When buying investment properties, most people focus on the cash flow. However, there are greater benefits that are sometimes overlooked – rental property depreciation and tax benefits. It can get complicated but we want to lay it all out for you.
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Rental Property Depreciation
Depreciation is the loss in value to a building over time due to age, wear and tear, and deterioration. You can also include land improvements you’ve made and items inside the property that are not part of the building like appliance and carpeting.
Simply put, rental property depreciation allows investors write off the structure and improvements to the property over a period of time. This is an “expense” that you can use as a write-off on your taxes.
However, you can only depreciate the improvements to the structure itself -not the land.
Depreciation is one of the biggest benefits to real estate investing because it can reduce reportable net income and therefore, your taxes.
Basically, the IRS allows owners to take a tax deduction based on the perceived decrease in the value of the property over a period of 27.5 years.
Depreciation deductions are spread out over the “useful life” of a property. The IRS allows an owner to depreciate the value of the home over a 27.5 year period. Depreciation is calculated with this formula:
Cost of the Building- Value of the Land = Building Value
Building Value / 27.5 = Yearly allowable depreciation deduction
It would look like this for a property worth $75,000 and land worth $25,000;
$75,000 – $25,000 = $50,000
$50,000 / 27.5 = $1,818
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Landlords usually depreciate all of the things that can be depreciated, together with over the 27.5 year period. That’s a long time. What if you want to speed things up? You can use a method called cross segregation.
Rather than grouping all the items together, you can depreciate them individually.
It’s more complicated to do so and requires a lot of detailed record keeping but it means a bigger total depreciation each year for the first several years you own the property.
Personal property and land improvements have shorter depreciation periods than the building itself, usually, five or seven years so can be depreciated on an accelerated schedule.
The total deduction doesn’t change but you get it more quickly; you get them upfront rather than on the back end.
Why would you want to do that? Because if you take that money and invest it, it will have more time to grow and there is no substitute for time when it comes to growing money through investing.
This is all too complicated for you to do on your own but you can hire someone to do it for you. It can be pricey though so unless your property is valued at more than $250,000, it’s probably not worth the cost.
It’s common to have losses on a rental property in the first few years. Losing money on an investment is a bad thing but in the case of rental property, it can have tax benefits.
You have a loss if the total operating expenses for your rental are greater than the yearly rent you make on it.
You can even have a loss for tax purposes if your rental income is more than your expenses because you can deduct a certain amount of depreciation on your rental every year.
Passive losses can only offset passive income, you can’t deduct them from income you earn at your job for example.
If you don’t have enough passive income, the rental losses are in limbo. You can’t deduct them until you have a sufficient amount of passive income sometime in the future or until you sell the property. Because those losses can sit there for years, you have to plan properly or you can lose your losses!
A lot of the expenses incurred when owning a rental property can be written off at tax time. Expenses for maintaining and managing the property, including the salaries for those hired to work for or on the property like property managers or contractors like plumbers and electricians. Property taxes and utilities as well.
Expenses like advertising a property, commission to the broker listing the property, the expenses incurred when putting in tenants like background and credit checks, cleaning the property between tenants, all can be written off.
If you have out of state property, some of your travel expenses can be written off too. That doesn’t mean you get to buy one in Hawaii, lay on the beach for ten days and write it off 100%.
The primary purpose for the trip must be related to rental activity. Those can include going to look at possible rental properties, visiting to deal with issues at an existing property like repairs, or showing it to prospective tenants, or meeting with people who will help you either transact or run the property like real estate attorneys or management companies.
Things like recreational activities and sightseeing trips cannot be written off.
A 1031 exchange allows an owner to sell a property, use the money to buy a new property and defer capital gains taxes. In theory, you could defer paying capital gains on your rental property until you get hit by the bus!
There are rules to follow and criteria to meet but 1031 exchanges are one of the best tax avoidance strategies available to investors.
Where to Hold Rental Property
If you hold your rental property in a single owner LLC, only the LLC’s assets are at risk if you’re sued and not your personal assets. This is why many owners hold their properties in an LLC but there are tax advantages too.
Pass through taxation is one of the benefits of an LLC. Normally a corporation is directly taxed on its profits and the owners and taxed a second time on the income from the business.
An LLC allows the company’s income to pass through the business owner so all income made by the LLC flows through your personal tax return, minimizing the money taken out of your income for taxes.
The IRS frowns upon mixing business and personal expenses. When you create an LLC and a bank account for it separate from your personal account it makes it easier to keep the two separate when tax time comes around.
What if you live in one state and have rental property in another, or in more than one? It depends on the state where the property is located. You have to report the income on your federal and local state returns and may need to pay taxes where your property is located as well.
Mistakes Owners Make
Putting your property in an S Corp instead of an LLC is a mistake because it means the income is still being paid to you personally instead of a legal entity.
Not properly depreciating your property is a big mistake. If you didn’t know you could deduct it or forget to, the IRS will assume it has been taken. When you sell, you may pay taxes on depreciation recapture that you never actually benefited from.
If you haven’t taken it, it’s not too late. You can file an amended return and claim that lost depreciation.
Key Tax Strategies
Real estate income is considered passive income by the IRS because the money you earn is from the money you’ve invested, not from work you performed.
That income has to be reported on your tax return and you can deduct related expenses (mortgage interest, property taxes, etc) from that income.
Setting up an LLC, using cross segregation and a 1031 exchange are good ways to avoid taxes and another is a medical expense reimbursement plan. Setting up a MERP gives you a tax break on medical expenses. Medical expenses are reimbursed using pre-tax money. A MERP is deductible for your LLC and can be used to cover some medical expenses that traditional insurance doesn’t over like dental and vision.
Into the Weeds
This is high-level stuff for rental property owners but if you’re going to invest your money this way, you want to use every tactic in the book to get the most profit out of your property. Hiring someone like Craig who specializes in this area is a great investment if you own property.
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Craig Cody and Company: Craig’s CPA company.
Secrets of a Tax Free Life: Get a free copy of Craig’s book
Simple Wealth: Research and evaluate rental properties.