Depreciation Can Pay Off For Landlord

Published: 02nd March 2010
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Nursing Your Profit

A tactic that can help convert your cash flow into nontaxed income

Owning rental property may force you to spend more time than you'd like on toilets, trash, and troublesome tenants. Fortunately, the Internal Revenue Code may make the process less taxing.

One tax break is depreciation. You can gradually recover your purchase price and money spent on improvements with these deductions.

When you buy a property, you'll have to allocate a certain amount of the price to land. That is not depreciable.

The building itself can be depreciated.

If your purchase includes furnishings and fixtures, you should allocate their share of the cost to those items. They can be depreciated more rapidly than the base building.

The overall portion of depreciation will vary from property to property. An accountant or valuation expert can help provide a breakdown.

Tax rules let you use this tactic only with business property. A different depreciation schedule is applied to residential rental property that houses a factory or offices. The schedule reflects a property's expected useful life. You can't depreciate your own residence.

To see how this tax break might work, say you buy a rental property for $500,000. Rents you receive from tenants exceed all operating expenses by $30,000 this year.

Suppose you financed the purchase with a $400,000, 7%, interest only mortgage.

You pay about $28,000 in interest in this year: 7% of $400,000.

In this simplified example, your net operating income ($30,000) exceeds your interest expense ($28,000) by $2,000. So you'd pocket $2,000 in cash.

But depreciation can help convert cash like that into tax-free income.

Say you can take $20,000 of depreciation deductions this year.

Now you have a net loss of $18,000, for tax purposes. Your $20,000 of depreciation, a noncash deduction, converts your $2,000 to an $18,000 loss.

Because you're reporting a loss, you'll owe no income tax from the venture. You get to keep your $2,000, tax-free.

Passive Payoff

That $18,000 loss is called a "passive activity loss." It can offset passive activity profit.

Look what happens if you own another real estate property that shows a $24,000 profit this year. Your $18,000 passive activity loss can bring the taxable profit down to $6,000.

If you don't have passive activity profit to offset, you may get a loss dedecution if you actively participate in the venture. You must own at least 10% of the property. Also, you must make management decisions such as approving tenants and capital improvements.

Active participants with adjusted gross income (AGI) up to $100,000 can deduct as much as $25,000 of losses. The AGI number applies to single or joint returns.

Your possible loss deduction phases out if your AGI is over $100,000. At $150,000, passive activity losses aren't deductible.

Say your AGI this year is $120,000. You are 40% of the way through the phaseout range. Your loss deduction would be capped at 60% of the $25,000 maximum: $15,000.

In the above example, you have an $18,000 passive activity loss. With AGI of $120,000, you can deduct $15,000 this year. The other $3,000 loss ($18,000 minus $15,000) can be carried forward to an unlimited number of future years.

In the future, suspended passive activity losses can offset passive activity income, if you have any. When the property is sold, any unused losses will reduce the taxable gain from the sale.

Your suspended losses might be valuable then. That's because depreciation deductions reduce your basis and increase your tax on a sale.

Say the building you bought for $500,000 is sold after six years for $700,000.

If you have taken $20,000 of depreciation deductions each year for six years, that's a total of $120,000. This will reduce your basis in the property from $500,000 to $380,000.

So your taxable gain on a $700,000 sale would be $320,000. But if you have, say, $108,000 in unused passive losses, your taxable gain would drop to $212,000.

When you sell investment property, any depreciation deductions you have taken will be taxed, up to the extent of any gain. The tax rate will be no higher than 25%.

Taxman Taketh

In this example, you would owe 25% tax on $120,000 in depreciation deductions you have taken. If your total taxable gain is $212,000, the other $92,000 would be taxed at 15%, as a long-term capital gain.

You don't have to sell to pull appreciation from a rental property. you may refinance instead.

In the above example, your propety is now valued at $700,000. You might be able to use the property to secure a $560,000 (80%) loan.

You could pay off the old $400,000 loan and pocket $160,000.

The new loan may well require higher interest payments. But you have recieved $160,000 in cash, tax-free, in this example.$

Ray Buckner (Chicago, Illinois) provides personal financial planning and wealth management services for professionals in the greater Chicago metropolitan area. His primary focus is serving pre-retirees who are preparing for a successful retirement as well as those who have already retired and want to develop a 100% retirement income personal paycheck. His pre-retiree clients want to focus on replacing 100% of their last year’s income and keep their current standard of living through out their retirement adjusted each year for inflation.

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