TL;DR: Investing in real estate equity has a tremendous tax advantage enabled through the ability to write off depreciation expense. This write off will shield or limit your taxable earnings and reduce / eliminate any taxes owed in the early years of an investment. While the IRS eventually wants to collect taxes on that depreciation, you can defer paying those taxes with the use of 1031 exchanges, and you can avoid paying the taxes entirely if you later pass on your property to your heirs through your estate at death. This is one huge benefit to investing directly in real estate.
I love real estate equity investments. They’re one of the fastest ways I know to help you reach Ramen Retirement. With high cash flow yields (8-12% range), and overall annualized returns of 15% or greater, it’s hard to beat as a conservative anchor to your investment portfolio. Of course, there’s one more kicker that makes real estate equity investments even more attractive: preferential tax treatment of depreciation
The tax benefits of depreciation
With real estate investment properties, you are able to write off a certain percent of the building value every year. For residential buildings, you depreciate the value of the building over a 27.5 year period. This is a really powerful way to shelter your income in the early years of an investment, putting more cash in your pocket up front. For example:
- Assume your purchase a property for $100K, that has a land value of $20K, and a building value of $80K (you can figure this out based on the latest assessments / appraisals – see IRS here)
- That $80K can be depreciated in a flat rate over 27.5 years, which is equal to $2,909 per year in depreciation
- That depreciation is a non-cash expense, which means it reduces the amount of ‘profit’ you earn without impacting your actual cash flow in any way
- Assuming a 75% LTV mortgage at 5%, on a property generating 7% in net operating income (reasonable for many Midwest cities in 2018), the property will throw off $2,121 in cash flow (before tax), with a total profit of $3,250 including the principal pay down on the mortgage
- After deducting the $2,909 in depreciation, taxable profit drops to $341
- Assuming a ~37% marginal tax rate, total taxes are $126 – which equates to a 3.87% tax rate on the $3,250 in profit, and 5.95% on the cash flow
See the Ramen Retirement Life Earnings Calculator for details. Ask for access and I can share a version with you.
First 20 years of cash flow for an example rental property investment:
So in your first year of ownership, the effective tax rate on the cash flow you generate from a property could be as low as 5.95%. In fact, the property I modeled here is pretty compelling with an ~8% cash on cash return. Many properties in more expensive markets won’t get returns that high, meaning you might post ‘losses’ in the early years of ownership. The good news is you can save up those ‘losses’ and use them to offset profit from other investment property you own today, or in the future.
Who has access to this benefit?
Any equity owner of real estate property. You could own the property outright, or you could be an investor in a syndicate, and still take advantage of your pro-rata share of depreciation on the property to help shield your taxable income.
What happens to the depreciation in the future?
At this point you might be thinking this is too good to be true. You might be wondering what happens with that depreciation expense in the future? Well, the IRS views the depreciation as a reduction in the basis of the property. This means after 27.5 years, you’ll no longer be able to depreciate that building any further (unless you made capital improvements over that time period). From the perspective of the IRS, after 27.5 years, your building is valued at zero. Aside from no longer being able to expense depreciation, this won’t affect you until you decide to sell the building. But if you decide to sell, it can have some big implications.
If you simply sell the property and keep the proceeds, then the IRS will want to ‘recapture’ the depreciation you previously wrote off. Any depreciation you previously took on the property will now be taxed as ordinary income up to a maximum Federal rate of 25% (see here for a more detailed example). If you’re already in a really high tax bracket, this is a welcome tax break. But it can get even better – if you don’t need that money for an immediate purpose, there are ways you can defer or avoid paying back that depreciation entirely.
Do a 1031 Exchange
The most common approach for real estate investors will be to reinvest the proceeds of the sale into another real estate investment. If you identify a target property within 45 days, and close on that property within 180 days, then you can roll all of the proceeds into that new property and avoid paying any depreciation recapture or capital gains on the previous sale. The laws are pretty flexible on this, so you can pretty much invest from any type of real estate to any type of real estate:
Any type of investment property can be exchanged for another type of investment property. A single-family residence can be exchanged for a duplex, raw land for a shopping center, or an office for apartments. Any combination will work. The exchanger has the flexibility to change investment strategies to fulfill their needs. Source
This is an incredible way to roll your money into a larger deal and defer a hefty tax payment. For details on how to execute a proper 1031 exchange start here. Theoretically, you can keep rolling your depreciation and gains into future deals indefinitely. This is perhaps the only major downside to investing in a syndicate – the LLC structure of most syndicates means that it will be more difficult for you to roll the proceeds of one deal into another real estate deal cleanly. It can be done, but you need to work with the deal sponsor and make sure they are open to that. Also, you will be limited to investing in a deal offered by that same sponsor, as it will require them rolling that LLC structure over to another property.
Wait until you’re in a lower tax bracket to sell
Another way to limit the amount of tax you pay would be to wait until you’re in a lower tax bracket to sell. If you expect to have limited income in a given year, it might make sense to sell and take the depreciation recapture and capital gains in that year. Of course, this isn’t always possible, particularly if you have a large base of cash generating assets already.
Wipe out depreciation recapture through your estate
Finally, the ultimate move is to pass on your property through your estate. When you die, any property passed on through your estate gets a ‘step up’ in basis to the current market value. This will also wipe out any outstanding ‘depreciation recapture’ associated with the property, thereby permanently changing the tax deferral to an outright tax savings. Yes, this requires dying to do it properly, but your heirs will thank you, and you can rest peacefully knowing that you managed to ‘optimize’ your tax situation to the end. Better for your heirs to have your wealth rather than the black hole that is the Federal or State budgets.
I hope you can see now why I’m such a fan of equity real estate investments. As a high income earner living in the highest income tax state in the nation (California), any way to defer taxes becomes a big deal from the perspective of cash flow and reaching Ramen Retirement. Real estate has some of the most advantageous tax laws on the books, allowing you to defer almost indefinitely a large portion of your profits. Run the numbers yourself by playing with the Lifetime Earnings Calculator, and I think you’ll agree. It’s worth figuring this one out!
- Ramen Retirement Lifetime Earnings Calculator
- Depreciation capture tax rate
- Tax implications of depreciation – Bigger pockets
- Example of depreciation recapture
- IRS guidance on depreciating investment property
Example of determining building cost basis for depreciation purposes:
You buy a house and land for $200,000. The purchase contract doesn’t specify how much of the purchase price is for the house and how much is for the land.
The latest real estate tax assessment on the property was based on an assessed value of $160,000, of which $136,000 was for the house and $24,000 was for the land.
You can allocate 85% ($136,000 ÷ $160,000) of the purchase price to the house and 15% ($24,000 ÷ $160,000) of the purchase price to the land.
Your basis in the house is $170,000 (85% of $200,000) and your basis in the land is $30,000 (15% of $200,000).
For some other helpful tax tips and tricks, check out Brandon Hall’s article on real estate taxes. The most helpful tips from this were:
- Passive losses that can’t be used this year, can be saved for the future
- Short term rentals are reported on Schedule C, and are subject to self employment taxes (be careful with Airbnb!)
- You can only deduct costs to rehab units if you’re already an active investor in that market, or if you have the property listed for rent
- You can have your child work for your corporation, pay them $5,500 and then deposit that directly into a Roth IRA in their name