Income Is offset by depreciation
Depreciation refers to a group of rules and schedules created by the IRS to account for the wear and tear of property over its useful life. The great thing about depreciation is that it shows up as a loss for tax purposes, even though the property may have made substantial income and increased in value that year.
For example, if you were to buy a new HVAC system for a rental property, that expense becomes a write-off, and, though you might avoid paying taxes on the money used to buy the HVAC, you still lose the use of that dollar. But with depreciation, you can show a dollar was lost, thus avoiding taxes on that dollar, but keep the untaxed dollar in your pocket. This is why depreciation schedules are a gift from the IRS. It allows real estate investments to earn income without the typical tax liability that comes with making more money.
Personally, I own several vacation rental properties, and I’ll use one of them as an example to make the point clearer. In year one (2017 calendar year), the property generated a gross income of $146,114, but as you would probably expect, there are cleaning fees, sales tax, service fees, repairs, property management fees, and so on. After subtracting all of these expenses including the mortgage payments, my net ordinary income was $40,738 for the year. Without the benefits of depreciation, I would normally pay Federal and State income tax on an additional $40,738 of income. Since this would be added at the end of the year to the income, I make from my day job, it would be taxed at the highest tax rate.
However, since I purchased the home fully furnished, the value of the furniture can be depreciated over 5 years and the value of the structure itself can be depreciated over 27.5 years. My depreciation in the first year was $52,859, so even though my distribution after expenses was $40,738 of income, I actually showed a loss on my K-1 at the end of the year and didn’t pay any income tax on those earnings. Any losses incurred beyond the income created by the property can be applied as a loss against my ordinary income. Ordinary income is any type of income earned by an organization or individual that is taxable at ordinary rates, such as wages, salaries, tips, interest income from bonds, or commissions. Applying excess losses from the property against ordinary income is a major tax benefit that is only the case with hotels and properties used as short-term rentals. The IRS considers short-term rental income as business income from the sale of a service rather than such being classified as passive income.
Why is this important?
Well, if you are generating rental income from a residential or commercial property being used as a long-term rental and such is considered passive income, the loss from depreciation can offset the passive income you earn, but any excess losses cannot reduce non-passive income if you make above $150,000 (married filing jointly) each year. If you have more losses than passive income in a given year and such are disallowed by limits, the rest of your losses will carry forward and can be used against your passive income in future years or when the home is sold.
1031 Exchange defers tax
With the depreciation of the furniture and structure, I still haven’t paid income taxes on any income distributions from this property since it was purchased in 2016.Some who are familiar with tax law might say, “Well, you avoid tax on that income for now but when you sell the property, you’ll be required to pay income tax on all the depreciation you’ve taken”.
Depreciation recapture is the portion of the gain attributable to the depreciation deductions previously allowed during the period the taxpayer owned the property. The depreciation recapture rate on this portion of the gain will be no higher than 25%, plus the 3.8% Net Investment Income Tax. However, paying taxes on the capital gains and the recaptured depreciation can be deferred by transferring the equity into a like-kind property.
There are several requirements when doing a 1031 exchange so be familiar with the requirements before you sell your property. By doing the 1031 exchange each time you sell, you are able to transfer the equity in your existing property to a new property without incurring capital gains or income tax, but in addition, you get to depreciate the furniture and structure of the new property just as you did with the prior property, which will allow you to continue showing major losses each year against the income of the new property. When the furniture depreciation schedule runs its course after 5 years, it’s likely you’ll start paying income taxes on a portion of your rental income each year from that point forward.
Receiving a step-up in Basis at death wipes out what was borrowed, the deferred tax on gains, and recaptured depreciation
For that reason, it makes sense for me to sell my properties at the five-year mark for a gain, move the equity into a newer property with a 1031 exchange, and let the depreciation of the new property continue to offset the income earned going forward. Doing so allows me to earn rental income without paying income taxes, defer the typical taxes due when selling a property, and it allows me to use the non-taxed capital gains and equity after each sell to buy property of greater value with greater income.The next question from someone is typically, “besides the benefit of being able to use the non-taxed equity to buy more real estate over the next several years, the tax bill eventually comes due on all the depreciation and capital gains, so aren’t you just deferring the inevitable?”
The answer is yes, and I will continue to do so until my dying day intentionally, so I can avoid all the taxes on capital gains and recaptured depreciation over my lifetime.
There’s this cool feature in the tax law called “step-up in basis”, which applies to a variety of items including property, even a taxable brokerage account.
Borrowing against the property appraisal value is not taxable
Here’s how it works: When you die, all the property you own will be received by an heir. When the heir receives the asset, they have the choice to keep it or sell it. Either way, their basis in the property is the fair market value on the day of your death, so if they sold the property two days after your death, they would only pay capital gains tax on the difference between what they sold it for and the fair market value on the day of death two days earlier. All of the recaptured depreciation and capital gains tax I deferred with 1031 exchange after 1031 exchange during my lifetime, is gone. All of that is wiped away when your heir receives a step-up in basis at your death.Now some would say, “Well, sure the tax was never paid by you or your heirs, which is great, but you were never able to sell the property and enjoy the money.”
