Understanding how depreciation counts as negative income?

Question

Hi guys, the following quote is from this BP article:

https://www.biggerpockets.com/renewsblog/2014/10/2...

Could somebody please help me understand this concept by giving a real life/hypothetical situation that makes more sense to me. Thanks

"The IRS allows you to write off the value of any property over 27.5 years. This depreciation counts as negative income, but it’s only negative on paper since the costs of keeping a property in good condition can be paid for out of the rental income.

Thus, the depreciation “losses” wipe out the positive cash flow from the property and remove any tax obligation. Unfortunately, due to the Tax Reform Act of 1986, only active investors can take advantage of this."

Cal C. · Answer

Here is sort of a real world example.  I'm greatly simplifying several things, but it will get the idea across.

I'm buying a property for $80K ready to rent.  I'll estimate 20% of that will be for land which you are not allowed to depreciate.  So I will have $64K ($80K * 80%) in depreciable assets.  So for each year I'll be able to use $2,327 ($64K/27.5) in depreciation.

I'm going to rent the place for $1,000 per month or $12,000 annually.  I'll have a mortgage on it which I'll pay $250 in interest or $3,000 annually.  I'm assuming my other costs (taxes, management, insurance, repairs, etc...) will be about $400 monthly or $4,800 annually.  So a total of about $7,800 in cash expenses.

That gives me about $4,200 ($12,000 -($4,800 + $3,000)) thus far.  I will also deduct the depreciation expense $2,327, a non-cash expense.  That leaves me $1873 ($4,200-$2,327) in taxable income.

A few things to keep in mind when I sell the property I will have to pay recapture tax on the depreciation whether I take it or not, the above assumes I am taking it.  Recapture tax is 25% (federal)  so if I am in a higher income tax bracket I am not only deferring taxes I am saving on taxes.  Also, I could delay paying the recapture tax by doing a 1031 exchange.

My actual cash flow on the property will be different than the taxable income.  Again, using my simplified figures- I'll have $4,200 left over after paying cash expenses.  There is one other cash expense that the IRS doesn't allow and that is principal paid on the mortgage.  In my case it would be $150 monthly or $1,800 annually.  Which means my cash flow will actually be $2,400.  PLEASE NOTE over the long term actual expenses will likely run higher because of tenant turn-over, vacancies, and capital repairs (roof, HVAC, etc...) I just used those numbers to keep it simple.

Daniel Chang · Answer

Depreciation is a "non cash expense".  If you have $10,000 in rental income, and $8000 in actual "cash" expenses (maintenance, marketing, taxes, insurance, etc), you would have $2000 of net profit/cashflow that normally you would pay taxes on.  However if you then add on non-cash expense of depreciation, that may reduce the net profit to less than zero so you have a net loss.  Add on $2500 of annual depreciation, you net income would be $-500.  So you won't owe any taxes despite having a cash flow of $2000.  The quote is slightly wrong.  ANY investor can take advantage of this.

What it's alluding to whether you can then use that $-500 and offset that against your earned income (ie a job that you work).   Back in the day, people who earned a lot of income buy real estate as "tax shelters" to use the depreciation to offset their earned income.  The Tax Reform Act 1986 did away with this.  Essentially IRS says real estate buy/hold is passive income and generally passive losses can only be deducted against passive income.  There are some exceptions to the rule if you "actively participate" or "materially participate" in the real estate investment.  It's pretty easy to fall under the "active participation" rules.

Mark Creason · Answer

I am currently working with a seller who is attempting a 1031 exchange on 5 million dollar sale.  He has no basis at this point, as a previous property was on a ground lease, so he was able to depreciate 100% of his costs.  His current problem is finding a property to purchase as cap rates are low.  If he does not purchase a property to replace, he will pay approximately 1.7 million in taxes, as he has a 25% recapture rate, along with a 3.8% Medicare tax plus state capital gains.

I would stress how important it is to have proper tax planning and if you are going to do a 1031 exchange, to find a declared property early in your 45 day window.

Mark

Cal C. · Answer

@Mark Creason I'd definitely be considering replacing current property with multiple properties, since it may be very difficult to find a single property worth the full amount of carryover.

Steven Hamilton II · Answer

Depreciation is your cost in the property and it MAY OR MAY not cause a loss on your tax return.  Your new costs will be either repairs or capital expenditures.

Joel Bowen · Answer

Thanks @Daniel Chang, that was a great example and helped me understand.

Also thanks @Cal C., def explained that in a super easy way for me to understand.

I appreciate it greatly guys, you guys are the man! :)

Understanding how depreciation counts as negative income?

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