Can you not depreciate for taxes?

Question

Hi,

I am trying to fully understand taxation of rental properties before I make my first purchase.  The scenario I'm looking at is a buy-and-hold strategy (100% cash) that would generate a moderate amount of income (with no other sources of income).  My tax situation varies a lot, but that's the scenario I'm looking at right now.

My understanding is that the highly touted tax benefits of owning rental property boils down to [1] you can write off expenses (but I don't see that as a benefit; I don't think people should pay taxes on money they didn't make), and [2] you can depreciate the property.

In the case I describe, it seems to me that not depreciating might be more beneficial.  In 2012, marginal tax rates for <$70K income were 15% (married filing jointly).  Using depreciation, you would pay a lot less in taxes today, but would owe capital gains on the depreciated amount in the future if/when selling.  So buying a property for $100K today and selling for $150K in the future could potentially cause as much as $150K capital gain (rather than the actual $50K gain).

It's impossible to predict what taxes will be like in the future, but [1] am I right than in the situation described, not depreciating the property might be beneficial (I.E. am I overlooking something obvious?), and [2] is there a way not to depreciate (the IRS says that the basis in the property needs to be adjusted my the allowable amount of depreciation, even if not deducted)?

Thanks in advance for any assistance.
                          -Scott

CL Ziegler · Answer

Great thread everyone, thanks!

Scott P. · Answer

Thanks all; that was very useful information.
                        -Scott

Steven Hamilton II · Answer

Steve Babiak,

Thank you for that reminder. I was typing the other post from my phone.

If your adjusted gross income is below 100K you can deduct up to a 25k(special allowance) in expenses exceeding your income.

If your adjusted gross income is above 100k (unless an exception applies). That 25k allowance is reduced by $0.50 for ever dollar of income over 100k. This is completely phased out at 150k.
Your expenses in any year are limited to the amount of rental income brought in.  That means If you brought in 13k in income and incurred 15k in expenses, you can only deduct 13k of expenses. The remaining expenses carryover to the future as a Passive Activity Loss (PAL).

Exception:

If you qualify as a real estate professional, you are able to deduct more than the 25k allowance and are able to deduct passive real estate losses if you AGI exceeds 150k.

Chris Masons, That is why I'm the Tax Guy.  Tax and accounting are how I make my living. I make my life much easier with my real estate investing. :D

-Steven

Chris Masons · Answer

Welcome to BP Scott. Listen to Steve he knows his RE accounting/tax information very well!!

As far as biggest benefit to RE investing another HUGE benefit in my opinion that is just as high up as the ability to leverage is the ability to actually have passive gains in the real world but be able to show a paper loss in the accounting world, again by the use of our friend called depreciation.

Steve Babiak · Answer

Well, for the most part the expenses that are a "write off" reduce income that was actually received in the form of rent; so that basically just lowers net income received.  There is a phase out for this too.  Steven Hamilton II is well qualified to go into specifics when he has the time.

Steven Hamilton II · Answer

Scott P., Welcome to the forum here.

The biggest benefit of real estate investing is doing so with leverage. This is because, you depreciate a residential property over 27.5 years. The benefit of this is that you pay the loan of 30 years. In the beginning of the mortgage you paying mostly interest, whereas your depreciation will stay constant throughout those 27.5 years.

You will have more depreciation than principal actually paid in. This will in essence actually double dip deductions

Since you paid cash you will not have an interest deduction.

You do want to depreciate the property. This is because when you sell you will have to decrease the basis by the depreciation you have taken or were allowed to take.

Some individuals will not take depreciation but then when they sell the property they make an adjustment to account for the depreciation in the final year. However, very rare the IRS can choose to not accept your change in accounting method.

-Steven