By Dr. James M. Dahle, WCI Founder
I realize this totally makes me a nerd, but I think I have a favorite tax break—Depreciation of rental property. Most tax breaks, like charitable contributions or mortgage interest require you to spend money to get a tax break. For instance, you might give $10K to charity, and if your marginal tax rate is 40%, you then get a tax deduction of $4K. Obviously spending $10K to save $4K is a losing business proposition. Depreciation isn't like that.
The Rules of Rental Property Depreciation
Your rental property is depreciated over 27.5 years. So each year when you do your taxes you take the value of your property when you bought it and divide it by 27.5. That amount is then subtracted from your rental property income.
So if you spent $200K on a rental property and it rents for $18K a year (let's say $10K after expenses), then you get to subtract $200K/27.5 = $7,273 off that rent. Now you only have to pay taxes on $2,727 of income instead of $10K. If your marginal tax rate is 40%, that's like $2,909 back in your pocket.
It's even better if you're not a high earner since you can actually deduct a real estate loss against your regular income, but most doctors won't be able to do that as this deduction phases out at an AGI between $100K and $150K.
Adding to Basis
But wait, it gets better. Any capital improvements you made to your rental property gets added on to the basis (original value). Examples of capital improvements include putting on a new roof, paving the driveway, building an addition, or installing air conditioning. You can also include casualty losses, legal fees, and the costs of restoring damaged property. This increases your basis, which is a good thing not only because you can then depreciate based on the increased basis, but you also owe less in capital gains taxes when you go to sell (since you owe tax on the difference between the value and the basis).
Rental Property Depreciation Recapture
Critics in the know will quickly respond that depreciation must be recaptured when you sell the property. This is true. It is also unfortunate that it is recaptured at 25% (see explanation in addendum below) rather than the lower capital gains tax rate. But just like with a 401(k), it is possible that you saved taxes at a higher rate during your working years and then paid it at a lower rate during retirement. Of course, the reverse is also possible, so it is a good idea to see if you can't avoid paying depreciation recapture taxes at all.
How to Avoid Depreciation Recapture Tax on Rental Property
Depreciation recapture taxes can be avoided for decades in two ways. First, you don't have to pay them until you sell. Don't want to pay them? Don't sell. Second, even if you want to sell, as long as you buy another investment property, you can defer paying the taxes by doing a Section 1031 exchange. As mentioned in a previous post, it's possible that depreciation recapture taxes won't have to be paid at all if you die without selling, convert the rental (or one you exchange into) into a personal residence prior to selling, or if you donate the property to charity either outright or via a charitable remainder trust (which gives you income til death, then the “remainder” goes to the charity).
An Example of Rental Property Depreciation
So let's say Joe buys a $200K property. He owns it for 10 years (now worth $300K) before exchanging it for a $400K property. 10 years after that, he exchanges that property (now worth $600K) into a $1M property. He dies 10 years later, leaving the investment now worth $1.5M to his son. His marginal tax rate was 40%. How much money did he save in taxes thanks to depreciation? $233K over 30 years. His son also gets to save the taxes due on the $800K in appreciation thanks to the step-up in basis at death, which assuming the son has the same 40% marginal rate, is another $320K in tax savings. But even if the owner stupidly sold the property prior to his death and paid the depreciation recapture taxes (not to mention the capital gains taxes), he still had the benefit of 40 years of using that deferred tax money for consumption or investment. In real estate investing, cash is king, and depreciation provides cash in the early years when it is most useful.
Free Money
The reason for the depreciation tax break is because stuff gets old and worn out. But in investment real estate, only the building gets old and worn out. The land itself will hold its value and likely appreciate at around the rate of inflation. Not to mention most houses and apartment buildings last far longer than 27.5 years. So the depreciation is mostly theoretical, especially if you make occasional exchanges for updated properties. Rather than getting a tax break for money you actually spent (like taxes, mortgage interest, or repairs), you're getting a tax break for nothing. Who doesn't like free money?
