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?”
Image Credit: GypsyRock