As stated in one of our previous blogs, the kind of income (passive or capital gains) that comes from real estate is taxed at a much lower rate than earned income (income from a job or short term investing.) Although this benefit alone is enough reason to commit to real estate investing, the secret hidden from many is that real estate investment income never needs to be taxed at all.
I know this sounds illegal or too good to be true. But this can be true depending on the property owned and the benefits utilized. The first way this can happen is:
RENTAL INCOME (PASSIVE INCOME)
- DEPRECIATION- Let’s say you purchased a single-family house as an investment property for $90,000 and you spent $10,000 to fix it up. You now have $100,000 invested in the property. For tax purposes your “basis” in the property is what you paid for it plus the rehab costs ($90,000 + $10,000) minus the value of the land that is sits on. Since this is a blog and what I am writing is only an illustration lets say your real tax basis in the property is $100,000. You get to depreciate this property every year, although it should be increasing in value, at approximately 1/28 of the $100,000. That is $3571 you get to deduct directly from the rental income. REMEMBER THIS DEPRECIATION DEDCUTION IS AN ARTIFICIAL LOSS THAT THE IRS ALLOWS AND IT ACTUALLY COSTS YOU NO MONEY OUT OF YOUR CASH FLOW.
- OTHER EXPENSES- Loan interest, real estate taxes, and other costs to manage the investment property are all tax deductible. Most of the time adding depreciation to the other expenses will cover any net cash flows from the property for tax purposes even though you have a positive cash flow (money you can use and spend).
SELL OF PROPERTY (CAPITAL GAINS)
- 1031 EXCHANGE- This tax benefit is absolutely amazing. If I sell that $100,000 property for $200,000 after I have owned it for more than 12 months I can utilize a 1031 exchange, which shelters me from paying any taxes on the capital gains of $100,000. NO TAXES! Now technically the taxes are “deferred” but for your lifetime no taxes are due. At the end of your investing life you can role the 1031’s into a charitable remainder trust and your heirs can receive benefits from those assets. By using all of these tax deduction benefits you can greatly reduce your tax bill or pay no taxes at all. Another benefit of the 1031 is it permits you as an investor to not have to “recapture” the depreciation advantages that we mentioned above and pay capital gains on the amounts that were depreciated. We will wait to another blog to explain in detail how that works.
We will be publishing a new blog post every Sunday, Monday, Tuesday, and Wednesday. Come back next Monday for more on real estate and join us tomorrow to talk about entrepreneurial investing.