3 Step Approach to Maximizing the Magic of Depreciation in Rental Real Estate

So, you have an interest in real estate and want to understand exactly how owning investment real estate can benefit your bottom line. Congratulations on taking the first steps.

Before I start, keep in mind that I am not a CPA. The numbers/assumptions below have been simplified to make the ideas easier to understand, so you are advised to run any questions by your trusted tax professional or CPA prior to any property purchase. Tax law changes often, and there are many criteria that investors have to meet to benefit from the many tax benefits of investment property ownership. I am using the following example for illustrative purposes only.

Assumptions (for simplicity):

Your annual gross income is $50,000
Your federal income tax is a flat 25% and your state income tax is a flat 10%
You purchase a modest $100,000 single-family home for rental purposes of which $10,000 is the value of the land.
Your monthly principal and interest mortgage payment on the rental home is $550, of which $450 is mortgage interest
Your property taxes are $600 per year (i.e. $50 per month)
Your insurance is $300 per year (i.e. $25 per month)
You rent the home for $950 per month
You pay a property manager $75 per month to manage the property for you and handle all tenant issues so that you don’t have to spend time on these.
You hold the property for 5 years
Appreciation in your area averages 3% per year

Your financial benefits of investment property ownership are many and can include cashflow, interest and depreciation deductions, principal payoff and appreciation. We’ll walk through each of these benefits below.

Cashflow

Cashflow is the difference between the rents you receive on a property minus the mortgage and other expenses you pay out. On this property you will receive cashflow in the amount of $950 -($550+$50+$35+75) = $240 each month. This passive income is real money in your pocket. So, to start you just gave yourself a $2880 annual raise just by purchasing this investment property. (It’s nice not having to ask your boss for a raise, isn’t it?)

Interest and Depreciation Deductions

Rental property owners can write off the amount of interest they pay on loans used to acquire or improve rental property. The IRS also requires real estate investors to depreciate their investment property. Depreciation is a “paper loss” that is required to account for estimated wear, tear and obsolescence. The value of the land that your rental home sits on, however, is not depreciable (as land rarely loses its value). In our example, residential investment property is depreciated over 27.5 years on a straight-line basis (your CPA can advise you on other methods of depreciation).

The value that you can depreciate is $100,000-$10,000 = $90,000

Therefore the annual depreciation deduction that you can take is $90,000/27.5=$3272.73

and the annual interest deduction you can take is (450*12)= $5400

So, without the rental property, you would have paid $50,000*(10%+25%) = $17,500 in taxes.

And with the rental property, you will only pay ($50,000-$3272.72-$5400)*(10%+25%) = $14,464.55 in taxes.

So, the rental property saved you an additional $3,035.45 in income taxes! (And this doesn’t take into account additional tax deductions for insurance, property management fees paid, property taxes and any allowable improvements/repairs made to the property). Imagine that; Uncle Sam requires you to pay less in income taxes as a rental property owner!

Principal Payoff

Over the 5 years that you own this property, your tenant’s monthly rent payments are paying off the mortgage for you. At the end of year 5, you should owe approximately $92,300 on your mortgage; down from your $100,000 purchase price. This is an additional $7,700 in value for you! How does it feel to make money while you sleep?

Appreciation

History has shown that over time, real estate appreciates. Appreciation rates vary by location so check with your local real estate expert (me!) for historic rates in your area. Don’t bother asking about future rates as no one has a crystal ball. (And if they give you an answer run the other way…FAST!) Just know that the historic trend over time from the early 20th century forward has been favorable. For this example, our conservative assumption of a 3% annual appreciation rate, when compounded over 5 years, gives your property a value of $115,927.40 at the end of year 5. This is an additional $15,927 in value that you didn’t have to lift a finger to earn!

Overall, your financial benefits after 5 years of ownership total:

drumroll please…

($2880 *5)+($3035*5)+($7,700 )+($15,927 )= $53,202!!! And this is from only one property. Imagine the power of these benefits with a small portfolio of properties. This is how real estate can propel you to early retirement. It doesn’t take outrageous amounts of money or huge investments. Just a slow and steady real estate investment plan that you consistently act on over time. If you’re not sure where to start, feel free to contact our office and we can work with you to create an investment plan that will work for you.

How NOT to waste $30 per day for the rest of your life

The numbers above are the very reason why many investors hold investment property in their portfolios. The $53,202 above equates to just under $30 per day for just one small property owned. ($29.15 to be exact). So, if you’re on the fence about investing in real estate and need a bit more time to mull it over, be sure to add up the 30 bucks you’re missing out on each night that you go to sleep without action! On the other hand, if you’re an action-taker and want to start earning your $30 “sleeping money” every night, get the ball rolling today, and buy rental property!

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3 Step Approach to Maximizing the Magic of Depreciation in Rental Real Estate

As I shared last week, real estate is one of the most complex areas when it comes to tax law and accounting which can easily lead to mistakes.

A common mistake I see with rental real estate is the amount of depreciation taken.

If you’ve ever heard me talk about depreciation, then you know I think depreciation is like magic. Rental real estate can be depreciated, and when done properly, it can take rental real estate with positive cash flow and turn it into a loss for tax purposes.

That is magical!

When I work with a new client who owns rental real estate, I don’t immediately jump to the depreciation step. Instead, I do a few other steps first to make sure the tax benefits of depreciation are maximized,

Here is my 3 Step Approach to Maximizing the Magic of Depreciation in Rental Real Estate

Step #1: How much tax did they pay? I want to know what the tax saving opportunities are and that starts with how much tax they are currently paying. If their tax liability is already low, then the immediate focus shifts from reducing taxes to building wealth.

