One of the greatest tax deductions offered to landlords is depreciation expense. The IRS allows landlords to depreciate the improvement of a rental property (single family residence) over 27.5 years. So, if you purchase a rental property for $125,000 and the land is worth $25,000, you can deduct the $100,000 improvement ($125,000 – $25,000 = $100,000) over 27.5 years, or $3,636.36 per year.
Depreciation is an invisible expense. The depreciation expense is added to yearly property taxes, mortgage interest, insurance, property management fees, and repairs. Below is a year 1 sample mortgage analysis with purchase price of $125,000 and financing $100,000 at 7% with a 30 year note:
Assuming a monthly rent of $1,000, you can deduct all above expenses except the $84 principle payment. Your total monthly deductions are $931 ($1,015 – $84 = $931). This calculates to a monthly gain of $69, or yearly gain of $828. Now apply yearly depreciation of $3,636, and your property shows a yearly loss of $2,808. Depreciation is a very powerful tool. If you owned eight properties with this scenario, you could deduct $22,464 against ordinary income. The IRS allows landlords to write off up to $25,000 in rental property losses against ordinary income.
Most investors who are high wage earners are not able to take advantage of rental property losses. The IRS limits the amount of losses you can deduct against ordinary income once your adjusted gross income (AGI) exceeds $100,000. AGI includes self employment income, W2 wages, interest, dividends, capital gains, and rental income. The IRS totals income for AGI before any Schedule A deductions or exemptions are considered. Once your AGI exceeds $100,000, the IRS multiplies the overage amount by 50% and reduces your loss by that amount. For example, if your AGI is $110,000 and you have a passive loss of $5,000, you are not able to write off any losses against ordinary income ($10,000 x 50% = $5,000). Instead, you can only carry over the loss. With an AGI of $150,000, all deductions are phased out.
If you are a licensed real estate agent, charge a management fee, and use the rental property you own to generate business income, you can apply the yearly depreciation expense against your Schedule C business return instead of Schedule E. Moving the depreciation to your Schedule C allows you to fully take advantage of your depreciation expense. The depreciation usually makes the property show a loss on your schedule E. When the depreciation expense is used as a business expense, the property most likely will show a profit on Schedule E instead of a loss. This loophole allows you to bypass the IRS AGI calculation and fully take advantage of the depreciation expense. Please check with your CPA for details.
Taking advantage of depreciation and acquiring more rental property can drastically reduce your tax liability. The longer you own the property, the more profitable it becomes. Rents usually increase yearly in a good market. In a standard amortization schedule, the principle payment increases and the interest expenses decreases slightly each year. The longer you keep the property, the more it will cash flow over time.
Once the property cash flows a couple hundred dollars per month, the depreciation expense makes the cash flow profit tax free. Take the tax free cash flow dollars and apply those funds to your Schedule A deductions for interest and property taxes on the home you live in. This is double dipping. You are taking tax free dollars and then using those funds to reduce ordinary income.
One final tip. Buy a property for each child when they are young. Rent the property out for 18 years. Once your child is ready for college, pull cash out with a line of credit or cash out refinance, and send your child to college for free. The interest is deductible; you pay no income taxes for the loan; and your tenant pays for the note and for your child’s college education. After you die, give the property to your children. The cost basis is the same as fair market value when they inherit the property. If they sell immediately, they pay no capital gains (assuming properties meet estate limits).