How many think of expenses and income as a black and white axiom? Where income is good, expenses are evil and profit is when good overcomes evil? In the first few years of operation, rental businesses flip this natural law of finance on its head and all because of an accounting expense known as depreciation.
The things that you buy to use for a business get used up over time, so the purpose of depreciation is to account for this natural loss of value. It exists strictly as a rule of accounting, you won’t get a bill in the mail for it, but it is fully deductible against your income taxes. This makes depreciation is a valuable expense for rental owners.
While depreciation can benefit any business owner, it can lead to losses for rental owners in the early years of operation. What is unique about the rental industry is that these losses are actually a large benefit to owning rental property.
To illustrate, it’s best if I give you a rental business example.
A Typical Rental Business
If we were to look at a landlord’s bank account, we see that the main outflow of money is his 30-year mortgage payment on a $150,000 home. The payment is roughly $800/month, which breaks down to about $625 in interest and $175 in principal for the first year. The landlord is looking for a 15% return on his investment so the rent coming in the door is about $925/month. This means that each month, after the he subtracts the mortgage payment from rent income, he has $125 left over.
After 12 months, he’ll have banked $1,500 more than his expenses, but he’ll be taking a loss when his income tax bill rolls around. The reason? Depreciation!
A Typical Rental Businesses Tax Return
The principal portion of a mortgage payment is not tax deductible as an expense. Instead, landlords must use depreciation, which is much larger than principal payments in early years.
The simplest way of calculating depreciation is the straight-line method. To calculate you divide the price of the home, $150,000, by 40 years. For our scenario, it works out to $3,750 per year or $312 per month.
By following the rules of tax accounting, the landlord subtracts the monthly rental income of $925 by the $625 in interest paid, $312 of depreciation and arrives at a loss of $12 each month.
How Expenses Can Be Exciting?
$12 of loss doesn’t sound like much, but think back to the landlord’s bank account. He has actually earned a 15% return on his investment. The return is tax free based on the rules of accounting and the losses that were recorded can be offset against income from other sources; like a day job. Structure your rental business as an LLC and passive investors can also share in the loss. A tax-free 15% return on investment, plus tax losses that can be used against other income makes pitching rental investment easy to other potential investors.
I need to stress that the example above is simplified and not every rental owner can structure their business in a way that would make a loss. Factors like interest rates, home prices and rental prices can have a large impact on whether income is positive or negative. However, a landlord should be able to claim higher depreciation than principle and dramatically reduce tax liabilities in the early years.
Expenses and losses don’t need to feel like a war against good and evil. When it’s depreciation, it’s ok to get excited about losses.
*featured image provided by: ishane