The U.S. Congress, through provisions in the Internal Revenue Code, encourages real estate investments by giving investors five special tax treatments. The first three may increase the real estate investor’s income while the last two may enhance capital gains.
1. Depreciation Is Tax Deductible Investors in real estate become successful by understanding the “numbers” of real estate investing. For example, assume that Jisue Han, a lawyer from Huntsville, Alabama, invested $200,000 in a residential building ($170,000) and land ($30,000). She rents the property to a tenant for $24,000 per year. You might think that Jisue has to pay income taxes on the entire $24,000 in rental income. Wrong. IRS regulations allow taxpayers to deduct depreciation from rentalincome. Depreciation represents the decline in value of an asset over time due to normal wear and tear and obsolescence. A proportionate amount of a capital asset representing depreciation may be deducted against income each year over the asset’s estimated life. Land cannot be depreciated.
Jisue can deduct an equal part of the building’s cost over the estimated life of the property. IRS guidelines provide that residential properties may be depreciated over27.5 years while nonresidential properties are allowed 39 years. Jisue calculates (fromTable 16.1) the amount she can annually deduct from income to be $6182 ($170,000 27.5). Table 16.1 shows the effects of depreciation on her income taxes, assuming Jisue pays income taxes at a combined federal and state rate of 36 percent. In this example, the depreciation deduction lowers taxable income on the property from $24,000 to $17,818 ($24,000 $6182) and increases the return on the investment to 8.79 percent.
2. Interest Is Tax Deductible Real estate investors incur many business expenses in attempting to earn a profit: interest on a mortgage, real estate taxes, insurance, utilities, capital improvements, and repairs. The largest of these costs often is the interest expense, as properties are often purchased with a mortgage loan. Table 16.2 illustrates the effect of interest expenses on income taxes. Assume Jisue borrowed $175,000 to purchase her $200,000 property. After deducting annual depreciation of $6182 and interest expenses of $13,050, her taxable income is reduced to $4768. Because her income tax liability is only $1716, Jisue’s after-tax return of $9234 yields 36.94 percent on her leveraged investment.
1. Depreciation Is Tax Deductible Investors in real estate become successful by understanding the “numbers” of real estate investing. For example, assume that Jisue Han, a lawyer from Huntsville, Alabama, invested $200,000 in a residential building ($170,000) and land ($30,000). She rents the property to a tenant for $24,000 per year. You might think that Jisue has to pay income taxes on the entire $24,000 in rental income. Wrong. IRS regulations allow taxpayers to deduct depreciation from rentalincome. Depreciation represents the decline in value of an asset over time due to normal wear and tear and obsolescence. A proportionate amount of a capital asset representing depreciation may be deducted against income each year over the asset’s estimated life. Land cannot be depreciated.
Jisue can deduct an equal part of the building’s cost over the estimated life of the property. IRS guidelines provide that residential properties may be depreciated over27.5 years while nonresidential properties are allowed 39 years. Jisue calculates (fromTable 16.1) the amount she can annually deduct from income to be $6182 ($170,000 27.5). Table 16.1 shows the effects of depreciation on her income taxes, assuming Jisue pays income taxes at a combined federal and state rate of 36 percent. In this example, the depreciation deduction lowers taxable income on the property from $24,000 to $17,818 ($24,000 $6182) and increases the return on the investment to 8.79 percent.
2. Interest Is Tax Deductible Real estate investors incur many business expenses in attempting to earn a profit: interest on a mortgage, real estate taxes, insurance, utilities, capital improvements, and repairs. The largest of these costs often is the interest expense, as properties are often purchased with a mortgage loan. Table 16.2 illustrates the effect of interest expenses on income taxes. Assume Jisue borrowed $175,000 to purchase her $200,000 property. After deducting annual depreciation of $6182 and interest expenses of $13,050, her taxable income is reduced to $4768. Because her income tax liability is only $1716, Jisue’s after-tax return of $9234 yields 36.94 percent on her leveraged investment.
