If you didn’t catch the first part of the TwoWiseAcres quick and dirty guide to taxes for the real estate investor, you might want to check it out. In the first part, I walked through reporting income and expenses for rental properties on Schedule E. In this part, I’m going to cover the basics of depreciation. I’m going to focus on calculating depreciation for the first year of a new investment purchase, but I’ll touch on depreciating capital expenditures incurred later on as well.

If you followed my advice in part one, you should now be well rested and/or liquored up. So, once again, let’s get busy.

Starting to Depreciate a Residential Rental Investment

Depreciation is essentially recovering the cost of an item (or “expensing” an item) over a number of years. To determine depreciation for tax purposes, you have to know three things: the basis, your start date for depreciation, and the depreciation period for the property.

Basis is generally cost. For a rental property, the cost includes a portion of the purchase price, expenses associated with the purchase (i.e. closing costs), and initial rehab or fix-up costs. The “portion” of the purchase price is the portion attributable to the house, and not the land. Since land is not depreciable, you’re required to divide the purchase price between the land and the building by their fair market values. There are a couple of ways to tackle this. First, you can base the allocation of the purchase price between land and building based on the assessed value for property tax purposes. For most, this means that you can go to your county auditor website which will assign a separate taxable value for the land and building and then use the percentage allocation used by the auditor to allocate your purchase price. Second, you can make your own fair market determination, as long as there’s a basis to do so. I use a standard percentage division between land and building of 20% and 80%, respectively, which I pretty much came up with from looking at assessed values to begin with. For those starting out, you’ll want to refer to the tax assessed values for your area rather than just adopt my percentage split.

Depreciating Closing Costs

For the closing costs component, you’ll probably need to refer to your Settlement Statement (or “HUD-1 Form”), but you’ll need to exclude any “pre-paids” that are typically listed as buyer’s expenses, such as pre-paid interest, property taxes, and insurance. Those items will generally be reported as expenses for the year of purchase, so they are not included in the cost basis of the property.

Depreciating Initial Rehab Costs

Fix-up costs include every expense that you incur to put the property in rent-ready condition. This is going to include items spent during the initial fix-up period that might otherwise be treated as current deductible expense items down the road. For example, your rehab will likely involve interior painting, which has to be treated as part of the basis of the property at the outset, but which would be fully deducted in the current year when you re-paint, say, at the time a tenant leaves. Why? Well, that’s what the tax code says.

Determining the Start Date for Depreciation of Rental Property

So now you’ve calculated the basis—i.e. the amount that you’re going to depreciate–now you need a start date. You start depreciating a rental property not when you buy it, but when the property is rent-ready. There’s a little bit of a judgment call here. If you buy it in January, but you’re doing a major rehab into March, then depreciation starts in March. But I almost always find that I have some punch out repairs that might even extend after the property has been rented. So, I’m generally going to pick a start date right around when I can show or advertise the property as a finished product.

For the start date, you actually just need a start month. The IRS helpfully has determined the day during the month that depreciation begins. It’s the 15th. The story goes that the IRS had originally started drafting a complicated set of rules to narrow the start date right down to the day, but got tired and ended up with the 15th, collectively reasoning “close enough.” Now, I could use some fancy IRS terminology like “mid-month convention”, but I’m going to just repeat—it’s the 15th. So if you finish your rehab on March 2, you’re depreciation start date is March 15. Close enough.

Determining the Depreciation or Cost Recovery Period for Rental Property

The last piece in the depreciation puzzle is the depreciation period (or “cost recovery” period in IRS parlance). Here’s where the IRS starts with its explanation:

MACRS consists of two systems that determine how you depreciate your property—the General Depreciation System (GDS) and the Alternative Depreciation System (ADS).

Since the whole purpose of this article is specifically not to use terms like “Modified Accelerated Cost Recovery System,” I’ll just cut to the chase. For the most part, two periods will be applicable to about any depreciable property for residential real estate investing. The first is the depreciation period for the house itself. It’s 27.5 years. This depreciation period also applies to about any major depreciable item that you attach to the house—such as a roof, a major kitchen remodel, window replacement, etc. Then there’s the period that applies to about anything that you put in the house. It’s 5 years. This applies to things like kitchen appliances, carpet, and furniture.

