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Growing Equity: A Guide for the Hopeful Investor, Part 4

Taxes

The hardest thing in the world to understand is the Income Tax
Albert Einstein

There are many reasons to invest in real estate. Not the least of these is the way the tax man looks at it. Favorable tax treatment means that the income you receive will be partially or completely sheltered from income tax. You will also have the ability to defer taxes you may owe when you sell the property at a profit. I am going to explore the tax aspect of investment real estate in a general sense, but please do not consider any of what I say to be tax advice. You should consult your regular tax advisor before making any decisions carrying tax consequences.

Cash Flow vs. Taxable Income

When you operate income property, you have money coming in (rents) and money going out (expenses and debt service). If expenses and debt service are less than the rents, you have a positive cash flow—money left over at the end of the month. Your cash flow will change from one month to the next because your expenses will change. If a dishwasher needs replacing, you will have to reach into your pocket that month. It is important to be prepared for unforeseen repairs. Setting money aside each month into a “sinking fund” for future repairs and replacements is a good idea. Sooner or later, things wear out and have to be replaced.

Let’s say you are enjoying regular cash flow of $200 each month after setting aside money onto your reserve fund. How much of that money are you going to have to pay out in taxes?

Possibly nothing. Here’s why.

When you file your income taxes, you will list the income and expenses from real estate on Schedule E (Supplemental Income and Loss). You will list each property you owned during the tax year, along with all the income collected and expenses claimed in operating the property. When you subtract the expenses from the income, you will have a net income or a net loss. If you show a net loss, you may be able to use that loss to reduce your taxable income from other sources. This is a subject to take up with your tax professional.

On Schedule E you will claim all the expenses you incurred in operating your rental property: insurance, repairs, maintenance, property taxes, mortgage interest—and depreciation. Let’s look at that last item.

Depreciation is defined as “a reduction in the value of an asset with the passage of time, particularly due to wear and tear.” Houses do wear out with time; carpets have to be replaced, roofs reach the end of their useful lives, appliances stop working. As an investor, you are allowed to assume that the entire house will be worth nothing at the end of a certain time. For residential property, that time is 27½ years.

Let’s say you have purchased a rental property for $400,000. We can’t depreciate the land (it won’t wear out), but we can assign a value to the structure. We will say that the house itself is worth $275,000 and the land is worth $125,000. We use “Straight Line Depreciation,” which means the house will lose the same amount of value each year. Dividing $275,000 by 27½ years gives us $10,000 annual depreciation. That figure is entered into Schedule E, where it reduces our taxable income.

Depreciation is important because, even though it is something we can write off, we did not have to take any money out of our pocket; it is a “paper loss.”

Another important expense item is “Mortgage Interest.” You can’t deduct the principal portion of your mortgage payment—only the interest. On a $300,000 loan at 4.5%, your monthly payment is $1,520. In the beginning, $1,125 of this is interest, $395 goes to reduce the principal. In the first twelve months, you will pay $4,840 in principal, $13,400 in interest. That is the amount you will enter as an expense on Schedule E.

Let’s see how the numbers look for our $400,000 rental:

We bought the property for $400,000 with $100,000 down and a $300,000 loan at 4.5%. We have rented it to a dependable, creditworthy tenant for $2,100 per month. Here are the numbers that would go on the tax return:

taxable-income

Because of the $10,000 depreciation we claim each year, this property shows a loss of $4,500 for that year. Depending on your individual situation, that $4,500 could reduce your taxable income from other sources, like your job. Check with your tax advisor for the specifics of this.

Here’s how this rental looks on a monthly basis:

cash-flow

This rental provides a positive cash flow each month. It’s not a huge cash flow, but keep in mind that your monthly mortgage payment ($1,520) includes nearly $400 toward paying off the mortgage; it’s a sort of enforced saving plan. Furthermore, with the tax “loss” (negative taxable income) of $4,500, you may be able to reduce your overall tax bill by sheltering your other income.

I know what you’re thinking. “$55.00 a month isn’t a very good return on my $100,000—even with the tax write-offs. I can do better than .66% return.” That would be true—if it were the whole story.

Real estate is a long-term investment. The time and expense of selling a property means that you have to be prepared to hold it for long enough to offset those costs and let the benefits accrue. Let’s see how our rental looks over a five year period.

We are emerging from an unusual period, where real estate values plummeted in the wake of the credit crisis of 2007-2008. The unprecedented number of foreclosures and other distress sales has depressed values by some 30% from their peak, and sometimes quite a lot more. This has created buying opportunities, but it has also given rise to fears that real estate values are going to plunge even further.

