I happened to read a question in reddit and took some summary/excerpts from the discussion. Here I am sharing the details, it is pure raw copy and paste. I do not know whether it is meaningful or useful to you, but thought of sharing my notes. The person answering is a CPA.
Question:
I was recently listening to a podcast with Robert Kiyosaki. In the podcast he was talking about he pays zero income tax. While I respect Robert and think he’s a smart man, he literally never gives actionable advice. I am no newb to finance, and I’ve achieved FI via investing in securities (REIT’s, Annuities, Munis, Blue Chips, etc.) and paying off any debt, but I am new to direct and leveraged investments into real estate. Can anyone give me a simple explanation of the tax benefits of owning rentals? I’m not looking to make a huge amount of money (and honestly I don’t think I will buy anything until we have the next recession) but I am interested. The idea of lowering my income taxes is also appealing.
Answer 1:
Think of investing in real estate rentals as tax DEFERRED rather than tax FREE income. When investing in rentals (with leverage), you get two major write-offs against the rental income: mortgage interest and depreciation of the rental property. The combination of these two in many cases will offset all rental income, so you’re tax free in the current year. The tax bill comes due when/if you sell.
Say theoretically you buy a $100k rental property and depreciate it at $3k per year for 10 years, at which point you sell it for $125k. Your tax bill at that point would be based on capital gains of $55k ($125k sales price less depreciated value of $70k).
Further Answer:
I’m going to correct a few things here…
Say theoretically you buy a $100k rental property and depreciate it at $3k per year for 10 years, at which point you sell it for $125k. Your tax bill at that point would be based on capital gains of $55k ($125k sales price less depreciated value of $70k).
You would have a basis of $70k, $30k in Depreciation Recapture, and $25k in Capital Gains. Therefore, you would pay tax at the ordinary rate, up to 25%, on $30k, and the capital gains rate on $25k.
If you were shielding ordinary income during the 10 years of depreciation and time the sale in a year with low to no income, you could effectively avoid the recapture. Alternatively, as long as you end up in a bracket lower than the bracket you deducted in, you come out ahead.
Think of investing in real estate rentals as tax DEFERRED rather than tax FREE income.
This is a good way to think about it.
The tax bill comes due when/if you sell.
If you die, there will be a step up in basis and the tax bill dies with you. This is where some serious planning can come in handy. You can start with SFH rentals, then 1031 them into some larger properties like duplexes or apartment buildings (to consolidate your holdings), and then 1031 into a commercial building.
You would have carried your basis of the original SFH purchases through to the commercial building, all while deferring taxes the entire time. When you die, your heirs receive a commercial building with the FMV as the new basis. And just like that, you kick Ole Uncle Sam right in the nuts one last time…
Question:
What happens in the case if your cost basis on the real estate was say $2.5M but is now worth $7.5M at death? Would it then be stepped up and be hit by the estate tax?
Answer:
I’m going to describe the estate tax exclusion and then answer your question.
There is no transfer tax assessed on estates up to $5.49 million for individuals and $10.98 million for married couples. The exclusion is portable meaning that one spouse would inherit the other spouse’s exclusion.
As of 2011 the exclusion is now indexed for inflation. AllianceBernstein projects that in ten years a couple will be able to pass on a combined $13.16 million and in 20 years $17.9 million–and that whole amount could be used by a widow or widower.
The real estate would be stepped up to the FMV at death, disposition, or 6 months after death (chosen by the executor). There are some tricky rules around this outside of my expertise.
To your question, if they are married, there is no estate tax since they are below the $10.98 exclusion amount. If they are single, there would be a potential for $2.5M over the exclusion resulting in $1M in taxes due from the estate. Whole Life insurance is usually what pays for this since it passes tax free.
In any event, the person inheriting the property would be able to depreciate $192,308 per year, for the next 39 years (assuming its one commercial building). At a 40% income tax rate, this could shield over $3M in taxes over the useful life of the building.
You kicked Uncle Sam in the nuts during your lifetime by deferring taxes, dying, and avoiding the taxes all together. You then reach from beyond the grave and allow your benefactors to kick him right in the nuts for 39 straight years. When they die, the system repeats itself. However, we have never seen a full 100 year cycle as our tax system has not been around that long and will change, as it has, over its lifetime.
This is the reason I wake up in the morning. This is what fires me up. Taxation is theft. Reading is fundamental. Don’t let someone take from you unwillingly; rather give freely where you see the most need.
Question:
One more question on real estate passive income (sch E). Over the 10 years period, I accumulated loss (book loss) of 50k with various real estate passive investment holding. Out of the 50k loss, The selling property has 5k tax loss, while other two property has 15k and 30k tax loss. This year, I sell one rental property whose capital gain is 60k (long term capital gain as I held 2 years) that depreciation recapture of 10k, will my loss be wiped of my gain so that I do not pay any tax?
Answer:
When you sell the property the passive loss is released, in full.
