advantages in real estate

28 Replies

I hear people often say that real estate is treated more advantageously from a tax perspective than other businesses.  I frequently hear people say something along the lines of "I get 15% rate of return, and that's not even considering my tax deduction so I know I'm making a killing".  However, I don't see how real estate is treated any differently than other businesses.  In business, profits are taxed, not income.  My profit on a rental property is my income (rent) minus my expenses (Interest on my debt, insurance, repairs, etc.) and that is precisely what I am taxed on and I am taxed at the same rate as every other business.  Some people might argue that depreciation on the house is a great benefit, but I don't see that either.  Although I do not have to repair my roof every year, I have to save money for that expense every year, so I don't really consider that profit, so the IRS allows me to deduct some amount of money for that, great.  Except that it goes against my cost basis and I get taxed on it when I sell the house.  I'm not saying that it's unfair, but I certainly don't see why people consider it to be a bigger tax benefit that any other business.  Am I missing something?

Depreciation, the phantom expense :)
This can be (actually it is an IRS requirement) used to offset your positive cash flow, lowering your effective tax rate significantly!

Ryan, I guess my argument is that it isn't actually a phantom expense, because a decent portion of it represents money that isn't actually profit since it must go to future Cap Ex expenses.  And it doesn't allow you to avoid taxes it just defers them until you sell the house and you have to have to pay depreciation recapture.

Originally posted by @Max Briggs :

Am I missing something?

I believe you are. It's called self-employment tax. You don't pay it on rental income, but you pay it on income generated from active trades or businesses. That's another ~15% landlords get to keep that other businesses don't.

Also, there are ways to avoid paying taxes on the depreciation recapture. Much has been written on that so it shouldn't be too hard to find something to read and ponder.

Best of Luck with your real estate investments! And, Go Browns!

I’m no too sure I buy that not paying self employment tax is a big benefit. You don’t pay into social security or Medicare, but you also don’t get social security or Medicare credits. Now I’m okay with keeping my money and not letting the social security administration invest it in government bonds, but I wouldn’t necessarily call it an advantage. And the only methods I know of to avoid depreciation recapture are to never sell or to to do a 1031 exchange, which again, doesn’t eliminate the problem, it only delays it. (Admittedly deferred taxation can be a substantial benefit) but still I don’t see real estate investing as being specifically favored by the tax code. 

@Max Briggs Just to clarify,  a 1031 exchange can be a significant estate planning tool. It allows you to continually defer your capital gain and depreciation recapture tax liability over your lifetime. The client continually exchanges properties as a life-long strategy, always deferring that payment to the IRS and keeping their entire equity working for them. Not only does the value of their real estate portfolio grow and of course, their net worth but it will grow even that much faster if they continually defer those tax liabilities. Once the real estate owner passes (not too fun here), their beneficiaries will inherit the property or properties and will receive a step-up in cost basis that will be equal to the fair market value at the time of the investor's death. In addition, if they sell soon after, they won't incur any capital gain and/or depreciation recapture income tax liabilities. They will not be responsible for paying the IRS for the amount the deceased family member deferred.

Thanks. I certainly don’t discount the value of deferred taxation. Neither does anyone investing in a 401k. I appreciate you explaining just how much of a benefit it can be. 

@Max Briggs If you live in a property for 2 years you qualify for up to $250,000 capital gains tax exemption if single and $500,000 if married upon selling. You could buy a quad in which you live in one unit and rent the other 3 with a 2 year window to rehab, raise rents and create equity. You sell after year two paying no taxes and use that money to fund your next owner occupied quad while pocketing any extra. Just another way to avoid taxes. 

@Joe Ferguson ,

The flaw in your suggestion is that the §121 capital gain exclusion only applies to the unit in the quad that was used for a primary residence.  The sale of the quad-property in your example would be treated by the IRS as the sale of four separate properties:  a residence unit and three investment rentals.  One-fourth of the profit from the sale of the property could be excluded from capital gains taxes, but the remaining profit would be fully taxable in your scenario.

I don’t think you’re missing anything. There used to be more favorable tax treatment decades ago but it was changed...I think you could depreciate more quickly. What little I see of the tax code seems pretty fair. I do think anyone with rental property should have to 1099 contractors paid over $600 in a given year, or whatever the dollar amount was going to be.

Originally posted by @Max Briggs :

I’m no too sure I buy that not paying self employment tax is a big benefit.

Dave is single and has a home business building furniture. After taking all his expenses and exemptions into consideration, Dave has $50,000 of taxable income. Using 2016 rates, Dave will owe the IRS $15,731 in taxes for that $50,000 of taxable income.