The Depreciation Calculation—the Straight Line Method

Now we have all of the necessary information to do the math. For most, depreciation will be calculated using the straight-line method—which means the depreciation deduction for each full year of depreciation period will be the same. To calculate a year’s depreciation, you divide the cost by the depreciation period. For the year that you start depreciating (as well as the last, when you sell it), you’ll be calculating depreciation based on the partial year. Let’s take our example of the property that was ready for rental on March 2 and assume that the cost including rehab is $100,000.

The annual depreciation amount is $100,000 divided by the depreciation period of 27.5 years which equals $3636.36. For the first partial year, the depreciation amount is calculated for 8 full months plus ½ month for March (if you didn’t catch it before—our start date is the 15th). The calculation is 8.5 months divided by 12 months times the annual depreciation of $3636.36 which equals $2575.76. If you bought some appliances for the home, the calculation is essentially the same but using a 5 year period to determine the annual depreciation.

The depreciation deduction for subsequent years, until the year of sale, will be the annual depreciation amount each year. In the year of sale, the partial year’s depreciation calculation will be the same as the first year’s. That is, you’ll figure the partial year’s depreciation up until the date of sale, but will treat the sale as occurring on the 15th day of the month in which the property was sold. Again, close enough.

Depreciating Capital Expenditures for Rental Property

If you incur a capital expenditure after the year of purchase, such as replacing a roof, the expenditure will be depreciated as a separate item. In other words, for tax reporting purposes, you’ll separately depreciate the roof over a 27.5 year period, calculating depreciation in the same way as you calculated depreciation of the home itself, including using a start date of the 15th day of the month in which the roof was installed.

As a final note, I’ll point out that there are alternatives to using a straight line method of depreciation and alternatives to using the depreciation periods referenced above. Different rules may also apply to property purchased prior to 1986. But this, my friends, is where I hop off the train. If you need more information on depreciation or alternatives available, a tax advisor may be in order. In the meantime, I’ll just wish you all a happy tax freedom day, which I believe falls somewhere in late April these days. Here’s hoping that taking advantage of some depreciation deductions will move it a bit earlier.

It’s tax time once again. And if you’re a real estate investor and you’re anything like me, it is about this time every year when you contemplate switching your investment portfolio to something like a savings account. Granted, savings accounts return about 1.5% per year, but at least you don’t have to fill out another Schedule E. Well, to attempt to help remove some of the pain for my fellow investors, I decided to put together the TwoWiseAcres quick and dirty guide to taxes for the real estate investor. I’m going to quickly cover the basics, but will be so bold as to run through some rules for calculating depreciation deductions.

Let’s all just keep one thing in mind at the outset. I will warrant this information only to the extent of Rob’s contribution to the process of calculating our taxes on the TWA investments. This, as you can imagine, is the most limited of the limited warranties. I will say, however, that this article generally covers the process that I follow in preparing my return, and I’m still a free man. So, with that said, let’s get busy.

Reporting Taxable Income from Residential Real Estate

For the beginners, if you haven’t figured this one out yet, taxable income and loss for residential real estate is reported on Schedule E. If you are using any form of accounting software to track your income and expenses, it’s probably a good idea to set up your accounts (either “chart of accounts” or “categories” or whatever terminology your software uses) to pattern the income and expense categories of Schedule E.

As a real estate investor, your primary income will be from rents. But you may also have other income, such as application fees, late fees, and what have you. For Schedule E tax purposes, you only have two choices for reporting all income—“Rents Received” and “Royalties Received”. Unless you are a songwriter, as well as real estate investor, in all probability, you can ignore the “Royalties Received” part. (If you haven’t guessed, Schedule E isn’t just for real estate investor types). So, all rents and fees paid by tenants will be reported as “Rents Received.” For software tracking purposes, consider setting up subaccounts under a primary “Rents” account to the extent that you want to separately track other specific fee items.

