Depreciation = 0 Taxes (Conceivably)??

11 Replies

Hello folks!

Can someone tell me if I am thinking of depreciation and write-offs in the correct manner for rental properties? I was trying to envision a scenario where someone could potentially have (close to) $0 tax liability. See my non-professional numbers below:

I was doing a quick on-the-napkin calculation of buying 15 of $100K homes, which would allow for ~$3636 in depreciation on each property per year, ~54K in total tax write-off/income reduction per year. 

Add ~$500/month in expenses (low-end), for a total of $6000/year in expenses per property = $90K taxable income reduction across 15 properties.

Let's say each home has an 80k mortgage with interest of 4.5%. I approximate about $4000 (low-end) interest payments per year for the first several years, per property. $60,000 taxable income reduction.

Add $500/year (low-end?) home insurance deduction per property = $7500 taxable income reduction.

Add $1000/year (low-end) property tax deduction per property (local taxes in Charlotte, NC for 100K home) = $15000 taxable income reduction.

Total tax write-off/reduction = $226K?

Let's assume each property rents for $1300 per month (conservative). Income = $234K.

Someone could potentially be getting taxed only on 8K, which at a 10% tax bracket = a whopping $800 in taxes.

Most likely I am leaving something out - please rip this apart. I probably have no idea what I am talking about. Just trying to see what it might take to be taxed at close to $0?

I didn't look through all your numbers, but depreciation and expenses could offset nearly all your rental income. The catch is if you sell the property you will have to pay taxes on all that depreciation recapture if you don't do a 1031 exchange.

@Ashton Ferrazzo , as @Andrew B. said, you will owe taxes on the depreciation when you sell, but that will be at long term capital gains rate for federal, which is likely much lower than your effective income tax rate (or you could 1031 exchange into another property to kick the tax bill further down the road).

Depreciation is a huge benefit, and it is especially important for positive cash flow when you have a mortgage.  By cash flow, I mean money in your pocket, not on paper.  If we didn't have depreciation our cash flow would need to be high enough to cover the the taxes on the prinicpal paydown of the mortgage (money on paper coming out of money in our pocket).  To keep things simple, let's say your principal paydown is the same as what your depreciation would be, $3,636 in your example.  If your effective federal tax rate was 25%, you'd need to pay $909 in taxes on that before you had any money to put in your pocket.  Furthermore, you'd be taxed on your cash flow, so you'd really need $1,212 in cash flow just to break even after federal taxes.

Originally posted by @Ashton Ferrazzo :

Hello folks!

Can someone tell me if I am thinking of depreciation and write-offs in the correct manner for rental properties? I was trying to envision a scenario where someone could potentially have (close to) $0 tax liability. See my non-professional numbers below:

I was doing a quick on-the-napkin calculation of buying 15 of $100K homes, which would allow for ~$3636 in depreciation on each property per year, ~54K in total tax write-off/income reduction per year. 

Add ~$500/month in expenses (low-end), for a total of $6000/year in expenses per property = $90K taxable income reduction across 15 properties.

Let's say each home has an 80k mortgage with interest of 4.5%. I approximate about $4000 (low-end) interest payments per year for the first several years, per property. $60,000 taxable income reduction.

Add $500/year (low-end?) home insurance deduction per property = $7500 taxable income reduction.

Add $1000/year (low-end) property tax deduction per property (local taxes in Charlotte, NC for 100K home) = $15000 taxable income reduction.

Total tax write-off/reduction = $226K?

Let's assume each property rents for $1300 per month (conservative). Income = $234K.

Someone could potentially be getting taxed only on 8K, which at a 10% tax bracket = a whopping $800 in taxes.

Most likely I am leaving something out - please rip this apart. I probably have no idea what I am talking about. Just trying to see what it might take to be taxed at close to $0?

The basic concept is correct. The depreciation will be on your building( not land),  so you have allocate 100k between the land and building. 

