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
Corey,
Thanks again for the opportunity to submit a post!
I am always happy to network with other bloggers! Glad to host your post. (no rhyme intended)
Very interesting post. I hadn’t thought of that. I am not sure what kind of rules they have around depreciation where I live. I will have to check that out since a rental property is something my husband and I are considering investing in.
Keep in mind that landlords also have repair cost. I put aside $100/month towards repairs. I made $4250 in profit last year, even with the repair costs and I only had to pay tax on $115 of it. Rental real estate can be very beneficial.
Ginger, that is a very good point. There certainly are many great tax benefits as Shaun points out. It is great to hear that you are doing well.
Ginger,
Thanks for pointing out repair costs and sharing what your budget is for. I considered including all of the usual costs in the post, but didn’t want to detract from the relationship between principal and interest payments and depreciation and interest expenses.
I’m pretty sure the straight line method can only depreciate over 27.5 years. I googled a bit and the 40 years is for non residential real estate.
Mortgage is the big bill, but there are a lot of other bills too – property tax, insurance, vacancy rate, repair, eviction bill, and more.
Retireby40, I am glad you mentioned this. I thought this was the case, but wasn’t sure. The material that I have read also suggests this. Thanks for the clarification. It is an important distinction.
Nice catch! I actually linked the IRS for the number of years for depreciation in the post, but inadvertently grabbed the years for the alternative depreciation system. 40 years is valid for residential property, but not the straight line method.
What is great about your clarification is that it makes the point even more attractive. At 27.5 years, depreciation would be about $450/month, which is even better!
I am aware of all the other costs, but simplified for illistration purposes. I wanted to focus on the fact that depreciation and not the principal payment is what is deducted. I feared taxes, operating and repair costs would muddle the point I was trying to make.
If you are interested, I have a lot of this data though! I hear that vacancy is at an all time low; around 5% right now.
That’s why I love rental properties!
I’m about to close on my first investment property – college real estate! I don’t even count the depreciation expense and any capital appreciation in my assumed returns, but it’s nice gravy!
Throughout the ages, laws have been structured to benefit landowners. That is only one reason that owning is better than renting.
Thanks CFM. You are right, there are many benefits to owning. I am excited to start the process soon.
How long have you been a landlord? I have been doing this for 3 years now and so far has worked out. However, it is very inconvenient when the tenants contact you with problems especially problems related to water.
Shaun, excellent post! Let’s talk a little more about this topic.
Say your rental is already $10,000 loss making already without depreciation, and your property costs $400,000. By law, I have to take on another $10,000 in depreciation to get to a total of $20,000 loss right?
When it comes time to sell my $400,000 property, I assume that if I have a cumulative loss due to depreciation & expenses of $100,000, that I add it to my cost basis to equal $500,000 right?
But not really right? Since every $10,000 a year depreciation LOWERS my cost basis by $10,000. So in essence, the depreciation stuff just rights itself at time of sale. Do I got this right?
Love to hear your thoughts, and also your thoughts on my post called “Cash Out Refi As A Way To Lower Your Taxes”.
Thx,
Sam
1. Depreciation is its own beast. The only thing that can impact it is if you have a change in the useful life of the property or increase the property value. So, yes, you can take a $20,000 loss, but only $10,000 is from depreciation.
2. Nope. You subtract accumulated depreciation from the purchase price to get at what is called, book value. When you sell any amount you receive over that book value would be a taxable gain.
3. Yes, it does, but there are certainly options to consider before it rights itself. You can cash out, you can improve the property and value; thus take on more interest and depreciation.
4. That’s quite the idea. I’d have to chew on it for a while, since it sounds too good to be true, but it certainly sounds like a great idea to me.
On point #2, gotcha, that makes sense.
However, let’s say the rental was already massively negative WITHOUT depreciation, and since one makes MORE than the $150K allowed for income deduction or whatever, what then? Does depreciation still lower the cost basis at point of sale, even though one doesn’t get the benefit of the tax shield since one makes over a certain income amount?
Thx, Sam
No that I see question #2 below about passive versus active rental, so I sent you an email.
When you exceed your loss maximum. You do something called a loss carry forward and reduce subsequent taxes by your loss.
Forgot to ask for clarification:
I coulda sworn there is an income limit for using rental losses to offset dayjob income. Isn’t it something like $150,000 in day job income?
Also, can you clarify the exact definition of passive vs. active rental activity and the tax implications? For example, I actively manage my rental properties myself. But, for some reason, it’s classified as passive….
thx, Sam