Reporting Taxable Expenses from Residential Real Estate

Most of the Schedule E expense categories are relatively self-explanatory, and many follow how you would probably track your expenses in any event. For example, Schedule E expense categories include advertising, insurance, utilities, and legal and professional fees. However, a few categories deserve a little explanation. For example, two of the Schedule E expense categories are “Cleaning and Maintenance” and “Repairs”. So, when you send the handyman out to fix the handle on the toilet so it stops running in perpetuity, have you just incurred a “maintenance” cost or a “repair” cost. My simple answer: Who cares? The effect on your taxable income or loss is the same regardless of which category you use, so let’s not get too hung up here. As a rule of thumb, I’ll categorize items like lawn care, painting, cleaning, and the like as maintenance and expenditures to fix the thing that isn’t working as a repair and most importantly not spend more than 10 seconds to debate the difference.

Schedule E expenses, of course, include a line item for mortgage interest. The interest portion of your mortgage payment is deductible. The principal portion is not. Since I’m generally more interested in tracking cash flow for my properties on a monthly basis, I will track my mortgage payment (both principal and interest) as an expense. This allows me to run a profit and loss report that is really reporting my cash flow. In short, this method is both a software “workaround” and a reflection of the fact that I don’t want to manually enter a mortgage payment each month that breaks down principal and interest. So, I have to do some year-end adjustments for tax purposes. Since mortgage lenders are required to issue Form 1098s to you, as borrower, that show the interest paid for the calendar year, the adjustment is a relatively simple one. Use the amount reported on Form 1098 to report Schedule E mortgage interest. (But periodically check the bank’s reporting of interest against your own amortization schedule. They do, in fact, make mistakes from time to time.)

Schedules E includes categories for “taxes” and “insurance”. For the real estate investor, the taxes category means property taxes. Insurance includes property insurance and mortgage insurance (if your loan required mortgage insurance). Pretty straightforward, but there are a couple of things to keep in mind here. If your mortgage loan requires that you pay taxes and insurance into escrow, the amounts you pay into escrow may not (and, in fact, probably won’t) reflect your actual expenses for these items. Banks set up escrow accounts to make sure these items get paid. The mysterious calculations that the banks use to calculate your contribution to this escrow account are designed to insure that the bank has enough of your money the cover the costs as they arise. What will never ever ever happen is the bank advancing these expenses because there wasn’t enough in your escrow account to cover the costs. That means that there will always be more than enough in the escrow account to cover anticipated costs. Your expenses, for tax purposes, are the actual expenses paid by the bank from the escrow account. For property taxes, you can again refer to Form 1098. Mortgage lenders maintaining an escrow are required, as with mortgage interest, to report property taxes paid on your behalf for the year on this form. As with mortgage interest, the occasional check against the county auditor’s records (mostly available online) wouldn’t hurt.

Insurance is a bit different. Form 1098 includes mortgage insurance; it doesn’t include property insurance. So, you need to know what your mortgage lender paid from the escrow account for property insurance during the calendar year. Most larger mortgage lenders provide online access to reports of escrow activity during the year. (They also should have sent you a statement of escrow activity that will show this expense). Otherwise, you may have to thumb through your monthly mortgage statement to extract the information. Typically, property insurance is paid in one annual premium, so it shouldn’t be that difficult to find if you haven’t tracked it during the year.

Finally, Schedule E includes a category for “other” expenses. My advice—track your expenses as “other” expenses sparingly. You’re going to have to include an itemized list for this category for the IRS’ amusement and edification. So, it’s best not to use other as a casual default category. I will typically have costs such as credit reports, lockboxes, and the like here.

So there you go. You now have your Schedule E Income and your Schedule E Expenses. The result is your net income before depreciation, or in Schedule E terms, your “add lines 5 through 18”. Calculating depreciation is always just a bit—how shall I put this?—maddening. So, let’s all take a break, grab a short nap, perhaps a beer, and then return for the next part on calculating depreciation.

In the meantime, if you still have questions on the income and expense side of Schedule E, here’s a handy IRS publication for your reference. It might just answer a couple of questions that I haven’t covered, but I warn you, it’s not for the feint of heart.

Earlier this week, Rob wrote an article about 1099-Misc filing requirements for real estate investors. After the bellyaching about my lack of timeliness, he noted that an electronic filing option is available but wrote that we use the paper filing method. There’s a reason.

