In Part 1 of this series, we introduced the 5 reasons to invest in real estate and we also looked at the Income benefits of real estate, including the most important reason:
Cash Flow. If you want to dig even deeper into Cash Flow, check out this great article.
Lace up and tie your boots, it’s time to kick Uncle Sam where it counts and discuss the second reason why real estate is an ideal investment–depreciation.
(Photo: Amy Meredith)
IDEAL Reason #2: Real Estate Depreciation – Less to Uncle Sam, More to Your Pocket
The IRS allows you to take tax deductions for your real estate if it is used in your business or income-producing activity. These tax deductions can’t all be taken at once, so that’s where depreciation comes in. Depreciation uses a very archaic and cryptic formula that, who else but the IRS, uses to come up with a “useful life” for your asset. For residential rental property, this is 27.5 years. For non-residential, i.e. commercial property, this jumps up to 39 years. The actual land surrounding your property doesn’t depreciate, so you can’t actually take a deduction on the land portion. Your property, excluding land, is called the dwelling and the value of that can be depreciated.
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You may be wondering, “how does all of this tax gobbledygook help me?” Here is where the magic happens. This depreciation can be claimed as a loss on your taxes although you really didn’t lose anything. Sure, the property may need the occasional maintenance, but your property is likely to increase in value while you are getting benefits of a “depreciating” asset.
Using our 27.5 year example and remembering that only the dwelling value can be depreciated, let’s look at a $116,500 property:
Total Property Value = $116,500
Dwelling Value = $100,000
Land Value = $16,500
The answer comes out to be a nice round $3,636.36! Don’t ask me where 27.5 originated from–the IRS works in mysterious ways.
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Let’s say you had a good year with your property and earned $2,500 in cash flow. Subtract your $3,636 of depreciation and you have yourself a ($1,136) passive income loss. Riddle me this though, what did you really lose? Your property might have even increased in value this year. With the loss, your $2,500 cash flow from this property has essentially become “invisible” to the IRS, with a little more besides. I think I see a tear coming from Uncle Sam’s eye. Don’t worry though, it’s perfectly legal and the government wants you to take this deduction in order to encourage affordable housing to the public. You may also be able to offset your other income with this loss. Please consult with your tax accountant to review depreciation losses and how they apply to you.
If you are a more experienced investor blessed with the gift of real estate education, you may already be clamoring behind your computer screen: “You forgot to mention depreciation recapture!” Uncle Sam is no dummy, so after he heals up from the swift kick you gave him, he will want your depreciation savings back. This occurs when you sell the property. The rebuttal to this concern, and a way to postpone the rematch with Uncle Sam, is to do a 1031 Exchange. Don’t know what that is? See our blog post and a great video explanation here!
Again, please do not use this advice directly for your situation without speaking to a professional such as a CPA. As you know, taxes are very complicated and one size or situation does not fit all. Talk with your CPA during tax time and make sure you have a discussion on Depreciation for your rental property, and how it applies to your specific situation.
The great thing about real estate is that you generally receive money in your pocket from your assets no matter what happens to you. If you’re sick or can’t work at your day job, or you get laid off due to an economic slowdown, recession or downsizing, your primary income source is gone. The old adage of “job security” just doesn’t exist anymore. I know people who have worked at the same company for 30+ years who get forced into early retirement due to a “slow year” in the business. During the recession of 2008, a great deal of companies laid off a lot of very skilled and unfortunate people.
How can real estate help prevent disaster due to job loss? Well, it can’t make you “un-fireable” or impress your boss so much that he/she makes you employee of the year, but real estate can add many more revenue streams under your belt. In real estate, you could have 5, 10, 20 rental properties, or many more, working for you day-in and day-out, while you sleep, while you eat breakfast, and while you work at your day job too! And hey, don’t worry, those trusty little revenue streams won’t fire you for having a bad day at work. If revenue doesn’t do it for you, maybe your humanitarian side will. Real estate helps others. You’re providing housing for people and contributing to your community.
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To put it simply, real estate is an asset you can control…that’s why we love it. The ability to control your investment is what makes real estate an infectious and enticing win, over and over again.