Tax laws permit investors to deduct interest expenses (with the amount of the deduction allowed depending on the investor’s marginal tax bracket). The interest deduction gives Jisue a cash flow after paying mortgage interest of $10,950 ($24,000 - $13,050). In essence, the $13,050 in interest is paid with $4698 ($13,050 x 36 percent combined federal and state income tax rate) of the money that was not sent to the federal and state governments and $8352 ($13,050 - $4698) of Jisue’s money.
3. Rental Income Tax Regulations on Vacation Homes If you rent out your vacation property for 14 or fewer days during the year, you can pocket the income tax-free, regardless of how much you charge. The IRS does not want to hear about this gain. The home is considered a personal residence, so you can deduct mortgage interest and property taxes just as you would for your principal residence. Renting a vacation home for more than 14 days turns the endeavor into a business, and you must report all rental income. You also can deduct rental expenses up to the level of rental income you report. When your adjusted gross income (AGI) is less than $100,000, a maximum of $25,000 of rental-related losses may be deducted each year to offset income from any source, including your salary. The $25,000 limit is gradually phased out as your AGI moves between $100,000 and $150,000. This ability to shelter income from taxes represents a terrific benefit for people who invest in real estate on a small scale.
4. Capital Gains Are Taxed at Reduced Rates Capital gains on real estate are realized through price appreciation. For most taxpayers, long-term capital gains are taxed at a rate of 15 percent, and taxpayers in the 10 to 15 percent tax brackets pay a long-term capital gains tax of 5 percent.
5. Tax-Free Exchanges Another special tax treatment results when a real estate investor trades equity in one property for equity in a similar property. If none of the people involved in the trade receives any other form of property or money, the transaction is considered a tax-free exchange. If one person receives some money or other property, only that person has to report the extra proceeds as a taxable gain. For example, assume you bought a residential rental property five years ago for $220,000 and today it is worth much more money. You trade it with your friend by giving $10,000 in cash for your friend’s $280,000 single-family rental home. Your friend needs to report only the $10,000 as income this year. In contrast, you do not need to report your long-term gain, $50,000 ($280,000 - $10,000 - $220,000), until you actually sell the new property.g-term capital gains tax of 5 percent.
3. Rental Income Tax Regulations on Vacation Homes If you rent out your vacation property for 14 or fewer days during the year, you can pocket the income tax-free, regardless of how much you charge. The IRS does not want to hear about this gain. The home is considered a personal residence, so you can deduct mortgage interest and property taxes just as you would for your principal residence. Renting a vacation home for more than 14 days turns the endeavor into a business, and you must report all rental income. You also can deduct rental expenses up to the level of rental income you report. When your adjusted gross income (AGI) is less than $100,000, a maximum of $25,000 of rental-related losses may be deducted each year to offset income from any source, including your salary. The $25,000 limit is gradually phased out as your AGI moves between $100,000 and $150,000. This ability to shelter income from taxes represents a terrific benefit for people who invest in real estate on a small scale.
4. Capital Gains Are Taxed at Reduced Rates Capital gains on real estate are realized through price appreciation. For most taxpayers, long-term capital gains are taxed at a rate of 15 percent, and taxpayers in the 10 to 15 percent tax brackets pay a long-term capital gains tax of 5 percent.
5. Tax-Free Exchanges Another special tax treatment results when a real estate investor trades equity in one property for equity in a similar property. If none of the people involved in the trade receives any other form of property or money, the transaction is considered a tax-free exchange. If one person receives some money or other property, only that person has to report the extra proceeds as a taxable gain. For example, assume you bought a residential rental property five years ago for $220,000 and today it is worth much more money. You trade it with your friend by giving $10,000 in cash for your friend’s $280,000 single-family rental home. Your friend needs to report only the $10,000 as income this year. In contrast, you do not need to report your long-term gain, $50,000 ($280,000 - $10,000 - $220,000), until you actually sell the new property.g-term capital gains tax of 5 percent.
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