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

Part 2

Tax Write Offs from Real EstateFeature Reader Request Article

(If you missed Part One, you can check it out here).

It felt like I won the lottery at tax time this year. My cheque from the government was five figures. I am not bragging about this, because the reality is that the sale of my Toronto Condo happened at a net loss to me after real estate agent fees and our Toronto tri-plex cost us almost $30,000 last year. So, the money I got from the government didn’t come close to easing the financial pain I experienced in 2006, but it did make me glad they were investments and not solely my homes. Had they been only my homes, that money would have been gone for good.

So, how can you maximize the tax write offs from real estate investments? Personally, I always consult my accountant. In over 15 years of using an accountant, I have only once paid him more than I have gotten back from the government. But, I don’t just rely on him, I do have a decent understanding of what qualifies as current and capital expenses.

First, the definitions. An easy way to think of a CAPITAL EXPENSE is that it provides a lasting benefit and improves the property beyond it’s original condition as most renovations do. If it’s a separate asset like a new stove or fridge then it can usually be treated as a capital expense. Typically these expenses are significant (in the thousands of dollars). Usually these expenses must be deducted over several years versus current expenses which usually get fully deducted in the year they are incurred.

Some examples of capital expenses include:

  • The purchase price of rental property,
  • Fees associated with the purchase of the property such as legal fees,
  • Purchase of furniture or appliances to go in the property,
  • The addition of a deck to the property, or the addition of another bathroom.

CURRENT EXPENSE is generally something that repairs the property to its original condition, for example a coat of paint or repairing stairs. The expense is usually one that recurs on a regular basis and provides a short term benefit. Some common current expenses include:

  • Costs of renting the property out (property manager, advertising, cleaning costs),
  • Insurance on the property,
  • Interest on your mortgage (note that your principal repayment is not deductible),
  • Maintenance and repairs that restore the property or item to it’s original condition,
  • Property taxes,
  • Your hired help: accounting fees, property manager fees, cleaning people’s wages, consultants, lawyers),
  • Utilities,
  • Travel costs to collect rent, view or work on the property (note that this includes transportation costs but not typically lodging or food),
  • And office expenses that are directly related to your investment (things like long distance fax charges and telephone bills we have expensed but pens and paper we have not, although you can if it’s directly related to your investment activities).

Published:October 29, 2007

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