REAL Exclusive Magazine

Benefits Of Investment And Rental Real Estate

By Jeff Riddell

The benefits of owning investment and rental real estate are pretty obvious: wealth building and cash flow. Don’t let the current market discourage you. The time to buy is when prices are low. Now let’s expand on that with some tax talk.

For rental properties one of the benefits is income, but another benefit is depreciation (sometimes referred to as cost recovery). Conceptually IRS treats the improvements (buildings, parking lots, exterior lighting, etc.) on rental and business real estate as if the improvements were deteriorating year by year and becoming less and less valuable—almost like a depletion allowance for oil and gas. Depreciation allows you to write off the theoretical deterioration each year even though we all know such properties do not deteriorate if they are well maintained—and usually go up in value over time, not down.

To compute the depreciation allowed for a rental property, first subtract the land value from the total value to determine the depreciable basis. For rental houses, condominiums and apartment complexes (residential), you then divide the depreciable basis by 27.5 years to determine your annual write-off. For other rental real estate such as office buildings and shopping centers (commercial), you divide the depreciable basis by 39 years—these are approximate because they do not take into consideration what month you bought the property, but otherwise the annual percentage write-off for residential is 3.636% for most years and non-residential is 2.564%. Why the difference in depreciation schedules? The answer is: our government encourages residential (housing) development through the bigger depreciation deduction.  So, for a $300,000 property with a $50,000 land value, the yearly depreciation deduction would be about $9,091 for residential property; $6,410 for commercial property.

For example, suppose you buy a $250,000 rental house, allocating $50,000 to nondepreciable land value. Dividing the $200,000 cost of the structure, each year for 27.5 years you can deduct on Schedule E of your tax return approximately $7,300 without having to pay even one dollar in cash for any actual depreciation expense.

If the depreciation tax loss on a rental property exceeds the rental income (where, for example, Schedule E of your tax return shows a negative number for a particular property), the rules passed in 1986 to stifle tax shelters (passive activity loss limitation rules or PALs) prevent you from writing off the excess losses against other income. There are two exceptions: active participation and material participation. Active participation allows real estate investors whose adjusted gross income (AGI) does not exceed $100,000 to deduct up to $25,000 of losses (after AGI reaches $100,000, the deduction phases out up to $150,000). Active participation requires involvement in management decisions and ownership of at least 10% of the property. Active participation is less stringent than material participation. Although Material participation may allow a real estate investor to write off all excess losses against other income, the investor must spend at least 50% of his working time in real estate activities (with minimum of 750 hours annually). Such activities include property development, construction, management, leasing and brokerage activities.

To summarize, depreciation deductions shelter approximately the same amount of the property’s rental income from tax, so an important benefit of owning rental real estate is the tax free income (cash flow) that results from depreciation deductions. By the way, taking depreciation on rental properties is mandatory under the IRS rules; if you don’t take the deprecation deductions along the way, you may have to account for them when you sell.

Jefferson F. Riddell is a Florida Board Certified Real Estate attorney with thirty-five years of experience assisting people with a variety of residential and commercial real estate matters. U.S. 1031 Exchange Services, Inc is a 1031 exchange qualified intermediary (QI) and a member of the Federation of Exchange Accommodators (FEA). As President of U.S. 1031 Exchange services Jeff has been facilitating 1031 exchanges for more than twenty years. Jeff has been awarded the Certified Exchange Specialist (CES) certification. Jeff may be reached at 941-366-1300 or via email at jeff@us1031.com. www.us1031.com