Addendum/Correction:
In case it wasn't clear above, you cannot depreciate the value of the land, only the value of the building. Also, depreciation recapture is paid at a flat 25%, NOT YOUR MARGINAL RATE (see line 30 of the Schedule D Tax Worksheet found in the Schedule D instructions). This can be extra valuable for a high earner. You may get the depreciation tax break at 33% or more, but then only pay depreciation recapture at 25%. Of course, you'd be best off not paying depreciation recapture at all by exchanging the property (or dying with it).
One other consideration is that the ratio of the value of the building to the value of the land need not remain constant. Consider a property worth $200K where the value of the building is 50% and the value of the land is 50%, or $100K each. You depreciate the building at $100K/27.5 = $3,636 a year. Let's say you own it for 10 years, so you've depreciated $36,360. Now, the property is worth $300K. If you assume the same ratio, the building is now worth $150K and the property is now worth $150K. You pay 25% on $36,360 of gain, and 15% on $100K of gain for a total of $24,090 in tax. But what if the property is now worth $300K, but the actual building depreciated 20% (meaning the land appreciated from $100K to $220K)? Then you'd only have to pay 25% on $16,360, and 15% on $120K, or $22,090. You'd better have a pretty good argument waiting for the IRS if you get audited pulling this stunt, but those arguments may very well exist for your property.
Are there any other benefits of rental property depreciation that I missed? Comment below!
If you love depreciation, you should love Royalty Trusts and certain MLPs! Of course it is extra work come tax time, but worth it in my opinion.
Great post. However this is in direct contrast to the advice I got from my tax strategist who said that I am disqualified from getting such tax breaks because I earn too much money from medicine. He said in order to get the full tax breaks such as depreciation, business expense write offs, legal fees, etc i would have to
1- make less than 100k/ year or
2- file my taxes as a real estate professional investor – and the IRS conditions tied to that in order to qualify are simply impossible for me to fulfill. This is the main reason I have baulked at investing in rental real estate.. The risks are simply too much without the great tax breaks attached. Supposing you don’t find a tenant for months? Supposing you get tenants from hell that destroy your property and it takes ages to evict them? Supposing you get sued if someone gets hurt on your property, etc.
What does anyone think about this? Is it truly legal for me to earn above 200k annually and invest in rental real estate and get tax breaks such as depreciation and expenses/cost of property upkeep/ mortgage interest? If it is, it may be time to fire my so called tax strategist !!
Have a spouse? Get your spouse to reach real estate pro tax status.
My lawyer told me there are two types of accountants/’tax strategists’ – those that won’t allow you any deductions and actually want you to pay in as much as possible, ‘to keep the system going’, as opposed to those who want you to get every deduction that’s legal, keep every cent that’s yours. I had the first type for years, have had the second for the last ten. I imagine I paid in several hundred thousand I shouldn’t have – but the second has made up for it. BTW, I think you have ‘the first type’.
A twist on this approach – any pluses/minuses to buying that realestate, but in a self-directed IRA? Income would be tax-deferred.
I couldn’t agree more. Depreciation is amazing.
What other investment can give you both yield and growth and legal tax shelters for both?
Yield = Cash Flow – sheltered via depreciation and accelerated depreciation
Growth = Appreciation and Principal Paydown by renters – sheltered via 1031 exchanges and equity harvesting through refinances.
Hi,
To Jared – thanks, Unfortunately my wife too has a full time career, earns 6 figures too, further compounding my problem of minimizing our taxes.
To George, yes, you are probably right some advisors are rubbish, and keep threatening an IRS audit if you are aggressive with taking tax breaks. But I don’t see the rationale in investing in a product (rental real estate) that already has fantastic tax breaks by itself in a tax shelter..I think it’s kinda defeating the purpose. I would invest paper assets or precious metals with no tax breaks in a self directed IRA.
I just need someone who knows what the real deal is with this real estate business and what tax breaks if any are allowed for high wage earners who are not professional real estate investors.
I think what your tax guy was saying is that you cannot fully deduct against your rental income if it creates a loss, given your income and not being designated a “professional real estate investor”. You can still deduct to the point that the real estate creates zero profit, and so it won’t add to your taxes. See this article:
http://www.forbes.com/sites/janetnovack/2013/03/26/how-real-estate-investors-can-protect-themselves-from-the-irs/
The third or fourth paragraph starts a succinct description of your situation, and the law that applies.