I believe these fears are unfounded; the conditions that led to the crisis and plunge in real estate prices no longer exist. The days of “stated income” and “no-doc” loans are far behind us. Anyone applying for a mortgage today is subject to lending standards that are far more rigorous than they have been in the past—although it is not true that lenders are requiring a DNA swab as part of the application process.

As we look at our hypothetical rental house, we should make some assumptions. Let’s say that the value of the home increases by 3% each year. Let’s also assume that we can increase the rents by 2% each year. When we sell the property, we’ll pay a 5% commission.

net-equityEven though the value of the property has increased after just a year, there is no net gain because of the cost of selling. Five years out, however, the gain is substantial—over 67% on our original investment.

What happens to our cash flow as we hold the property?

net-cash-flow

We are able to increase rents slightly each year, but the main expenses for the property—especially the mortgage payment—do not increase. At the end of five years, the cash flow for the property has increased fourfold.

What about the tax aspects? Aren’t we going to have to pay income tax on the increased cash flow? Take a look:

net-taxable

The Net Taxable income increases (the write off is less), but we still show a tax “loss” because of depreciation.

You may have noticed that I did not address any tax liability when we sell the property. As of the current state of the tax code (2013), long term capital gains are due at a rate of between 0% (taxable income up to $72,850 for married taxpayers filing jointly) and 23.8% (taxable income over $450,000). The capital gain is calculated by subtracting the “cost basis” from the selling price. The cost basis is the purchase price of the property plus capital expenditures (let’s say you added a room), less depreciation taken.

Remember how we’ve been claiming $10,000 each year in “paper loss,” and that has given us  a tax write off each year, even though we have had a positive cash flow. We paid $400,000 for the rental. That is our cost basis at the time we bought the property. We claimed $10,000 in depreciation each year, so our cost basis at the end of five years would be $350,000 ($400,000 less five years of depreciation at $10,000 per year). If we sell the property for $467,000 and pay a commission of $23,000, our adjusted selling price is $444,000. Subtracting the adjusted cost basis of $350,000, we have a “Realized Gain” of $94,000 ($467,000 minus $350,000). In a straight sale, we would pay capital gains tax on $94,000. The tax liability could be between $14,000 and $22,000, depending on your other taxable income.

But there are ways to avoid this tax completely—or at least, to defer it indefinitely. Under a much-loved section of the Internal Revenue Code, §1031, you can do a “tax deferred exchange” into “like-kind property.” This means that you can transfer the gain from your old property, the rental house, into a new, larger one—let’s say a four unit apartment building. When the IRS says “like-kind property,” it means investment real estate for investment real estate. You could, for example, exchange your rental house with its appreciated equity into a tract of development land. You could exchange into a commercial building. So long as you are exchanging into other investment property, you have met the primary criterion for a tax deferred exchange.

What you cannot do is to exchange a rental property for a personal residence. That is not considered “like-kind” property.

The specifics of tax deferred exchanges is beyond the scope of this document. You should meet with a real estate broker who is experienced in this important strategy to learn more. Before I leave the topic, however, I do want to mention briefly in a general sense how an exchange works, and why it is so useful.

You have held your rental house for five years. You have grown your equity from the initial $100,000 to a very respectable $167,000—all while collecting some cash flow and without having to pay any tax on that income. Because the property is worth more money and your loan is smaller, you have lost some of the benefits of leverage. You started with a 75% loan, but now it is down to less than 60%. It may be time to regain some of the benefits of the leverage we spoke about earlier.

You find a buyer for your property at $463,000. He agrees to cooperate in your 1031 exchange. This means that he will be receiving title from someone other than you. You have found a nice fourplex for $660,000. You and your broker determine that it will provide good cash flow with a down payment of $165,000 and a new loan of $495,000. The seller agrees to cooperate in your exchange. At close of escrow, you will convey your rental house to the seller of the fourplex. Because you will get a new loan on the fourplex, he will receive the cash he wants. He conveys the fourplex to you. He doesn’t want to own your rental house, though; he conveys that property to your buyer and receives the purchase price you and your buyer had agreed to. When all the dust settles, you own the fourplex, the other buyer owns your former rental house, and the seller of the fourplex has been cashed out. Everyone has gotten what they wanted—and you have not had to pay any taxes.

If you have ever been through this process or have investigated how it works, you may be pounding the table and saying, “That’s not how it works!” through clenched teeth. You would be right—partially. In today’s world, tax-deferred exchanges are typically accomplished through facilitators and intermediaries. These companies provide a valuable service and give a great deal of flexibility through the exchange process. The thought I want you to take away is that you can move from one investment property into another, taking advantage of your accumulated appreciation to reestablish leverage—all without paying a dime of capital gains tax.

Next: Financing Your Empire

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