Usually, I find they have a large tax liability, so I move to Step #2 because reducing their taxes is the fastest way to put cash in their pocket to build their wealth.

Step #2: Are they able to take all of their rental losses against their other income? In the U.S., the ability to take rental losses against other income depends on specific facts and circumstances. If my new client is not able to claim all of their rental losses against their other income, my immediate focus will be on fixing this. If I can fix this, it can result in big tax savings.

Once they are able to claim their rental losses against their other income, I then move on to Step #3 – this is where the magic of depreciation happens.

Step #3: Are they maximizing their depreciation? It’s pretty rare that I see a tax return from a new client with depreciation done in a way that accelerates the depreciation deduction (legally).

What I most commonly see on these tax returns is a rental property being treated as having two components: land and building. These happen to be the two worst classifications when it comes to depreciation.

Most rental properties have many more components than this. There may be appliances, parking structures, landscaping, furniture, fixtures, and much more. These items can be depreciated much faster than land and building.

This concept of identifying the different components is known as a cost segregation.

Even though the total depreciation over the lifetime of the property will be the same, by taking the depreciation sooner, the tax savings occur sooner which means more cash in your pocket now to build your wealth faster.

For those who have large tax liabilities (Step 1) and can take their rental losses against their other income (Step 2), a cost segregation can mean big tax savings – NOW.

My 3 Step Approach I find that sometimes taxpayers get caught up in the excitement of claiming the biggest deduction possible without first looking to determine if it will actually reduce their taxes.

A big deduction doesn’t always result in big tax savings.

This is why I do Step #1 and Step #2 first. These 2 steps identify the key factors to make sure the magic of depreciation in your rental real estate is maximized.

As I shared last week, real estate is one of the most complex areas when it comes to tax law and accounting which can easily lead to mistakes.

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Your #1 Investment Tax Write Off – Real Estate Depreciation

Sometimes Tax Time can be so painful…

Remember the last time your Mutual Funds took a loss and you STILL had to pay taxes. Doesn’t seem fair. AND when your stocks take a loss all you can do is write that off against your stock gains.

Have you ever thought to yourself,

“Wouldn’t it be nice to be able to get good cash flow and a generous tax deduction from the same investment?”

Think of it… a single investment offering you the best of both worlds. Is that even possible?

I have good news, because that is Exactly what direct ownership in Commercial Property offers you. AND I guarantee you this is information your Stock Broker doesn’t want you to know.

Here’s the best tax write off in Investing…

When you own Commercial Real Estate you can take as much cash flow as the property will produce as income AND use Depreciation to write off thousands of dollars of that income every single year.

Commercial Real Estate is depreciated using a 39 year tax life. This means every year you can write off one thirty ninth of the value of the building(s) against your income for the year.

It’s a leveraged write off too…

Here’s what I mean. You get to write off 1/39th of the Entire Value of the entire property, not just money you personally put in to the deal.

Check out this example…

If you put $200K cash down on a $1M Commercial Property, you can use Depreciation to write off 1/39th of the full $1M – not just the $200K you put in. This equals $29,614 per year, every year for 39 years in a row if you wish.

And it gets even better…

You can even “Accelerate the Depreciation” and take a bigger write off than this.

Certain parts of your Commercial Property can actually be depreciated over shorter tax life periods and give you an even larger depreciation deduction. It’s done using a technique called Cost Segregation.

Here’s how it works…

Some components of your Property have a tax life of five years, some seven or even 15. There are consultants who can routinely add thousands to your annual Depreciation write off by taking a week to do a Cost Segregation analysis for you.

Accelerated Depreciation is totally painless, gives the generous deduction write off a major boost and is completely accepted by the IRS.

At Tax Time it is important to remember this…

Depreciation is the #1 Tax Write Off available to investors today and just one of the reasons Commercial Property deserves a prominent place in your portfolio.

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Three Reasons Why You Should Really Consider Investing in Real Estate

If you would like to start invest in real estate, you require a change in mindset. Many people think that investing in real estate is risky because of fear. Remember F-E-A-R is just “False Expectations Appearing Real”!

There are three reasons why you should really consider investing in real estate at this time:

1. There will always be a marketplace. In a civilized world, a roof over your head is as essential as clothing, energy, food, transport and water. Investors are necessary to keeping this vital human need available at a affordable price. In countries where investing in real estate is limited or excessively controlled by the government, such as it was in former Communist Bloc countries, people suffer, and real estate depreciates.

2. There are many different ways a person can involve and make money. For most people, their only real estate investment is where they stay. Their house/home is their biggest investment. During the boom from 2000 to 2007, many amateurs got involved with flipping houses – buying low and wishing to sell higher. As you know, many flippers flopped and lost all. In true investor vocabulary, flipping is known as speculating or trading. You can call it gambling. While flipping is one technique of investing, there are many, more sophisticated, less risky ways to do well with real estate. You have to gain the knowledge and learn from the experiences of professionals who invest rather than flip, speculate, trade, or gamble.

3. It gives you control over your investments, that is, if you have the skills. In the volatile times of early 2009, millions of people were losing trillions of dollars simply because they handed over control of their wealth to other people. Even since the middle of 2008, the great Warren Buffett’s fund, Berkshire Hathaway, has lost 40 percent of its value! Millions of people have lost their jobs, which means they had no control over their own employment either. You need to learn from the real professionals that have control over both their businesses and investments. The learning process is ongoing.

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