Disclaimer: Before jumping into the article, there are two disclaimers that I would like to make. First, this article is mainly based on US tax laws, as my property investments are mostly in United States. If your investment is outside of United States, this article may still be relevant in principle, but details may be different in your case. Second, the article is solely based on my knowledge that I acquire throughout the years. I am not an accountant, nor do I aim to be one. I am a real estate investor deep in the heart. So my tax knowledge may not be comprehensive or even perfectly accurate. If in doubt, consult your accountant. (I consult my accountant as well, especially when I finalize my tax returns and before I make major buy / sell decisions.)
One big thing that I love about real estate investing is its tax efficiency.
If you are in real estate investing, especially in cashflow properties, you should know something about depreciation. Depreciation is an important subject to you because it can save you large sums of money.
How does depreciation save you money?
Depreciation saves you money by reducing the income tax that you have to pay. From IRS (US Tax Department)’s perspective, depreciation is a type of expense. As an expense, depreciation can offset your rental income that you make in your properties, so your profit looks smaller. Smaller profit, smaller amount of tax that you need to pay.
I will give you a real life example. The rental property’s monthly income is $3,000, or $36,000 per year. The Operating Expenses (maintenance, property tax, insurance etc.) total to roughly $17,000 per year. Without any depreciation, the profit will have been $(36,000 – 17,000) = $19,000 per year (1st column below). However, if you look at the 2nd column, by claiming depreciation as a $10,000 expense, the profit drops from $19,000 per year to $9,000 per year. Assume we pay 30% tax in profit, the tax just drops from $5,700 to $2,700, saving of $3,000 per year. Cool, right?
In this example, the government is giving you more money (you receive $1,200 tax credit) for making a $6,000 true profit. Pretty eye-opening to me!
Here is a little background for depreciation. The tax code says each asset that you own has a finite, economic life. Use our houses as examples. The code says the building has an expected life of 27.5 years. Because of that, I am allowed to take roughly 3.6% (1 divided by 27.5, ie. 1 / 27.5) of the building’s worth as an expense.
Say the building is worth $275,000 as I bought it, each year, I am allowed to take $10,000 ($275,000 divided by 27.5) as depreciation expense!
There are two features that are so awesome about deprecation that I would like to bring up.
First, depreciation is a non-cash expense. To illustrate this, I will contrast with something that is a cash-expense. For example, whenever I hire a plumber to fix a toilet, it is a cash expense. Yes, I can claim some tax credit at the end of year, but I actually have to fork out money to the plumber. Since the tax credit must be less than the actual expense, overall, my bank account actually goes down as a result of this.
Depreciation, on the other hand, does not require you to spend any cash in order to claim a tax credit. Depreciation is merely an accounting concept (trick). Using the previous house as the example, I never have to pay anyone a single dime for depreciation. However, on the tax return I can claim a $10,000 depreciation expense and claim tax credit for that. So no money in, only money in!
I like to think, with depreciation, I am almost writing myself a free check.
Second, depreciation has nothing to do with real market value, and it usually works to your favor. Houses tend to go up in value year over year. Let’s say you bought your house 20 years ago for $100,000, and your deprecation is $3,000 per year. Now the house is now worth $1,000,000 (by the way, 20 years for a ten-fold increase is very possible in certain parts of the country). Does the tax code treat you as if you make $900,000 over 20 years, or $45,000 per year? NO! It still treats as if you lose $3,000 per year. So you can (and often) have situations you save tax due to “losses” where you make money in reality. How sweet is this?
As I mention earlier, depreciation can save you money year after year and you don’t really have to work for it, just some paperwork change. Does it mean it is practically an annual gift from the IRS?
Pretty much so. There is a small caveat though.
When you sell the house, you MAY have to pay back the tax related to depreciation loss (The technical term is called “depreciation recapture“)
Notice I use the word MAY, not WILL, not MUST, not FOR SURE. Sometimes you don’t have to pay back, or at least you only have to pay the tax much later.
