As a long term real estate investor, tax shelter is almost always a popular topic for sure. Who doesn’t love the idea of a paper loss (paper = pretend) against their ordinary income, right? For the record, ‘ordinary’ income is what the Internal Revenue Code (IRC) calls your job income. I’ve never liked that. 🙂 Anywho, in terms of real estate investment property tax shelter comes mostly in the form of depreciation.
Depreciation is merely the acquiescence by the IRS that physical property — mostly buildings and what goes in ’em — deteriorate over time, losing ‘value’. So they give it a ‘life’, so to speak. Generally speaking, residential income property will last 27.5 years according to the seers at the IRS. Apparently commercial property eats better and exercises as they’re expected to live longer, 39 years or so. In my experience, the residential side has seen as short as 15 years, though pretty quickly that term was lengthened to 19 years. Man, those were the days.
Back in my youth, before indoor plumbing and running water, there was no limit to how much depreciation a taxpayer/investor could apply to their ordinary income. They either had a legit amount of it and applied it, or they didn’t. Also, the same rules applied whether they made $30,000 a year at work or $30,000 a week. Depreciation was depreciation. But that was far too easy, right?
How I Bought, Rehabbed, Rented, Refinanced, and Repeated for 14 Rental Properties
This is the dream right? Going from zero to 10+ rental properties, providing stable cash flow and long-term wealth for you and your family, and building a scalable business model to boot! Learn how this investor did just that, in this exclusive story featured on BiggerPockets!
Rules — There are Rules.
Want to amass tons of depreciation so your income taxes are slashed to almost nothin’? Dream on. With the exception of qualifying for Professional Investor status via IRS standards, you’re limited to a maximum of $25,000 yearly against your ordinary income. The rest? It gathers dust on the shelf ’til it’s finally allowed to be used. But, as you might’ve suspected, there’s a little hitch. There’s always a little hitch, right?
As soon as your ordinary income breaches the six figure level, you begin the trek to becoming completely persona non gratis when it comes to the ability to apply legitimate depreciation against job income. From $100,000 to $150,000 the IRS gradually reduces the percentage of the available depreciation eligible to be applied to your ordinary income to zero. For example, if you made $125,000 this year, and had $25,000 of depreciation left over after sheltering your properties’ cash flow, you’d only be allowed to take $12,500. That’s cuz you’d be half way from the maximum of $100,000 income to the maximum allowed income of $150,000. Once you succeed in earning $150,000 a year at work? No more depreciation for you. You’re done, put a depreciation fork in you.
You make over $150,000 — How do you use depreciation to reduce income taxes?
The cash flow generated from real estate bought for investment is safe. I used to feel confident in saying it’ll always be safe, but given all the changes in recent times, I’ll just say cash flow is safe for now. The other way to save taxes on your income is to apply unused depreciation on a particular property you’ve sold, which produces a capital gain. Though you’ll owe the capital gains tax due, the property’s unused depreciation will now break the IRS shackles and rush to the aid of that year’s ordinary income. Here’s an example.
Let’s say an investor making $250,000 a year at work, sells a property generating an impressive capital gain, upon which he’ll be taxed. During this property’s holding period there was approximately $100,000 dollars of unused depreciation warehoused. That $100,000 gets pushed immediately over to their job income, as the property producing it has been sold. To the extent it then ‘shelters’ that investor, that is, lowers the amount of income tax owed that year, it helps or some cases completely offsets his capital gains tax. Furthermore, if this example had used an investor making less than $100,000 at work, he would’ve also been allowed the annual limit of $25,000 depreciation that year. Thing is, most folks making under six figures don’t accumulate too much unused depreciation in real life.
Cost Segregation is more universally employed to cover BigTime cash flow.
What if you could take humungous yearly cash flow for five years without any of it, or at least very little being taxable? That’s the main attraction most investors use it for. Imagine being able to recoup much if not all of your down payment in untaxed cash flow in five years. Sure, there’s a terrific downside in that cash flow from that point forward would be all but naked. But many don’t worry about that since at that point they view themselves as operating on ‘house money’ so to speak. They then have a mostly taxable income stream, but with most/all of their original skin in the game back in their Levis.
What’s your ‘right’ question?
Though this has barely touched all that’s possible, you can readily discern that depreciation as a factor in long term real estate investment is often under utilized. There’s a problem though in that some investors base too much of their purchase decisions on tax shelter. Saving taxes is cool. Long term investing is generally for retirement income. After tax income. The timing of tax shelter, and what depreciation strategy should be employed are usually important. Still, the downside of executing a strategy that’s a bad fit can backfire at exactly the wrong time — retirement.
Use depreciation as a tool, like anything else.
Photo: Let Ideas Compete