One of the most confusing, or at least misunderstood, facets of real estate is the tax implications. Without getting into too much detail, the government allows owners to depreciate the value of buildings over its depreciable life which can be used to offset interest payments on the loan, thus creating favorable tax implications. Because of favorable tax treatment of real estate, investors pay little or no taxes on returns from real estate investments.
Overview of Federal Tax Policy Toward Real Estate
- Depreciation enables cash flow from your real estate investments to be partially tax-deferred. Multi-family buildings are depreciated over 27.5 years, while commercial buildings are depreciated over 39 years using a straight-line depreciation method. Note that only the building is depreciated, not the land. Also, only the interest portion of a loan payment, not the total payment, is deductible.
- The federal tax rate for depreciation recapture is currently 25% while the tax on price appreciation is 15%.
- The amount of interest deductible in a given taxable year equals the total interest paid to the lender during that year.
This simplified example walks through a scenario that illustrates how real estate taxes work:
(click to enlarge)
In this example, we purchased a building for $7,000,000 sold it for $8,000,000 and while we held it took a $1,000,000 in depreciation as a tax deduction. In addition, we made $500,000 in capital improvements. Selling expenses are 5% of the sales price and the remaining mortgage balance is $5,000,000. What is the tax due on the sale?
By walking through the model, we see the before tax cash flow is $2,600,000 (sales price – sales costs – mortgage balance). The adjusted basis is $6,500,000 (original cost – accumulated depreciation + capital improvements). Capital gain is therefore $1,100,000 (sales price – sales costs – adjusted basis) and price appreciation is $100,000 (capital gain – depreciation recapture). We’re taxed $15,000 (15% on price appreciation) and $250,000 (25% tax on depreciation recapture). Therefore, our after tax cash flow from the sale is $2,335,000 (before tax cash flow – total capital gain tax).
As you can see, we use the $1,000,000 in depreciation to offset a large amount of the capital gain, and therefore we are taxed much less.
In real estate, there are a few ways to defer the payment of taxes such as the 1031 like-kind exchange, which I will cover in a later post.
Post any questions you have about the taxation of real estate in the comment section below.
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