Analyzing a Property Using Tax Benefits

Is it a good deal? Have you ever asked yourself that question when you’re looking at a property?

There are four ways to make money from real estate: Cash Flow, Appreciation, Principal Paydown, and Tax Benefits. Understanding this will help you to determine whether or not a property is a good investment.

In this article, we are going to take a closer look at how Tax Benefits can affect profitability. When analyzing a property, cash flow and forced appreciation are going to be your two primary methods of making money on a deal. Principal paydown and tax benefits should be “the cherry on top.”

Find out how much of the Purchase Price is allocated to the land or how much of it can be allocated to land. You can estimate these using tax assessments or better yet, ask your accountant for a loose rule of thumb they use. Once you get the numbers, take the purchase price and subtract the amount allocated to land from it. The difference is the Depreciable Real Estate Amount.

From our example above, the Depreciable Real Estate amount is $180,000. The next step is to figure out the Annual Depreciation. You can do that by dividing the Depreciable Real Estate amount by 27.5 years if it is residential, and 39 years if it is commercial. Since it is a residential property, the annual depreciation is $6,545.

The next thing is to figure out income before depreciation. We can use the cash flow spreadsheet that we created in Part 1 but with a small adjustment to the mortgage amount. Instead of using the full mortgage amount of principal + interest, we are only going to deduct the interest that we are paying on an annual basis. For our purposes, use a mortgage calculator with an amortization table and get the sum of the first 12 months of interest, which is a total of $5,543.00 in our example. This leaves us with an Income Before Depreciation of $7,557.00.

The IRS allows us to subtract the annual depreciation from Income Before Depreciation to get the taxable income for our rental property. We are only going to be taxed on about a thousand dollars of income even though we’re cash flowing about $4500.00 from the property. That’s the power of real estate and this is how most wealthy real estate investors get away with paying low or even no taxes; it is through depreciation and creating losses for tax purposes.

Now, let’s say we are in the 35% tax bracket and we want to get the value of the actual tax savings. We take the Annual Depreciation, and then multiply it by 35%. This leaves us with a tax savings of about $2300/year.

It doesn’t end there! It can still get a little more interesting. Ask your accountant to get a little more aggressive with your depreciation by doing some cost segregation. This is more common for commercial properties but I have seen clients who do it with their residential properties as well. For example, when doing a new rehab, you can opt to depreciate some rehab items as personal property over 5 or 7 years, instead of 27.5 years.

Let’s assume we decide to get really aggressive and depreciate about $10,000 this year. As a result, we generate an income before depreciation of about $7500, we deduct the depreciation value, and we have a taxable loss of $2400. This loss can be used to offset your other income (like your W-2 salary) if your adjusted gross income is below a certain amount (as of this article less than $100,000 a year and gets phased out by $150,000).

Basically, if you are making a W-2 income of $100,000, you can take the W-2 income minus the tax loss from real estate, and you’ll pay taxes on that difference. Based on this example, you are going to get additional savings. All you have to do is take the loss and multiply it by your tax bracket to figure out tax savings.

Using the tax savings, and dividing it by our cash invested, we have a return of 1.82% on an annual basis from tax savings.

Finally, if we take the cash flow, plus the principal paydown, plus the return from the tax savings, we have a total return of 17.89%, which is rather impressive. Keep in mind, this does not include the cash flow going up over time, which on average grows about 3% annually. If the cash flow is expected to grow into perpetuity at 3%, you can add the 3% to the 17.89% for a total expected return of 20.89%. If we include potential appreciation, which grows on average at 3 to 5%, you are looking at a staggering return of about 24 to 26%. Absolutely amazing! Definitely, Real Estate is the ultimate wealth-building tool.

If you'd like to watch the video, CLICK HERE.