Chandler Properties Blog

Death and Taxes
Paying taxes is something we all hate doing.  However, savvy real estate investors know that real estate offers some great tax advantages.  Often a rental property will operate at a taxable loss, while simultaneously creating positive cash flow for the owner.  This is beneficial because these taxable losses reduce our tax liability while at the same time creating cash flow and building appreciation in our property.  

This blog entry is the first of a two part series on rental property taxes.  It will explain how to compute taxable income for your annual tax return. Part two will explain how to compute taxable gains/losses from the sale of rental real estate.  

Hypothetical Example
Let’s take a look at a hypothetical example that compares Taxable Income vs. Actual Cash Flow.  Assume we buy a $125,000 house that will be rented out.  We allocate $25,000 of the purchase price to land and $100,000 to the building.  This is important because land does not get depreciated.  The IRS allows us to depreciate the basis in the building over 27.5 years resulting in $3,636 of depreciation a year ($100k / 27.5 years).  Depreciation is a taxable expense, but has no effect on cash flow.  See the below example that compares Cash Basis Income to Taxable Income for a hypothetical year:

                                    Taxable                 Actual 
Revenue                     Income               Cash Flow  

Rent                            $12,000                $12,000

Expenses

Mortgage                      $6,300                   $8,400

Insurance                          600                         600

Property Tax                   1,500                     1,500

Depreciation                   3,636                            0

Total Expenses           $12,036                $10,500

Net Loss                        <$36>                 $1,500

In the above example there are two differences between “Taxable Income” and “Actual Cash Flow.”  For taxable income, only the interest portion of the mortgage is tax deductible.  For cash flow purposes, the entire $8,400 payment ($2,100 of principal & $6,300 of interest) is a cash outflow.  The $3,636 depreciation is not a cash outflow.  However, it is a taxable expense for computing taxable income.  The benefit of depreciation is that IRS rules let us assume the property will decrease in value 3.6% a year (1 / 27.5 years), when property typically appreciates a couple percent a year.  The IRS is giving us a break by allowing us to expense this depreciation now.  As we can see this property is creating $1,500 in positive cash flow, while generating a <$36> taxable loss.  If you were in the 25% tax bracket, this would save you $9 in taxes ($36 x 25%).  In sum, we are able to create $1,500 of cash while getting a $9 tax break.

Conclusion
I hope this is a clear example of some of the tax advantages of rental property.  On the next installment, I will discuss how to calculate gains/losses when a rental property is sold.  If you have any questions feel free to post a comment.