Also, most of the time, the net rental income get taxed at your marginal rate. Meaning you don’t look at the 8k as separate income for tax purpose.

Unless your rentals are under C-Corp,  It gets added to your individual income and get taxed at your highest marginal rates.

Let’s say you make 200k from other sources, and you are at the marginal rate of 32%, the 8k get taxed at 32%. 

Let me know if that makes sense. 

Originally posted by @Ashton Ferrazzo :

Someone could potentially be getting taxed only on 8K, which at a 10% tax bracket = a whopping $800 in taxes.

Unless you have children, in which case you would likely get a large tax refund. 

@Ashish Acharya How much do you have to allocate between land and building? Or is that based on the tax info for the county?

Also, unless you have a job outside of the rental property, you would only be taxed on the $8k right?

@Larry T. @Paul Allen thank you all for your responses!! Very very helpful. 

@Andrew B. I like the idea of the 1031 exchange, and I forgot about having to pay down the total depreciation at sale, which could significantly impact the property, unless I had a condo or something (which could potentially depreciate on its own). Then I never pay Big Brother until I die. And maybe not even then...

Hey @Ashton Ferrazzo I'm new to Charlotte - Maybe we'll run into each other at a local REIA event?

Any how- The allocation can be done one of several ways, the most common is to use the split of land/building percentages that the county uses. 

There was also some mis-information above. When/If you sell you do pay depreciation recapture- this is NOT at LT capital gains rates, It's actually at ordinary income tax rates (but caps at 25%). 

If you utilize a 1031 exchange the gain related to depreciation rolls over with the normal capital gains as well. 

In theory- If your portfolio is planned well and if you qualify to take rental losses...you can actually reduce your w-2 income even with the losses that will generate via depreciation. 

It's trickier in lower value markets- but depending on how your portfolio is setup it's very doable. 

 @Ashton Ferrazzo ,

Yes, using the tax assessment from your county is the safest way to go, unless you think that is not correct and you can allocate more to building, but you should be able defend your allocation if ever audited. 

If you don’t have other source or income, than yes, 8k is taxed as you had mentioned. 

Basic concept is correct.

However, in simple terms, after all other expenses, your depreciation would need to equal the sum of your actual Cash Fow and your principle reduction.....which would mean you have a near break even or negative cash flow investment, more so as your principle reductions increase.

 A good investment Should yield a taxable income, after depreciation.

@Ashton Ferrazzo

In theory, you're correct, but...

1. Zero taxes mean that you do not have other income, only rentals. Depreciation is roughly the difference between your real cash flow and your paper cash flow. So, if your taxable (after depreciation) income is so low that your taxes are zero, then your real cash flow is not very impressive. Using your example, try living off of $54k in SC.

2. In your calculations of cash flow you conveniently forget about vacancies and repairs. OK, maybe repairs are part of your $500 expenses allowance, but vacancies and major repairs, like roofs and HVAC, are MIA.

3. In your example, you need $20k x 15 = $300k cash tied in this operation.

@Larry T. oh wow, I think you just hit on something I haven't seen anybody mention before. @Natalie Kolodij you mentioned it as well.

Taxation on principal paydown? Can you elaborate on that?

In retrospect, it totally makes sense. Am I gathering that the IRS catches on to the fact that while you're losing mortgage payments to the bank, you're actually recapturing some of that value (from your tenant) in the form of principal paydown, and therefore that should be treated as taxable income?

How does that work? Is it taxed as regular income or at some special rate?

Thanks so much!

"Taxation on principal paydown? Can you elaborate on that?"

Paydown on debt isn't a taxable event.  Cancellation of debt would be (at ordinary income tax rates).

"while you're losing mortgage payments to the bank, you're actually recapturing some of that value (from your tenant) in the form of principal paydown, and therefore that should be treated as taxable income?"

Principal paydown isn't taxable.  It's a balance sheet movement.  Doesn't make it's way onto the P&L.  High level on the P&L you have rents received, less expenses & non-cash transactions like depreciation and amortization.