Debbie is single and owns residential rental properties. After taking all her expenses and exemptions into consideration, Debbie also has $50,000 of taxable income. Using 2016 rates, Debbie will owe the IRS $8,271 in taxes for her $50,000 of taxable income.

As for depreciation recapture, if you die owning the property, you never have to repay it. My father-in-law- is 80 and owns 12 properties. He has depreciated them for about $1.5 million. That equates to $1.5 million of tax free income to him over his lifetime. His heirs will sell the properties for about $4 million and pay no income taxes on that money.

These meet most people's threshold for a "big" tax benefit. Your personal threshold might be higher.

that’s fair Paul. Thanks for the responses. When i said that I don’t know if I consider it a big benefit to not pay payroll tax I didn’t mean that the savings wasn’t there. I just meant that the savings comes with consequences. For example my wife is a teacher and in Ohio (not sure about the rest of the country) teachers are exempt from payroll tax. You could say that is a benefit, but she’s also will not receive any social security benefit. So In your example about Dave and Debbie, when Dave reaches 60 year she old he collect some social security and Debbie doesn’t. 

Your depreciation example is a good one. And you’re right, that is a substantial benefit. It doesn’t necessarily apply to my personal exit strategy because I plan on selling my properties when my marginal rate of return is within a couple percentage points of my expected 10 year stock market returns. But just because I probably won’t take advantage of it doesn’t mean it isn’t a real benefit. 

@Max Briggs your wife will get OPERS instead of SS, though, right? (I am originally from Ohio and my mother is a retired school administrator.)

Your point is taken, though. Real estate investors need to make arrangements to replace SS in their retirement strategy if they don't have enough 'day job' credits to qualify for SS benefits. I suspect most of the BP crowd has that covered. They take rugged DIY individualism to new heights around here. 

Go Buckeyes!

Originally posted by @Max Briggs :

that’s fair Paul. Thanks for the responses. When i said that I don’t know if I consider it a big benefit to not pay payroll tax I didn’t mean that the savings wasn’t there. I just meant that the savings comes with consequences. For example my wife is a teacher and in Ohio (not sure about the rest of the country) teachers are exempt from payroll tax. You could say that is a benefit, but she’s also will not receive any social security benefit. So In your example about Dave and Debbie, when Dave reaches 60 year she old he collect some social security and Debbie doesn’t. 

Your depreciation example is a good one. And you’re right, that is a substantial benefit. It doesn’t necessarily apply to my personal exit strategy because I plan on selling my properties when my marginal rate of return is within a couple percentage points of my expected 10 year stock market returns. But just because I probably won’t take advantage of it doesn’t mean it isn’t a real benefit. 

Max, as long as your model for real estate investing involves seeking to only reap avg stock returns then your going to see similarities in those two strategies.  Except for the fact that active real estate investing will require you to make around 15% more in gross profit in order to match passive stock investing gains. 

The tax advantages for real estate investing do come with strings and consequences as you mention. To take advantage of them you have to adjust your model and expectations.  If you're not willing to adjust then you won't see significant differences in returns or tax   

@Dave Foster  thanks for your response. I wouldn’t say that I am only trying to reap average stock market returns. One of the reasons that I got into real estate was because early in a financed deal the marginal returns are superior to the stock market. However, When i crunch the numbers (and my numbers/logic could be wrong) the marginal rate of return (income divided by equity) approaches the cap rate as you build equity in the house. In my area the cap rates are close to historical stock market return stock, so at some point it becomes a wash, and I prefer passive stock market investing to more activel real estate investing all things being equal.

I guess the alternative is to use the equity to buy more property, which may be the way to go, but I’ll cross that’s bridge when I come to it.

Originally posted by @Max Briggs :

Your depreciation example is a good one. And you’re right, that is a substantial benefit. It doesn’t necessarily apply to my personal exit strategy because I plan on selling my properties when my marginal rate of return is within a couple percentage points of my expected 10 year stock market returns. But just because I probably won’t take advantage of it doesn’t mean it isn’t a real benefit. 

 But Max, why sell when you can borrow out the equity (tax free) and move it into a new property? You can then own two properties with the same amount of capital you had sitting in one, all without paying any taxes to acquire the second one.

I'm trying to understand this. You are not satisfied because you may have to pay taxes on an asset that someone else paid 75-80% of?

I am not as smart as the other folks here and frankly I cannot distil the benefits of REI into just tax benefits/ just income benefits/ etc. But sometimes I like to break out my crayons and dream about a beautiful world...

In this world I can buy stock in a company that may have rough patches, but over time will always increase in value. Now the cool thing about this stock is that for every 2 shares I buy- I get 8 more! Pretty awesome.

