One common question we hear when it comes to real estate is: how do people actually make money on rental properties? If you break down the numbers on rent received and expenses incurred, it may net you a positive cash flow of $5,000 - 10,000 per year. As a passive income stream this isn’t terrible. However, if you think of the liability on potential major expenses, a tenant not paying rent, and maintenance in between tenants, a lot of people don’t see the reward being worth the risk. Often, though, people are not familiar with the tax benefit of having rental properties and a little thing called depreciation.
The Logic Behind Deductions
The IRS tax code has over 5,800 pages in it, and believe it or not, 99.5% of those pages are outlining the legal tax deductions for individuals. The IRS incentivizes people whose source of income stimulates the economy. This includes job creation, providing housing, energy, and food production. All 4 of which are key to human survival. So, while we think that the IRS wants to nickel and dime us on our taxes (I’m not saying they don’t sometimes, but overall), they actually believe that providing deductions on expenses now will increase the overall taxable income in the future.
Depreciation
The IRS allows you to write off about 3.6% of your purchase as a depreciable asset. What this essentially allows you to do is to take a deduction that isn’t technically a cashflow expense. By having this expense on the profit and loss of the rental, it typically makes your positive cash flow for the year tax free. Often times, the depreciation will show a net loss for your property for the year which will reduce your other taxable income (although there are some limits here). We don’t want to bore you with all of the technicalities but want to make sure you understand the general principles with it.
Example
Let’s say you purchase a home for $600,000 for a rental and the house is valued at $500,000 and the land at $100,000 (land isn’t depreciable). With the 3.6% depreciation deduction each year, $18,000 is considered an expense to the property. Let’s say that the cash flow from renting the home is $12,000, this leaves you with a net loss of $6,000 on the property while receiving your $12,000 tax free. Furthermore this $6,000 can reduce your tax liability on other income you have.
Depreciation is something that can get very confusing very quickly. We wanted to give some general thoughts on how real estate can be worth the investment for some people. We don’t think everyone should run out and get into real estate just for tax purposes… especially if you aren’t really sure what you’re doing. But one thing we do know, if you want to get into it, you have a tax strategist on your team that can help you navigate it all to make sure it’s worth it!
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