Or, “The Tax Man Giveth, and The Tax Man Taketh Away”
Real Estate enjoys an enviable position as an investment that many other asset classes do not.
To the extent that real estate is physical, tangible property, it has a finite life.
Although it is possible that a well-built (house, office building, etc.) may in fact outlast our own time here on earth, some wear, tear, and deterioration are not only expected, but unavoidable. Even with periodic maintenance and capital improvement, it will eventually exceed its useful life and a higher and better use for the land below will make itself known.
Shingles wear out. Siding needs to be replaced. Flooring wears out or we get tired of looking at it. And according to Joe Lstiburek of Building Science Corporation, “There are only two types of windows: Those that leak and those that WILL leak.”
The government realizes this and permits a deduction against otherwise taxable income to account for the expected and gradual decline in functional value of investment real estate over time.
Residential real estate has a 27.5-year depreciation allowance (100% / 27.5 = 3.636% per year), and commercial real estate has a 39-year depreciation allowance (100% / 39 = 2.564% per year).
Let’s keep the math simple. If you had taxable income of $10,000 and a residential investment property worth $100,000, you could deduct $3,636 from your taxable income. Now you’re only paying tax on $6,364 of income. If you were in a combined (state and federal) marginal tax bracket of 30%, that represents over $1,000 shaved off of your tax bill. Every year.
In other words, depreciation is a non-cash expense. It is a deduction, but the money never left your pocket as an actual expense.
Note that land does not apply – it is not expected to wear out, ever.
Also note that there are other maneuvers, such as a cost segregation study, that may accelerate your ability to depreciate your property and enjoy more tax savings sooner. Ask your CPA for more details.
Q. Where does the taketh away part come in?
A. If you sell your property, you have to “recapture” (add back to your profit of sale) all the depreciation you took over all the years you owned the property and pay capital gains tax on the proceeds.
Q. Is there a way around that?
A. Yes:
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- Don’t sell. Selling real estate for capital gains when you are receiving cash flow from it is what Robert Kiyosaki calls “killing the goose that lays golden eggs” in his book, Second Chance. Instead, buy more golden egg – laying geese.
- If you still want to sell, you can do something called a 1031 exchange and roll the proceeds from sale into another property purchase. There are many applicable rules – again, ask your CPA.
Q. Sounds great, but I’m sure that will catch up with me – you’ll probably tell me, “yes, when you die”, right? But won’t my estate be burdened with all the deferred taxes?
A. If your estate planning is done right, your heirs will inherit your property at its stepped-up basis and will not have to pay capital gains tax. Again, consult your CPA, and also your attorney, on this one. And note that tax rules can change over time. Also, for those of you inclined to further reading and research, an entity known as a Delaware Statutory Trust (DST) can allow your real estate syndications and partnerships to be eligible for 1031 exchanges.
Q. Is there anything else I’m missing about the tax advantages of real estate?
A. I may have forgotten to mention that the income you are actually taxed on (after all applicable deductions) is taxed at passive rates. These are lower than ordinary (earned) income rates. In other words, if you earned the same amount of money by working a second job, you’d pay more in tax that way (and probably consume many more hours of your life doing it).
Is it any coincidence that the overwhelming majority of millionaires reached that status by owning real estate? That was true over 200 years ago, and it remains true today.
As you think about that, always remember that income is not what you earn, it is what remains available to you after our universal biggest expense – taxes.
Until next time,
Dr. Lee Newton
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References:
- https://thecollegeinvestor.com/11300/90-percent-worlds-millionaires-do-this/#:~:text=Over%20the%20last%20two%20centuries,way%20to%20develop%20significant%20wealth.
- Second Chance: For Your Money, Your Life, and Our World by Robert T Kiyosaki; Plata Publishing, LLC; copyright 2015
