Another Reason to Love Real Estate Investing

Those of us who invest in rental properties need the occasional affirmation. Managing properties presents frequent challenges that can often cause doubt about our decision. For many of us, that positive affirmation comes around this time of year, during tax preparation season.

In last week’s blog, I suggested owning real estate is a necessary financial truth for the average American worker to build wealth. I briefly covered the two most obvious ways of building wealth from real estate through rental income and growing equity.

This week I want to offer a layperson’s perspective on a third source of real estate “income”, the tax advantages. Disclaimer up front, I am certainly not a licensed CPA or tax preparer! This blog is not meant as tax advice but simply my taxpayer’s perspective from the past 13 years as an amateur real estate investor.

I said it last week and will say it again, although considered passive income by the IRS, there is nothing “passive” about managing a rental property portfolio. It is in reality, a part time job! That being said, for the average investor, rental income is reflected on a personal income tax return.

I can’t recommend enough for real estate investors to consult a tax professional or at a minimum, use tax software designed for rental property owners. We’ve used tax software over the years and have not had any issues.

At the very basic level, taxable rental income is based on the difference between the gross collected rent and the expense to maintain and operate the property as a rental. The definition for these expenses is fairly broad. This is one distinct advantage real estate investments hold over traditional market based investments. Most people can’t write off investment account expenses anymore.

Repairs, maintenance and cleaning expenses are pretty straight forward. If hiring someone to make repairs, the cost of the bill is deductible from the gross income on the property.  Similarly, if doing it yourself, the cost of materials as well as in some cases even tools is deductible.

If repairs are major, such as replacing an HVAC, roof or new windows, then the repair becomes real property that can be depreciated over time (more on depreciation coming up).

Cleaning supplies, a gallon of paint or a bag of grass seeds are all examples of materials commonly deducted as expenses to maintain or repair a rental property.  Only the cost of the materials that are used for the rental property are supposed to be deducted.

Similarly, if an appliance breaks and it’s time for a new one, the cost to replace that refrigerator, oven or dishwasher could be considered a repair.  This presents an excellent opportunity to upgrade to nicer appliances that potentially could help increase rent or property value as well as a nice deduction.

A quick note on this point, only repairs, cleaning or maintenance can be claimed as expenses. While a property owner can certainly add a deck, patio or other upgrades to a rental property, that is an improvement and not deductible!

The other common expenses are what I like to call the price of doing business items. This can include insurance premiums, HOA dues, property taxes, advertising, tenant screening and my personal favorite, mortgage or business loan interest! There are other price of doing business expenses out there but they must be directly related to owning and maintaining the property. I’ve said it once, I’ll say it again, check with a tax professional if any questions!

One expense I particularly love is mileage deductions. As of 2020 the IRS mileage allowance is .58 cents per mile. If the owner stops by the property to show it, repair it or collect rent then the mileage can be claimed. Similarly, if running an errand to maintain or operate the property, that trip is deductible as well.

Mileage expense adds up very quickly and I daresay it doesn’t cost exactly .58 cents a mile to operate a vehicle. When you plan business mileage wisely, this is an excellent way to realize a tax benefit of rental property ownership.

The IRS does require well documented mileage reports for these trips. Thankfully, there are some awesome smartphone apps that helps the investor manage. We average around $2000 a year in deductions on business mileage!

Lastly, the most impactful deduction from rental income is depreciation. Depreciation is simply reducing the value of a certain property over its useful life. To begin depreciating, one must know cost basis for the property. Basis is what it cost to take ownership and place the property into operation.

For an example, let’s assume a property was acquired with a basis of $175000.  For tax year 2019, this property could be depreciated $5727! The depreciation is deducted from gross rental income along with all other expenses, greatly reducing or perhaps even creating a loss on net taxable rent income.

As mentioned earlier, real estate owners may also depreciate major repairs and even tools required to operate the property.  This gets a little complicated to keep up with and yet again a reason to secure a good tax software program or accountant.

Depreciation is the best tax benefit of owning investment property but does come with a catch. When divesting from a property, the seller will have to pay capital gains taxes on the net profit based on the depreciated value.

So isn’t this a question of pay taxes now or pay later? Well, sort of. Think about the time value of money I mentioned a few blogs back. Real estate is a long term investment. The growth of 20 years’ worth of tax advantaged income from real estate wisely reinvested should outweigh any capital gains tax burden when the property is sold.

Additionally, there are tax advantaged means to dispose of a real estate investment, including a 1031 exchange to roll the profit towards the purchase of a like kind investment or pass on to heirs as part of an estate. Finally, capital gains tax rates are not quite as high as regular income tax brackets. Regardless, even with a potential capital gains tax upon selling, the tax advantages to owning real estate in the here and now are substantial.

So what does all this look like in practice? I’ll share in general terms my own tax situation for tax year 2020. After all the aforementioned expenses were deducted from our annual gross rental income, taxable rental income was 50% less than our actual “pocketed” income!

This is what make the returns on a rental property investment so attractive. I can’t stress enough, seek help when considering real estate investing tax implications. Not only to stay out of trouble, but more importantly, to ensure you are not leaving any money on the table!

If you’ve found the last several blogs on what I like to call “financial truths” interesting, then keep an eye on www.normspivey.com for my new book “Millionaire on a Worker’s Budget” available for pre order soon on Amazon.

Next week I’ll shift gears back to leading. Tune in for a series of blogs reflecting about one of my favorite assignments in the military, serving on the staff at the United States Military Academy at West Point!

The commentary provided in this blog is for informational purposes only and is not intended to be a source of financial, tax or investing advice.