Let’s talk about the tax benefits of real estate. We’re going to cover depreciation and 1031 exchanges. The easiest way to go over this is with an example. Let’s say we want to purchase a piece of real estate for $100,000. We put $20,000 down and finance the rest with a loan for $80,000. Let’s just say that after all our expenses, we make $200 a month. One quick tangent. You and I when we work at a job and receive a W2, we qmake our money, we are taxed, and then we save with what’s left over. Now this is not 100% accurate because there are some deductions we can take but you get the picture. An investment property makes money, pays all of it’s expenses, and then is taxed on what’s left over. A HUGE difference! Now, back to our example. Let’s say we hold the property for 10 years. Every year for a piece of residential real estate, we can depreciate 1/27.5th of the purchase price. In this case, since our purchase price is $100,000, we divide by 27.5 and get $3,636.36 per year of depreciation. If we’re making $200 a month, $200 times twelve months equals an annual profit of $2400. Since we depreciate more than we make in profit, how much do we pay in taxes on the monthly cashflow? Zero. We can likely even deduct $1,236.36 ($3,636.36 – $2,400) from our personal tax return. Now, let’s say after 10 years we have now depreciated the property $3,636.36 times 10 years which equals $36,363.60. If we were to sell the property now for $100,000, the same price we paid for it, we would have to pay taxes on the $36,363.60 of depreciation at the depreciation recapture rate of 25%..ouch! Now let’s say that instead of buying one, we bought 3 pieces of real estate each for $100,000. We hold them for 10 years and now they’re worth $200,000 and we would like to sell all three of them. How much tax would we have to pay? Well, we depreciated each one $36,363.60 so multiply that by 3 and we get $109,090.8. At the depreciation recapture rate of 25% that is $27,272.70 in taxes. Additionally, we have to pay capital gains tax on the $100,000 increase in property value for each of the 3 properties which is $300,000. There are currently 3 long term capital gains tax rates depending on your income so let’s just assume 15%. $300,000 times 15% equals $45,000. If we sell all three properties we would have to pay $27,272.70 plus $45,000 which equals $72,272.70 in taxes..ouch! But wait it gets better. Let’s say you buy another piece of real estate using what’s called a 1031 exchange. If you take the money from the three properties you sold and buy another piece of real-estate, and you meet the requirements of the 1031 exchange – YOU WILL PAY NONE of the $72,272.70 in taxes. Now the taxes are deferred, but there is no limit to the number of times you can execute a 1031 exchange.
Now let’s talk exit strategy. Let’s say you hold a piece of residential investment real estate for 27.5 years and you have thus depreciated it to zero. You pass away and will it to your children. The cost basis of your investment property that you willed to your children is now “stepped up” to fair market value. This means that your children can either depreciate the piece of real estate for another 27.5 years, at the current market price not the price you paid for it, or they can sell it at market value with no capital gains.
Yes, you can invest in real estate without paying taxes legally. As always this is for educational purposes only. If you intend on executing one of these strategies, please contact a qualified accountant. As Andy Dufrene says in Shawshank Redemption: “It’s perfectly legal, go ask the IRS, they’ll say the same thing.”
-Vincent Cyran