At Realized, we believe that tax planning in real estate is about seeking opportunities that can help ensure the amount of money you make remains money you keep. And knowing your actual, taxable cash flow is one opportunity. In this three-part series, we’ll examine different ways to use tax planning that are designed to help keep potential profits in your pocket.
If you’re sizing up a rental property for its potential return, the first route might be to look at net income -- rental revenue minus expenses and mortgage payment. That’s a simple calculation that can be done quickly, but it can miss out on some big differences.
Namely, that taxable cash flow (the actual cash you have in your pocket at the end of the day) and taxable income are two different things. And while it’s more complicated to calculate cash flow, it can print a bigger picture of how your bank account will look when Uncle Sam goes home.
It’s a worthy exercise, though, because the two things that are taxable with real estate investment properties are today’s revenue and tomorrow’s capital gains. Knowing where you stand with Uncle Sam can help you create a solid strategy for managing -- or at least delaying -- both.
In this blog post series, we’ll cover three different ways to use tax planning in an effort to increase the amount of money you can keep in your pocket. There are three topics we’ll cover: depreciation, increasing your cost basis, and leverage real estate exchanges.
This post will cover the first concept: depreciation.
Tax Management Strategy: Depreciation
One of the biggest differences between cash flow and income is depreciation. It’s a deduction that lowers the amount of your taxable income up to the entire value of the home and lasts for almost three decades (27.5 years). Over time, the potential savings can be enormous -- but it’s only a “loss” on paper. In reality, it’s still part of your cash flow equation.
Here’s an example of how it changes the bottom line:
An investor takes out a $150,000 loan at 3% to buy a $200,000 property, which generates $1,000/mo in revenue from rental income. Generally speaking, operating expenses total around 40% of total revenue ($4,800 in this example), and depreciation comes in at a standard 3.6%, or $7,272 in this example.
Here’s the calculation to find pre-tax income:
$12,000 income
– $4,800 40% operating expenses
– $4,500 3% mortgage interest tax deduction
– $7,272 annual depreciation
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(-$4,572) pre-tax income loss
This investor has a paper loss for the year and will not owe taxes on this investment. But that doesn’t mean their cash flow is negative. Here’s what happens when depreciation is added back into the equation:
-$4,572 tax loss
+ $7,272 depreciation
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$2,700 after-tax cash flow
From another perspective, here’s how the numbers look if the same investor didn’t take depreciation, and fell into a 30% tax rate:
$12,000 income
– $4,800 expenses
– $4,500 mortgage interest
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$2,700 pre-tax income
– $810 30% tax rate
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$1,890 after-tax cash flow
That’s a 30% increase in cash to you, purely by taking depreciation on the property. That cash flow, though? It’s subject to taxes. The next step is figuring out how to keep as much of it as possible.
In the next post, we’ll cover an additional tax planning strategy that is designed to help you increase the amount of potential returns you keep in your pocket: increasing your cost basis.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Examples shown are hypothetical and for illustrative purposes only. All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure. Income, cash flow and/or appreciation are not guaranteed. Programs that depend on tenants for their revenue may suffer adverse consequences as a result of any financial difficulties, bankruptcy or insolvency of their tenants. The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
