"Tax benefits" explain?

[Jackson Long]

Hey guys,  we often talk about the tax benefits of owning real estate.  Do these benefits extend beyond the rental income?  Could somebody give me a laymen's overview of how this works?

[Austin Fruechting]

Copied from my blog:

THE MAGIC OF DEPRECIATION

One of the biggest tax advantage provided to you for owning rental property is depreciation expense. Depreciation is magical! It’s a phantom loss, a paper expense you get write it in. It lowers your taxable income even though it does not actually lower your revenue. Everything but the land gets to be depreciated down to zero. That means that if the land is worth twenty thousand dollars and the building is worth eighty thousand, you get to write off the full eighty thousand of the building value over time against the income you make.

Currently buildings are depreciated over a 27.5-year life span. (using a $100k property, 20k to land, 80k to building) This means over that time you can deduct the full $80,000 from your income. It happens in equal installments and in this case that would be just over $2,900 a year. That’s $2,900 worth of income that you don’t have to pay any taxes on, just for owning the property. At the end of the year if you have $4,000 of income and profit for the property, you get to subtract $2,900 of your taxes. You only have to report and pay taxes on $1,100 of the income. You still made $4,000, but only have to report $1,100!! It’s magical!! If you pay over 30% in taxes, this means you would have around one thousand extra dollars in your pocket every year. An extra $1,000 in your pocket just for writing in the phantom expense of depreciation. Segregating the depreciation can make it even more powerful. Different systems and parts of the building have shorter or longer depreciation lives.

LOW TAX RATES

Another big one is simply the tax rate you are charged. Rental properties are considered passive income sources. As such are not subject to the personal employment taxes of social security and Medicare taxes. If you are self-employed that is a 15.3% tax savings. If you are an employee that is a savings of 7.65% compared to your W-2 income. Thanks to depreciation not only is your taxable income basis lower than your actual income, the income that is left to report is taxed at a lower rate!

Even when selling your property you pay a much lower tax rate. If you have owned it for more than one year your profit is only subject to long-term capital gains taxes. The long-term capital gains tax rate is typically a flat 15% for most people. If you buy and sell a property in less than a year though any profit will be subject to your standard tax rate and all self-employment taxes. I rarely sell anything. But it’s nice to know that if I do, I won’t lose a huge chunk of it to taxes!