Unlike most tax forms, which can be obtained in fillable format from the IRS website and printed for filing, the IRS still requires certain forms, such as W-2s and 1099s, to be filed in a format that can be optically scanned. This means that the old laser printer won’t comply with the IRS requirements, and the IRS can even assess a penalty to emphasize the point. While the IRS does indeed accept electronic filing of 1099 data, it has to be transmitted in a particular format which requires specialized software. For the individual real estate investor, it probably doesn’t make sense to purchase the software at a price of $85 or more to do the job.

But where Rob’s all about problems, I’m about solutions.

Low Cost Online Filing Options for 1099-Misc Forms

I’ve recently run across some online filing solutions for getting the job done.

PayCycle offers on online service for filing 1099s. The service allows you to print 1099s for mailing to the recipients and files the information on your behalf with the IRS. $39 will get you up to 50. That’s about the price for a forms and template kit at the office supply stores.

Here’s another option, which may be our winner. Cleverly named, FileTaxes.com offers an e-filing option for $3.79 a crack. If you have only a few 1099 forms to file, this may be the option for you.

Official disclaimer: We haven’t tried either of these services yet. Two reasons here. First, I didn’t know about them until today. Second, it was pretty funny hearing about Rob running around trying to find the last of the paper forms yesterday.

The mailing deadline for recipient copies is today, so get on it!

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The deadline for issuing Form 1099-Misc to contractors reminds me of my anniversary. I know when it is every year because the date never changes, yet some how I’m always racing around the day before trying to stave off disaster. Well not this year, I told myself. The Form 1099s must be sent to contractors whom we’ve paid at least $600 in the past year by January 31, 2008. Mike and I always divide the labor on this one. He gets me all the data, and I complete the forms and send them out. He was going to get me the data weeks ago. So far I haven’t received it, and he’s out of town until Monday (which means, among other things, that he can’t edit this post). So here we go again. But I thought this would be a good time to review the 1099 rules for real estate investors:

• Who gets a 1099: Each person to whom you paid during the past year at least $600 in services. Payments to a corporation generally are not reported on Form 1099. Certain payments to lawyers are reportable regardless of amount. You can check out the details in the IRS Instruction for Form 1099-MISC.
• Deadline: Form 1099s must be sent out to the contractors by January 31, 2008. They are due to the IRS by February 28, 2008, unless you’re file them electronically, in which case the due date is March 31, 2008.
• Penalties for late filing: There are a range of penalties for filing the 1099 late, generally up to $50, although it can be much higher in extreme cases.
• Don’t forget state filing requirements: The requirements vary from state to state as to whether you are required to file a 1099, so be sure to check your state’s requirements.

How to prepare 1099s

Although you can file electronically, we never have. We buy a Form 1099 packet from Staples and prepare our own. In a typical year we issue fewer than 10, and I think this year we’ll issue fewer than 5. Staples and other office supply stores sell the forms bundled with software for data entry and printing. The process is simple and only takes a few minutes once you have all the data collected.

Now if I could only get Mike to send me the #@!% data!

Depreciation is one of the great tax advantages to real estate investing. But as the tax man giveth, he taketh away. With real estate, the taketh-ing is by means of depreciation recapture. Recently, in response to Mike’s article about depreciation deductions for real estate investors, a reader asked about the effect of those deductions at sale. In this article, I’ll describe how depreciation recapture works with an example and a link to a depreciation recapture calculator.

How Depreciation Recapture Works with Real Estate Investments

Under current tax law, residential rental property generally is depreciated over 27.5 years. This means that each year you can offset rental income by the cost basis of your rental property (but not the land) divided by 27.5. For example, if you a property costs $125,000 (price plus rehab costs), and $100,000 represents the portion of costs allocated to the home, a depreciation deduction could be taken each year in the amount of about $3,636. This amount can offset rental income, and along with other deductions such as interest, insurance and repairs, may result in a net tax loss for the year. As long as your income doesn’t disqualify you from taking the deduction, you can also deduct up to $25,000 of losses from your ordinary income. So, depreciation can be a powerful financial benefit to real estate investors.

