Last week I wrote about the 1031 Exchange and the common misconceptions that many individuals have regarding the wealthy and how much or how little tax they actually end up paying. In an nutshell, the tax code and it’s advantages were written for ALL Americans to utilize, not just the wealthy, though they are the ones that have taken the time to understand it and how it can work to their advantage. The 1031 Exchange is one such advantage that saves real estate investors a lot of money in deferred taxes. I encourage you to go back and read that article here, if you haven’t already.
Another tax advantage in real estate (and my favorite) is Depreciation expense. Below is a brief definition of Depreciation expense from the Internal Revenue Service as it pertains to rental properties. If you want to do further reading on this, you may do so directly on irs.gov by clicking here.
Depreciation of Rental Property: You recover the cost of income-producing property through yearly tax deductions. You do this by depreciating the property; that is, by deducting some of the cost each year on your tax return.
Depreciation basically allows you to deduct a percentage of the cost of your rental every year from your income on that property. That percentage is derived by taking the cost of your property and dividing it by 27.5 years. This is the number of years that the IRS has decided it takes for a piece of real estate to become “obsolete.” Therefore, they allow you to take that much as an expense each year for the duration in which you own this property.
For example, let’s say that I bought a piece of property for $100,000. The property generates a net income of $4,800 per year (after all expenses, mortgage interest, insurance, maintenance, etc.). This means that I have a taxable income of $4,800. However, you may also subtract depreciation as an expense. You are not allowed to depreciate land, therefore you must subtract the value of the land from the total amount. Let’s assume for this example, that out of the $100,000, the land is worth $20,000. This means that I can depreciate the difference, $80,000, from my taxable income. $80,000 divided by 27.5 years is $2,909. The IRS actually allows you to subtract that amount from your rental income as an expense every year, making your taxable income only $1,890. In the eyes of the IRS, you only made $1,890 on that property and therefore must only pay tax on that amount, not the actual net income of $4,800. After the 27.5 years, your property is fully depreciated and you may no longer take this expense.
Of course we all know that this was not a “real” expense. It is what is called a “phantom” loss and it is 100% legal. This is a tremendous advantage to real estate investors, saving them a lot of money every year in taxes. The origin of “rich people don’t pay taxes” may be rooted in the concept of depreciation, given that this “expense” on a rental purchased at the right price with the right income, could potentially bring your taxable income close to zero if not below zero, allowing you to not have to pay any income tax on your rental income. Again, depreciation expense is not available only to the wealthy. It is available to ALL Americans. It is blatantly written out in the tax code and publicly available to everyone to read, understand, and utilize. Those that condemn the wealthy for not paying taxes don’t understand that they themselves could be using the same tax code to their own benefit. Our educational system, and society, just don’t do a good enough job of teaching these types of principles.
Depreciation expense is probably the most powerful tax advantage available to investors, making real estate an incredibly desirable asset class to hold. I cannot stress enough the power of real estate as a wealth building tool. Those that manage to get into it and understand it, will build tremendous long term wealth. Everyone should be investing in real estate and understand it’s tax advantages. Again, the next time you find yourself at a party and hear someone complain that the rich just get richer and don’t pay any taxes, please stop them and make sure to respectfully inform them that they are incorrect (and feel free to link them to this article, it may inspire them!).