On the contrary, I was able to enjoy the ever-increasing rental income due to my capacity to buy more real estate by way of the 1031 exchange over my lifetime! Why would I need to sell it if the equity within the property can constantly be recycled into new, more profitable projects that generate more income each year? At a certain point, you won’t need the distribution of equity from property to meet your retirement income needs because the income (tax-free if offset by depreciation) created by doing this process over the years is more than enough to cover your lifestyle.
If it isn’t enough and you wish to tap into the equity, then do so by borrowing against the property through a secured business line of credit. Though selling the property creates a taxable event of all gains and recaptured depreciation, assigning the property as collateral and borrowing against it does not. The line of credit will typically have an interest rate similar to the prime rate. Most banks will allow you to borrow up to 70-80% of the property appraisal value.
This is a benefit in two ways.
One, you could borrow against the equity of a property and use this money to do a down payment on a second property. I would only do this if the income generated by the second property is enough to cover its own mortgage, expenses, and nets a profit with which you can then use to repay the money you borrowed to do the down payment. This approach allows you to acquire a new property and additional income without using your own personal income or assets to buy it.
The second possibility (if you just prefer to take the equity out for income during retirement) is to borrow a certain amount each year systematically as if you were taking income distributions from any investment account. The loan is not taxable, so you are essentially pulling the equity and gains out in a way that is not taxed. You are required to make interest only payments on the loan over time, so be mindful of that cost in this scenario and plan for it to reduce the income earned by the property. Also, lines of credit are normally set to mature every 12 to 24 months, depending on the terms you’ve set with the bank; however, as long as you’re making payments, most banks will renew the line before the loan matures. If you’re not careful and calculated when implementing this approach, the interest only payments will eventually add up to the tax you would have paid had you sold the property in the beginning. Therefore, for this to be of any benefit, the property will need to be sold before the amount of interest paid on the loan exceeds the tax you would have paid, or the loan should purchase an income producing asset that can service the loan and pay it back in full.
For example, if you assume a 28.3% tax rate is applied to $500,000 of gains from recaptured depreciation and a 23.8% tax rate is applied to $300,000 of capital gains when you sell, the tax bill would be $212,900. If you withdrew $50,000 per year in the form of a loan at 5.5% against the equity in the property, which we’ll say is $700,000 in this example, in year 12, the total interest paid ($214,500) on the aggregate total of the loan ($600,000) would exceed the total tax ($212,900) you would have paid in year one if you had sold the property.
At that point, it’s a wash and you probably would have been better off cashing out, paying the tax, and investing the proceeds 12 years ago. It works well in situations where you plan to take distributions for a few years, then sell the property through a 1031 exchange, or in situations where you wish to access as much of the equity as possible for a short period of time with the intention to sell in the near future through a 1031 exchange. If I withdrew up to 80% of the $700,000, which is $560,000, the interest payment that year would be $30,800 if you continue to assume a 5.5% interest rate. Gaining access to $560,000 of my $700,000 at a cost of $30,800 in interest payments while maintaining ownership of the property, the remaining equity, and the income it creates, is far better than a scenario where I pay the taxes of $212,900 and only have access to $487,100. Also, you could simply carry the loan against the equity of the property, using a portion of the net income derived from the property to service the interest only payment, and then when you pass away, your heir can sell the property, clear the loan, receive the step-up in basis, and pay only capital gains tax on the increase in value between the day of death and the day it sold.
The IRS is generous with this asset class
Utilizing these features of the tax law gives you a way to enjoy the equity, income, and capital gains from your property investments during your lifetime without paying income tax or capital gains tax.It’s really quite amazing that our tax code allows a path where a person can avoid income taxes with depreciation, defer capital gains when selling property, and then on top of that, a chance to avoid tax on all of those gains by holding the assets until death. These tax advantages allow you to have substantial income over your lifetime — and substantial growth in asset value – that isn’t taxed.
Too many advisors are unaware of these tax laws and will often guide clients to invest money in conventional methods that involve significant tax bills down the road. Real estate ownership isn’t for everyone and I’ll be the first to say that; however, I see far more people not participating because they don’t know the rules, tax benefits, or what to buy rather than the reason being because the asset doesn’t fit the clients risk tolerance and specific financial goals.
In exploring our vast tax law, I’ve found the code to be quite generous, but as you can see the rules and ideas are buried in the details. Diving deeper could unveil creative ideas like the ones we just discussed that go beyond what is obvious to most. I would encourage you to consider real estate as an investment asset class when reviewing your investment strategy if you haven’t already. Partly for diversification as it has performed well historically, but also because of the great tax advantages that come with investing in this specific asset.
You may need help navigating the space and thinking through the methods, but don’t let the complexity scare you. Our team can come along side you and guide you through the rules and tactics typically used when investing in real estate. In the end, you may find yourself paying less in taxes than you ever imagined to be possible. For more personal finance tips read on here!