The Tax Byte

Tax Advantages Increase Rental
Real Estate Returns

Favorable tax rules are a major reason why so many people have gotten rich from real estate. You can shelter your cash flow and defer taxes on appreciation and gains. That means higher returns on your real estate investments. After reading this, you'll see what we mean. Tax Byte Graphic

Writeoffs, Sweet Writeoffs

As you know, you can deduct mortgage interest and real estate taxes on a rental property. However, if you pay mortgage points, you must amortize them over the term of the loan (unlike points on a mortgage to purchase a principal residence, which you can generally deduct immediately.

You can also write off all the various operating expenses -- like utilities, insurance, homeowner association fees, repairs, and maintenance, yard care, etc.

But the biggest tax-saving writeoff is depreciation. You can depreciate a residential building over 27.5 years, even while it is -- you hope -- increasing substantially in value.

Say you buy a rent house for $135,000. The price allocable to the building (not the land) is $100,000. You can depreciate the $100,000 over 27.5 years. Your annual depreciation writeoff is about $3,6000, which means you can have that much positive cash flow each year without owing any income taxes. If you own several properties, you can readily see that you can shelter a significant amount of cash flow with your depreciation deductions.

Commercial buildings must be depreciated over a much longer 39-year period. But the depreciation is still a very valuable tax benefit, because it shelters cash flow from taxes.

Observation: You should rejoice at any opportunity to have positive cash flow without paying any current taxes! You can reinvest the full amount of the sheltered cash flow, which means much higher returns for you.

Passive Loss Rules May Apply

When your property throws off a tax loss -- and most do at least during the early years of ownership -- things get trickier. The complicated passive activity loss (PAL) rules will probably come into play. The fundamental PAL concert is this: you can only deduct passive losses to the extent you have positive passive income from other sources -- like positive operating income from other rental properties or taxable gains from selling them.

Fortunately, there's a special exception intended to help small landlords. If you are eligible for this break, you can deduct up to $25,000 in annual passive losses from rental real estate, even if you have little or no passive income. You qualify if: (1) your adjusted gross income -- before the rental losses -- is under $100,000 ($50,000 if you are married and file separately), and (2) you "actively participate" in the rental activity.

Active participation means owning a 10% or greater stake in the property and being energetic enough to at least make management decisions like approving tenants, signing leases, and authorizing repairs. In other words, you don't have to fix the toilets yourself to actively participate. On the other hand, if you hire a management company to handle all the details, you definitely won't qualify for the $25,000 exception.

If your AGI is between $100,000 and $150,000, the exception is phased out. For example, $130,000 of AGI means you can deduct up to $10,000 in passive real estate losses (40% of the $25,000 maximum) whether or not you have any passive income.

If you want to cash in on the $25,000 exception, you may have to carefully monitor your adjusted gross income and take action to keep it under control, because every $2 of excess AGI will cost you $1 of passive deductions. (Any disallowed passive deductions will carry over to next year, but that doesn't help you any right now.)

Example: Say your AGI for this year is shaping up to be right around the $100,000 level. Selling some doggy stocks or mutual funds will lower your AGI. In contrast, selling some winners could push you over the edge and result in lost deductions. Another way to reduce your AGI is by contributing more to your SEP or Keogh retirement plan. Also, your spouse may qualify to make a deductible IRA contribution.

If your AGI is above $150,000 and you have no passive income, you generally cannot currently deduct a rental real estate loss. However, your loss carries over to future tax years. You will eventually be able to deduct your carryover losses when you either sell the property or generate some passive income. Note: Realtors may qualify for a special exemption from the PAL rules, more on that in a later issue.

When Your Properties Throw Off Positive Income

Eventually your rental properties should start generating positive taxable income instead of losses, because escalating rests will finally surpass your deductible expenses (including depreciation). Of course, you must pay income taxes on those profits. But if you piled up some carryover passive losses in earlier years, you now get to use them to offset your profits. So you may not actually owe any taxes for quite a while. See? Those carryover passive losses turned out to be worth something after all.

More good news. Positive taxable income from rental real estate is not hit with self-employment (SE) tax, which applies to most other profit-making ventures other than working as an employee and investing. Depending on your situation, the SE tax can be either 15.3% or 2.9%. In either case, it's a wonderful thing when you don't have to pay it!

Favorable Rules for Sales

When you sell real state that you've owned over a year, your profit -- the difference between sales proceeds and basis after reductions for depreciation -- is generally considered a capital gain. However, part of the gain -- the amount equal to the depreciation -- is taxed at a maximum rate of 25% rather than the normal 20%. Before you complain, remember that those earlier depreciation writeoffs probably sheltered income that would have been taxed at 28%, 31%, or higher.

The rest of your gain is taxed at a maximum of 20%.

Remember those carryover passive losses? You also get to use them to offset gains from selling your properties. So your taxable gain may be smaller than you think. (This is why it definitely pays to keep careful track of your carryover losses, even though you don't get any current tax benefit from them.)

Remember too that you are able to defer income taxes on rental property appreciation until you actually sell. So your property can grow in value year after year without Uncle Sam constantly skimming off part of your gains. Good properties can generate the kind of compounded tax-deferred growth that investors dream about. You can even pocket part of your gain in advance by taking out a second mortgage against your property or refinancing it with a bigger first mortgage. Is this a tax-free maneuver? You bet.

You also have the option of selling real estate on the installment plan by taking back a note for part of the sale price. Then your taxable gain can be spread over several years. This could really work out great if Congress once again lowers capital gains taxes in the relatively near future. You also get to charge the buyer interest on the deferred payments, but you generally don't have to pay interest to the government on your deferred taxes. Can you do this with publicly traded securities like stocks and bonds? Nope.

Finally, tax law allows real estate owners to unload appreciated properties while still deferring income taxes indefinitely. Here we are talking about so-called "like-kind exchanges," which are also known as "Section 1031 exchanges." Basically you swap one piece of real estate for another, and put off paying taxes until you sell the new piece. Or when you are ready to unload that property, you can arrange yet another like-kind exchange. For example, you can trade your holdings in one geographical area for properties in other more promising locations. Or you can, for example, exit the rental apartment business by making a like-kind exchange for a strip shopping center. The ability to make these tax-deferred exchanges puts the icing on the cake for real estate investors.