Real estate has a number of tax advantages.
One of the key preferential treatments tax-wise with real estate is DEPRECIATION.
Depreciation is a required accounting method that spreads the cost of an asset over multiple years. The Federal Tax Code requires us to depreciate or take a paper loss on the property each year. Unlike other business expenses (taxes, maintenance, utilities, etc.) depreciation is a paper loss, which means we don’t spend any money, but still get to count it as an “expense” to reduce net income for tax purposes, saving money on the tax bill.
The Time-Value of Money
These tax-reduction possibilities allow investors in real estate to reduce their taxes and thus have more money for other purposes.
We know the time-value of money, that today’s dollars are worth more than tomorrow’s dollars.
The tax advantage for each investor may be different. We recommend each person consult with their own accountant or tax advisor to understand their unique personal situation and options.
Delay the Eventual Payment of Taxes
Now, what the tax code gives, the tax code takes away. When the property is sold, the accumulated depreciation has the effect of increasing the net gain on the sale and therefore on the capital gains taxes to be paid in that year.
There are a number of tools we use to mitigate this future tax bill.
One is what is called a 1031-EXCHANGE, which is a bit tricky. The 1031-Exchange allows us to roll the net capital gain into another property and delay paying taxes on that gain for the life cycle of the newly purchased property.
Another is a REFINANCING EVENT, in which we pull out equity with a new loan. The numbers and cash flow would still have to work, but a refinance allows capital to be harvested tax-free. This allows us to keep a well-performing property, not have the expenses of a sale, benefit from future loan amortization, and cascade up with returns on the redeployment of capital into a new property. As long as the new debt is attractive (right interest rate, long amortization, covering expenses to keep cash flowing) this is a great alternative.
Generational Wealth Building
And, for those of us who are looking to provide generational wealth, the current tax codes allow a great benefit for our heirs. At the time of the PASSING ON OUR ESTATE TO OUR HEIRS, the basis changes to the value at the transfer to them, rather than the original basis in our lifetime.
This is one of the best tax advantages – to die with your real estate. Instead of facing the tax issues of recaptured depreciation or capital gains tax, our heirs get a stepped-up basis. Again, this is a conversation for us with our own tax advisors. Inherited assets are still subject to estate taxes, but the amount that is exempt from taxes is remarkably high for most of our estates.