Another cool feature of this stock- besides it's appreciation is that it pays a dividend and a sizeable one at that. You know what is cool about that dividend- I get it paid on the whole 100% of the stocks BUT- remember those 8 free stocks that someone else paid for- well I get to claim the interest of the other person's payment for those 8 free stocks against the whole dividends tax.

Not only that, but I will buy insurance to make sure my stock is protected... guess what? Yup, I don't pay for that insurance- can you believe it! BUT... Yup you guessed it, I get to take the cost of that insurance and subtract it from the taxable amount of my dividend!

Another very cool feature about this stock unlike all the other stocks out there- I have an enormous amount of control over the value of that stock and the potential to dramatically increase the dividend that will be paid. Now this will cost money- for the most part money that, yes, someone else will be paying... and YUP it reduces the taxable amount of my dividend! Now, sometimes we have to put in our own cash to increase the value of the stock- but guess what- I can offset my other taxes by any amount which I lost (which I really didn't did I.)

Funny thing is- even though my asset is steadily increasing in value- the government thinks it is decreasing and allows me to take a deduction... year after year, and, you got it, not just on the 2 stocks- but those other 8 that someone else paid for!

So I have had my fun- ready to move on- gonna sell my very valuable 10 stocks for a profit and along comes another magical stock! This one is a bit more expensive- but the dividend is through the roof. If I take the entire profit from my 10 stocks and buy 25 of this companies stock they will give me 75 stocks to play the same game with! And I won't have to pay any taxes on the profit from my 1st Stock!

A magical place my crayons make.

@Ryan D.  I agree that is another option, as I said later in the post "I guess the alternative is to use the equity to buy more property, which may be the way to go...".  So your point is well taken.  Although with the properties I have now, my cash on cash return is about 14%, since my anticipated 10 year stock market returns are miserable because the Shuiller PE ratio is so high, this looks especially good.  My point about selling to buy stock is simply that if the Shiller PE ratio goes low enough that my anticipated stock market return is average to above average (10-14%) I would rather do that and be more passive with my money.  What I actually do will depend on the returns in the real estate market compared to my anticipated stock market returns.

@Patrick M.  I too like real estate as an investment strategy, but I don't necessarily think that the benefits that you mention are exclusive to real estate, or are quite as magical as your post seems to indicate.  I like your comparison of real estate to a dividend stock.  Could I find a dividend stock that yields 14%, probably not, so I agree that is a big edge for real estate.  But a disadvantage is that I cannot easily reinvest that dividend.  I have to wait until I accumulate enough money to buy another house and get it rent ready if I want to enjoy the compounding benefits of the dividend and that could take years.  And yes, for every two shares I get 8, but I only get those additional 6 if I wait 30 years, and it accumulates very slowly in the beginning (when most of my mortgage payment is paying interest on the loan).  And I agree that as I put money into the house I can reduce my taxable income, but that is not unique to real estate.  If I owned a restaurant and bough better tables I could deduct that expense and that would also increase the value of the business.  So, I'm not disagreeing with you that it is a good investment tool.  I am just trying to understand what elements of the tax code are specifically favorable to real estate, as opposed to other businesses.  

As others have mentioned, depreciation and 1039 exchanges are two elements and are good examples.  Thanks to everyone for your responses.

@Max Briggs Why would you only get them after 30 years? You enjoy the full benefit of them immediately. You can reinvest the dividend however you want and whenever you want. It is the "stock" that is illiquid. If you want to own a restaurant, I agree- that is very different, you will be going to work every day to run a restaurant and especially the holidays- yippee. That restaurant will be profitable if a large number of variables, many of which are completely out of your control, line up right. You are comparing apples and kumquats.

How is taking an entire income producing asset- selling it and reinvesting it into a bigger more profitable asset tax free, not magical?

Depreciation is not magical?

How is allowing someone else to pay for 75-80% of your investment vehicle not magical?

Someone else pays for your investment vehicle to be insured.

Someone else pays to have your investment vehicle increase in value (and dividend).

And even if you cut and run- please tell me what is not magical about paying a low tax rate on an asset which you only paid for 20% of?

Sorry- too many great things for me and I am having a blast! I have never met someone who has needed persuading on the benefits of REI if they have done there research. I am in the AMT so I don't even gain the full benefits- but man, when I educated myself I could not wait to get my hands on a multi-family and I am so happy I did!

Good luck with the restaurant!

