Effects of depreciation and interest expense.

10 Replies

Anyone able to shed some light on how you personally figure in the savings of interest expense and depreciation on your investment?  I have heard a ton about cash flow, but there is the other great tax benefits, although I don't know how to go about guesstimating or calculating what these might be.  Anyone with more knowledge care to share on either a specific method, or broad based thoughts on whether you would even take that into consideration when looking at an investment?

Thanks in advance. 

I don't really calculate the "savings" of interest or depriciation. There are expenses that will be deducted off your income taxes.

As an example, my wife and I own a rental that is cash flow positive, but it is an expensive home, therefore our mortgage interest in quite substantial. Additionally, since it was a more expensive home, the depreciation is quite a bit a well. The IRS let's you depriciate it over 29 1/2 years.

So, although we are cash flow positive, because of the mortgage interest, deprecation and other expenses, we show a loss every year, which is deducted from our taxable income annually.

I hope that answers your question.

Like almost all money you spend on a rental, interest is just another pre-tax deduction.  There's no "savings" associated with it.  Its a real cost.  Its just paid from the gross income, not after tax income.

Depreciation is best thought of as a loan from the IRS.  You do get to deducted it from your revenue (rents received) when you're computing your taxable income.  If it puts you at a net loss, you might be able to use that to offset other income.  There are limitations, and those may reduce or eliminate your ability to offset other income.

The kicker is that depreciation reduces your basis.  That means your gains will be increased when you sell.  And the amount of gain up to the depreciation (taken or allowed, whichever is greater) is subject to a tax on non-recaptured depreciation.  That's currently capped at 25%.  So, if you're in the 28% tax bracket, you can deduct the depreciation which gives you a 28% tax break.  Then, when you sell, you pay the tax on unrecaptured depreciation at 25%.  Which is why I say its best to view the depreciation deduction as a loan, not a real deduction.

Of course the real trick is to die.  Then your properties transfer to your heirs and they get the stepped up basis as of the date of your death.  

Jon Holdman, Flying Phoenix LLC

Sorry @Scott Trench but this isn't quite how depreciation works:

If you make an investment in a 360,000 property, then over 30 years (360 months) it will depreciate at $1,000 per month all the way to zero.

For one, you can only depreciation the improvements, not the full cost.  With the 80/20 rule of thumb (there are better ways to do this), the improvements would be $288K.  You depreciation residential properties over 27.5 years, not 30.  Those two offset vs. your calculation, so the net result is about the same.

But you are correct that the depreciation you take each year reduces your tax bill.  But if you sell after 27.5 years, your remaining basis will be only $72K.  So, say you sell it for $720K (doubling in value after 30years).  You would have $648K in gain.  Of that, $288K would be subject to the recapture tax at 25% and the remaining $360K would be subject to long term capital gains at 15%.  So while you're saving 28% each year as you hold the property, you're paying a big chunk of that back if you sell.

And that assumes tax law remains unchanged.  That's definitely a bet I won't take.

Not to say that deferring the tax bill is bad.  Its not.   But depreciation is less valuable than many gurus and sellers make it out to be.

And its often slapped on crummy rentals as lipstick.  Say you're just above break even with real expenses.  You subtract depreciation and you get a passive loss.  No problem, says the seller, you can use that to offset other income.  Yeah, right.  If your AGI is under $100K you can do that, up to $25K in passive losses.  Over $150K (that's for a couple, too), you cannot.  In between it phases out.  Now I know that's a lot of money but I would say many people who are investing in rentals are relative high income.  So, this is a consideration.  And one that's often overlooked by people selling crummy rentals.

Jon Holdman, Flying Phoenix LLC

Originally posted by @Jon Holdman :

Sorry @Scott Trench but this isn't quite how depreciation works:

If you make an investment in a 360,000 property, then over 30 years (360 months) it will depreciate at $1,000 per month all the way to zero.

For one, you can only depreciation the improvements, not the full cost.  With the 80/20 rule of thumb (there are better ways to do this), the improvements would be $288K.  You depreciation residential properties over 27.5 years, not 30.  Those two offset vs. your calculation, so the net result is about the same.

But you are correct that the depreciation you take each year reduces your tax bill.  But if you sell after 27.5 years, your remaining basis will be only $72K.  So, say you sell it for $720K (doubling in value after 30years).  You would have $648K in gain.  Of that, $288K would be subject to the recapture tax at 25% and the remaining $360K would be subject to long term capital gains at 15%.  So while you're saving 28% each year as you hold the property, you're paying a big chunk of that back if you sell.

And that assumes tax law remains unchanged.  That's definitely a bet I won't take.

