The IRS allows generous tax deductions for business owners and landlords. Unlike an employee, a business owner generates revenue and pays income taxes AFTER deducting business expenses. Business owners pay income taxes on net income, while employees have income taxes deducted from gross income. Employees receive remaining funds after taxes are deducted. Landlords are similar to businesses. They collect rent and pay income taxes after expenses. One of the best deductions for investors is depreciation expense. Depreciation is a very powerful tool for lowering taxes and building wealth.
Depreciation expense is a very unique deduction for investors and landlords. Real estate is the only type of asset that can be depreciated, but is an APPRECIATING asset. Most businesses depreciate capital equipment over the life of the asset. For example, a company truck may be depreciated over five years. If the vehicle costs $50,000, the business expenses $10,000 deduction yearly for five years. After five years, the truck is fully expensed and has a remaining salvage value. The value is substantially less than what the owner paid for the asset. However, real estate in most situations is an appreciating long term asset.
Landlords can depreciate the improvement portion of the property over 27.5 years for a residential rental property and 39 years for commercial property. Improvement is the total value of the property minus the cost of land. For example, if an investor purchases a rental property for $150,000, and the land has a value of $25,000, the amount allowed for depreciation is $125,000 ($150,000 – $25,000 = $125,000). The yearly depreciation expense in the above scenario is $4,545 per year ($125,000 / 27.5 = $4,545.45).
Landlords can deduct interest, property taxes, maintenance and repairs, property taxes, hazard insurance, mortgage insurance (if applicable), management fees, leasing fees and depreciation expense. The only expense a landlord cannot write off against rental income is monthly principle payment. The depreciation expense is added to the other expenses incurred by landlord. However, you don’t actually cut a check for the depreciation expense. It is known as a phantom expense. The $4,545 expense is added to interest, property taxes, insurance, repairs, etc.
Below is a year one scenario assuming a purchase price of $150,000, 80LTV, interest rate of 6.25%, tax rate of 2.5%, and $1,000 in repairs and maintenance, and $1,100 in monthly rent.
Principle Pmt $117.18 NA
Interest Pmt $621.68 $7,460.16
Hazard Insurance $50 $600
Property Taxes $312.50 $3,750
Repairs $83.33 $1,000
Totals $1,184.69 $12,810.16
Rent $1,100 $13,200
Yearly Gain/Loss $389.84
Depreciation Expense <$4,545.45>
Loss after Depreciation <$4,155.61>
As you can see, the landlord actually realized a gain of $389.84 before using the depreciation expense. Again this is a phantom expense. The investor did not write a check for the depreciation expense. It was simply added to all other rental expenses. Now the property will show a loss of $4,155.61 and can be deducted from ordinary income assuming investor’s adjusted gross income does not exceed $100,000.
The IRS allows individuals to deduct up to $25,000 in real estate losses (not from sales transaction) against ordinary income. If an investor owned six properties with similar deductions, they could write off $24,933.69 against ordinary income. Once the adjusted gross income exceeds $100,000, the IRS reduces the amount over $100,000 by 50% and deducts this amount from the loss. For example, if an investor has an adjusted gross income of $110,000, he or she would only be allowed to incur a maximum $5,000 loss against ordinary income ($110K – $100K = $10K x 50% = $5,000). After $150,000, the deduction is completely phased out. Any losses not incurred can be rolled over to the following year(s).