Originally posted by @Max Briggs :

I’m no too sure I buy that not paying self employment tax is a big benefit. You don’t pay into social security or Medicare, but you also don’t get social security or Medicare credits. Now I’m okay with keeping my money and not letting the social security administration invest it in government bonds, but I wouldn’t necessarily call it an advantage. And the only methods I know of to avoid depreciation recapture are to never sell or to to do a 1031 exchange, which again, doesn’t eliminate the problem, it only delays it. (Admittedly deferred taxation can be a substantial benefit) but still I don’t see real estate investing as being specifically favored by the tax code. 

 I suppose, in your case, it will boil down to whether you would rather have a government check at a certain age, or be able to invest that money as you earn it and rely on your own investment decisions. I would rather receive a lump-sum payment of all of the SS taxes I have paid to date, without interest, today and use it to buy a single home than to receive a future annuity from the government (the value of which is not guaranteed at this point, especially for people in my generation and younger). What is the present value of the future Social Security payments? What return am I receiving on any Social Security taxes paid? Is the return even as high as inflation? So not only are my future payments likely to be reduced either in terms of the amount or the age at which I will receive them, but the return on investment is likely lower than inflation, constituting a negative return on investment. On the other hand, I could buy one or more homes now, and leverage them to receive a significantly higher rate of return. 

To summarize:

1. You aren't paying Social Security and Medicare tax

2. The returns on the money  you save will likely be higher than the present value of the Social Security taxes paid, and can be parlayed into other investments.

3. If for some reason you die early, your family may get nothing from the Social Security payments you've made (other than survivor benefits for spouses, if you are old enough).

Personally, I would rather own and manage property or otherwise earn money than rely on a Socialist government program. When I die, the fruits of my labors will still benefit future generations of my family.

Another advantage that hasn't been mentioned is the use of retirement accounts. Technically, it is possible to invest in real estate using a SOLO ROTH 401k or similar vehicle, avoiding taxes almost entirely, except for UBIT taxes related to leverage.

Originally posted by @Max Briggs :

Thanks. I certainly don’t discount the value of deferred taxation. Neither does anyone investing in a 401k. I appreciate you explaining just how much of a benefit it can be. 

 There is a significant difference between the tax deferral coming from depreciation and contributing to a 401(k). Depreciation lowers your cost basis so that you have a bigger capital gain later on. The important point is that the taxable amount never really changes. Tax rates may change a little. Which would you rather have: $1000 today or $1000 in 30 years? The present value of the future obligation is very low. Its more like an interest-free loan of the government's money. If I can invest that money and make a great return, then I'm paying the taxes with future dollars AND I made a boatload of cash off the government's money.

In an IRA or 401(k), you get the tax deferral on the amount you contribute, but the government is going to tax every penny of growth on that contribution. Its going to be a big bite out of your savings. Its more like a very high interest rate loan of the government's money. You can make money off the government's money, but its costing you.

@Patrick M. I have no intention of opening a resteraunt. And I’ve already bought a few rentals, because I agree with you that it is a good way to go. But I’m not sure I share your unbridled enthusiasm. And maybe I’m misunderstanding your argument. 

When you buy a house with 20% down you have a 100k asset for for 20k, but you also have $80k in debt. It isnt until this debt is paid off (30 years from purchase) that you have the full equity. So your analogy of buying 2 shares and geting 8 only applies after the loan isn’t paid off. 

You can reinvest the dividend immediately, but, not necessarily into another house, because the cost of buying and repairing houses is high, so you could reinvest into other things, but not into the original investment, the way people typically do with dividend stocks. 

As for selling and reinvesting tax free, that happens in any tax sheltered stock account (Roth or 401k), so sure it’s nice, but not unique to real estate. 

Allowing someone to pay for your investment sounds nice, but in the end it all just amounts to rate of return, which can be good for real estate. So we’re in agreement there. 

And as for the low tax rate, it’s no lower than any other capital gain, including stocks. 

Originally posted by @Wilson Churchill :
Originally posted by @Max Briggs:

Another advantage that hasn't been mentioned is the use of retirement accounts. Technically, it is possible to invest in real estate using a SOLO ROTH 401k or similar vehicle, avoiding taxes almost entirely, except for UBIT taxes related to leverage.

Good point about the retirement accounts, Wilson. Speaking specifically of the Solo 401k, it is actually exempt from taxation on debt-leveraged real estate. It is a specific type of UBIT that you are referring to, Unrelated Debt Financed Income (UDFI) tax and it would apply to an IRA in that scenario, but not with a Solo 401k.

This post has been removed.

@Wilson Churchill

It is true that the 401k does not pay UDFI on leveraged real  estate. UBIT for regular and ongoing business activity does still apply. It's not quite as simple as saying "any flipping would still be subject to UBIT," as that depends on several factors. However, one should be aware of that possibility as well as other potential issues with business activity within a retirement account.

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