Rental Property Depreciation Cash Flow

[Cameron Belknap]

I am trying to calculate the cash flow "tax savings" due to depreciation for a property I am under contract for, and plan to rent out.

Everywhere I read, I am told to use effective tax rate (total taxes you pay/total income), but that does not make sense to me.  The taxes I pay on every extra dollar I make are not taxed at this effective tax rate, they are taxed on a "next dollar tax rate".  This is what my depreciation expense will be biting into correct?

For example, I make mid 60s, my effective tax rate is around 23%, but my next dollar tax rate is much higher at 37% (22%+Fica+state).  Shouldn't I use this number, and not my effective tax rate when calculating depreciation cash flow?

Lets assume that my depreciation will not bump me down to a different Federal income tax bracket.

Let me know what you think!

Cameron 

[Paul Caputo]

@Cameron Belknap Here's how it works. Depreciation is a deduction on your federal and state income tax returns that will lower your taxable income. So since you're sending less off to the IRS this will increase your cash flow on whatever timetable you're paying income taxes. 

Your rental income is put on top of your W-2 income so depreciation applies to the rental income first. If you're able to wipe out your rental income to $0 taxable after taking all other expenses and depreciation into account good for you, get more rentals and increase your income!! Since your active income is under $100k you're allowed to deduct a passive loss of up to $25,000 per year against your active income. I'm assuming your passive loss isn't going to max out the $25k, but if it does you'll have to carry forward anything beyond it. Since this takes it off the top the savings calculation should look at your combined federal and state income marginal tax rates. Since you're in Colorado with $60k active income the number you should use in the calculation is 22% federal and 4.63% state for a total of 26.43%. I think that's what you're looking for here.

As far as including FICA in your calculations I'd say no. FICA taxes are based on your earned wages less any pre-tax deductions from your employer that are exempt from FICA which is generally stuff having to do with health insurance or group life insurance. Your taxable income for income tax purposes is not the same as your earned wages to which FICA applies. A simple example is your 401(k) deductions do apply to taxable income, but don't apply to FICA. 

I'm not a CPA, so it'd be a good idea to check with yours, but I've never seen anything that has led me to believe that depreciation would impact FICA. I look at depreciation benefits everyday and we never take FICA into account. I assume that's because there's no interplay between the two since the depreciation benefit applies to taxable income, not earned wages.

It's true that you'll have to pay back the depreciation eventually in the form of recapture, but don't discount the fact that time value of money is working in your favor here. Not only can you reinvest those saved tax dollars today and get a good return on them, when you sell you're repaying the depreciation in future dollars of the same amount which will be worth less than today's dollars. Say you get $100 tax savings today and through investing it you're able to turn it into $200 over some period of time after which you sell the property. At that future date you pay back the $100, but if you look at that $100 in future dollars today it's only worth $75 in today's dollars due to inflation over that time period. And that's not even getting into partial asset dispositions and other mitigation strategies which could turn that $100 payback into a $50 payback.

It's good that you're factoring the tax implications into your calculations, you'd be surprised how many people don't do that. I hope this helps. Let me know if you have any other questions on depreciation and feel free to PM me.