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Depreciation and the IRS - 2007-03-17 |
Last week, we looked at the various ways the IRS taxes profits made in real estate transactions. We saw that our plans and intentions have a direct impact on the level of taxation we experience. When we discussed long term capital gains, I glossed over the topic of depreciation, because I wanted to focus on core tax rates for different classes of real estate.
But the truth is that depreciation is a much-misunderstood benefit in residential real estate, and is therefore worthy of our examination this week.
I'll bet that if you asked ten different real estate investors or agents to explain the concept of depreciation, you would get ten entirely different answers. Even so, the concept of real estate as a tax shelter is, in many cases, entirely dependent on depreciation and it's impact on owners of real property.
Technically, depreciation is a "non-cash" expenditure that owners of real estate investments must take as an expense against income from their investments. Under current tax law, owners of improved residential investment property are required to take a tax deduction for an amount equal to 3.64% of the value of the improvement each year for a total of 27.5 years.
If the property is later sold, all previously taken depreciation must be "recaptured" at a rate of 25% as part of the calculation of tax due in relation to the sale.
So let's buy a brand new little rental house, say for $100,000, from a builder who is trying to sell out his subdivision and gives you a good deal. And let's say you get a loan for the entire purchase price, so you have no down payment.
Your monthly payment of principal, interest, tax and insurance is exactly $1,000. And fortunately for my calculator, your monthly rental income is exactly $1,000 per month. Assuming you have no other expenses during the year, your income is $12,000 and your out-of-pocket expenditure is $12,000. That is called "break-even cash flow," and it's the goal of every investor who uses significant leverage.
It would seem that, as long as you experience break even cash flow, you would owe no taxes at the end of the year. But it's not that simple.
First, the IRS says you can't take a deduction for the principal portion of your payment. That's because you are paying yourself back for the loan, and interest is the only deductible part of the actual loan payment. Fortunately, you are in the first year of your loan, and your payment is almost 99% interest, so let's forget about the principal portion for now.
Now we get to the depreciation.
The IRS assumes that any structure on the premises will eventually wear out over time. In other words, it is being consumed as it is rented over the years. Eventually, you will no longer be able to rent it to anyone. The concept of depreciation is that the owner should get a tax break now for the consumption of the structure over the useful life of that structure.
Since land can't be worn out, you must subtract the value of the land from the cost of the rental property. In this case, the builder is selling vacant lots down the street for $17,500 each, so you establish the value of your house alone at $82,500. That is the value of the depreciable asset.
Congress most recently set the useful life of residential real estate at 27 years and six months. I know that sounds crazy, but that was the compromise between those who wanted longer periods and those who wanted shorter periods. So you divide $82,500 by 27.5 years to arrive at your annual depreciation figure. In this case, it works out to exactly $3,000 per year.
And it's that $3,000 of non-cash expense which creates your tax shelter, year after year.
Here's how it works. At the end of the year, you report income of approximately $12,000 and deductible expense of approximately the same amount, but you get to add your allowable depreciation to the expense side of the column, even though you didn't actually pay for it. Now you show a "paper loss" of $3,000 for this rental property.
That loss can be applied against other income to lower your taxable income by as much as $25,000 per year, depending on your occupation and your income level. The passive loss rule limits you to a deductible loss of $25,000 on an annual basis if your income is not over $100,000. That might seem limiting, but there are exceptions to the passive loss rule for those engaged in real estate on more than a part time basis.
In the case of a full time real estate professional, there is no limit to the amount of loss that real estate can generate, so it's conceivable that a person with an income of, say, $60,000 might own 20 rental homes similar to yours, and totally offset their income for tax purposes. In other words, the paper loss from the rental houses of $3,000 per year might totally shelter the earned income of $60,000 from any taxation whatsoever.
Here's the catch: if you ever sell your investment property, you are required to pay tax on the depreciation you have deducted over the years, at a rate of 25% for federal taxes. The good news is that, for most taxpayers, you used that deduction to shelter income that would have been taxed at a federal rate of 28% or higher, so you probably come out ahead in the long run.
If all this has left you totally confused, let me submit another way to think about the concept of depreciation. Some people consider it to be nothing more than an interest free loan from the government to you, and payment is made in the form of tax savings. Some day, if you ever sell, you'll have to pay those savings back, but in an amount slightly less than the savings you got over the years.
Depreciation is a mandatory deduction, so if you own rental property, you need to understand it. And know this: the only way to beat the recapture is to never sell. When you die, all depreciation is forgiven, and your heirs receive the property with a "stepped-up" basis. It's a tough way to save income taxes, but it works every time.
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