Investment Property Tax Law
Many of America's wealthiest people are heavily invested in real estate. It offers the benefit of significant ongoing cash flow coupled with the potential for appreciation through growth in value and through the process of paying down the loan balance. In addition to these benefits, investment property tax law is also extremely generous, further increasing income from investment real estate due to reduced tax liability.
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Personal Residence vs. Investment Property
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Many people buy personal residences in part because the interest and some other expenses are tax deductible. However, many of these deductions are limited by a number of factors, including the alternative minimum tax as well as other income caps. Furthermore, a number of expenses for a personal residence are not tax deductible at all. Investment property, on the other hand, is treated similarly to a business, in which only the profit is taxed.
Allowed Expenses
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According to the IRS' own Tax Tips, just about every expense related to investment property can be used to reduce taxable income. Like a personal residence, mortgage interest and property taxes are deductible. In addition to these common expenses, you can also deduct insurance, utility costs, management, maintenance and repairs and even advertising costs. Since all of these expenses are considered reductions to gross income rather than deductions, they are not subject to personal deduction limits.
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Capital Expenditures
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A good rule of thumb is that anything that will last more than a year, other than minor repairs, is considered a capital expenditure. Investment property tax law does not allow capital expenditures, such as the cost of a new building or of replacement HVAC units, to be an expense. The logic behind this is that since these items will have a long life, they add to the value of the property and should, instead, be used up over time. This process is called depreciation and allows the gradual expensing of that cost.
Building Depreciation
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Just as roofs, new HVAC systems and the like have a limited life, buildings do, too. The IRS allows you to depreciate your investment real estate over its life as well. Depending on the type of building, its value can be spread out over either 39 years for commercial property or 27.5 years for residential or multi-family property. Land, however, is not deductible. The way that this works is that you take the value of the building on a property, divide it by 27.5 or 39, and use that amount every year to reduce taxable income. This is a gigantic benefit of investment real estate.
A Real-World Example
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Let's assume you purchase a $2 million apartment building at an 8.5 percent capitalization rate. This property would generate approximately $340,000 in rent. This income would be immediately reduced by $170,000 in expenses, leaving a net operating income of $170,000. Against this income, you would then subtract depreciation. Assuming that 75 percent of the value of the $2,000,000 is allocated to the building, the depreciable value would be $1,500,000, which leads to a $54,545 deduction for depreciation. This makes the taxable income only $115,455.
Selling Investment Property
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Thanks to Section 1031 of the IRS code, you can sell your investment property and buy more property without paying any capital gains or depreciation recapture tax. In most states, you will not have to pay state income or capital gains tax, either. This ability to both accrue and realize gains tax-free may very well be the biggest benefit in investment property tax law.
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References
- Photo Credit TAX TIME image by brelsbil from Fotolia.com
