Each category is depreciated over a different number of years:
- Land: Not depreciable
- Building: 27.5 years for a residential rental building; 39 years for a non-residential rental building
- Personal Property (appliances, carpet, furniture): 5 years in a residential rental property
- Land Improvements (parking lot, landscaping, fence): 15 years
Assume that your total depreciation for the year is $5,000. Every dollar of depreciation shelters a dollar of income, starting with income from the property. So, the depreciation first shelters the $1,000 cash flow plus the $500 principal reduction. They’re completely tax sheltered. And you’ve still got $3,500 of unused depreciation left over.
This leftover depreciation is reported as a “loss” for income tax purposes. For most people, this loss can be used to shelter income from a job or other sources, resulting in tax savings. That’s the third benefit: the tax savings are in addition to the tax-sheltered cash flow and principal reduction. Not bad!
Why did I say most people can use the leftover depreciation to shelter their income? Well, as you know, tax law is never simple, and rules called “passive loss rules” govern when a real estate tax loss can be applied. These rules are beyond the scope of this article, so be sure to ask your good tax manager how your unique situation is affected. Be extra sure to ask about the special “exception for real estate professionals.” You’ll love it!
4. Appreciation: The fourth financial benefit of owning investment real estate is appreciation — or increase in value. We all know someone who owns a property that’s worth a lot more than they paid for it years ago. It didn’t happen overnight, but over the years.
The combination of these four benefits can be a powerful wealth-building tool!
Helping sellers: return on equity
Once you’re comfortable with how the four benefits affect investor buyers, you can use these same concepts to work with investor sellers. One approach is to show a property owner their “return on equity.” Consider the following.
Assume an investor, Ben, bought a rental house 16 years ago. Ben invested $10,000 and borrowed the rest. He was smart and did the pre-purchase analysis. The cash flow, principal reduction and tax savings added up to net benefits of $1,400 that first year. By dividing the net benefits by the $10,000 investment, Ben’s rate of return was 14% ($1,400 divided by $10,000). Not bad — plus, the property was appreciating. He’s an investment genius!
Fast-forward 16 years. Today, Ben’s cash flow and principal reduction are still positive, however, much of the depreciation has been used up over the years. There’s no longer enough depreciation to completely shelter the cash flow and principal reduction (let alone shelter income from other sources). Instead of having a loss that saves tax, Ben now has to pay tax.
In order to calculate net benefits, Ben adds his cash flow plus principal reduction, then subtracts the tax he has to pay. If he divides these current net benefits by his original $10,000 investment, the rate of return might still look good. But here’s the key point: Ben’s investment is not the amount he originally invested 16 years ago. Instead, his investment is the amount he could get out of the property if he disposed of it today.
For the sake of this example, assume Ben’s loan has been paid down significantly over the years and the property has increased in value. Let’s say he could sell the rental property today and walk out of the closing with net proceeds of $80,000. If that’s the case, Ben doesn’t have $10,000 invested — he has $80,000 invested. If he divides his current net benefits by $80,000, his return on equity is probably very low. As equity grows, return on equity usually falls.
Ben should consider if his $80,000 equity may perform better if invested in a different property. If the answer is “yes,” he should move his equity. The best way to move equity is by doing a 1031 exchange. Exchanging allows investors to move net equity from one property to another without paying tax.
Therefore, if Ben wants to retain his membership in the “investment genius” club, he’ll exchange the equity into a different property — or properties — and re-boot his rate of return. A successful investor’s goal is to maintain the highest possible rate of return throughout their investing lifetime. This is accomplished by wisely moving equity from property to property.
A REALTOR® who attended one of my seminars called me recently. He was proud to report that after the seminar, he explained return on equity to an investor who owned seven properties free and clear. After the REALTOR® demonstrated that the return on equity was only 4.2%, the investor listed all seven properties and exchanged them into two larger ones that produced a much higher return. That REALTOR® definitely captured his share!
Other important issues
Before concluding, let’s touch on a few issues that are important but beyond the scope of this article.
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Analyzing a property is only as good as the accuracy of the numbers. Be specific and verify the accuracy of income and expenses. One way to do this is by making the transaction contingent on seeing the seller’s Schedule E (the tax form reported to the IRS). Be diligent and require accuracy — otherwise the analysis is a classic case of “garbage in, garbage out.”
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All dollars are not equal. There are significant differences in how dollars are taxed. If you earn a dollar from your job, you pay federal and state income tax plus Social Security tax (or self-employment tax) on that dollar. However, if the dollar comes from rental property cash flow, it can be sheltered from income tax and is exempt from Social Security tax (or self-employment tax). Therefore, a dollar of cash flow is better than a dollar from your job.
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Depreciation is great while you own the property — but what happens when you sell? When you buy a rental property, the IRS says, “Climb on the depreciation bus and ride it as long as you own the property.” When you sell, you jump off the depreciation bus. Then, the bus turns around and runs over you. The depreciation deductions you enjoyed during ownership are taxed back when you sell. This is referred to as “recapture” — an accounting term, not a zoological term. But the good news is there are several methods and strategies to reduce or eliminate recapture.
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Utilize the services of a good tax manager. By tax “manager,” I mean someone who’ll help you understand the tax implications of real estate investing; not merely prepare your tax return. Most people don’t have a tax manager … they have a tax preparer they see once a year on April 14. And the tax preparer tells them how much tax they owe! That’s not what I’m talking about. I’m talking about seeing your good tax manager throughout the year to plan ahead and proactively manage your unique tax situation.
Okay, that’s it. You’ve got a good start on the basics — but there’s plenty more to learn.
Investors are searching for good REALTORS® to be part of their team. If you commit to learning and improving, I’ll bet you’ll capture your share of the investment market and be fishing the entire lake in no time. I hope you catch a WHOPPER!
Tom Lundstedt, CCIM, is known as the funniest investment and tax guy in America! His programs for REALTORS® have entertained and enlightened thousands of audiences from sea to shining sea. He’s a former Major League Baseball player whose striking combination of humor and real world examples makes powerful subjects spring to life. He’s the author of a series of audio CDs and Study Guides on the subjects of investment real estate and taxation. Visit his website at www.tomlundstedt.com or contact him at 920-854-7046.