Tax implications of reinvesting 100% of profits

[Steven Torok]

Hi all!

I would like to understand what general tax benefits exist if 100% of rental profits are reinvested into new properties.

I own, through a LLC, a few rentals which are fully paid for, and am in the position to just reinvest all profits.

I assume there are local/state tax implications, therefore I am looking for some general direction here.

I am new to Biggerpocketsville, thus your feedback is highly appreciated!

Many thanks!

Cheers,Steve

[Erik W.]

@Steven Torok, hi and welcome to BP!

For the sake of keeping the scope of this thread manageable, we will assume there are no tax incentives or credits that apply to your town or state only and just think in terms of general, nationwide tax law.  Furthermore, we will assume you are not participating in any Govt backed programs such as "Opportunity Zones."  Those are very specific and we could go down rabbit trails for hours and still not scratch the surface.

Basically, profits are the money left over after all operating expenses and debt service interest is paid.  Notice I emphasized interest, because debt service amortization (i.e. principle payoff) is still considered part of your profit.  That's important to remember.  You do not get to deduct the entire amount of your mortgage payment, just the interest portion (and Taxes and Insurance if your lender escrows).

So what does buying more rentals do to your tax bill?  Well, it could increase it because you're collecting more rent, it could decrease it because you have more expenses and/or more paper loss (i.e. depreciation), or it could all come out in a wash if your increases in rent approximately match your new deductions.

Let's say for 2020 you have $100,000 in profits that would be taxed at whatever your tax rate is.  You finance the entire $100,000 purchase price over 20 years at 5% interest.

However, you bought a $100,000 building on January 1st, 2020.  

For 2020, you collect $12,000 rent from that building. That would increase your income for 2020. But first you would deduct all of your expenses (estimate 40%), leaving you a Net Operating income (NOI) of $7,200.

Then you would deduct your interest expense, which for 2020 would be $4,932, leaving you a PROFIT of $2,268.

But the IRS have given us the magic of depreciation, the 9th wonder of the world right after compound interest, in my opinion.  Depreciation is a fiction that costs us no money but saves us by delaying/deferring taxes on our actual profit.  For depreciation, you would deduct ($100,000 / 27.5) or $3,636 from your profit, leaving you a PAPER loss of $1,368.  You can use that "loss" to reduce the tax bill on other income from W-2 or rents, up to a certain amount in any given year.

Paper loss?

Yes, the IRS says your building is slowly falling apart and becoming worthless.  But in fact you are keeping it repaired and in good condition (remember that 40% of expenses includes maintenance and capital expense set asides?) and the building/land is most likely going up in value, at least keeping pace with inflation and possibly doing even better as the location becomes more desirable.  You bought that $100,000 building in a decent neighborhood, right?

So you get to deduct for something that costs you nothing, and in turn that makes you look like you did worse that you really did.  You made about $2,200 in profit, but as far as the IRS is concerned you LOST money and that loss offsets other income that is in your pocket.

This is a simplified example.  For example, I am not counting your full mortgage payment to include principle or the accompanying amortization on the loan balance, which essentially wipe each other out in terms of net worth, but may cause you to cash flow negative.  You should always consult a tax professional for your own situation.

Hope that helps.