Over my years as a real estate investor, I have come to realize one thing: real estate is what you make of it. Provided you work hard and give it your all, it can very easily reward you for your efforts. In fact, investing in real estate has become synonymous with a multitude of perks, not the least of which are tax benefits. And on that note, it is of the utmost importance that you familiarize yourself with the tax incentives that can take your business to the next level.
Passive income real estate investors, in particular, are awarded one of the greatest opportunities to take advantages of: deductions. However, I am not referring to standard, itemized deductions; there is one with the power to really boost your bottom line come tax time. Otherwise known as depreciation losses, these deductions allow you to write off the cost of the house over a predetermined amount of time.
The I.R.S. defines depreciation losses as “allowances for exhaustion, wear and tear (including obsolescence) of property.” According to their website, “You begin to depreciate your rental property when you place it in service. You can recover some or all of your original acquisition cost and the cost of improvements by using Form 4562, Depreciation and Amortization, (to report depreciation) beginning in the year your rental property is first placed in service, and beginning in any year you make improvements or add furnishings.”
Let me explain:
Let’s assume you are the sole proprietor of a local coffee shop, and it just so happens that you are in the market for a new printer. Assuming the printer is going to be used for business purposes only, it classifies as a business expense, and can therefore be written off come tax time. But here is where things get interesting; the I.R.S. won’t allow you to write off the entire cost of the printer in the same year you bought it because it is expected to last longer than 12 months. Instead, they will spread the deduction out over the predetermined life of the printer, which – according to the I.R.S. – is five years. As a result, you will be allowed to deduct a portion of the cost of the printer in the first year, another portion in the following year, and so on until the entire cost of the printer has been accounted for over the course of five years.
The same concept holds true for passive income real estate investors, or rental property owners. Just as in the printer analogy, single-family homes have a predetermined lifespan, and are thus subject to depreciation. Not unlike your office supplies, the I.R.S. has accounted for the deterioration of homes. And why shouldn’t they? Homes can’t be expected to last forever. In fact, every day that passes causes homes to depreciate in the eyes of the I.R.S. As a result, homeowners are allowed to deduct the cost of the building no differently than the printer. It essentially brings the colloquial business expense to a whole new level.
Of course, single-family homes are expected to last much longer than the five years allotted to office supplies. In fact, the brain trust associated with the I.R.S. has determined that the deductible life of a single-family home is 27.5 years. That means homeowners can deduct a portion of the cost of the home every year for the next 27.5 years.
Depreciation losses are without question one of the biggest perks associated with owning rental properties. However, I have only begun to scratch the surface of their potential.
I encourage you to take special note of the duration the I.R.S. has given homes to “break down.” You may have noticed that 27.5 years isn’t that long. Massachusetts alone has a bevy of homes that have been standing since the 1600s. You are telling me that the I.R.S. expects homes to last just under 30 years? I don’t think so, but you won’t hear me complaining.
In fact, it is the depreciation period that landlords have to thank for one of the most advantageous tax breaks I have ever seen: the “phantom deduction,” otherwise known as the aforementioned depreciation losses.
It’s no secret that property values tend to trend upwards over long periods of time. Even in the wake of one of the worst recessions ever, property values have proven resilient and are now heading up at a brisk pace. It isn’t until you account for said appreciation, however, that depreciation losses reveal their true power.
You see; if home values are constantly on the rise, depreciation never really takes place. That said, any deductions you make on a single-family home over the course of the allotted 27.5 years are most likely made in the face of rising prices – hence the name phantom deduction. More often than not, the loss never actually occurs. Homeowners are therefore able to take advantage of deductions without their asset depreciating. It’s almost too good to be true.
With the right steps, depreciation losses can certainly contribute to the bottom line of any passive income rental portfolio. However, the deductions aren’t going to take care of themselves. It is entirely up to you to know which costs may be deducted from your rental income.
Hopefully my advice will help to shed some light on the situation before April 18th. At the very least, you should now have an idea of how powerful of an asset deductions are. There is no reason you can’t count on tax time to boost your passive income profits.