You’re a married couple in your mid-30’s living in your first home, bought five years ago. You’ve discussed your future, especially as it relates to retirement, and agree that real estate provides a much more predictable potential for capital growth. You have about $20K in your company retirement plans combined. Your cash savings amount to about $8K, held as a cushion and for peace of mind. You realize you have enough home equity to pull enough cash out to begin your real estate investment portfolio. However, you’re not sure about much else. You decide buying a small duplex in your area makes the most sense because they seem to be priced about the same as your home, which is now worth about $300K or so. You contact your buddy Fred who sold you your home way back. He asks what you want to buy and where. Before you know it Fred has half a dozen duplexes ready for your inspection.
This approach should raise a giant red flag, as you’ve now been designated by your buddy Fred, as knowledgeable investors. If that doesn’t scare you, you’re truly fearless. 🙂 You have stumbled upon what I call the Nordstrom’s Shoe Salesman Syndrome, or NSSS. Of course, Nordstrom’s approach is wildly successful as perceived by its very loyal customers — as far as selling shoes is concerned. They don’t sell income properties. I’ve discussed this before.
Your ‘analysis’ of these properties will be superficial at best because you’re looking at money in, money out, and your budget. Nothing wrong with that, as far as it goes. But as a first time investor you should also understand just how important after-tax analysis is. It can go straight to your weekly paycheck if you understand how it works.
If you guys are in the federal tax bracket of 25% and state bracket of 5%, every dollar ‘lost’ through the use of depreciation will act as a producer of positive cash flow. “What?” you ask.
If you purchase one of those duplexes for say, $300K you’ll be able to show depreciation of roughly $12K which will include both the building itself and personal property. At your combined state/fed tax rate of 30% this will result in a tax savings of about $3,600. That’s income tax you aren’t paying as a direct result of your duplex purchase.
We in the industry call that positive cash flow. But let’s go a step further. Why should Uncle Sam have that money for free until you file your next income tax return? Why not go to your employer and have them increase the number of exemptions you claim? (Your CPA can tell you how many more to claim.) This will result in a significant increase in your take-home pay. Why wait for the IRS to refund your money?
Of course, this isn’t the only reason you want to see an after-tax analysis of a potential investment property. Not by a long shot. But for starters you have to admit it’s pretty cool.
Kevin Boer says:
There’s a certain amount of fine print associated with these passive losses. Check with your tax accountant to be sure, but here’s my understanding:
1) IRS-classified real estate professionals can deduct an unlimited amount of passive losses against their regular income.
2) Non real estate professionals can deduct a maximum of $25,000 of passive losses against their current income, provided their adjusted gross income is $100,000 or less. Above $100K, they lose 50 cents on the dollar of deductibility — so, for instance, someone with an AGI of $130,000 can deduct a maximum of $10K of passive losses. ($130K – $100K = $30K; $30K / 2 = $15K; 25$K – %15K = $10K). At and above $150K of AGI, you can’t take any passive losses.
3) When the property is sold, uncle Sam charges a 25% depreciation gains recapture tax on the cumulative total of depreciation written-off during the years. It’s still a good deal, however, because it’s better to pay 25% in the future than, say, 30% in regular income tax now.
4) I believe the depreciation recapture gains tax is delayed when the property is sold and the proceeds are rolled into another one via a 1031 exchange.
February 9, 2007 — 7:46 pm