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.
-Donald Trump

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

Tax Advantages of Real EstateThe 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


Tax Write offs from Real Estate

Tax Write Offs from Real Estate


If you are paying taxes, it means you are making money.If you are paying a lot of taxes, then it stands to reason that you are making a lot of money. However much you make, it doesn’t make it any less painful to pass it along to the government though. Unfortunately I haven’t been faced with the problem of paying a big bundle of tax to the government (but I am hoping I have that problem really soon!!), but I have been through enough in the last seven years to give you a few pointers on some ways to minimize taxes surrounding residential real estate dispositions.

I know taxes might seem boring, but we know someone out there is interested in it because we are going down this long and dusty road at a reader’s request. There is so much to cover that this will be part one of a series. To roll it out, let’s start with the basics. As a real estate investor, you will pay tax on the rental income you earn on the property as well as on any capital gains when you sell. The amount of tax you pay on rental income can be reduced dramatically by expenses such as maintenance, property management, capital cost allowance (depreciation), interest on your mortgage (but not the principal pay down), and other money spent to run your property. In another edition we will come back to some of the elements above. For this edition, let’s focus in on the second major area you will pay tax on, and that is on Capital Gains when you sell your investment.

Capital Gain occurs when you sell your property for more than you paid for it. You do not realize your capital gains until you sell.

To calculate your capital gain take the:
Money from the sale of your property
Costs of disposition (real estate agent fees, lawyers etc.)
What you paid for the property.

You will owe tax on 50% of the amount from the above calculation if the resulting number is positive (a capital gain). This amount gets added (or subtracted if it’s a net loss) to your personal income and you are taxed accordingly.

If the property you are selling is your principal residence, then it is exempt from tax. According to Canada Revenue Agency, a property qualifies as your principal residence if in that year of filing:

  • you acquire only to get the right to inhabit
  • you own the property alone or jointly with another person
  • you, your current or former spouse or common-law partner, or any of your children lived in it at some time during the year
  • and, you designate the property as your principal residence.

Now, what if you live in the home for a few years, and then move out and rent it out for a few years as I did with the condo that I owned in Toronto? In that situation, the answer for me was that the condo could still be considered my principal residence for four years after I changed it’s use. The catch is that I could not claim capital cost allowance on the condo, nor could I claim any other property as my principal residence at the same time. For me, this choice was easy because I moved into a property Dave and I already owned and had been treating as a rental property from the accounting sense of things. It was easier to keep the condo as my primary residence and continue to treat my new “home” as a rental property for accounting purposes. It’s important to note that you and your significant other (including common law or same sex partner) cannot own two principal residences at the same time for tax purposes. You must choose one during the over-lapping period.

It’s complicated and that is why both Dave and I have accountants that we consult with on a regular basis to get the best advice.

THE DISCLAIMER: Neither of us have any legal training, nor do either of us have extensive accounting training. We are not experts and we always consult with our accountants and legal counsel before we make decisions. We pay money to get quality advice when we need it and always advise our friends, family and readers to do the same.

Item added to cart.
0 items - $0.00