Federal Income Taxes

As a real estate investor, you should not purchase property solely because of tax considerations. Many remember the large losses suffered by those who did so and were ruined financially by the 1986 Tax Reform Act. However, careful tax planning may help to maximize your return on certain investments and should be considered when weighing alternative investments.

Income property owners enjoy certain tax advantages other investors do not. An owner is allowed three types of deductions from gross income when calculating taxable income from investment property: operating expenses, financing expenses, and deprecation.

Operating Expenses

Operating expenses include those cash outlays necessary for operating and maintaining the property.

Financing Expenses

Financing expenses include interest on indebtedness and amortization of the costs of borrowing money, such as discount points.

Deprecation Deduction

Deprecation deduction is not related to the deprecation used in appraising, which is based on realistic improvement lives. This is an arbitrary method of allowing you, as an investor, to recover the cost of improvements over a specific period.

Cost of residential income property may be recovered over a life of 27.5 years. Non-residential income property may be written off over 39 years. For example, if a person bought a duplex three years ago for $125,000 paid closing costs of $5,000 and obtained an appraisal showing the building was worth 80% of the total, what is the deprecation deduction?

To determine the deduction, first, allocate the acquisition costs to the building and the land, then divide the building’s acquisition costs by the applicable depreciable life. The $125,000 purchase price plus the $5,000 in closing costs equals the acquisition cost of $130,000. Because the building is worth 80% of the value, the building’s depreciable basis is $104,000. Residential property is depreciated over 27.5 years, so $104,000 divided by 27.5 years equals a deduction fort this year of $3,781.81.

Federal Income Taxes Considerations: Tax-Deferred Exchange

While the new capital gains rates are attractive, most investors attempt to defer (not eliminate) paying any taxes by exchanging the property for like investment property. Like investment property includes real estate such as vacant land, residential income property, commercial income property or industrial income property.

To learn more about tax-deferred exchange read my other article here: 1031 Tax Deferred Exchange.

Asset Preservation is 1031 exchange company (qualified intermediary) and they can help you accommodate the 1031 Tax Deferred Exchange.

Federal Income Taxes Considerations: Installment Basis Reporting

Taxes on the gain from the sale of a property need not be paid at once if the seller does not receive the proceeds in the year of sale. The law allows the taxpayer to pay taxes on the gain as the seller receives the proceeds. No minimum or maximum down payment is required. A loss on sale may not be reported using installment basis reporting.

NOTE: I am not a tax advisor, please refer to your CPA for a detailed explanation on your situation.