rental property tax example - please advise!

Tax, SDIRAs & Cost Segregation

rental property tax example - please advise!

Real Estate Agent · Tampa, FL · Member since 2009 · 456 posts · 123 votes

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!

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J ScottPro Member

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Investor · Sarasota, FL · Member since 2008 · 18k+ posts · 17k+ votes

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...

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David Duong
Member since 2010 · 27 posts · 1 vote
15y
What an awesome post and answers. Thanks everyone! So much easier learing from BP than reading a book!
0 Reply
Kyle K.
Real Estate Investor · Chicago, IL · Member since 2008 · 122 posts · 46 votes
15y
Originally posted by Bryan Hancock:
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?

I disagree--sometimes. In certain instances, it may make sense to sell property without an exchange. High income earners (>$150K/year) cannot deduct depreciation against their ordinary income. However, this unused depreciation doesn't disappear, it accumulates. Later on, this unused depreciation can be used to offset any capital gains upon the disposition of an investment property.

I'm not a CPA, but that's how I understand it. Perhaps Charles Perkins can explain this concept better than me.
1 Reply
Dave Toelkes
Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
15y
Kyle,

In your example, the depreciation is always used to offset rental income. If the net rental income after depreciation is negative, there is a net passive loss.

High income earners can not use the net passive loss allowance against ordinary income, so they suspend the loss and carry it forward to a future tax year when it offsets passive income or income drops so the net passive loss allowance can be taken. If the property with suspended losses is sold in a taxable event, then the suspended losses can be deducted against other ordinary income as a net passive loss allowance regardless of the high income limits.

Even for high income earners, the unrecaptured depreciation is still taxed when the property sale is a taxable event.
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Dave Toelkes
Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
15y
Originally posted by Corey Demuth:

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

Corey,

The "rental profit" in your example is ordinary income, not capital gain. You only realize capital gain when the property is sold for a profit. The profit is capital gain. The rental income you receive while you hold the property is ordinary income.

Most rental property investors don't buy rental property for the tax benefits. They aren't even buying the "property", they are buying the cash flow the property can generate.

If the property does not generate a positive cash flow, then there is no reason to own the property, certainly not for the tax benefit alone.

The real benefit in owning rental property with a positive cash flow is that you are not paying for the property out of pocket. Your tenants are buying the property for you and putting extra cash in your pocket along the way.

At some point in time, you own the property free and clear although your tenants "paid" for it. Along the way, any tax benefits you may have realized is just a bonus.
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Taylor Green
Vancouver · Member since 2013 · 159 posts · 6 votes
13y
What a great thread... I was wondering if anybody was willing to share an example of a flipped property instead of a rental property and the way the taxes would be done, thanks!
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