Knowing that there might be a chance that we have to pay back the tax, here are several reasons why depreciation still matters to you:
You only have to pay when you sell, and this can work to your great advantage if you plan to keep your properties as a long-term hold. You only need to pay the back taxes when you sell the houses. If you sell the house 30 years later, that’s when you have to pay the tax, but you save the money NOW. With inflation, I am sure you would agree $1 today is worth so much more than $1 30 years later right?
Point #1 suggests you pay tax 30 years later if you sell the house 30 years later. If you take this idea to even more extreme, if you never sell the house, you will never need to pay that tax! (By the way: if the house is a cashflow property, that it prints you money every month, why would you want to sell it in the first place?)
You may say: “But sometimes I need a large chunk of cash, so I have to sell the house.” No, you don’t. You just need the cash, and it does not necessarily mean selling the house. Have you thought of taking a mortgage or some other types of financing? The whole financing subject will need to be in another article, but I will leave it at this: As long as you take a prudent approach in financing, it is okay to get a large chunk of cash occasionally by taking on debt instead of selling the house outright.
Even if you decide to sell your houses, under certain circumstances, you can either defer the tax further or even avoid (legally) it altogether. I will highlight two popular ways.
The first one is called a Like-Kind change (aka “1031 Exchange”). The principle is that if you sell a house and buy another one, you can defer the tax gain on the sold house. It is a very powerful tool for real estate investors. As your portfolio gets bigger and bigger, you would want to trade up on your investment. For example, you can sell your 2-family house and buy another 10-unit property to collect more rent. Good news is that there are lots of ways to fulfill this 1031 Exchange condition. At the same time, the rules can be quite tricky as well, and you will need your accountant to guide you through this. Trust me, definitely money well spent.
The second one is applicable if the house you are selling is your primary residence (ie. where you live mostly). When you sell your primary residence, you may get a tax exemption. Tax Exemption is different from the Tax Deferral in previous example. Tax Exemption means you don’t need to pay tax gain altogether (so better than Tax Deferral).
Before you think about “living” in the house for a day and sell it right away, keep in mind there are rules that prevent this behavior. You need to meet certain residence requirements and there is a limit on how much tax you can save. As of time of writing (2014), you will need to live in the place for at least 2 years for the last 5 years, and the tax limit is $250,000 / $500,000, depending on whether you are married or not. There are some other special conditions as well. Requirements change from time to time and you should have an accountant to keep you updated to ensure that you are compliant.
You are not going to see this benefit, but I guarantee your heirs are going to be super thankful for you for doing this!
As the great Benjamin Franklin said, “…in this world nothing can be said to be certain, except death and taxes.” I beg to differ. Death is inevitable, I agree, but as a result of death, tax (on the house) can get completely wiped out!
Earlier we said for any depreciation expenses, we may have to pay back at a later time as depreciation recapture. However, one of the game changers is the death of the owner. (Technical term: “Step Up Basis” as a result of death)
When the owner dies, everything starts from scratch. Forget about the taxes that have been accumulating due to depreciation. Forget about the capital gain tax because market goes up.
Everything gets reset during the time of death of owner.
Here is a good example:
You need proper structure and paperwork (e.g. a will) to do this. As much as I like to experiment new things on my own (in order to gain experience) in the real estate business, these are things that I feel is best to leave it to the professionals.
Let your accountant and lawyer advise you on this specific matter. Don’t worry. It can be done. Just need to do it properly. To them, it is standard paperwork, don’t let them overwhelm you otherwise!
Depreciation is like this: You get to save a dollar for sure today, but you may have to pay it back some long time after. Maybe 30 years later, maybe 50 years later, maybe never. Ask yourself this. Would you want one bird in hand? Or one (not even two!) bird in the bush?
Caution: I strongly, Strongly, STRONGLY suggest before selling your house, consult an accountant who is familiar with these rules (ask them whether they have experience in doing “1031 Exchange”, “Primary Residence Tax Exemption”, “Tax Deferral on Sale”). Not all accountants know these special rules, but such accountant is possible to find. If these special accountants are too pricey (and rightfully so), you can always hire them to do specific items (e.g. a house sale) and let your other accountant(s) to do other standard tasks (e.g. keeping track of regular expenses).
Click here for Part 2.