Question: How does real estate ownership reduce my income taxes or my income tax burden?
Answer: Uncle Sam (ie the US Treasury) allows you to deduct from your income, certain expenses. The following real estate investment expenses are deductible on your Schedule C or Schedule E Forms:
- Mortgage Interest (the amount of interest you paid to an investor, bank or mortgage company on the loan secured by real estate)
- Depreciation (the amount that the building "deteriorates" or wears-out each year; spread over 27.5 years for residential or 39 years for commercial, don’t count the value of the land, common areas, etc.)
- Management fees (property manager, leasing fees)
- Improvements (not repairs… replacement windows, replacement furnace, landscaping, new roof, etc.) can increase the "basis" or depreciable amount each year over the life of the replacement.
- Repairs (ie glass replacement, furnace repair, roof repairs, etc.)
- Travel to visit the property for inspections, oversee repairs, check-in/out tenants, etc.
- Expenses (phone call, advertising, condo fees, utilities, landscaping, investment real estate magazines-Fortune, Money, etc… This category is HUGE and nearly unlimited in what can be considered an expense.)
- Home office expenses (portion of your personal residence that you use EXCLUSIVELY to manage the investments, otherwise a portion of expenses may be permitted.)
- Lender fees, closing costs, loan points, inspections, etc.
As you can see, the total yearly costs to "maintain" your investment real estate can result in a substantial "PAPER LOSS" that can be used to offset other income (your spouses job….)
For example, suppose your spouse makes $50,000 from a job at the local high-technology company. The tax on your spouse’s salary is 30% (or $15,000). And your salary of $60,000 was taxed at 30% (or $18,000). Your total tax bill without "deductions" is $33,000 out of total income of $110,000.
Now assume your investment real estate was rented out and "breaking even" or even a small negative of $300 per month, the loss would amount to $3,600 per year. Also assume you have a $250,000 rental property that has a depreciation value of $200,000 ($250,000 – $50,000 for the value of the land = $200,000). The yearly depreciation is $200,000 / 27.5 = $7,272. With depreciation, mortgage interest and other expenses, you could easily have a paper loss of $16,000 (or more if you are really active in the property management and oversight).
The paper loss will lower your actual taxable amount ($110,000 – $16,000 = $94,000). The 30% tax on $94,000 = $28,200. The difference between your OLD and NEW tax is: $33,000 – $28,200 = $4,800 and the amount you "saved" by holding investment real estate.
Imagine having multiple properties that gives you a "paper loss" equal to your regular job salary….. You offset your income with losses and you reduce your tax to $0.00……imagine that!
The CCIM (Certified Commercial Investment Member Course 101, 102, 103, 104) and the CRS (Certified Residential Specialist) courses are great for learning about investment real estate. My favorite is the CRS 204 Class-Creating Wealth through Residential Real Estate Investments. The class is best summarized with the I.D.E.A.L. acronym. Each letter represents HOW a particular investment real estate property will contribute to your wealth building.
- I=Income generated by the rental property (ie Rents, laundry/vending machines, parking lot fees, etc.)
- D=Depreciation (see above)
- E=Equity build up as the mortgage is paid down
- A=Appreciation as the property goes up in value over the holding period (some periods of negative appreciation can occur…these are the best times to buy!)
- L=Leverage (you borrow 70% to 100% of the purchase price, but only invest 0% to 30% of your own money)