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Many investors jump into real estate fully expecting to realize all sorts of great tax benefits and are especially excited when they are told they won't pay tax on rental income. This is primarily due to famous books such as Rich Dad Poor Dad and real estate gurus encouraging you to get excited about real estate so that they can sell you more products.
While it's most certainly true that real estate investing offers enormous tax benefits, simply investing in real estate will likely not grant you the tax benefits you are expecting. Use this rental income tax information to develop a strategic tax plan because without such a plan, you may find the tax on your rental income to be much higher than you expected.
Depreciation Isn't as Great as it Seems
Depreciation is a means of slowly writing off the cost of an asset over several years. In the case of rental properties, the depreciation time frame for the building will be 27.5 years long. Depreciation is intended to track the deterioration of an asset and many investors think it's counter intuitive as real estate appreciates but it should be noted that the various components of the building will deteriorate.
Depreciation is a non-cash expense. That's a fancy way of saying that you can claim the deduction every single year without actually having to pay for it during the current year. This is because you've paid for it all upfront when you bought the rental.
Real estate gurus love to talk about depreciation. It's an easy concept to discuss on a high level and it gets investors all jazzed up. It's considered an excellent way to shelter your rental income.
What they don't tell you is that you will have to pay depreciation recapture tax when you sell your rental property. This tax comes at a hefty rate of 25%. For the uninformed investor, it generally comes as a shock.
Some investors attempt to avoid depreciation recapture by simply not claiming depreciation on their tax returns. The IRS has a little clause that essentially says "we're going to tax you on the depreciation you've taken or could have taken." It's in your best interest to go ahead and claim depreciation every year and expect to pay it back at a 25% rate.
Depreciation recapture significantly changes the drive to invest in real estate. Some investors hate it, but I tell them to think of it as a loan from the IRS. A loan that you will one day have to repay.
Regardless, depreciation is a great way to avoid tax on rental income as it's one of those non-cash expenses that ultimately puts more working capital in your pocket every year.
Spend Money to Save Money
The truth about any tax break is that you must spend money in order to save money. You may be able to spend money in a certain way that delivers a higher impact (like donating to charity to move down in tax brackets), but the argument holds true that money must be spent to realize tax savings.
In most tax strategies, you must recognize that in order to save money, you have to spend money. Of course, spending money in a feasible manner is always a consideration in any tax strategy. For instance, it may not make financial sense to buy a car in the name of the business so that you can have a deduction, but it may make perfect sense to legitimately hold more "business meals" which of course are an allowable deduction.
As you can see, how you spend is important and another big factor is when you spend.
In some cases, it may make sense to accelerate expenses such as maintenance, improvements and repairs. In other cases, it may make sense to perform 50% of the work before December 31st and the remaining 50% of the work at the beginning of the next year to have qualified write-offs in both years. And of course it may also make sense to defer expenses until the next year. It depends on your unique situation.
Ways to Avoid Tax on Rental Income
We've already discussed a few: depreciation, how you spend money, and the timing of the expense. There are plenty of other legitimate ways to avoid taxes altogether.
A well known way avoid tax on rental income is to commission a cost segregation study which is a way to depreciate personal property on a faster time frame and provide you with a larger depreciation write-off. It's also well known that these studies can cost several thousands of dollars. This fact alone deters many investors from engaging a CPA in a cost segregation study, but this doesn't have to be the case.
Cost segregation studies have decreased in cost dramatically as information becomes readily available and new players enter the market. They used to only be feasible if your property cost $1MM, but now you can find savings at property values around $200k.
Even if that is out of your price range, you can run a portion of the study yourself. You can look at your personal property like appliances and determine their current value by checking out websites like Ebay.
Another way to reduce your tax on rental income is to be the money partner in a deal. You may bring a certain amount of funds to the partnership and you may be able to convince the partner that you want to be allocated a majority of the depreciation.
You may also want to check out how historic tax credits work. Generally, you and a developer would partner on a deal and the developer would grant you the tax credit for bringing money to the table. You will need to vest into the tax credit over a period of five years, but you will receive the tax credit up front and this is an excellent way to shelter any income the partnership generates.
I'd be remiss if I didn't mention the last, and likely most important, method of reducing tax on rental income. The ultimate key is to document everything which was the subject of our first podcast.
Conclusion
It's easy to be fooled by the gurus about how easy it is to avoid tax on rental income. Just keep in mind that there is a lot more to avoiding tax on rental income than meets the eye. Along with this rental income tax information, proactive tax planning will help you realize all the benefits that being a real estate investor has to offer.