rental property tax example - please advise!

Tax, Legal Issues, Contracts, Self-Directed IRA 43.8K Posts 6.6K Discussions

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!

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...

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.

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

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.

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... ???

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

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?

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.

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

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...

Medium realstarter2Bryan Hancock MBA, RealStarter | [email protected] | (512) 827‑9638 | https://www.realstarter.co/Home/BH

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.

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?

Medium realstarter2Bryan Hancock MBA, RealStarter | [email protected] | (512) 827‑9638 | https://www.realstarter.co/Home/BH

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.

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.

Medium realstarter2Bryan Hancock MBA, RealStarter | [email protected] | (512) 827‑9638 | https://www.realstarter.co/Home/BH

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

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.

Medium realstarter2Bryan Hancock MBA, RealStarter | [email protected] | (512) 827‑9638 | https://www.realstarter.co/Home/BH

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.

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?

Medium realstarter2Bryan Hancock MBA, RealStarter | [email protected] | (512) 827‑9638 | https://www.realstarter.co/Home/BH

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.

Originally posted by Corey Demuth:
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... ???

Just to touch on this question a bit more...

In the example above, you are both putting money in your pocket (the cash flow from the property) *AND* paying less in taxes!

Any time you can do both of those, you are in essence beating the system...

Scale this up a bit with several properties, and before you know it, you're putting a lot of money in your pocket and paying a lot less in taxes. The American dream... :)

Taxes are the LARGEST expense you pay. Think about it...what else puts cash flow in your pocket if purchase properly AND gives you *paper* losses to offset a portion of ordinary income? Every dollar you make in ordinary income you have to make almost $2 in top-line income to produce b/c of FICA taxes, income taxes, etc.

Tax saving strategies become a bigger deal as you get wealthier too....and much more complicated. I don't pretend to understand it very well...as is evidenced in this thread. It is quite complicated and a GREAT CPA can be worth their weight in gold!

Medium realstarter2Bryan Hancock MBA, RealStarter | [email protected] | (512) 827‑9638 | https://www.realstarter.co/Home/BH

Having a business creates opportunity for managing taxes. Real estate investing creates yet another more power opportunity to manage taxes. A good CPA can help minimize the impact of taxes.

I have friends that bring in 6 figure incomes and pay little or no tax. Nearly all of their income is from real estate. Depreciation is a great way to defer income recognition. Using a 1031 exchange allows built in capital gains to be put into larger properties that allow further depreciation.

There are a number of strategies to employ that becomes more valuable with scale.

For those that work a W-2 job, real estate investments can shield a significant portion of your ordinary income.

Corey,

Let's simplify the discussion.

Assume that you have a rental property that generates $300 per month in cash flow. Cash flow is what is left over from your gross rent AFTER all your expenses have been paid.

Over the course of one year of rental use, you bank $3600 in net rental income (cash flow).

Depreciation is a "phantom" expense because it does not really take any money out of your pocket. So, if that rental property has a depreciation basis of $99000, you are allowed a depreciation expense of $3600 for the year that you had your rental property in service.

The depreciation expense reduces your taxable rental income to $0. In effect, your rental has paid you $3600 for the year, tax free. Imagine, repeating this with ten rental properties in your portfolio will shelter $36000 in annual income from faxes. That's $36000 "tax-free" cash in your bank account.

This is the concept behind the tax benefit of owning rental property.

Bryan,

"Boot" only applies to the 1031 exchange.

The most common form of exchange today is the Starker exchange, also called a forward exchange, wherein a qualified intermediary will facilitate the sale of B's investment property to A, and the later purchase of property from C to replace B's investment property.

In the forward exchange, the completed exchange is fully tax deferred if the value of the replacement property equals or exceeds the value of the relinquished property AND all of the net proceeds from the sale of the relinquished property are reinvested in the replacement property.

If either of these two conditions fail, then there will be taxable boot.

Thanks Dave...So do the rules change if you do a reversed delayed exchange or any other arrangement? I just got done reading a book on exchanges and I think I understood maybe 20% of it ;-)

Medium realstarter2Bryan Hancock MBA, RealStarter | [email protected] | (512) 827‑9638 | https://www.realstarter.co/Home/BH