The US tax code has many incentives written into it that promotes rental property investing as a way to provide housing to our country's citizens. With the help of an experienced CPA and proper tax planning, even high-income earners can dramatically reduce their tax bill. The following shows some examples of the tax benefits that can come from investment property ownership.
In accounting terms, depreciation means systematically writing down the cost of a fixed asset (including buildings) over its "useful life."
Depreciation is an accounting expense that you do not actually incur. For example, suppose you have purchased a property for $500,000 using $125,000 (25%). In the first year, let's say you have collected $50,000 in revenue, you spent $6,000 in operating expenses, as well as $30,000 in interest, taxes, and insurance (notice that the principal portion of your mortgage payment is not tax-deductible). Your profit for the year was $14,000 in your pocket.
At tax time, you decide to calculate your depreciation using a STRAIGHT-LINE METHOD. The cost of your building (the land portion of your property is not tax deductible) is $425,000. The IRS says that the useful life of a residential building is 27.5 years, so you would deduct $15,454 in depreciation expense each year until the end of the asset's useful life.
This means that although you actually profited $14,000, your tax return will show that this property had a passive loss of -$1,454. Your profits were all protected from tax!
A few things to remember about depreciation:
It's required, so you may as well take advantage of it;
when you sell the property, you will be required to pay depreciation recapture at a rate of 25% (unless using a 1031 exchange);
if heirs inherit your property, they won't need to pay depreciation recapture;
passive losses can only offset passive income (unless your income meets IRS limitations).
That's the straight-line method. However, savvy investors can use other depreciation methods to significantly reduce their tax burden even further.
Cost Segregation Study
The purpose of this method is to front-load depreciation expense in the first few years of property ownership. This would be particularly beneficial to investors who expect to have a large amount of passive income (for example, K-1 income as a limited partner in a business). Instead of depreciating over 27.5 years evenly each year, a cost segregation study breaks down each of the individual components of the building, i.e. the lighting, flooring, roof, plumbing, which can individually be depreciated over a shorter period of time - usually five, seven, 10, or 15 years. Passive losses can be significant with this method, providing potentially huge tax savings!
Massive tax savings
Consider a physician who receives $200,000 in K-1 income from their partnership in the physician group in which they are a limited partner. With this K-1 income in addition to regular W2 earned income, the physician would be paying taxes in the 37% tax bracket.
Let's say the physician decides to purchase an investment property to protect that K-1 income from taxation. The physician obtains a cost segregation study and is also able to take advantage of Bonus Depreciation. In the end, the total depreciation this doctor expenses this year is $125,000. Because of this deduction, they saved $46,250 in taxes! This allows the physician to be able to invest more now. Read more about this strategy here.
Further, when the property is eventually sold and the depreciation recapture comes due, it is taxed at a lower rate (25% rather than 37%) and the investor was able to use the tax savings to grow their net worth during the property's holding period.
These are hypothetical examples. Depreciation can be very complex, so it is imperative that you speak to a CPA about the right tax planning strategy for you.
Tax planning with real estate ownership can contribute significantly to wealth-building.