Not to say that deferring the tax bill is bad.  Its not.   But depreciation is less valuable than many gurus and sellers make it out to be.

And its often slapped on crummy rentals as lipstick.  Say you're just above break even with real expenses.  You subtract depreciation and you get a passive loss.  No problem, says the seller, you can use that to offset other income.  Yeah, right.  If your AGI is under $100K you can do that, up to $25K in passive losses.  Over $150K (that's for a couple, too), you cannot.  In between it phases out.  Now I know that's a lot of money but I would say many people who are investing in rentals are relative high income.  So, this is a consideration.  And one that's often overlooked by people selling crummy rentals.

Thank you for pointing that out Jon!  I am certainly not an expert on the specifics of Real Estate Depreciation and am learning all the time.  I hoped with my simple example to demonstrate why depreciation on a property is beneficial on a cashflow basis - though you certainly do pay later in Real Estate.  

I was incorrect with the specifics here and I'm glad you pointed this out.  I have a ton to learn. 

Take your effective tax rate and multiply it by the amount of depreciation.  

If your effective tax rate is 30% and you have a depreciation expense of $10,000, then you have a tax savings of $3,000.

There are other factors to consider such as passive activity loss limits and depreciation recapture, but this is a good place to start.  

Let me know if you want to discuss further.

David Powers CPA

Originally posted by @Jon Holdman :

Sorry @Scott Trench but this isn't quite how depreciation works:

If you make an investment in a 360,000 property, then over 30 years (360 months) it will depreciate at $1,000 per month all the way to zero.

For one, you can only depreciation the improvements, not the full cost.  With the 80/20 rule of thumb (there are better ways to do this), the improvements would be $288K.  You depreciation residential properties over 27.5 years, not 30.  Those two offset vs. your calculation, so the net result is about the same.

But you are correct that the depreciation you take each year reduces your tax bill.  But if you sell after 27.5 years, your remaining basis will be only $72K.  So, say you sell it for $720K (doubling in value after 30years).  You would have $648K in gain.  Of that, $288K would be subject to the recapture tax at 25% and the remaining $360K would be subject to long term capital gains at 15%.  So while you're saving 28% each year as you hold the property, you're paying a big chunk of that back if you sell.

And that assumes tax law remains unchanged.  That's definitely a bet I won't take.

Not to say that deferring the tax bill is bad.  Its not.   But depreciation is less valuable than many gurus and sellers make it out to be.

And its often slapped on crummy rentals as lipstick.  Say you're just above break even with real expenses.  You subtract depreciation and you get a passive loss.  No problem, says the seller, you can use that to offset other income.  Yeah, right.  If your AGI is under $100K you can do that, up to $25K in passive losses.  Over $150K (that's for a couple, too), you cannot.  In between it phases out.  Now I know that's a lot of money but I would say many people who are investing in rentals are relative high income.  So, this is a consideration.  And one that's often overlooked by people selling crummy rentals.

Yep! that is what happened to my wife and I. We did not know we were so close to that $150K income limit until last year at tax time. We are still paying the tax bill off to the tune of $200/month.

This is probably not the answer you want to hear, but I do not track it except during tax season.  As mentioned above, depreciation is definitely nice but you give a lot of it back when you sell.  A 1031 exchange can be a good way to delay it even further but eventually you'll have to pay it back...unless you die first.

I typically ignore principal pay down and depreciation when calculating my cash flow to be conservative.  There are no "savings" associated with interest expense.  It's a rental property, so it's all deducted against rental income unlike a primary residence where you just get a "discount".

The 1031 Exchange will allow you to defer your depreciation recapture amount into your new property, and you can continue to 1031 Exchange and defer your depreciation recapture amounts throughout your lifetime so that you keep the money in your pocket working for you (and not paying taxes to the government).  It allows you to accumulate wealth faster than a normal investor that merely pays the taxes as they go. 

And, as was previously pointed out, if you continue to 1031 Exchange throughout your life and then pass on your heirs that inherit the property will get a step-up in cost basis.  This means that the capital gain and depreciation recapture amounts essentially disappear so that no taxes are due on these items.  You heirs can start their depreciation all over again based on the fair market value of the date of death. 

The 1031 Exchange is much more than a transactional tool.  It is a wealth building tool as you can see from the comments above.

Medium exeter 1031 clr cntr bBill Exeter, Exeter 1031 Exchange Services, LLC | [email protected] | (619) 239‑3091 | http://www.Exeter1031.com

Sorry @Scott Trench didn't mean to be beating you up on details.  Just wanted to avoid confusing anyone about the depreciation calculation.

Jon Holdman, Flying Phoenix LLC