Now here’s the good news: for tax purposes,
these benefits can be sheltered by depreciation. Depreciation is a “non-cash” deduction
(it’s also known as cost recovery).
The tax rules allow the owner of rental
property to depreciate their cost over a number of years. The specific number of years
depends on how the cost is allocated. It’s important to allocate the cost of the property
into categories that include: land, building,
personal property and land improvements.
Many people lose money by only dividing
their cost into land and building.
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 5 years in a residential rental property
(appliances, carpet, furniture, etc.)
LAND IMPROVEMENTS 15 years
(parking lot, landscaping, fence, etc.)
Returning to the example, let’s assume
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 their 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
there are rules called “passive loss rules” which
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 affecte
d. 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, powerful wealth-building tool!
HELPING SELLERS: RETURN ON EQUITY
Once you’re comfortable with how the four
benefits affect investor buyers you can also
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 named Ben bought a
rental house sixteen 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!
But…fast forward sixteen 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).
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