Tax Advantages of Real Estate
It’s tangible, it’s solid, it’s beautiful. It’s artistic, from my standpoint, and I just love real estate.
This week we have a guest post from tax expert Tim Clay. Tim’s been an enrolled agent for over 25 years, and helps small business owners choose the right business structure, grow their business and keep the tax man at bay.This article is for our American readers. The rules are NOT the same in Canada.
Canadians, you can find our past articles on taxes and real estate here.
46 Billionaires Have Made Their Fortune in Real Estate
by Tim Clay
The Donald’s not alone …there are at least 45 other billionaires who think real estate is a good investment.
In an article titled The 10 Common Traits of Real Estate Billionaires, Karen Hanover says 46 of the world’s billionaires made their fortunes in real estate.
One of the beauties of real estate is that, for middle and high income individuals alike, the tax advantages can be substantial. Here are just three things to consider about real estate:
1. Real Estate cash flows are sheltered from taxes
* Depreciation is a long term write off against cash flow
2. Real Estate has the ability to defer profit over time with an installment sale
* Installment sales will be big in the wake of the sub-prime crisis
3. Real Estate offers nontaxable exchanges (a.k.a. 1031 swaps) to avoid taxes altogether
* Some real estate gurus suggest a literal “swap till you drop” strategy
1. Tax Sheltered Cash Flows
As a real estate investor, you are very familiar with the concept of cash flow: buy a property that has more money coming in on a monthly basis than what is going out.
Investing in real estate allows you to shelter that cash flow using depreciation to write off the cost of your investment over a set number of years. So even while you have money coming in, and the market value of your property is rising, the government let’s you deduct (write off or depreciate) the cost of the building as it ages.
Depreciation is writing off (expensing) a portion of your investment each year until its value reaches zero. Because of depreciation, you will show less cash flow than you actually receive. Let’s look at an example
- You buy a residential rental property for $100,000 with a $20,000 down payment.
- You finance the remaining balance of $80,000 at 7% for 30 years, and a monthly note of $532.
- We’ll assume repairs are $3,500 in the first year.
- Other expenses (taxes, insurance, cleaning, etc) are assumed as 25% of revenue.
- The property rents for $1,100 per month.
Looking at this case on an annual basis:
|Rental Income||$ 13,200||$ 13,200|
|Mortgage Interest||$ 5,574||$ 5,574|
|Remaining Expenses (25%)||$ 3,300||$ 3,300|
|Repairs||$ 3,500||$ 3,500|
|Depreciation||$ 0||$ 3,448|
|Total Expenses||$ 12,374||$ 15,822|
|Total Income/(Loss)||$ 826||($ 2,622)|
This is one of the few times in life when we’re happy to lose!
Rather than pay tax on $826, depreciation gives you $2,622 to use as a write off against other income. Assuming a 25% tax bracket, this puts $656 (25% of $2,622) in your pocket.
2. Real Estate Installment Sale
An installment sale is when the real estate owner provides the financing for the buyer to get the property. It’s also known as “seller financing” or “owner financing.”
An advantage of an installment sale is that the profit is spread out over the term of the financing. This profit is recognized as interest (ordinary income), and profit (capital gain).
Installment sales provide an advantage by lessening and deferring the tax bite over time.
As a simple example, let’s say you sell a property for $350,000. Let’s look at what happens with an outright sale.
|Property Sales Price||$ 350,000|
|Net Profit on Sale||$ 85,000|
|Tax on Net Profit (25%)||$ 21,250|
Let’s assume you provide owner financing for the sale (rather than the buyer finding financing somewhere else and cashing you out). The sales price is still $350,000. You get a 10% down payment of $35,000, and you finance the $315,000 balance at 10% for 30 years. This gives a monthly payment of $2,764. You receive 6 payments during the year.
With owner financing, the sale is broken up into three parts. The first part is return of capital (your cost of the asset). The other two parts combine to form the income received. This income is broken up into interest (your charge for financing) and profit (your capital gain on the property).
The installment sale looks like this:
|Property Sales Price||$ 350,000|
|Net Profit on Sale||$ 85,000|
|Net Profit Percentage ($85,000/$350,000)||24.3%|
|Total received during the year|
|Down payment||$ 35,000|
|6 Monthly Payments ($2,764 each)||$ 16,584|
|Total Received||$ 51,584|
|Interest Income on 6 payments||$ 15,732|
|24.3% of principal & down payment||$ 8,712|
|Total taxable income||$ 24,444|
|Tax at 25%||$ 6,111|
Please note that this simple example does not include depreciation recapture which would increase the taxable amount of this transaction. We will deal with depreciation recapture in a later article.
Installment sales have the benefit of stretching out the tax due over the life of the financing.
In the wake of the sub-prime crisis, many people thrown out of their homes will continue to look for creative financing to get another home. An installment sale will be one major option for savvy investors to meet this need and pocket substantial profits.
3. Nontaxable Exchanges
A nontaxable exchange is when you exchange your property for a similar type of investment property. Nontaxable exchanges are commonly known as a 1031 swap. A gain or loss is not recognized until the property is disposed of.
You can see how 1031 swaps are a very good way to avoid tax on your real estate assets. There are, of course, a few things to keep in mind when you’re considering a 1031 exchange:
- The properties have to be “like-kind.” This term is not as restrictive as it may seem. You could exchange a single family home for an apartment building, for example.
- The transaction has to take place with a third party, known as a qualified intermediary. This intermediary is a specialized position, and usually has an inventory of properties available for exchange.
- The “swap until you drop” approach involves the inheritance of 1031 property. You never dispose of real estate. You continue to do 1031 swaps until you die (“drop”). In this case, your heirs receive the property at the Fair Market Value (FMV).
As a simple example, you have a single family home worth $250,000. You have equity built into the property of $50,000. You exchange the property for a 4 unit apartment building worth $250,000. You pay zero tax on the $50,000.
The idea is to continue to swap properties to defer tax, and then pass this property on to your heirs at FMV. You heirs receive all your deferred profit (equity) tax free.
Using the same example, let’s say you hold onto the apartment building until you die. The apartment is now worth $500,000. Your profit in the property is now $300,000. Your heirs would receive the property at a FMV of $500,000, without recognizing the $300,000 gain on the transfer.
This is a brief overview and introduction to the tax advantages of investing in real estate which are:
* Protection of cash flows using depreciation
* The ability to defer profit over time with an installment sale
* The possibility of avoiding any tax using a 1031 swap
For more information, the IRS web site has a specific section on real estate tax tips.
Tim Clay has a free monthly newsletter full of useful, actionable advice – written in plain English – on real estate and other small business topics. You can sign up for his newsletter at :www.asktaxguys.com.
Posted on May 25th, 2009