But there’s no free lunch. Depreciation recapture comes from the Taxpayer Relief Act of 1997, which imposed the higher tax rate for all IRC Section 1250 gains, which for our purposes means all rental property investments. When you sell the property, you must “recapture” any depreciation you’ve taken (or could have taken). Consequently, a portion of your gain equal to the amount of depreciation you’ve previously taken is taxed at 25%, rather than the 15% long-term capital gains tax rate.

An Example of Depreciation Recapture upon Sale of a Rental Property

Returning to our example, assume you purchase a rental property for $125,000. Over the period you plan to own the home, let’s assume you depreciate $25,000 per IRS rules, and then you sell the property for $160,000. At sale, your adjusted basis in the property is $100,000 ($125,000 – $25,000) resulting in a tax gain of $60,000. Because your gain exceeds the amount of depreciation taken, the depreciation recapture rule will apply. As a result, your tax will not be $9,000 ($60,000 x 15%), but $6,250 ($25,000 x 25%) +$5,250 ($35,000 x 15%), or $11,500. Thus, the depreciation recapture rule costs you $2,500 more in taxes in this example.

I recently came across a calculator that will show you the tax on your gain, including the depreciation recapture. You can access the calculator here. The point of this particular calculator is to promote the benefits of a 1031 exchange, but it may prove helpful in getting an idea of your tax liability.

The Tax Upside and Downside to Depreciation for the Real Estate Investor

Depreciation recapture is a reality if you sell a property for a gain and pocket the money. However, the depreciation deduction can still represent a net gain to the investor. First, your federal marginal tax rate at the time of taking depreciation deductions may be 28%, while the tax on that depreciation at the time of sale will be 25%. Second, you’re repaying today’s tax savings with tomorrow’s dollars. Third, if the gain attributable to the building is less than the amount of depreciation taken, then you may not have to recapture all of the depreciation. This could happen, for example, where the rental property has aged significantly, and the land becomes the more valuable part of the property.

Finally, by taking advantage of a 1031 like-kind exchange, you may be able to further defer all taxes on the sale, including depreciation recapture. Previously, we’ve written about 1031 exchanges that, in addition to discussing tax avoidance strategies, also resurrects the word “moxie.” (That part was Mike). As always, you should consult a tax professional before making any tax-planning decisions. For our part, we’ll be returning to the topic of 1031 exchanges in the future to provide a further look at 1031 exchange options, and I’ll see what I can do about using terminology strictly from this century.

As we approach the end of the year, it is a time to reflect on the year, to celebrate the season, and for some of us, to begin a three and a half month long curse of the tax man. Even as many W-2 employees start to look forward to the largesse of “free money” in the form of a tax refund check, the self-employed and small business owners among us begin a low grumble that crescendos on April 14 into a full tirade on the evils of self-employment tax, and with all conviction, proclaim that tax withholding regulations tear at the very fabric of our Democracy.

I am among the latter.

But in the spirit of the season, we should attempt to focus on the things for which we are grateful, the blessings bestowed upon us. It is not to minimize the benefits of friends, family and the true blessings of life to say that I find comfort, in the context of these troubled thoughts of taxation, in losses. Preferably the tax kind.

For the real estate investor, rental property can provide substantial tax benefits through “tax losses.” In this article, I will provide an overview of how rental property provides tax savings through losses against ordinary income, reducing your tax bill now.

Income Tax on Rental Income

Rental income, like business income, is taxable net of expenses. In other words, the amount subject to tax is profits–gross rents less all ordinary and necessary expenses, such as maintenance and repair costs, property taxes, mortgage interest paid, and advertising costs.
The real tax benefit of rental property, however, is depreciation. While rental property will generally appreciate over time, for tax purposes, it is considered a depreciating asset. So, tax law provides for a depreciation deduction in calculating rental income or loss for rental property.

