Today I continue to explain why I’m investing in real estate over stocks. This post goes into the powerful tax benefits of rental real estate.
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Part of the “Road to Rental Real Estate” series.
This is a follow up post to Part 1. This multi-part post discusses why starting this year, I’m sinking more of my capital into real estate as my preferred taxable investment class. This post goes into the powerful tax benefits of rental real estate.
If you haven’t read the first part yet, please take a second and check it out: Why I’m investing in real estate over stocks – Part 1
What about retirement accounts?
I’d like to be specific that the money I’m putting into real estate is left over from my paycheck after I’ve fully filled up my tax deferred retirement accounts. This includes a 401(k) for me, a 457(b) and 403(b) for the Dr-ess, and backdoor Roth IRAs for the both of us.
I’m not going to pass up that sweet tax deferred (or tax free) investment space!
So the money I’m using for real estate is the cash that otherwise would go into my taxable Vanguard brokerage account.
My financial plan, which outlines my 15 year plan to financial independence, has us saving about $5000 a month towards this purpose this year.
As I mentioned in Part 1, real estate investing has major advantages as an investment vehicle. In this post, I’m going to focus on some of the tax advantages.
American loves businesses
One thing that became clear from my ongoing education about taxes is that the US rewards business owners and real estate investors more than “mere W2 employees”.
At a high level, this makes sense. The government uses the tax code to encourage or discourage various activities, and the IRS is their way of enforcing these policies.
The economy doesn’t function without businesses producing services and goods. Businesses sell their products and employ people, creating more revenue and income that the IRS can then tax. It’s a symbiotic relationship.
Likewise, investment into real estate ensures housing stock is available for everyone to live in. It also ensures that there are buildings where all of the precious businesses can operate.
So if you want favorable tax treatment in the US, it’s time to start a business.
“But I don’t want to start a business!” you might be saying to yourself. “That sounds difficult and scary!”
Well I have good news for you: If you purchase rental real estate, all of a sudden, you’re a business owner! Boom. No late nights or sales experience needed.
As a new business owner of rental real estate, you have access to some incredible deductions.
Let’s start out with one of the most powerful deductions as a real estate investor.
Depreciation: The “stuff wears out” deduction
“Depreciation” is the concept that property “put into service” for business purposes wears out. So every year, some percent of its worth can be deducted against your income from the property.
The Tax Cuts and Jobs Act of 2017 kept this depreciation period as 27.5 years for residential real estate. That means that every year, 1/27.5 of the value of your rental building can be deducted from the income generated.
That works out to about 3.6%. This may not seem like a large percentage, but consider that the value of a building is significantly more than the amount of income you receive from the building every year.
For example, if you have a building worth $250,000 (excluding land value), you may receive $2500 in rent every month. Of that rent, you might expect to cash flow $500 a month after expenses, or $6000 a year. This income would be completely covered by depreciation (3.6% of $250,000 is $9000 a year).
This deduction is pretty huge. The IRS tries to “recapture” 25% of the annual depreciation if you sell the property, but you can avoid this with something called a 1031 exchange.
Just like the interest on your primary home can be deducted (up to a limit) on your annual taxes, mortgage interest on your rental properties can be deducted as well! This is considered an expense.
Especially in the beginning of a new mortgage, this means that the majority of the mortgage payment can be deducted from the property’s income.
Keep in mind that in properly selected rental property, your tenants are the ones paying off your mortgage.
You can also deduct almost everything else related to keeping the rental property running, including:
- Property management costs
- Repairs and upkeep
- Travel related to your rental property
- Legal and professional services
- State and local real estate taxes
If you have any actual rental income after all of these deductions, you might be able to also take advantage of the “pass through” deduction. Between 2018-2025, this lets you deduct 20% of your rental income if you meet certain income criteria.
It’d take a genius to invest in real estate and pay taxes.Fortney Stark, House Ways and Means Committee, 1986.
Even though you can make a substantial return from investing in rental real estate, after all the deductions, you might show very little income or even a “loss”!
This is our government’s way of promoting small businesses, which according to reports create 66% of new jobs and account for 44% of total economic activity in our country.
In Part 3 of the series, I’m going to discuss the power of leverage to super-charge your returns on real estate.
This will be followed by an analysis of a real property that I’m purchasing, including my expected returns. Later on, I’ll give reports on the property to see if reality matches my projections.
–The Darwinian Doctor
Want to see how my real estate investments are going? Check out my Anno Darwinii series!
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