Note that if your investments look like WCI’s example – running a profit even after all deductions, then you may fully make all deductions related to the property.
The limits only come up to the extent they create a loss. Even then, you can keep track of the disallowed deductions and reduce your tax burden when you sell the property.
So, while your real estate investments may not reduce your taxable income from Medicine / other activities, they only add to your taxable income if you are actually showing a profit after all deductions.
Thank you Dan. Amazing. Free clear explanation that’s less murky than paid advice!
KC
I thought that you are not allowed to depreciate the value of the land.
The IRS says:
Separating cost of land and buildings. If you buy buildings and your cost includes the cost of the land on which they stand, you must divide the cost between the land and the buildings to figure the basis for depreciation of the buildings. The part of the cost that you allocate to each asset is the ratio of the fair market value of that asset to the fair market value of the whole property at the time you buy it.
If you are not certain of the fair market values of the land and the buildings, you can divide the cost between them based on their assessed values for real estate tax purposes.
You said:
So if you spent $200K on a rental property and it rents for $18K a year (let’s say $10K after expenses), then you get to subtract $200K/27.5 = $7273 off that rent.
Don’t you have to reduce the $200K by the value of the land?
Correct
That’s correct. You can’t depreciate the land. But there can be a lot of leeway in determining the value of the land.
You have to reduce the property by the value of the land only if you break it out. Most residential neighborhoods have tiny lots where that’s not a real concern. However, if you buy a farmhouse with 80 acres, then you’ll have to break it out. We do not break-out the land/building on my rental, but the house is $50k and the lot is something like .1 acre.
WCI, can you give some insight into the when you think it is appropriate to fit real estate investing into someone’s financial plan? I am just finishing residency, working hard to pay off my higher interest student loans, maximizing all my tax deferred retirement and backdoor Roth IRA, when do I think about adding real estate to my portfolio? Is it best ensure all debt is gone before considering, or start earlier after a few years and higher interest debt is gone? Do you use money that would normally go into a taxable account or do you do this instead of a Roth? Just not sure if/when this fits into someone’s financial plan. Thanks for your comments
Real estate investing probably isn’t a hot idea for most docs, at least if we’re talking about the hands on version. I certainly wouldn’t do it prior to maxing out a Roth IRA. It belongs in a taxable account, protected inside an LLC.
Another way to beat capital gains taxes on the sale of your rental property applies to those who serve in the military (or who have recently retired/separated) The IRS ownership/use test which applies to the tax states that you are exempt from capital gains on the sale if you’ve lived in the home for at least 2 of the last 5 years. However, if you serve in the military and you’re required to move at least 50 miles away from your primary duty station, you can suspend this period for up to 10 years before restarting the clock.
Example: I own a home in Virginia that I’ve lived in or rented (on and off) for the last 12 years. I last lived in the house from 2006-2009. I was required to move in 2009 and continued to serve in another state until Oct 2012, when I separated from the service. Since I lived in the house from 2006-2009, the clock stopped in 2009 when I moved away and didn’t restart until I left the service in 2012. Now, I’ve got until Oct 2015 (3 years from the date I left service to satisfy the 2 in 5 years rule) to sell the house and pay avoid capital gains tax. I only pay capital gains on the amount I’ve depreciated since 2009. I verified this by actually talking with the IRS.
Hi, Great article. I had a question about the 20K depreciation of building value and 120K increase in land value. You said, the 20K can be knocked off from the 36K of ‘IRS’ depreciation. So instead of paying 25% of 36K, we pay 25% of 16K.
Now, IRS can say the current value of the building has nothing to do with the rule that the flat 25% was always based off the original bldg’s depreciation. I mean does the language somewhere tell ‘btw, if the depreciated value changed between then and now, use the new number’?
Not that I know of. That’s why you’d better be careful doing that.
Two questions. Am I correct that “accelerated” depreciation is recaptured at ordinary income, not 25%?
Second, how does depreciation recapture work in a Roth IRA? Thanks!
Good questions. I don’t know the answer to either. You might try asking in the forum if nobody answers here in the next day or two. You’ll get a lot more eyeballs on your question.