Calculating Depreciation for Rental Properties

Depreciation on residential real estate is calculated by dividing the cost of purchasing the home (price plus most closing costs) by 27.5 years. Since the costs of purchase generally includes land, which is a non-depreciable asset, the costs must be allocated between land and building based on the their fair market values. Typically, this allocation is made based on the tax assessed value of the property. For example, for a rental property with a cost of $100,000, assuming we allocate 80% of the costs to the home and 20% to the land, then the depreciation deduction would be $2909 ($80,000 divided by 27.5) per year. So if, for our $100,000 property, we have net income or profits before depreciation of $1500, we will still have a tax loss of $1409–a loss than can be deducted against ordinary income. Losses for tax purposes; profits for all others. That’s roughly where we were on The Ranch last year. Apply that across a few properties, and it starts to add up to real money.

As with all good things, certain limitations and restrictions apply. The deduction of losses against ordinary income starts to phase out for incomes in excess of $100,000, and the maximum deduction is $25,000 annually, although for real estate professionals (investors spending more than 500 hours annually in the biz) are not subject to the maximum deduction limit. Oh, and as is universally true of all things good, batteries are not included.

So, as I begin the process of closing out the financial year and preparing for the day of tax reckoning, it’s nice to know that I have at least the one tax advantage working for me. A thought that I can take comfort in as I sit in front of the Christmas tree wondering “Is there a way to write that off?”

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Congress wants to help those who’ve lost their home to foreclosure. One bill that has passed in the House and is racing through the Senate would do just that by getting rid of what I call the “kick’em when they’re down” tax. Under current law, if a mortgage lender forgives some portion of a homeowners debt, the amount of debt forgiven is taxable as income to the homeowner. So not only does a family lose its home, presumably because of a financial crisis, but they end up owing thousands of dollars in income taxes to the IRS. Under the proposed bill, this income would no longer be taxable.

So how do those who own second homes fit into this equation? It’s called pay as you go or the “Paygo ” rule. The Democrats have implemented the Paygo rule, which means that all proposed tax cuts must be paid by either new tax increases or spending cuts. To pay for the proposed tax break, the House bill restricts the ability of a homeowner to avoid or reduce the tax bill on the sale of a second home.

Today, you can avoid taxes on the first $250,000 of gain from the sale of a home ($500,000 if married) so long as you have lived in the home as your primary residence for two of the last five years. A second home can become a primary residence under current law if the homeowners move in for the two year minimum requirement, which many folks do at retirement. The proposed bill would change all this. Instead of the two year requirement, the tax break would be tied to the percentage of time the second home was used as the primary residence. If you owned the second home for 10 years, five of which you used it as your primary residence, you’d be entitled to 50% of the tax exclusion.

So you not only want to make money in real estate but you want to keep it all too? Jeez, it’s always more, more, more with you. Well, we like your moxie. So here are 5 ways to keep what you make with real estate investing (and perhaps a wee bit more).

1. Pocket the cash flow tax-free

Let’s say you buy a great house for $100,000, rent it out, and you earn profits from your investment in year 1 of $2000. How much will you pay in taxes at the end of the year? Zero. U.S. tax laws provide for a depreciation deduction for real estate that will be offset against income from the property.

In our example, our purchase price will be allocated to the house (say, about 80%) and a portion to the land. The portion allocated to the house, $80,000 in our example, will be depreciated for tax purposes over 27.5 years, resulting in a deduction of $2,909.09 per year. So, our taxable income from our example is $2000 minus $2909.09 which equals zero. Zero income, zero taxes.

Wait, we just ran these numbers on our financial calculators and found out that $2000 minus $2909.09 does not equal zero. It equals $-909.09. Well, if you haven’t quit your day job (and you make less than $100,000 per year), then you can deduct the $-909.09 from your ordinary income (up to $25,000). Bonus! (That’s the “wee bit more”).

2. Sell the House Tax-Free

Let’s say in year 2 you sell that great house for $120,000 (we’ll make that number net of selling costs, so I don’t have to open any spreadsheets). Congratulations, you just made $20,000. How much will you pay in taxes? Zero. Tax laws allow you to buy another property (or two, for that matter) and defer paying taxes on profits from the one you sold, known as a Like-Kind or 1031 Exchange.

True, you can’t go out and spend the cash from Property No. 1, but is that the plan anyway? And if you plow those profits back into good real estate investments, it certainly should increase your cash flow on the next property.

3. Get Your Equity Tax-Free

So, now you have Property No. 2. You bought this one with the cash from the sale of Property No. 1, which included any down payment, plus profits, plus the reduction in the mortgage amount from your regular mortgage payment. All told, let’s say that amounts to $30,000 in cash reinvested in Property No. 2.

Let’s assume that you bought Property No. 2 for $120,000. You made a good buy and it’s worth $150,000. Since you had $30,000 cash, your mortgage is $90,000. So, you have $60,000 in equity in Property No. 2. You pause here to look contentedly at this line item on your financial statement.

Snapping out of it, you decide you want to get some of that equity. Well, you can take a trip to the bank and borrow against the equity of Property No. 2. We’ll assume your bank will loan up to 75% loan-to-value. Seventy-five percent of $150,000 (the value of Property No. 2) is $112,500. Since you owe $90,000 on your first mortgage to purchase Property No. 2, your bank hands you $22,500 in cash. How much will you pay in taxes on this tidy sum? Zero. Tax laws don’t treat borrowed funds as income, even though borrowing in this example allows you to get access to profits from your wise real estate investments.

4. Pocket Profits from Selling Real Estate Tax-Free

Let’s jump back to Property No. 1. Instead of selling it and buying Property No. 2, you decide to, well, just keep your money. You’ll recall you made $20,000 on Property No. 1. If you’ve kept Property No. 1 for more than a year, you’ll pay taxes on your capital gain of only 15% or $3000. I know, you’ll point out that $3000 is not tax-free, and technically (as well as non-technically) you’re right. But consider this—on the income from your day job, you may be paying income taxes at somewhere around 28%, which means that you would pay the same $3000 in taxes, but on only $10,714 in income. From your wise real estate investment, you’ve incurred that same $3000 in tax liability on $20,000. Comparing mangoes to mangoes, that’s like getting $9286 ($20,000 minus $10,714) from your real estate investment tax free.

5. Never Ever Never Pay Taxes from Selling Real Estate, Ever

So, you’re wondering what the catch is. And indeed, the catch with many tax savings now is that you have to pay for them later. For example, that depreciation up in item number one that you’ve enjoyed all these years may result in “depreciation recapture”—a tax rate of 25% when you sell your property. Or that tax-free exchange you did in item number two may result in paying taxes on the profits from Property No. 1 when you sell Property No. 2.

So you’re saying you not only want to make money in real estate but you want to keep it all too—forever? Well, your moxie’s starting to get a little annoying. But OK, fine. Die. You don’t have to get around to it anytime soon. 50 or 60 years will be fine—whenever you find the time. Tax laws provide that your lucky heirs will receive a “stepped-up” basis in your assets when you croak. This means that your lucky heirs will receive your real estate empire and for tax purposes be treated as if they bought it from you at market value at the time of your demise. In other words, they can immediately sell the property and pocket the cash tax free.

So, all told, your strategy looks something like this. Let’s say, from our example, you have Property No. 1 for a few years, you take the income tax-free after your depreciation deduction, then you sell it and buy Property No. 2 in a tax-free exchange, keeping the profits tax-free. You enjoy the higher cash flow from Property No. 2 for awhile, then sell it, and buy more real estate, then do it again, and so on and quit your day job, then buy a yacht, write your memoir, reflect on life, then die. Lucky Heirs sell all of your properties and pocket the cash tax free.

Keep in mind a couple of final notes on tax aspects of real estate investing. Never make an investment decision based on tax consequences. In short, it leads to bad investment decisions. Instead, make your investing decisions based on the merits of an investment. Just execute those decisions with tax consequences in mind. This is where a tax advisor certainly can come in handy. You probably should have one anyway at the outset of a real estate investment strategy. Also (and we know this one’s a shocker), tax laws change. This means that any tax strategy should allow for the possibility that Congress will muck around with the laws next year.

One final thing, because item number 5 is so replete with material, we would like to solicit your thoughts for names for this tax strategy. We’ve come up with three so far:

• “Swap ’till you drop” (We borrowed this one)
• “Buy the house, then buy the farm” (Rob’s)
• “The Charlton Heston Gambit”–a/k/a “You can have my money when you pry it from my cold, dead hands” (Mike’s)